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Introduction to Management Accounting
Introduction to Management Accounting
Chapter 6
Relevant Information for
Decision Making with a Focus
on Operational Decisions
Company went from a small, two person, operation to
a company with sales of over $60 million
They became profitable after they got out of
distribution and changed their marketing approach
They contracted with existing beverage co-packers to
limit their capital expenditures
They now are able to carefully scrutinize all of their
costs through an Enterprise Resource Planning
system that was developed by Oracle
All companies make similar production decision
Company went from a small, two person, operation to
a company with sales of over $60 million
They became profitable after they got out of
distribution and changed their marketing approach
They contracted with existing beverage co-packers to
limit their capital expenditures
They now are able to carefully scrutinize all of their
costs through an Enterprise Resource Planning
system that was developed by Oracle
All companies make similar production decision
Learning
Objective 1
Opportunity, Outlay, and Differential Costs
Differential cost is the difference in
total cost between two alternatives.
Differential revenue is the difference in
total revenue between two alternatives.
Incremental cost are additional costs or reduced
benefits generated by the proposed alternative.
Incremental benefits are the additional revenues or reduced
costs generated by the proposed alternative.
Opportunity, Outlay, and Differential Costs
An incremental analysis is an analysis of the
additional costs and benefits of a proposed alternative.
An opportunity cost is the maximum available
contribution to profit forgone (or passed up) by
using limited resources for a particular purpose.
An outlay cost requires a cash disbursement.
Opportunity, Outlay, and Differential Costs
Nantucket Nectars has a machine for
which it paid $100,000 and it is sitting idle.
Nantucket Nectars has three alternatives:
1. Increase production of Peach juice
2. Sell the machine
3. Produce a new drink Papaya Mango
Opportunity Cost
Peach Juice Contribution margin is $60,000.
Sell machine for $50,000.
Produce Papaya Mango juice with projected sales of $500,000.
Revenue
Costs:
Outlay Costs
Financial benefit before opportunity costs
Opportunity cost of machine
Net financial benefit
$500,000
400,000
$100,000
60,000
$ 40,000
Learning
Objective 2
Make-or-Buy Decisions
Managers often must decide whether to
produce a product or service within the
firm or purchase it from an outside supplier.
Make or Buy Decisions
Nantucket Nectars Company’s
Cost of Making 12-ounce Bottles
Direct material
$ 60,000
Direct labor
20,000
Variable factory overhead 40,000
Fixed factory overhead
80,000
Total costs
$200,000
$.06
.02
.04
.08
$.20
Make-or-Buy Example
Another manufacturer offers to sell
Nantucket the bottles for $.18.
If the company buys the bottles, $50,000
of fixed overhead would be eliminated.
Should Nantucket make or buy the bottles?
Relevant Cost Comparison
Buy
Make
Total
Purchase cost
Direct material
Direct labor
Variable overhead
Fixed OH avoided by
not making
Total relevant costs
Difference in favor
of making
Per Bottle
$ 60,000
20,000
40,000
$.06
.02
.04
50,000
$170,000
.05
$.17
$ 10,000
$.01
Total
Per Bottle
$180,000
$.18
0
$180,000
0
$.18
Make or Buy and the Use of Facilities
Suppose Nantucket can use the released
facilities in other manufacturing activities
to produce a contribution to profits of
$55,000, or can rent them out for $25,000.
What are the alternatives?
Make or Buy and the Use of Facilities
Buy and
leave
facilities
idle
Buy and
rent out
facilities
Buy and use
facilities
for other
products
(000)
Make
Rent revenue
Contribution from
other products
Variable cost of bottles
Net relevant costs
$ —
$ —
$ 25
$ —
—
(170)
$(170)
—
(180)
$(180)
—
(180)
$(155)
55
(180)
$(125)
Learning
Objective 3
Avoidable and Unavoidable Costs
Avoidable costs are costs that will
not continue if an ongoing
operation is changed or deleted.
Unavoidable costs are costs that
continue even if an operation is halted.
Common costs are costs of facilities and
services that are shared by users.
Learning Objective 4
Choose whether to add
or delete a product line
using relevant information.
Avoidable and Unavoidable Costs
Avoidable costs are costs that will
not continue if an ongoing
operation is changed or deleted.
Unavoidable costs are costs that
continue even if an operation is halted.
Department Store Example
Consider a discount department store
that has three major departments:
Groceries
General merchandise
Drugs
Department Store Example
Departments ($000)
General
Groceries Mdse.
Sales
Variable expenses
Contribution margin
Fixed expenses:
Avoidable
Unavoidable
Total fixed expenses
Operating income
Drugs
Total
$1,000
800
$ 200
$800
560
$240
$100
60
$ 40
$1,900
1,420
$ 480
$ 150
60
$ 210
$ (10)
$100
100
$200
$ 40
$ 15
20
$ 35
$ 5
$ 265
180
$ 445
$ 35
Department Store Example
For this example, assume first that the only
alternatives to be considered are dropping
or continuing the grocery department,
which shows a loss of $10,000.
Assume further that the total assets invested
would be unaffected by the decision.
The vacated space would be idle and
the unavoidable costs would continue.
Department Store Example
Store as a Whole ($000)
Sales
Variable expenses
Contribution margin
Avoidable fixed expenses
Profit contribution to
common space and
other unavoidable costs
Unavoidable expenses
Operating income
Total
Before
Change
Effect of
Dropping
Groceries
$1,900
1,420
$ 480
265
$1,000
800
$ 200
150
$ 215
180
$ 35
$
$
50
0
50
Total
After
Change
$900
620
$280
115
$165
180
$ (15)
Learning
Objective 4
Optimal Use of Limited Resources
A limiting factor or scarce resource
restricts or constrains the production
or sale of a product or service.
Assume that the capacity of the facility is
determined by machine time, and the
maximum capacity is 10,000 machine hours.
The facility can produce 10 pairs of Air Court
Shoes or 5 pairs of Air Max shoes per hour.
Optimal Use of Limited Resources
Air
Court
Selling price per pair
Variable costs per pair
Contribution margin per pair
Contribution margin ratio
$80
60
$20
25%
Air
Max
$120
84
$ 36
30%
Optimal Use of Limited Resources
Which is more profitable?
If the limiting factor is demand, that is, pairs
of shoes, the more profitable product is Air Max.
Optimal Use of Limited Resources
Air Max is the product with
the higher contribution per unit.
The sale of a pair of Air Court
shoes adds $20 to profit.
The sale of a pair of Air Max
shoes adds $36 to profit.
Optimal Use of Limited Resources
Suppose that demand for either shoe would fill the
plant’s capacity. Now, capacity is the limiting factor.
Which is more profitable?
If the limiting factor is capacity,
the more profitable product is Air Court.
Optimal Use of Limited Resources
Air Court
$20 contribution margin per pair × 10,000 hours
= $2,000,000 contribution
Air Max:
$36 contribution margin per pair × 10,000 hours
= $1,800,000 contribution
Optimal Use of Limited Resources
In retails stores, the limiting factor is often floor space.
The focus is on products taking up less space or
on using the space for shorter periods of time.
Retail stores seek faster inventory turnover
(the number of times the average
inventory is sold per year).
Optimal Use of Limited Resources
Faster inventory turnover makes the same product
a more profitable use of space in a discount store.
Regular
Department
Store
Discount
Department
Store
Retail Price
$4.00
$3.50
Costs of Merchandise and other variable costs
3.00
3.00
Contribution to profit per unit
$1.00 (25%) $ .50 (14%)
Units sold per year
10,000
22,000
Total contribution to profit, assuming the
same space allotment in both stores
$10,000
11,000
Learning
Objective 5
Joint Product Costs
Joint products have relatively significant sales values.
They are not separately identifiable as
individual products until their split-off point.
The split-off point is that juncture of
manufacturing where the joint products
become individually identifiable.
Joint Product Costs
Separable costs are any costs
beyond the split-off point.
Joint costs are the costs of manufacturing
joint products before the split-off point.
Joint Product Costs
Suppose Dow Chemical Company produces
two chemical products, X and Y, as
a result of a particular joint process.
The joint processing cost is $100,000.
Both products are sold to the petroleum
industry to be used as ingredients of gasoline.
Joint Product Costs
1 million liters of X at a
selling price of $.09 = $90,000
500,000 liters of Y at a
selling price of $.06 = $30,000
Total sales value at
split-off is $120,000
Joint-processing
cost is $100,000
Split-off point
Illustration of Sell or Process Further
Suppose the 500,000 liters of Y can be
processed further and sold to the
plastics industry as product YA.
The additional processing cost would
be $.08 per liter for manufacturing
and distribution, a total of $40,000.
The net sales price of YA would be
$.16 per liter, a total of $80,000.
Illustration of Sell or Process Further
Revenues
Separable costs
beyond split-off
@ $.08
Income effects
Sell at
Split-off
as Y
Process
Further and
Sell as YA
Difference
$30,000
$80,000
$50,000
–
$30,000
40,000
$40,000
40,000
$10,000
Learning
Objective 6
Equipment Replacement
The book value of equipment is not
a relevant consideration in deciding
whether to replace the equipment.
Because it is a past, not a future cost.
Book Value of Old Equipment
Depreciation is the periodic allocation
of the cost of equipment.
The equipment’s book value (or net book value)
is the original cost less accumulated depreciation.
Book Value of Old Equipment
Suppose a $10,000 machine with a 10-year life
span has depreciation of $1,000 per year.
What is the book value at the end of 6 years?
Original cost
Accumulated depreciation (6 × $1,000)
Book value
$10,000
6,000
$ 4,000
Keep or Replace the Old Machine?
Original cost
Useful life in years
Current age in years
Useful life remaining in years
Accumulated depreciation
Book value
Disposal value (in cash) now
Disposal value in 4 years
Annual cash operating costs
Old
Machine
Replacement
Machine
$10,000
10
6
4
$ 6,000
$ 4,000
$ 2,500
0
$ 5,000
$8,000
4
0
4
0
N/A
N/A
0
$3,000
Relevance of Equipment Data
A sunk cost is a cost already incurred and is
irrelevant to the decision-making process.
Book value of old equipment
 Disposal value of old equipment
 Gain or loss on disposal
 Cost of new equipment

Relevance of Equipment Data
The book value of old equipment is irrelevant
because it is a past (historical) cost.
Therefore, depreciation on
old equipment is irrelevant.
Disposal Value of Old Equipment
The disposal value of old equipment
is relevant because it is an expected
future inflow that usually differs
among alternatives.
Gain or Loss on Disposal
This is the difference between
book value and disposal value.
It is a meaningless combination of irrelevant
(book value) and relevant items (disposal value).
It is best to think of each separately.
Cost of New Equipment
The cost of new equipment is relevant
because it is an expected future outflow
that will differ among alternatives.
Cost Comparison
Four Years Together
Keep
Replace
Difference
Cash operating costs
Old equipment (book value):
Depreciation, or
Lump-sum write-off
Disposal value
New machine
acquisition cost
Total costs
$20,000
$12,000
4,000
–
–
–
4,000
(2,500)
–
$24,000
8,000
$21,500
$8,000
–
–
2,500
(8,000)
$2,500
Learning
Objective 7
Irrelevant Costs
The ability to recognize irrelevant costs
is important to decision makers.
Irrelevant Costs
Suppose General Dynamics has 100
obsolete aircraft parts in its inventory.
The original manufacturing cost
of these parts was $100,000.
General Dynamics can remachine the parts for $30,000
and then sell them for $50,000, or scrap them for $5,000.
Irrelevant Costs
Remachine
Expected future revenue
Expected future costs
Relevant excess of
revenue over costs
Accumulated historical
inventory cost*
Net loss on project
Scrap
Difference
$ 50,000
30,000
$
5,000
0
$45,000
30,000
$ 20,000
$
5,000
$15,000
100,000
$(80,000)
100,000
$ (95,000)
* Irrelevant because it is unaffected by the decision.
0
$15,000
Irrelevant Costs
Assume that a new $100,000 machine with
a five-year life can produce 100,000 units
a year at a variable cost of $1 per unit,
as opposed to a variable cost per unit
of $1.50 with an old machine.
Is the new machine a worthwhile acquisition?
Irrelevant Costs
Old Machine New Machine
Units
Variable cost
Straight-line depreciation
Total relevant costs
Unit relevant costs
100,000
100,000
$150,000
$100,000
0
20,000
$ 150,000
$120,000
$
1.50
$
1.20
Irrelevant Costs
It appears that the new machine
will reduce costs by $.30 per unit.
However, if the expected volume is only
30,000 units per year, the unit costs
change in favor of the old machine.
Irrelevant Costs
Units
Variable costs
Straight-line depreciation
Total relevant costs
Unit relevant costs
Old Machine
New Machine
30,000
$45,000
0
$45,000
$1.50
30,000
$30,000
20,000
$50,000
$1.6667
Learning
Objective 8
Decision Making and Performance Evaluation
To motivate managers to make the right choice,
the method used to evaluate performance should
be consistent with the decision model.
Consider the replacement decision where replacing a
machine has a $2,500 advantage over keeping it.
Decision Making and Performance Evaluation
Year 1
Keep
Replace
Cash operating
costs
$5,000
Depreciation
1,000
Loss on disposal
($4,000 – $2,500)
0
Total charges
against revenue
$6,000
Years 2, 3, and 4
Keep
Replace
$3,000
2,000
$5,000
1,000
$3,000
2,000
$1,500
0
0
$6,500
$6,000
$5,000
Decision Making and Performance Evaluation
Performance is often measured by accounting
income, consider the accounting income
in the first year after replacement
compared with that in years 2, 3, and 4.
If the machine is kept rather than replaced,
first-year costs will be $500 lower
($6,500 – $6,000), and first-year
income will be $500 higher.
The End
End of Chapter 6