May 27, 2009 – Part 2

1. May 27, 2009 – Part 2 Relevant Costs for Decision Making

2. Relevant Costs vs. Irrelevant Costs Differential Approach vs. Total Cost Approach Product Transfer Decision Example Constrained Resources Today’s Agenda

3. Relevant Costs • Costs that are relevant to decision making are those costs which differ between two or more alternatives • Differential costing • Costs that are irrelevant to decision making are those that cannot be altered • Sunk costs • Future costs that cannot be changed • By definition, these costs will not be different from each other in differing scenarios • These costs are unavoidable • Costs that are relevant to one decision may not be relevant to a different decision • One can use a total cost approach as opposed to a differential cost approach

4. Total Cost versus Differential Cost Approach • Total Cost Approach • Factor in ALL costs • More time consuming • Provides a complete picture and budget basis • Differential Cost Approach • Only factor in relevant costs; ie, those that differ between scenarios • Quicker • Does not provide the full cost picture • Either approach should lead to the same business decision conclusion

5. Total and Differential Cost Approaches • Using the differential approach is desirable for two reasons: • Only rarely will enough information be available to prepare detailed income statements for both alternatives. • Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical.

6. Production Transfer Decision • James Company manufactures Switches • It manufactures and sells its products in North America • Its best customer has received a price quote from James Co’s competitor for $7,000 per unit • The customer expects to grow significantly and says that costs are its #1 issue • What would happen to the company if it matched the competitor’s quote? • What should James Co do?

7. Production Transfer Decision • James Co options: • Keep prices the same and hope the customer stays • Suggest the extra cost is provided in value added service • Argue that James Co knows the customer better & can better serve it • Argue that James Co quality and timeliness of delivery is superior • Match the price, lose money and try to cut costs over time • Manufacture in a lower cost location • Investigate whether James Co can manufacture the product profitably elsewhere

8. Production Transfer Decision • You are the head of managerial accounting and you learn the following about producing in China: • Component parts can be sourced for 70% of current costs • Because they are made in China and would not require shipping • Labour costs are 20% of what they are in North America • Shipping completed product back to North America would cost $250 per unit AND it would add two weeks to the delivery schedule • Power is approximately the same cost in both locations • If the company transferred, the customer would conduct a detailed one-time facility inspection at a cost to James Co of $2 million • There are other “one-time” costs • Building up extra inventory for the transfer period to ensure continuity of supply • Parallel production until China facility is in steady-state • It would take a full 12 months to sub-lease the North American facility • What information is missing to make a decision whether to transfer production?

9. Product Transfer Decision

10. Product Transfer Decision • Do you have a conclusion? Is there anything analysis still missing?

11. Product Transfer Decision • There has been no consideration for additional inventory required due to increase in delivery time • Two weeks additional inventory costs • However, there is less inventory ($ value) because it now costs less • Also, still need to consider “on-time” costs • How can these one-time costs be addressed?

12. Tutorial • Assignment • Review Build versus Buy Decisions • Study Review Problems • Complete Alternative Question