Chapter 9 Decision Making with Relevant Costs and

Chapter 9 Decision Making with Relevant Costs and a Strategic Emphasis

3 Learning Objectives n Define the decision-making process and identify the types of cost information relevant for decision making n Use relevant and strategic cost analysis to make special order decisions n Use relevant and strategic cost analysis in the make, lease, or buy decision Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

4 Learning Objectives n Use relevant and strategic cost analysis in the decision to sell before or after additional processing n Use relevant and strategic cost analysis in the decision to keep or drop products or services n Use relevant and strategic cost analysis to evaluate programs Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

5 Learning Objectives n Analyze decisions with multiple products and limited resources n Discuss the behavioral, implementation, and legal issues in decision making Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

6 Learning Objective One Define the decision-making process and identify the types of cost information relevant for decision making Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

7 The Decision-Making Process First: Determine the Strategic Issues Second: Specify the Criteria and Identify the Alternative Actions Third: Relevant Cost Analysis and Strategic Cost Analysis Identify and Collect Relevant Information Predict Future Values of Relevant Costs & Revenues Fourth: Select and Implement the Best Course of Action Consider Strategic Issues Fifth: Evaluate Performance Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 Relevant Cost Analysis Relevant costs are costs to be incurred at some future time and that differ for each option available to the decision maker. Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

9 Relevant Costs The Car Purchase Decision Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 Relevant Costs in Equipment Replacement Decision Which costs are not relevant to the decision to keep the old machine or replace it with a new, more efficient one? • • • Old machine cost $4, 200 when purchased Old machine has a book value of $2, 100 Purchase price of a new machine is $7, 000 New machine is expected to last one year New machine will have zero salvage value Repairs to old machine would be $3, 500 and would allow one more year of productivity Power for either machine is expected to be $2. 50 New machine will reduce labor costs by $0. 50 per hour Expected level of output for next year is 2, 000 units Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

11 Relevant Costs in Equipment Replacement Decision Which costs are not relevant to the decision to keep the old machine or replace it with a new, more efficient one? • • • Old machine cost $4, 200 when purchased Old machine has a book value of $2, 100 Purchase price of a new machine is $7, 000 New machine is expected to last one year New machine will have zero salvage value Repairs to old machine would be $3, 500 and would allow one more year of productivity relevant because Power for either. Not machine is expected to be $2. 50 the zero salvage. New machine willofreduce labor costs by $0. 50 per hour Expected level of output for next year is 2, 000 units Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

12 Relevant Costs in Equipment Replacement Decision Which costs are not relevant to the decision to keep the old machine replace it with a new, more efficient one? Relevant or because • • • Old cost $4, 200 when purchased themachine one year Old machine relates tohas a a book value of $2, 100 Purchase price of a new machine is $7, 000 relevant item. New machine is expected to last one year New machine will have zero salvage value Repairs to old machine would be $3, 500 and would allow one more year of productivity Power for either machine is expected to be $2. 50 New machine will reduce labor costs by $0. 50 per hour Expected level of output for next year is 2, 000 units Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

13 Relevant Costs in Equipment Replacement Decision Which costs are not relevant to the decision to keep the old machine or replace it with a new, more efficient one? • • • Old machine cost $4, 200 when purchased Old machine has a book value of $2, 100 Purchase price of a new machine is $7, 000 New machine is expected to last one year New machine will have zero salvage value Repairs to old machine would be $3, 500 and would allow one more year of productivity Relevant because the 2, 000 unit output Power for either machine is expected to be $2. 50 is related labor costs andbysavings. New machine willtoreduce $0. 50 per hour Expected level of output for next year is 2, 000 units Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

14 Relevant Costs in Equipment Replacement Decision So, the relevant costs are. . . • • • Old machine cost $4, 200 when purchased Old machine has a book value of $2, 100 Purchase price of a new machine is $7, 000 New machine is expected to last one year New machine will have zero salvage value Repairs to old machine would be $3, 500 and would allow one more year of productivity Power for either machine is expected to be $2. 50 New machine will reduce labor costs by $0. 50 per hour Expected level of output for next year is 2, 000 units Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

15 Relevant Cost Analysis in Equipment Replacement Decision Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

16 Determining Relevant Costs versus Strategic Cost Analysis Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

17 Learning Objective Two Use relevant and strategic cost analysis to make special order decisions Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

18 The Special Order Decision Annual Fund Raiser Run Mc. Graw-Hill/Irwin TTS, Inc. normally charges $9. 00 per T-shirt, but Alpha Beta Gamma has offered to pay $6. 50 for 1, 000 T-shirts. What are the relevant costs in determining if the offer should be accepted? © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

19 The Special Order Decision Relevant Costs Not Relevant (Some batch-level costs are relevant) Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

20 The Special Order Decision If TTS has excess capacity, the offer should be accepted because it will add $1, 250 to net income (1, 000 T-shirts × $1. 25). Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

21 The Special Order Decision If TTS is operating at full capacity, the offer should be rejected. Contribution margin from Alpha Beta Gamma order ($1. 25 x 1, 000 t-shirts) Opportunity cost of lost sales ($9. 00 - $5. 25) x 1, 000 Contribution loss Mc. Graw-Hill/Irwin $1, 250 (3, 750) $(2, 500 ) © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

22 Learning Objective Three Use relevant and strategic cost analysis in the make, lease, or buy decision Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

23 Make, Lease, or Buy Blue Tone is currently manufacturing the mouthpiece for its clarinet, but has the option to buy it from a supplier. Fixed overhead costs will not change whether or not Blue Tone chooses to make or to buy the mouthpiece. Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

24 Make, Lease, or Buy Blue Tone is currently manufacturing the mouthpiece for its clarinet, but has the option to buy it from a supplier. Fixed overhead costs will not change whether or not Blue Tone chooses to make or to buy the mouthpiece. Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

25 Make, Lease, or Buy Quick Copy is considering an upgrade to the latest model copier that is not available for lease but must be purchased for $160, 000. The purchased copier is useful for one year, after which it could be sold back to the manufacturer for $40, 000. In addition, the new machine has a required annual service contract of $20, 000. Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

26 Make, Lease, or Buy Lease Cost = Purchase Cost Annual fee = Net purchase cost + service contract $40, 000 + $. 02 × Q = ($160, 000 - $40, 000) + $20, 000 Q = $100, 000 ÷ $. 02 = 5, 000 copies The indifference point, 5, 000 copies, is lower than the expected annual machine usage of 6, 000 copies. So, Quick copy should purchase the machine. Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

27 Cost Make, Lease, or Buy Cost to Lease Copier $140, 000 $40, 000 Net cost to Purchase Copier Q = 5, 000 Number of Copies per Year Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

28 Learning Objective Four Use relevant and strategic cost analysis in the decision to sell before or after additional processing Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

29 Sell Before or After Additional Processing Malfunctioning equipment caused 400 T-shirts not to be of acceptable color. They can be sold to an outlet store for $1, 800 ($4. 50 each) or run them through the printing again. The cost of running the Tshirts through the printer a second time is the ink, supplies, and labor costs of $1. 80 per shirt. In addition, setup, inspection, and materials handling costs for the batch will be incurred. Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

30 Sell Before or After Additional Processing The net advantage to reprinting the T-shirts is $880 ($2, 680 - $1, 800). Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

31 Learning Objective Five Use relevant and strategic cost analysis in the decision to keep or drop products or services Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

32 Keep or Drop a Product or Service Issues that should be addressed. . . o o o Which products are most profitable? Are the products priced properly? Which products should be promoted and advertised most aggressively? o Which product managers should be rewarded? Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

33 Keep or Drop a Product or Service Windbreakers, Inc. manufactures three jackets. Management is concerned about the low profitability of the “Gale” jacket and is thinking about dropping the product. If the jacket is dropped, there will be no change in total fixed costs for the coming year. Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

34 Keep or Drop a Product or Service The company is $15, 000 better off retaining rather than deleting the “Gale” jacket. Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

35 Keep or Drop a Product or Service Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

36 Learning Objective Six Use relevant and strategic cost analysis to evaluate programs Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

37 Evaluate Programs Insert Exhibit 9. 17 Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

38 Learning Objective Seven Analyze decisions with multiple products and limited resources Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

39 Multiple Products and Limited Resources The Windy and Gale jackets are manufactured in the same plant. Both jackets require an automated sewing machine for assembly. There are 3 machines that can be run up to 20 hours per day, 5 days per week (1, 200 hours per month) at maximum capacity. The demand for both jackets exceeds the capacity of the 3 machines. One Production Constraint Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

40 Multiple Products and Limited Resources Slope = – 36, 000 ÷ 24, 000 = – 3/2 Intercept = 36, 000 – 24, 000 – Units of Sales for Gale Production constraint for sewing machine. All possible sales mixes are represented on this line. Mc. Graw-Hill/Irwin Units of Sales for Windy © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

41 Multiple Products and Limited Resources The completed jackets are inspected, labels added, and packaged. Forty workers are required for this operation. Each of the 40 workers actually works 35 productive hours per week. So, 5, 600 hours are available per month for inspecting and packaging. Two Production Constraint Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

42 Multiple Products and Limited Resources 67, 200 – Production constraint for Inspection and Packaging Production constraint for sewing machine 22, 400 24, 000 Units of Sales for Gale Maximum contribution margin – – 36, 000 – Mc. Graw-Hill/Irwin Units of Sales for Windy © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

43 Multiple Products and Limited Resources 67, 200 – 15 W + 5 G = 35 × 40 × 4 × 60 = 336, 000 minutes 3 W + 2 G = 400 × 3 × 60 = 72, 000 minutes W = 20, 800 G = 4, 800 22, 400 24, 000 Units of Sales for Gale Maximum contribution margin – – 36, 000 – Mc. Graw-Hill/Irwin Units of Sales for Windy © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

44 Learning Objective Eight Discuss the behavioral, implementation, and legal issues in decision making Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

45 Behavioral and Implementation Issues n n Consideration of Strategic Objectives Predatory Pricing Replacement of Variable Costs with Fixed Costs Proper identification of Irrelevant Factors Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

46 End of Chapter Nine Mc. Graw-Hill/Irwin © 2005 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.