chapter 11 decision making: relevant costs and benefits
TRANSCRIPT
Chapter 11
Decision making:
Relevant Costs and Benefits
DIFFERENTIAL COSTS AND REVENUES
Bill is currently employed as a lifeguard, but he has been offered a job in an auto service center in the same town. The
differential revenues and costs between the two jobs are listed below:
Life-
guard
Auto
Service
Center
Differential costs
and revenues
Monthly salary $1,200 $1,500 $300
Monthly expenses:
Commuting 30 90 60
Meals 150 150 0
Apartment rent 450 450 0
Uniform rental 0 50 50
Union dues 10 0 (10)
Total monthly expenses 640 740 100
Net monthly income $ 560 $ 760 $200
Identifying Relevant Costs
7 Reduction in resale value of car per mile of wear 0.026$ 8 Round-trip train fare 104$ 9 Cost of hotel in New York 200$
10 Cost of putting dog in kennel while gone 40$ 11 Benefit of having car in New York ????12 Hassle of parking car in New York ????13 Per day cost of parking car in New York 25$
Some Additional Information
Annual Cost of Fixed Items
Cost per Mile
1 Annual straight-line depreciation on car 2,800$ 0.280$ 2 Cost of gasoline 0.050 3 Annual cost of auto insurance and license 1,380 0.138 4 Maintenance and repairs 0.065 5 Parking fees at school 360 0.036 6 Total average cost 0.569$
Automobile Costs (based on 10,000 miles driven per year)
Total and Differential Cost Approaches
The management of a company is considering a new laborsaving machine that rents for $3,000 per year. Data about the company’s
annual sales and costs with and without the new machine are:
Current Situation
Situation With New Machine
Differential Costs and Benefits
Sales (5,000 units @ $40 per unit) 200,000$ 200,000$ - Less variable expenses: Direct materials (5,000 units @ $14 per unit) 70,000 70,000 - Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000 Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 - Total variable expenses 120,000 105,000 - Contribution margin 80,000 95,000 15,000 Less fixed expense: Other 62,000 62,000 - Rent on new machine - 3,000 (3,000) Total fixed expenses 62,000 65,000 (3,000) Net operating income 18,000$ 30,000$ 12,000
Analysis of Special DecisionsLet’s take a look at another decision faced by many businesses.
W
We need a particular component for our manufacturing process. Do you think we should
make or buy this particular item?
“Make or Buy” Decision• Essex manufactures part 4A that is
currently used in one of its products.• The unit cost to make this part is:
Direct materials $ 9 Direct labor 5 Variable overhead 1 Depreciation of special equip. 3 Supervisor's salary 2 General factory overhead 10 Total cost per unit 30$
Direct materials $ 9 Direct labor 5 Variable overhead 1 Depreciation of special equip. 3 Supervisor's salary 2 General factory overhead 10 Total cost per unit 30$
“Make or Buy” Decision
• The special equipment used to manufacture part 4A has no resale value
• General factory overhead is allocated on the basis of direct labor hours
• The $30 total unit cost is based on 20,000 parts produced each year
• An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part
• Should we accept the supplier’s offer?Should we accept the supplier’s offer?
Analysis of Special Pricing DecisionsLet’s take a look at another decision faced by many businesses:
W
Another firm has offered to pay us $10 for a product that normally sells for $25. Do you think we should
accept this special order?
Special Orders
Jet, Inc. makes a single product whose normal selling Jet, Inc. makes a single product whose normal selling price is $20 per unit.price is $20 per unit.
A foreign distributor offers to purchase 3,000 units for A foreign distributor offers to purchase 3,000 units for $10 per unit. $10 per unit.
This is a one-time order that would not affect the This is a one-time order that would not affect the company’s regular business.company’s regular business.
Annual capacity is 10,000 units, but Jet, Inc. is currently Annual capacity is 10,000 units, but Jet, Inc. is currently producing and selling only 5,000 units.producing and selling only 5,000 units.
Jet, Inc. makes a single product whose normal selling Jet, Inc. makes a single product whose normal selling price is $20 per unit.price is $20 per unit.
A foreign distributor offers to purchase 3,000 units for A foreign distributor offers to purchase 3,000 units for $10 per unit. $10 per unit.
This is a one-time order that would not affect the This is a one-time order that would not affect the company’s regular business.company’s regular business.
Annual capacity is 10,000 units, but Jet, Inc. is currently Annual capacity is 10,000 units, but Jet, Inc. is currently producing and selling only 5,000 units.producing and selling only 5,000 units.
Should Jet accept the offer?Should Jet accept the offer?
Special Orders
$8 variable cost$8 variable cost$8 variable cost$8 variable cost
Accept or Reject a Special Order
Jamestown Candleworks has just received a request from the Williamsburg Foundation for 800 candles to be used in a special event for major donors. The candles will be used as the only illumination in the reception room and will be given out as gifts to the donors as they leave. The candles will be imprinted with the Williamsburg Foundation logo. This sale will have no effect on the company’s normal sales to retail outlets. The normal selling price of a candle of about the size and weight of the special candles is $3.95 and its unit product cost is $2.30, as shown below:
Direct materials $1.35 Direct labor 0.15 Manufacturing overhead 0.80 Unit product cost $2.30
The variable portion of the manufacturing overhead is $0.05 per candle; the other $0.75 represents fixed manufacturing costs that would not be affected by this special order.
Accept or Reject a Special Order (continued)
Jamestown Candleworks would have to order a special candle mold in which the Williamsburg Foundation logo is inscribed. Such a mold would cost $800. In addition, the Williamsburg Foundation wants a special wick containing gold-like thread that would add $0.20 to the cost of each candle.
Because of the large size of the order and the charitable nature of the work, the Williamsburg Foundation has asked to pay only $2.95 each for this candle.
If accepted, what effect would this order have on the company’s net operating income?
Accept or Reject a Special Order
Your firm has the capacity to produce 10,000 pencils monthly.
It’s December 15th. To date your firm has orders for 8,000 pencils. You don’t anticipate getting any more orders until next January.
Your cost and revenue information is as follows:
Sales price per pencil $ 10
Variable cost per pencil 3
Total fixed costs $28,000
Accept or Reject a Special Order
Jack Frost,Mayor of Burnville, comes to you and says he would like to give all his staff pencils as Christmas presents, but doesn’t want to pay a lot for them. He offers you $4 per pencil for 2,000 pencils.
Should you take this deal?
Accept or Reject a Special Order
What if, instead, Jack Frost says he will give you $4 per pencil for 4,000 pencils.
Should you take this deal?
Carrying Costs of InventoryAnnual estimated stereo CD player requirements for next year 1,000,000 units
Cost per unit when each purchase is equal to 10,000 units $16.00Cost per unit when each purchase is equal to or greater than 500,000 units;
$16 minus 1% discount $15.84
Cost of a purchase order $500Alternatives under consideration:
A. Make 100 purchases of 10,000 units each during next year
B. Make 2 purchases of 500,000 units during the year
Average investment in inventory:
A. (10,000 units x $16.00 per unit) / 2 a
B. (500,000 units x $15.84 per unit / 2 a
$80,000
$3,960,000
Annual rate of return if cash is invested elsewhere (for example, bonds or stocks at the same level of risk as investment in inventory) 9%
a The example assumes that stereo-CD-player purchases will be used uniformly throughout the year. The average investment in inventory during the year is the cost of the inventory when a purchase is received plus the cost of inventory just before the next purchase is delivered (in our example, zero) divided by 2.
Soho will pay cash for the stereo CD players it buys. Which purchasing alternative is more economical for Soho?
Scarce Resource Constraint
A company has two products: a plain cellular phone and a fancier cellular phone with many special features:
Plain Fancy
Phone Phone
Selling price $ 80 $ 120
Variable costs 64 84
Contribution margin $ 16 $ 36
Contribution-margin ratio 20% 30%
Scarce Resource Constraint
Which product is more profitable?
On which should the firm spend its resources?
It depends.
If sales are restricted by demand for only a limited number of phones, fancy phones are more profitable.
Scarce Resource Constraint
Suppose annual demand for phones of both types is more than the company can produce in the next year.
Only 10,000 hours of capacity are available
If in one hour plant workers can make either three plain phones or one fancy phone, which phone is more profitable?
Scarce Resource Constraint
Plain Fancy
Phone Phone
1. Units per hour 3 1
2. Contribution margin per unit $ 16 $ 36
Contribution margin per hour
Total contribution for
10,000 hours
Another Scarce Resource Decision
Power Recreation assembles two engines - a snowmobile engine and a boat engine - at its Lexington, Kentucky, plant.
Snowmobile Engine
Boat Engine
Selling Price $800 $1,000
Variable cost per unit 560 625
Contribution margin per unit $240 $375
Contribution margin percentage
($240/$800; $375/$1,000)30% 37.5%
Scarce Resource Decision (cont.)
Assume that only 600 machine-hours are available daily for assembling engines. Additional capacity cannot be obtained in the short run. Power Recreation can sell as many engines as it produces. The constraining resource, then, is machine-hours. It takes two machine-hours to produce one snowmobile engine and five machine-hours to produce one boat engine.
What product mix should Power Recreation choose to maximize its operating income?
Analysis of Equipment Replacement Decisions
Let’s take a look at another decision faced by many businesses:
W
Should we replace a machine with a newer and more efficient one?
Equipment Replacement DecisionA manager at White Co. wants to replace an old machine with a new, more
efficient machine:
New machine: List price 90,000$ Annual variable expenses 80,000 Expected life in years 5 Old machine: Original cost 72,000$ Remaining book value 60,000 Disposal value now 15,000 Annual variable expenses 100,000 Remaining life in years 5
Equipment Replacement Decision
White’s sales are $200,000 per yearFixed expenses, other than depreciation, are $70,000 per year
Should the manager purchase the new machine?
Another Equipment Replacement Decision
Toledo Company is considering replacing a metal-cutting machine with a newer model. The new machine is more efficient than the old machine, but it has a shorter life. Revenues from aircraft parts ($1.1 million per year) will be unaffected by the replacement decision. Here’s the data on the existing (old) machine and the replacement (new) machine:
Equipment Replacement Decision (cont.)
Old Machine New Machine
Original Cost $1,000,000 $600,000
Useful Life 5 years 2 years
Current age 3 years 0 years
Remaining useful life 2 years 2 years
Accumulated Depreciation $600,000 Not acquired yet
Book Value $400,000 Not acquired yet
Current disposal value (in cash) $40,000 Not acquired yet
Terminal disposal value (in cash 2 years from now)
$0 $0
Annual operating costs (maintenance, energy, repairs, coolants, and so on)
$800,000 $460,000
Equipment Replacement Decision (cont.)
Toledo Corporation uses straight-line depreciation. To focus on relevance, we ignore time value of money and income taxes.
Should Toledo replace its old machine?