Prof. McDermott’s Substitute for Chapter 11
Decision-Making and Relevant Information
Earlier this semester we talked about the difference between data and information. Data are numbers
that we record and manipulate. Information is data that is useful for decision-making.
When we study the difference between
data and information, we often use the
term relevant cost.
A relevant cost is a cost that is useful for
a particular decision. There are a couple
of things we need to remember about
relevant costs: (1) they always occur in
the future, and (2) they always differ
between two or more courses of action.
Let me illustrate. Let’s assume you have
inherited a manufacturing plant from your
grandfather. This plant has the capability
of manufacturing either motorcycles or
bicycles.
Which product should you manufacture?
This is dependent on the alternative that will make you the most money. In making this decision, you will
of course focus on the price you can charge for each product. You will also focus on the cost. Put another
way, how much more (or less) will you make if you manufacture motorcycles instead of bicycles?
To answer this question, we only need to look at relevant revenues and relevant costs—those revenues
and costs that will differ if we manufacture bicycles rather than motorcycles.
Let me illustrate by classifying the costs incurred in manufacturing either product into relevant or nonrelevant costs.
The cost of mowing the lawn of the factory will not differ whether we manufactured bicycles or
motorcycles. Therefore this cost is not relevant and should not be considered in making the final decision.
Direct labor costs do vary, one alternative to the next, and are therefore relevant costs.
Lockheed L-1011
We will come back to this in a moment, but first let’s
define a couple of other terms we will be use. A sunk
cost is a cost: (1) that was incurred in the past and (2) is
non-recoverable. Sunk costs are never relevant..
Let me give an example of sunk costs and why they are
never relevant. Many years ago Lockheed designed an
aircraft known as the L–1011. This was a wide-body jet,
similar to the DC-10. Lockheed spent something like
$200,000,000 designing this aircraft. Before it went into
production, however, the market had changed and the company realized that it could not be profitable.
The variable cost of producing the aircraft would exceed the price.
The Board of Directors should have written off the cost and abandoned the project. It was emotionally
difficult, however, to write off $200,000,000, and so the Board decided to manufacture the product
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anyway, throwing good money after bad. The $200,000,000 was a sunk cost and should not have been
considered in the decision.
Let’s define another term – opportunity cost. An opportunity cost is a cost that is given up when one
option is chosen over another. If you decide to go to school rather than work full time, there is a short
term opportunity cost (the salary you are giving up to get your degree).
If you don’t go to school but decide to get a job right out of high school, the opportunity cost is the
difference between the salary you could have earned with a college degree versus the salary you will earn
with a high school degree. Opportunity costs are never shown in the general ledger. Opportunity,
however, costs are relevant costs.
In this chapter we will use relevant costs and relevant revenues in making five types of decisions:
1.
2.
3.
4.
The decision to make or buy a product
The decision to keep or shut down an unprofitable business segment
The decision to keep or replace an existing piece of equipment
The decision of which of several products to manufacture when there is a limited production
resource (such as labor, materials or the output of an essential piece of machinery
5. The decision to sell a product at less than full cost
We will illustrate each of these below. The questions you see on the test will be similar to those
illustrated.
THE DECISION TO MAKE OR BUY A PRODUCT
Sometimes a manufacturer makes a product that is a component of another product. For example, the
manufacture of Toyota automobiles might make door locks that are used in their cars.
Sometimes in this situation, an outside manufacturer proposes to sell the same component for a price that
is less than the full cost of manufacturing the product internally.
For those not acquainted with the concept of relevant costs, a knee-jerk reaction might be to go with the
“lower cost” and outsource the product.
What managers sometimes fail to understand, however, is that the fixed costs incurred in the manufacture
of the product might not go away if the product is outsourced.
Again, it is helpful to illustrate a principle with an example.
McDermott Manufacturing makes integrated circuits for its PC computers. One of the integrated circuits
used in its computer is the ML–140. McDermott Manufacturing’s full cost to manufacture this product is
shown in the two tables below.
At a Yearly Production of 100,000 Units, the per Unit Cost to Manufacture
The ML 140 Internally Is:
Direct labor
$
50.00 Per unit
Direct materials
25.00 Per unit
Variable overhead
17.00 Per unit
Fixed overhead
32.50 Per unit
Variable administrative and marketing expense
20.00 Per unit
Fixed administrative and marketing expense
20.00 Per unit
Total cost per unit
$164.50 Per unit
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Cincinnati Manufacturing approaches McDermott Manufacturing and proposes to sell the unit for
$112.00 per unit. Should McDermott accept this offer and discontinue manufacturing the ML-140
internally?
At first glance, this looks like a good deal. The $112.00 to purchase the unit is cheaper than the cost of
$164.50 to make it internally.
However, not all of the costs included in the $164.50 figure are relevant. That is to say, not all of these
costs will differ, one alternative to another. Put still another way, not all of $164.50 will cost will go away
if the item is outsourced.
In this example we will assume that only $10.00 of the variable administrative and marketing expense
will be eliminated (by firing some administrative personnel); $10.00 will still remain. In addition let’s
assume that only $250,000 of the fixed overhead costs will go away (the salaries of the supervisor of
manufacturing and her staff). Should the president of McDermott Manufacturing accept the proposal to
outsource the ML-140?
To make this decision we need to examine relevant costs.
Direct labor, direct materials, and variable overhead costs will all go away of if we outsource. Therefore,
these costs are relevant. Also, $250,000 of fixed overhead will go away if we outsource the product, so
these are also relevant. In addition, $12.00 of variable administrative and marketing expense will go away
and so these costs are also relevant.
Since the fixed administrative and marketing expense of $20.00 per unit will not be different regardless of
whether we manufacture or outsource, this cost is not relevant.
In comparing the impact of outsourcing versus manufacturing the ML-140, we should prepare a schedule
that looks something like the following:
Relevant Revenue and Cost if Product is Outsourced
Cost to purchase the ML – 140
($112.00)
Savings from purchasing the ML 140
Direct labor
$
50.00
Direct materials
25.00
Variable overhead
17.00
Fixed overhead
2.50 $250,000 divided by 100,000 units
Variable administrative and marketing expense
10.00
Less total savings
104.50
Net loss of purchasing ML – 140 outside
$
(7.50)
These are the
only costs that
differ one option
to another—the
only relevant
costs—the only
costs we need to
consider in
making this
decision.
From this analysis we conclude the companywill incur a net loss of $7.50 per unit if it purchaes the ML–
140 from Cincinnati Manufacturing rather than manufacturing it internally.
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THE DECISION TO KEEP OR SHUT DOWN AN UNPROFITABLE BUSINESS SEGMENT
Lambert Manufacturing makes five electronic products at its Columbus Ohio plant. These products are
sold to distributors. A product income statement for 2012 is shown below.
Product Income Statement Lambert Manufacturing
Revenue
Direct labor
Direct materials
Variable factory overhead
Fixed factory overhead
Variable administrative and marketing expense
Fixed marketing and administrative expense
Total costs
Profit
Product
KC-90
UN-35
VB-340
MC-450
DG-22
Total
$ 2,350,000.00 $ 4,500,000.00 $ 4,300,000.00 $ 7,300,000.00 $ 1,900,000.00 $ 20,350,000.00
470,000.00
900,000.00
860,000.00
1,460,000.00
380,000.00
4,070,000.00
200,000.00
450,000.00
620,000.00
2,000,000.00
200,000.00
3,470,000.00
56,400.00
108,000.00
103,200.00
175,200.00
45,600.00
488,400.00
900,000.00
900,000.00
900,000.00
900,000.00
900,000.00
4,500,000.00
540,500.00
1,035,000.00
989,000.00
1,679,000.00
100,000.00
4,343,500.00
230,000.00
230,000.00
230,000.00
230,000.00
230,000.00
1,150,000.00
2,396,900.00
3,623,000.00
3,702,200.00
6,444,200.00
1,855,600.00
18,021,900.00
$ (46,900.00) $ 877,000.00 $ 597,800.00 $ 855,800.00 $ 44,400.00 $ 2,328,100.00
The president wants to discontinue the KC–90 product line because it is unprofitable (it has a loss of
$46,900 a year). He reasons that discontinuing this product line will increase the company’s total profits
by $46,900. By focusing on total costs, rather than relevant costs, however, he is wrong.
The controller does a more detailed analysis and discovers that if the company discontinues
manufacturing the KC-90, total fixed factory overhead will remain unchanged as this is an allocated cost.
The controller also discovers that the company’s total fixed marketing and administrative expense will
only decrease by $100,000—the company can only fire part of their sales staff.
What, therefore, will be the impact on the bottom line if the president has his way and discontinues the
KC-90 product line? This is shown in the schedule below.
Relevant Revenues and Costs
Lost revenue
$ (2,350,000.00)
Savings
Direct labor
470,000.00
Direct materials
200,000.00
Variable factory overhead
56,400.00
Variable administrative and marketing expense
540,500.00
Fixed marketing and administrative expense
100,000.00
Total savings
1,366,900.00
Loss from discontinuing product line
$ (983,100.00)
The president was wrong! If he discontinues the unprofitable product line the company will incur a loss of
$983,100. A bad decision!
THE DECISION TO KEEP OR REPLACE AN EXISTING PIECE OF EQUIPMENT
Aldrich Industries uses a manual piece of equipment to manufacture its primary product. This equipment
originally cost $3,000,000 and has accumulated depreciation of $1,500,000, giving it a book value of
$1,500,000. It has a remaining life of five years. If the equipment is sold now, it will have a residual value
of $500,000. If sold at the end of its useful life, it will have a scrap value of $25,000.
The company is considering replacing this equipment with a computerized model at a cost of $2,500,000.
The computerized model would have an estimated life of five years and would be depreciated on a
straight-line basis. The computerized model would generate an annual labor savings of $625,000.
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The president is skeptical about purchasing the new equipment as he would have to write off the
$1,500,000 remaining book value of the old machine (he doesn’t realize this is a sunk cost and therefore
is not relevant).
He also recognizes that the residual value of the existing machine would decrease from $500,000 to
$25,000. The $475,000 is relevant.
What would be the impact on the company’s profit of buying the new machine? As demonstrated in the
table below, the company would earn an additional profit of $150,000 over a five year period if it buys
the new machine.
Aldrich Industries Relevant Cost Analysis
Cost of New Equipment
$ (2,500,000.00)
Yearly Labor Savings
$ 3,125,000.00 (5 years x $625,000)
Differential Salvage Value
$ 475,000.00 ($500,000 - $25,000)
Additional Profit from Buying New Machine $ 1,100,000.00
THE DECISION OF WHICH OF SEVERAL PRODUCTS TO MANUFACTURE
WHEN THERE IS A LIMITED PRODUCTION RESOURCE
Normally when deciding which product to manufacture from a range of two or more choices, one would
choose the product with the highest contribution margin per unit. Remember the contribution margin
per unit is the price per unit minus the total variable cost per unit. The total variable costs include variable
administrative and selling costs as well as direct labor, direct materials and variable overhead.
There is one exception to this rule, however. When there is a constraint on one of the resources of
production. Resources of production include machinery, materials, and direct labor. When there is a
constraint on a resource (i.e. when there is a limited amount of one of these resources) the rule changes. In
this case one should first produce the product that has the highest contribution margin per unit of scarce
resource. Let’s illustrate:
Remington Incorporated makes two products: Product A and Product B. Revenues and expenses for both
of these products (on a per unit basis) are shown below.
Remington Incorporated
Profit per unit
Product A Product B
Price
$ 55.00 $ 100.00
Direct labor
(10.00) (35.00)
Direct materials
(12.00) (24.00)
Variable overhead
(6.00)
(5.00)
Fixed overhead
(9.00) (12.00)
Variable administrative and selling
(3.00)
(6.00)
Fixed administrative and selling
(4.00)
(8.00)
Profit per unit
$ 11.00 $ 10.00
The contribution margin per unit is shown below.
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Remington Incorporated
Contribution Margin per Unit
Product A Product B
Price
$ 55.00 $ 100.00
Direct labor
$ (10.00) $ (35.00)
Direct materials
$ (12.00) $ (24.00)
Variable overhead
$ (6.00) $ (5.00)
Variable administrative and selling
(3.00)
(6.00)
Contribution margin per unit
$ 24.00 $ 30.00
Assume there are no scarce resources, and an unlimited demand exists for each product. Which product
should the company produce?
The answer of course is the product with the highest contribution margin per unit which is Product B.
Now assume that both products use a rare mineral of which there is a limited quantity. Product A uses one
pound of the scarce direct material per unit, while Product B uses two pounds. Which product should the
company produce first?
The answer is the product with the highest contribution margin per unit of scarce resource. The company
should produce Product A first as it has the highest contribution margin per unit of scarce resource, as
shown below. After satisfying the demand for product A, if there is any excess direct material, then the
company can produce Product B.
Remington Incorporated
Contribution Margin Per Pound of Direct Material
Product A Product B
Contribution margin per unit
$ 24.00 $ 30.00
Divided by hours per unit
1.00
2.00
CM per unit of direct material
24.00
15.00
THE DECISION TO SELL A PRODUCT AT LESS THAN FULL COST
There is a school of thought (disputed by some) that states believes that a company can sometimes sell
their products for less than full cost, and still make a profit. In textbooks, this discussion is usually
included under the subheading of Short-Term Pricing Decisions.
This school of thought believes that relevant costs in the short run are different from relevant costs in the
long run. Specifically it states that fixed costs are not relevant in the short run, and do not therefore need
to be taken into consideration when establishing a short-term price. The belief, therefore, is that a short
term price need only cover variable costs.
This philosophy can sometimes be dangerous. In the long run, a company's price must cover both fixed
and variable costs. Also, the long run is of course made up of nothing more than a series of short runs.
When do the advocates of this school of thought say that a company can make money by selling products
at below full cost?
1. When the company can separate fixed and variable costs. Not all companies are able to do
this, however. Also, as we have learned in ABC cost accounting, many costs are variable but do
not vary based on units produced. Instead, they vary based on other factors including the number
of setups, maintenance hours, the number of product lines, and so on.
2. When the company can segregate its market. What this means is that the company can charge
different customers different prices, and get away with it. A good example is the airline industry.
Suppose that you are flying to Chicago to interview for a new job. If you were to survey all of the
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passengers on your plane, you would find that they had paid a variety of prices for their tickets.
Airlines can segregate their markets by charging a different price for business fliers than they do
for recreation fliers.
3. When the sale produces a positive contribution margin. Remember, the total contribution
margin is calculated by subtracting variable costs from revenue.
4. When the company has excess capacity, or can charge the new customer for the opportunity
cost of lost sales to existing customers. If a company does not have excess capacity (if it is
selling all of its capacity at a price that covers full costs), it would be foolish (in most situations)
to discount its price.
If a company with limited capacity is willing to sell its product to a new customer at a reduced
price, however, (perhaps to open a new market), then it must charge the new customer an amount
equal to the contribution margin it loses by taking sales away from existing customers. This will
make more sense once we see an example.
All of the above conditions must be met for the principle we are discussing to work. Let me illustrate this
principle with two examples.
Example One
Bellevue Manufacturing makes a product, the CM-12. The company sells this product for $125.00 to local
customers. Its full cost of production and distribution are shown below.
Bellevue Manufacturing
Direct labor
$
Direct materials
Variable overhead
Fixed overhead
Variable selling and administration
Fixed selling an administration
Total cost
$
25.00
30.00
12.00
15.00
8.00
9.00
99.00
Per unit
Per unit
Per unit
Per unit
Per unit
Per unit
A distributor from Hong Kong wishes to purchase 10,000 units at a cost of $85.00. The president of
Bellevue Manufacturing is reluctant to accept this sale, as the proposed price of $85.00 is below the
$99.00 total cost of manufacturing the product.
Assuming the four criteria listed above are met, how much would the company make or lose if it accepts
this proposal?
Assume in this example that none of the company’s production costs would change as a result of the sale.
Also assume that the company has the excess capacity to produce the additional units.
To calculate the answer, we need only consider relevant costs. Since fixed costs are not relevant in the
short run, we only need to look at revenues minus variable. Put another way, we need only a positive
contribution margin to accept the sale.
The contribution margin per unit for the Hong Kong customer is shown below.
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Bellevue Manufacturing Contribution Margin Per Product CM-12.
Hong Kong Customer
Price
$ 85.00
Variable costs
Direct labor
$
25.00
Direct materials
30.00
Variable overhead
12.00
Variable selling and administration
8.00
Total cost
$ 75.00
Contribution margin per unit
$ 10.00
Please note that we use
the $85.00 special price
for the Hong Kong
customer and the reduced
variable selling and
administrative cost of
$4.00.
By accepting this order, Bellevue Manufacturing will earn an additional contribution margin of $10.00
per unit. All of this will go to the bottom line. The company will therefore increase its income by 10,000
units × $10.00 = $100,000.
Again, one must be careful. If the present customers of Bellevue Manufacturing find out that the CM-12
is being sold for less elsewhere, they may demand the same price. This of course would put the company
out of business as they would no longer be able to cover their fixed costs.
Example Two
Okay, now let’s make the problem a little more complex.
In the above problem, none of the company’s existing variable costs
would change if they sold to the Hong Kong customer. Let’s now
assume that Bellevue Manufacturing would not have to pay sales
commissions. Their variable and selling expenses would decrease
from $8.00 per unit to $4.00.
Steps for Determining Impact on
Profit of Short-Term Sale for Less
than Full Cost.
1.
2.
Let’s also assume that the manufacturing capacity of the company
is 100,000 units per year, and the company is currently selling
95,000 units to existing customers. They can’t fill the new 10,000
unit order without giving up sales to existing customers.
What this means is there is now an opportunity cost of 5,000 units
(100,000 units manufacturing capacity minus 95,000 units of
existing demand minus 10,000 units to be sold to Hong Kong
equals 5,000 unit shortfall).
What is the opportunity cost in dollars if Bellevue Manufacturing
decides to take the order from Hong Kong?
3.
4.
This is calculated by multiplying the opportunity cost (in units) by
the contribution margin (per unit) of sales to existing customers.
Students please note: we do not use the contribution margin for the
new customer in this calculation, but the contribution margin for
existing customers. That is because we are calculating the
contribution margin given up to make the new sales. This is an error
that some students make on examinations.
First let’s calculate the contribution margin for our existing
customers. This calculation is shown below.
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5.
6.
Determine if the transaction
meets the four criteria listed
above.
Calculate total opportunity cost in
units. Do this with the following
formula: Capacity in units minus
present sales in units minus
proposed new customer sales in
units. The deficit is the
opportunity cost in units.
Calculate the total opportunity
cost in dollars. Do this multiplying
the opportunity cost in units by
the contribution margin per unit
of the existing customer.
Divide total opportunity costs in
dollars by the number of units
new customer wants. This will
give the per-unit opportunity cost
to be charged to the new
customer.
Add opportunity cost per-unit to
new customer’s variable cost per
unit to get minimum price seller
will accept.
Realize that this is a breakeven
price. Any price in excess of that
will earn the company money.
Bellevue Manufacturing Contribution Margin Per Product CM-12.
Existing Customers
Price
$ 125.00
Variable costs
Direct labor
$
25.00
Direct materials
30.00
Variable overhead
12.00
Variable selling and administration
8.00
Total cost
75.00
Contribution margin per unit
$ 50.00
Again, note that the
contribution margin for
our existing customers is
different than for the
Hong Kong Customer as
the price, and variable
selling and administrative
costs are different.
The total opportunity cost is therefore $50.00 (the contribution margin per unit for our existing
customers) × 5,000 units of lost sales = $250,000.
Now lets calculate the new variable costs of the Hong Kong product, recognizing that in Example Two
variable and selling costs have decreased from $8.00 per unit to $4.00 per unit. This is shown below:
Bellevue Manufacturing Variable Costs for Hong Kong
With Reduced Variable Selling & Administration Costs
Direct labor
$
25.00
Direct materials
30.00
Variable overhead
12.00
Variable selling and administration
4.00
Total cost
$
71.00
In order for the sale to Hong Kong to be profitable, we must add this opportunity cost to the price we
charge to Hong Kong.
Since Hong Kong is buying 10,000 units, we will divide $250,000 by 10,000 units = $25.00 per unit. In
calculating the price for the Hong Kong customer, we will need to recoup our variable per unit costs of
producing and selling the product to Hong Kong (that is $71.00 not $75.00) customer plus the opportunity
cost of $25.00 per unit.
Now here’s another place the students sometimes go astray. The relevant costs for the Hong Kong
customer are the variable cost of the Hong Kong customer. This is obviously not the same as the variable
cost of existing customers since the variable selling and administration costs are $4.00 lower for the Hong
Kong customer than for existing customers.
So what is the minimum price we would be willing to accept? Well, our break-even price would be
$71.00 variable cost + $25.00 opportunity cost = $96.00. If I ask you for the minimum price the
manufacturer would accept on a test then that is what you should give. Hopefully, however, we will make
some money and the transaction. At any price above breakeven, we will have a short term profit.
Okay, that is what you need to know for this chapter!
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