Chapter 10
Relevant Information
and Decision
Making:
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 2
Learning Objective 1
Use opportunity cost to
analyze the income
Costs
An opportunity cost is the maximum available contribution to profit forgone (or passed up)
by using limited resources for a particular purpose.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 4
Costs
Differential cost and incremental cost are
Learning Objective 2
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Make-or-Buy Decisions
The basic make-or-buy question is whether
a company should make its own parts to be used in its products or buy them from
Make-or-Buy Decisions
Qualitative Factors: Control quality
Protect long-term relationships with suppliers
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 8
Make-or-Buy Example
GE Company Cost of Making Part N900:
Total Cost for Cost
Make-or-Buy Example
Another manufacturer offers to sell GE the
same part for $10.
The essential question is the difference in
expected future costs between the alternatives.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 10
Make-or-Buy Example
If the $4 fixed overhead per unit consists of
costs that will continue regardless of the decision, the entire $4 becomes irrelevant.
If $20,000 of the fixed costs will be
Relevant Cost Comparison
Make Buy
Total Per Unit Total Per Unit
Purchase cost $200,000 $10
Direct material $ 20,000 $ 1 Direct labor 80,000 4 Variable overhead 40,000 2 Fixed OH avoided by
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 12
Learning Objective 3
Decide whether a joint product
should be processed beyond
Joint Products
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
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 14
Joint Products
Separable costs are any costs beyond the split-off point.
Illustration of Joint 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
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 16
Illustration of Joint 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
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
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 18
Illustration of
Sell or Process Further
Revenue $30,000 $80,000 $50,000
Separable costs beyond split-off
@ $.08 – 40,000 40,000
Income effects $30,000 $40,000 $10,000
Sell at Split-off
as Y
Process Further and
Learning Objective 4
Identify irrelevant information
in disposal of obsolete inventory
and equipment replacement
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 20
Irrelevance of Past Costs
Two examples of past costs that we can
consider, to see why they are irrelevant to decisions, are:
1 The cost of obsolete inventory
Example of Irrelevance of
Obsolete Inventory
Suppose General Dynamics has 100
obsolete aircraft parts in its inventory.
The original manufacturing cost of these
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 22
Example of Irrelevance of
Obsolete Inventory
General Dynamics can...
1 remachine the parts for $30,000 and then
sell them for $50,000, or
2 scrap them for $5,000.
Example of Irrelevance of
Obsolete Inventory
Remachine Scrap Difference
Expected future revenue $ 50,000 $ 5,000 $45,000
Expected future costs 30,000 0 30,000
Relevant excess of
revenue over costs $ 20,000 $ 5,000 $15,000
Accumulated historical
inventory cost* 100,000 100,000 0
Net loss on project $(80,000) $ (95,000) $15,000
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Irrelevance of Book Value
of Old Equipment
The book value of equipment is not a relevant consideration in deciding
whether to replace the equipment.
Why?
Irrelevance of Book Value
of Old Equipment
Depreciation is the periodic allocation of the cost of equipment.
The equipment’s book value (or net book value)
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Example of Book Value
Computation
Suppose a $10,000 machine with a 10-year life has depreciation of $1,000 per year.
What is the book value at the end of 6 years?
Original cost $10,000
Accumulated depreciation (6 × $1,000) 6,000
Keep or Replace an Old
Machine?
Old Replacement
Machine Machine
Original cost $10,000 $8,000
Useful life in years 10 4
Current age in years 6 0
Useful life remaining in years 4 4
Accumulated depreciation $ 6,000 0
Book value $ 4,000 N/A
Disposal value (in cash) now $ 2,500 N/A
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Keep or Replace an Old
Machine?
What is a sunk cost?
A sunk cost is a cost that has already been
Relevance of Equipment Data
In deciding whether to replace or keep
existing equipment, we must consider the relevance of four commonly encountered items:
1 Book value of old equipment
2 Disposal value of old equipment
3 Gain or loss on disposal
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Book Value of Old Equipment
The book value of old equipment is
irrelevant because it is a past (historical) cost.
Therefore, depreciation on old equipment is
Disposal Value of Old Equipment
The disposal value of old equipment is
relevant (ordinarily) because it is an
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 32
Gain or Loss on Disposal
This is the difference between book value
and disposal value.
It is therefore a meaningless combination of
irrelevant (book value) and relevant items (disposal value).
Cost of New Equipment
The cost of the new equipment is relevant
because it is an expected future outflow that will differ among alternatives.
Therefore depreciation on new equipment is
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 34
Comparative Analysis
of the Two Alternatives
Four Years Together
Keep Replace Difference
Cash operating costs $20,000 $12,000 $ 8,000
Old equipment (book value)
depreciation, or 4,000 – –
lump-sum write-off 4,000 –
Disposal value – (2,500) 2,500
New machine
acquisition cost – 8,000 (8,000)
Learning Objective 5
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Beware of Unit Costs
There are two major ways to go wrong
when using unit costs in decision making:
1 The inclusion of irrelevant costs
2 Comparisons of unit costs not computed on
Example of
Volume Basis Decision
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
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 38
Example of
Volume Basis Decision
Old New
Machine Machine
Units 100,000 100,000
Variable cost per unit $1.50 $1.00
Variable costs $150,000 $100,000
Straight-line depreciation 0 20,000
Total relevant costs $150,000 $120,000
Example of
Volume Basis Decision
It appears that the new machine will reduce
costs by $.30 per unit.
However, if the expected volume is only
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 40
Example of
Volume Basis Decision
Old New
Machine Machine
Units 30,000 30,000
Variable cost per unit $1.50 $1.00
Variable costs $45,000 $30,000
Straight-line depreciation 0 20,000
Total relevant costs $45,000 $50,000
Learning Objective 6
Discuss how performance
measures can affect
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 42
Performance Measures Can
Affect Decision Making
To motivate managers to make the right
choices, the method used to evaluate
Example of Affect on
Decision Making
Consider the replacement decision,
discussed earlier, where replacing the machine had a $2,500 advantage over keeping it.
Because performance is often measured by
accounting income, consider the accounting income in the first year after replacement
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 44
Example of Affect on
Decision Making
Year 1 Years 2, 3, and 4
Keep Replace Keep Replace
Cash operating
costs $5,000 $3,000 $5,000 $3,000
Depreciation 1,000 2,000 1,000 2,000
Loss on disposal
($4,000 – $2,500) 0 $1,500 0 0
Total charges
Example of Affect on
Decision Making
If the machine is kept rather than replaced, first-year costs will be $500 lower
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 46
Learning Objective 7
Construct absorption and
contribution format income
Absorption Approach
The absorption approach is a costing
approach that considers all factory overhead (both variable and fixed) to be product
(inventoriable) costs.
Factory overhead becomes an expense in
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 6 - 48
Contribution Approach
In contrast, the contribution approach is
used by many companies for internal (management accounting) reporting.
It emphasizes the distinction between
variable and fixed costs.
The contribution approach is not allowed
Comparing Contribution and
costs Nonmanufacturingcosts
A. Variable
10 - 50
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