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CHAPTER 11
DECISION MAKING AND RELEVANT INFORMATION
11-1 The five steps in the decision process outlined in Exhibit 11-1 of the text are
- Identify the problem and uncertainties
- Obtain information
- Make predictions about the future
- Make decisions by choosing among alternatives
- Implement the decision, evaluate performance, and learn
11-2 Relevant costs are expected future costs that differ among the alternative courses of action being considered. Historical costs are irrelevant because they are past costs and, therefore, cannot differ among alternative future courses of action.
11-3 No. Relevant costs are defined as those expected future costs that differ among alternative courses of action being considered. Thus, future costs that do not differ among the alternatives are irrelevant to deciding which alternative to choose.
11-4 Quantitative factors are outcomes that are measured in numerical terms. Some quantitative factors are financial––that is, they can be easily expressed in monetary terms. Direct materials is an example of a quantitative financial factor. Other quantitative nonfinancial factors, such as on-time flight arrivals, cannot be easily expressed in monetary terms. Qualitative factors are outcomes that are difficult to measure accurately in numerical terms. An example is employee morale.
11-5 Two potential problems that should be avoided in relevant cost analysis are (i) Do not assume all variable costs are relevant and all fixed costs are irrelevant. (ii) Do not use unit-cost data directly. It can mislead decision makers because a. it may include irrelevant costs, and b. comparisons of unit costs computed at different output levels lead to erroneous conclusions
11-6 No. Some variable costs may not differ among the alternatives under consideration and, hence, will be irrelevant. Some fixed costs may differ among the alternatives and, hence, will be relevant.
11-7 No. Some of the total manufacturing cost per unit of a product may be fixed, and, hence, will not differ between the make and buy alternatives. These fixed costs are irrelevant to the make-or-buy decision. The key comparison is between purchase costs and the costs that will be saved if the company purchases the component parts from outside plus the additional benefits of using the resources freed up in the next best alternative use (opportunity cost). Furthermore, managers should consider nonfinancial factors such as quality and timely delivery when making outsourcing decisions.
11-8 Opportunity cost is the contribution to income that is forgone (rejected) by not using a limited resource in its next-best alternative use.
11-9 No. When deciding on the quantity of inventory to buy, managers must consider both the purchase cost per unit and the opportunity cost of funds invested in the inventory. For example, the purchase cost per unit may be low when the quantity of inventory purchased is large, but the benefit of the lower cost may be more than offset by the high opportunity cost of the funds invested in acquiring and holding inventory.
11-10 No. Managers should aim to get the highest contribution margin per unit of the constraining (that is, scarce, limiting, or critical) factor. The constraining factor is what restricts or limits the production or sale of a given product (for example, availability of machine-hours).
11-11 No. For example, if the revenues that will be lost exceed the costs that will be saved, the branch or business segment should not be shut down. Shutting down will only increase the loss. Allocated costs and fixed costs that will not be saved are irrelevant to the shut-down decision.
11-12 Cost written off as depreciation is irrelevant when it pertains to a past cost such as equipment already purchased. But the purchase cost of new equipment to be acquired in the future that will then be written off as depreciation is often relevant.
11-13 No. Managers often favor the alternative that makes their performance look best so they focus on the measures used in the performance-evaluation model. If the performance-evaluation model does not emphasize maximizing operating income or minimizing costs, managers will most likely not choose the alternative that maximizes operating income or minimizes costs.
11-14 The three steps in solving a linear programming problem are (i) Determine the objective function. (ii) Specify the constraints. (iii) Compute the optimal solution.
11-15 The text outlines two methods of determining the optimal solution to an LP problem: (i) Trial-and-error approach (ii) Graphic approach
Most LP applications in practice use standard software packages that rely on the simplex method to compute the optimal solution.
11-17 (20 min.) Relevant and irrelevant costs.
Make Buy Relevant costs Variable costs $ Avoidable fixed costs 10 Purchase price ____ $ Unit relevant cost $200 $
Dalton Computers should reject Peach’s offer. The $80 of fixed costs are irrelevant because they will be incurred regardless of this decision. When comparing relevant costs between the choices, Peach’s offer price is higher than the cost to continue to produce.
Keep Replace Difference Cash operating costs (3 years) $52,500 $46,500 $6, Current disposal value of old machine (2,200) 2, Cost of new machine _ _____ 9,000 (9,000) Total relevant costs $52,500 $53,300 $ (800)
AP Manufacturing should keep the old machine. The cost savings are less than the cost to purchase the new machine.
11-18 (15 min.) Multiple choice.
- (b) Special order price per unit $6. Variable manufacturing cost per unit 4. Contribution margin per unit $1.
Effect on operating income = $1.50 × 20,000 units = $30,000 increase
- (b) Costs of purchases, 20,000 units × $60 $1,200, Total relevant costs of making: Variable manufacturing costs, $6 + $30 + $12 $ Fixed costs eliminated 9 Costs saved by not making $ Multiply by 20,000 units, so total costs saved are $57 × 20,000 1,140, Extra costs of purchasing outside 60, Minimum overall savings for Reno 25, Necessary relevant costs that would have to be saved in manufacturing Part No. 575 $ 85,
11-19 (30 min.) Special order, activity-based costing.
- Direct materials cost per unit ($262,500 ÷ 7,500 units) = $35 per unit Direct manufacturing labor cost per unit ($300,000 ÷ 7,500 units) = $40 per unit Variable cost per batch = $500 per batch
Award Plus’ operating income under the alternatives of accepting/rejecting the special order are:
Without One- Time Only Special Order 7,500 Units
With One- Time Only Special Order 10,000 Units
Difference 2,500 Units
Revenues $1,125,000 $1,375,000 $250, Variable costs:
Direct materials 262,500 350,
1 87, Direct manufacturing labor 300,000 400,
2 100, Batch manufacturing costs 75,000 87,
3 12, Fixed costs: Fixed manufacturing costs 275,000 275,000 –– Fixed marketing costs 175,000 175,000 –– Total costs 1,087,500 1,287,500 200, Operating income $ 37,500 $ 87,500 $ 50,
(^1) $262,500 + ($35 × 2,500 units) 2 $300,000 + ($40 × 2,500 units) 3 $75,000 + ($500 × 25 batches)
Alternatively, we could calculate the incremental revenue and the incremental costs of the additional 2,500 units as follows:
Incremental revenue $100 × 2,500 $250, Incremental direct manufacturing costs $35 × 2,500 units 87, Incremental direct manufacturing costs $40 × 2,500 units 100, Incremental batch manufacturing costs $500 × 25 batches 12, Total incremental costs 200, Total incremental operating income from accepting the special order $ 50,
Award Plus should accept the one-time-only special order if it has no long-term implications because accepting the order increases Award Plus’ operating income by $50,000. If, however, accepting the special order would cause the regular customers to be dissatisfied or to demand lower prices, then Award Plus will have to trade off the $50,000 gain from accepting the special order against the operating income it might lose from regular customers.
11-20 (30 min.) Make versus buy, activity-based costing.
- The expected manufacturing cost per unit of CMCBs in 2012 is as follows:
Total Manufacturing Costs of CMCB (1)
Manufacturing Cost per Unit (2) = (1) ÷ 10, Direct materials, $170 × 10, Direct manufacturing labor, $45 × 10, Variable batch manufacturing costs, $1,500 × 80 Fixed manufacturing costs Avoidable fixed manufacturing costs Unavoidable fixed manufacturing costs Total manufacturing costs
- The following table identifies the incremental costs in 2012 if Svenson (a) made CMCBs and (b) purchased CMCBs from Minton.
Total Incremental Costs
Per-Unit Incremental Costs Incremental Items Make Buy Make Buy Cost of purchasing CMCBs from Minton Direct materials Direct manufacturing labor Variable batch manufacturing costs Avoidable fixed manufacturing costs Total incremental costs
Difference in favor of making (^) $ 410,000 $
Note that the opportunity cost of using capacity to make CMCBs is zero since Svenson would keep this capacity idle if it purchases CMCBs from Minton. Svenson should continue to manufacture the CMCBs internally since the incremental costs to manufacture are $259 per unit compared to the $300 per unit that Minton has quoted. Note that the unavoidable fixed manufacturing costs of $800,000 ($80 per unit) will continue to be incurred whether Svenson makes or buys CMCBs. These are not incremental costs under either the make or the buy alternative and hence, are irrelevant.
- Svenson should continue to make CMCBs. The simplest way to analyze this problem is to recognize that Svenson would prefer to keep any excess capacity idle rather than use it to make CB3s. Why? Because expected incremental future revenues from CB3s, $2,000,000, are less than expected incremental future costs, $2,150,000. If Svenson keeps its capacity idle, we know from requirement 2 that it should make CMCBs rather than buy them. An important point to note is that, because Svenson forgoes no contribution by not being able to make and sell CB3s, the opportunity cost of using its facilities to make CMCBs is zero. It is, therefore, not forgoing any profits by using the capacity to manufacture CMCBs. If it does not manufacture CMCBs, rather than lose money on CB3s, Svenson will keep capacity idle. A longer and more detailed approach is to use the total alternatives or opportunity cost analyses shown in Exhibit 11-7 of the chapter.
Choices for Svenson
Relevant Items
Make CMCBs and Do Not Make CB3s
Buy CMCBs and Make CB3s, if Profitable TOTAL-ALTERNATIVES APPROACH TO MAKE-OR-BUY DECISIONS
Total incremental costs of making/buying CMCBs (from requirement 2)
Because incremental future costs exceed incremental future revenues from CB3s, Svenson will make zero CB3s even if it buys CMCBs from Minton
Total relevant costs
Svenson will minimize manufacturing costs and maximize operating income by making CMCBs.
OPPORTUNITY-COST APPROACH TO MAKE-OR-BUY DECISIONS
Total incremental costs of making/buying CMCBs (from requirement 2) $2,590,000 $3,000, Opportunity cost: profit contribution forgone because capacity will not be used to make CB3s 0 *^0 Total relevant costs $2,590,000 $3,000,
- (^) Opportunity cost is 0 because Svenson does not give up anything by not making CB3s. Svenson is best off leaving
the capacity idle (rather than manufacturing and selling CB3s).
11-22 (20–25 min.) Relevant costs, contribution margin, product emphasis.
Cola Lemonade Punch
Natural Orange Juice Selling price $18.75 $20.50 $27.75 $39. Deduct variable cost per case 13.75 15.60 20.70 30. Contribution margin per case $ 5.00 $ 4.90 $ 7.05 $ 8.
- The argument fails to recognize that shelf space is the constraining factor. There are only 12 feet of front shelf space to be devoted to drinks. Sexton should aim to get the highest daily contribution margin per foot of front shelf space:
Cola Lemonade Punch
Natural Orange Juice Contribution margin per case $ 5.00 $ 4.90 $ 7.05 $ 8. Sales (number of cases) per foot of shelf space per day × 22 × 12 × 6 × 13 Daily contribution per foot of front shelf space $110.00 $58.80 $42.30 $115.
- The allocation that maximizes the daily contribution from soft drink sales is:
Daily Contribution Feet of per Foot of Total Contribution Shelf Space Front Shelf Space Margin per Day Natural Orange Juice 6 $115.70 $ 694. Cola 4 110.00 440. Lemonade 1 58.80 58. Punch 1 42.30 42. $1,235.
The maximum of six feet of front shelf space will be devoted to Natural Orange Juice because it has the highest contribution margin per unit of the constraining factor. Four feet of front shelf space will be devoted to Cola, which has the second highest contribution margin per unit of the constraining factor. No more shelf space can be devoted to Cola since each of the remaining two products, Lemonade and Punch (that have the second lowest and lowest contribution margins per unit of the constraining factor) must each be given at least one foot of front shelf space.
11-23 (10 min.) Selection of most profitable product.
Only Model 14 should be produced. The key to this problem is the relationship of manufacturing overhead to each product. Note that it takes twice as long to produce Model 9; machine-hours for Model 9 are twice that for Model 14. Management should choose the product mix that maximizes operating income for a given production capacity (the scarce resource in this situation). In this case, Model 14 will yield a $9.50 contribution to fixed costs per machine hour, and Model 9 will yield $9.00:
Model 9 Model 14
Selling price Variable cost per unit* ($28 + $15 + $25 + $14; $13 + $25 + $12.50 + $10) Contribution margin per unit Relative use of machine-hours per unit of product Contribution margin per machine hour
÷ 2
÷ 1
*Variable cost per unit = Direct material cost per unit + Direct manufacturing labor cost per unit
- Variable manufacturing cost per unit + Marketing cost per unit.
11-24 (20 min.) Which center to close, relevant-cost analysis, opportunity costs.
- The annual operating costs of $2.5 million for the Groveton center and $3 million for the Stockdale center are irrelevant because these are past costs. The future annual operating costs will be $3.5 million regardless of which ambulatory surgery center is closed. Further, one of the centers will permanently remain open while the other will be shut down. Thus, future operating costs are irrelevant.
- Also irrelevant are the allocated common administrative costs of $800,000 for the Groveton center and $1 million for the Stockdale center because the total common administrative costs will not change and will simply be reallocated to other ambulatory centers, regardless of whether the Groveton center or the Stockdale center is closed.
- The only relevant revenue and cost comparisons are:
a. $7 million from sale of the Stockdale center. Note that the historical cost of building the Stockdale center ($4.8 million) and the cost of renovation ($2 million) are irrelevant because these are past costs. Note that future increases in the value of the Stockdale center land is also irrelevant. One of the centers must be kept open, so if Fair Lakes decided to keep the Stockdale center open, it will not be able to sell this land at a future date. b. $1 million in savings in fixed income note if the Groveton center is closed. Again, the historical cost of building the Groveton center ($5 million) is irrelevant.
The relevant costs and benefits analysis favors closing the Stockdale center despite the objections raised by the City Council of Stockdale. The net benefit equals $6 ($7 – $1) million.
11-26 (20 min.) Choosing customers.
If Broadway accepts the additional business from Kelly, it would take an additional 500 machine-hours. If Broadway accepts all of Kelly’s and Taylor’s business for February, it would require 2,500 machine-hours (1,500 hours for Taylor and 1,000 hours for Kelly). Broadway has only 2,000 hours of machine capacity. It must, therefore, choose how much of the Taylor or Kelly business to accept. To maximize operating income, Broadway should maximize contribution margin per unit of the constrained resource. (Fixed costs will remain unchanged at $100,000 regardless of the business Broadway chooses to accept in February, and is, therefore, irrelevant.) The contribution margin per unit of the constrained resource for each customer in January is:
Taylor Kelly Corporation Corporation
Contribution margin per machine-hour 1,
Since the $80,000 of additional Kelly business in February is identical to jobs done in January, it will also have a contribution margin of $64 per machine-hour, which is greater than the contribution margin of $52 per machine-hour from Taylor. To maximize operating income, Broadway should first allocate all the capacity needed to take the Kelly Corporation business (1,000 machine-hours) and then allocate the remaining 1,000 (2,000 – 1,000) machine-hours to Taylor.
Taylor Kelly Corporation Corporation Total Contribution margin per machine-hour $52 $ Machine-hours to be worked × 1,000 × 1, Contribution margin $52,000 $64,000 $116, Fixed costs 100, Operating income $ 16,
An alternative approach is to use the opportunity cost approach. The opportunity cost of giving up 500 machine-hours for the Taylor Corporation jobs is the contribution margin forgone of $52 per machine-hour × 500 machine-hours equal to $26,000. The contribution margin gained from using the 500 machine-hours for the Kelly Corporation business is the contribution margin per machine-hour of $64 × 500 machine-hours equal to $32,000.
The net benefit is: Contribution margin from Kelly Corporation business $32, Less: Opportunity cost (of giving up Taylor Corporation business) (26,000) Net benefit $ 6,
11-27 (30–40 min.) Relevance of equipment costs.
1a. Statements of Cash Receipts and Disbursements
Keep Machine Buy New Machine
Year 1
Each Year 2, 3, 4
Four Years Together Year 1
Each Year 2, 3, 4
Four Years Together Receipts from operations: Revenues $150,000 $150,000 $600,000 $150,000 $150,000 $600, Deduct disbursements: Other operating costs (110,000) (110,000) (440,000) (110,000) (110,000) (440,000) Operation of machine (15,000) (15,000) (60,000) (9,000) (9,000) (36,000) Purchase of “old” machine (20,000)* (20,000) (20,000) (20,000) Purchase of “new” machine (24,000) (24,000) Cash inflow from sale of old machine 8,000 8, Net cash inflow $ 5,000 $ 25,000 $ 80,000 $ (5,000) $ 31,000 $ 88,
*Some students ignore this item because it is the same for each alternative. However, note that a statement for the entire year has been requested. Obviously, the $20,000 would affect only Year 1 under both the “keep” and “buy” alternatives. The difference is $8,000 for four years taken together. In particular, note that the $20, book value of the old machine can be omitted from the comparison. Merely cross out the entire line; although the column totals are affected, the net difference is still $8,000.
1b. Again, the difference is $8,000: Income Statements
Keep Machine Buy New Machine Each Year 1, 2, 3, 4
Four Years Together Year 1
Each Year 2, 3, 4
Four Years Together
Revenues Costs (excluding disposal): Other operating costs Depreciation Operating costs of machine Total costs (excluding disposal) Loss on disposal: Book value (“cost”) Proceeds (“revenue”) Loss on disposal Total costs Operating income
*As in part (1), the $20,000 book value may be omitted from the comparison without changing the $8,
difference. This adjustment would mean excluding the depreciation item of $5,000 per year (a cumulative effect of $20,000) under the “keep” alternative and excluding the book value item of $20,000 in the loss on disposal computation under the “buy” alternative.
11-28 (30 min.) Equipment upgrade versus replacement.
- Based on the analysis in the table below, TechGuide will be better off by $337,500 over three years if it replaces the current equipment. Over 3 years Difference in Comparing Relevant Costs of Upgrade and Upgrade Replace favor of Replace Replace Alternatives (1) (2) (3) = (1) – (2) Cash operating costs $150; $75 per desk × 7,500 desks per yr. × 3 yrs. $3,375,000 $1,687,500 $1,687, Current disposal price (450,000) 450, One time capital costs, written off periodically as depreciation 3,000,000 4,800,000 (1,800,000) Total relevant costs $6,375,000 $6,037,500 $ 337,
Note that the book value of the current machine, $1,800,000 ×
= $1,080,000 would either be
written off as depreciation over three years under the upgrade option, or, all at once in the current year under the replace option. Its net effect would be the same in both alternatives: to increase costs by $1,080,000 over three years, hence it is irrelevant in this analysis.
- Suppose the capital expenditure to replace the equipment is $X. From requirement 1, column (2), substituting for the one-time capital cost of replacement, the relevant cost of replacing is $1,687,500 – $450,000 + $X. From column (1), the relevant cost of upgrading is $6,375,000. We want to find X such that
$1,687,500 – $450,000 + $X < $6,375,000 (i.e., TechGuide will favor replacing)
Solving the above inequality gives us X < $6,375,000 – $1,237,500 = $5,137,500.
TechGuide would prefer to replace, rather than upgrade, if the replacement cost of the new equipment does not exceed $5,137,500. Note that this result can also be obtained by taking the original replacement cost of $4,800,000 and adding to it the $337,500 difference in favor of replacement calculated in requirement 1.
- Suppose the units produced and sold over 3 years equal y. Using data from requirement 1, column (1), the relevant cost of upgrade would be $150y + $3,000,000, and from column (2), the relevant cost of replacing the equipment would be $75y – $450,000 + $4,800,000. TechGuide would want to upgrade when
$150y + $3,000,000 < $75y – $450,000 + $4,800, $75y < $1,350, y < $1,350,000 ÷ $75 = 18,000 units
That is, upgrade when y < 18,000 units (or 6,000 per year for 3 years) and replace when y > 18,000 units over 3 years. When production and sales volume is low (less than 6,000 per year), the higher operating costs under the upgrade option are more than offset by the savings in capital costs from upgrading. When production and sales volume is high, the higher capital costs of replacement are more than offset by the savings in operating costs in the replace option.
- Operating income for the first year under the upgrade and replace alternatives are shown below: Year 1 Upgrade Replace (1) (2) Revenues (7,500 × $750) $5,625,000 $5,625, Cash operating costs $150; $75 per desk × 7,500 desks per year 1,125,000 562, Depreciation ($1,080,000 a^ + $3,000,000) ÷ 3; $4,800,000 ÷ 3 1,360,000 1,600, Loss on disposal of old equipment (0; $1,080,000 – $450,000) 0 630, Total costs 2,485,000 2,792, Operating Income $3,140,000 $2,832,
a (^) The book value of the current production equipment is $1,800,000 ÷ 5 × 3 = $1,080,000; it has a remaining useful life of 3 years.
First-year operating income is higher by $307,500 ($3,140,000 – $2,832,500) under the upgrade alternative, and Dan Doria, with his one-year horizon and operating income-based bonus, will choose the upgrade alternative, even though, as seen in requirement 1, the replace alternative is better in the long run for TechGuide. This exercise illustrates the possible conflict between the decision model and the performance evaluation model.
11-30 (20 min.) International outsourcing.
- Cost to purchase each figurine from Indonesian supplier =
27,300 IDR
9,100 IDR/$
Cost of purchasing 400,000 figurines from Indonesian supplier = $3 × 400,000 figurines = $1,200,000.
Costs of manufacturing figurines in Cleveland facility
Variable manufacturing cost per unit
×
Quantity of figurines produced
Incremental fixed manufacturing costs
= $2.85 × 400,000 units + $200, = $1,340,
Variable and fixed selling and distribution costs are irrelevant because they do not differ between the two alternatives of purchasing the figurines from the Indonesian supplier or manufacturing the figurines in Cleveland.
Bernie’s Bears should purchase the figurines from the Indonesian supplier because the cost of $1,200,000 is less than the relevant cost of $1,340,000 to manufacture the figurines in Cleveland.
- If Bernie’s Bears enters into a forward contract to purchase 27,300 IDRs for $3.40, each figurine acquired from the Indonesian supplier will cost $3.40.
Total cost of purchasing 400,000 figurines from Indonesian supplier = $3.40 × 400, figurines = $1,360,000. Cost of manufacturing 400,000 figurines in Cleveland (see requirement 1) = $1,340,000.
As in requirement 1, selling and distribution costs are irrelevant.
Bernie’s Bears should manufacture the figurines in Cleveland because the relevant cost of $1,340,000 to manufacture the figurines in Cleveland is less than the cost of $1,360,000 to enter into the forward contract and purchase the figurines from the Indonesian supplier.
- In deciding whether to purchase figurines from the Indonesian supplier, Bernie’s Bears should consider factors such as (a) quality, (b) delivery lead times, (c) fluctuations in the value of the Indonesian Rupiah relative to the U.S. dollar, and (d) the negative public and media reaction to not providing jobs in Cleveland and instead supporting job creation in Indonesia.
11-31 (30 min.) Relevant costs, opportunity costs.
- Easyspread 2.0 has a higher relevant operating income than Easyspread 1.0. Based on this analysis, Easyspread 2.0 should be introduced immediately:
Easyspread 1.0 Easyspread 2. Relevant revenues $160 $ Relevant costs: Manuals, diskettes, compact discs $ 0 $ Total relevant costs 0 30 Relevant operating income $160 $
Reasons for other cost items being irrelevant are
Easyspread 1.
- Manuals, diskettes—already incurred
- Development costs—already incurred
- Marketing and administrative—fixed costs of period
Easyspread 2.
- Development costs—already incurred
- Marketing and administration—fixed costs of period
Note that total marketing and administration costs will not change whether Easyspread 2.0 is introduced on July 1, 2011, or on October 1, 2011.
- Other factors to be considered: a. Customer satisfaction. If 2.0 is significantly better than 1.0 for its customers, a customer driven organization would immediately introduce it unless other factors offset this bias towards “do what is best for the customer.” b. Quality level of Easyspread 2.0. It is critical for new software products to be fully debugged. Easyspread 2.0 must be error-free. Consider an immediate release only if 2.0 passes all quality tests and can be fully supported by the salesforce. c. Importance of being perceived to be a market leader. Being first in the market with a new product can give Basil Software a “first-mover advantage,” e.g., capturing an initial large share of the market that, in itself, causes future potential customers to lean towards purchasing Easyspread 2.0. Moreover, by introducing 2.0 earlier, Basil can get quick feedback from users about ways to further refine the software while its competitors are still working on their own first versions. Moreover, by locking in early customers, Basil may increase the likelihood of these customers also buying future upgrades of Easyspread 2.0. d. Morale of developers. These are key people at Basil Software. Delaying introduction of a new product can hurt their morale, especially if a competitor then preempts Basil from being viewed as a market leader.
