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Relevant Information and Decision Making: Production Decisions

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Introduction to Management Accounting * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * Illustration of Sell or Process ... – PowerPoint PPT presentation

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Title: Relevant Information and Decision Making: Production Decisions


1
Introduction to Management Accounting
2
Introduction to Management Accounting
Chapter 6
Relevant Information for Decision Making with a
Focus on Operational Decisions
3
  • 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

4
  • 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

5
Opportunity, Outlay, and Differential Costs
Learning Objective 1
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.
6
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.
7
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
  • Increase production of Peach juice
  • Sell the machine
  • 3. Produce a new drink Papaya Mango

8
Opportunity Cost
Peach Juice Contribution margin is 60,000.
1
Sell machine for 50,000.
2
Produce Papaya Mango juice with projected sales
of 500,000.
3
9
Make-or-Buy Decisions
Learning Objective 2
Managers often must decide whether to produce a
product or service within the firm or purchase it
from an outside supplier.
10
Make or Buy Decisions
Nantucket Nectars Companys Cost of Making
12-ounce Bottles
11
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?
12
Relevant Cost Comparison
13
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?
14
Make or Buy and the Use of Facilities
Make
Buy and leave facilities idle
Buy and rent out facilities
Buy and use facilities for other products
(000)
Rent revenue 25
Contribution from other products
55 Variable cost
of bottles (170) (180) (180) (180)
Net relevant costs (170) (180) (155) (1
25)
15
Avoidable and Unavoidable Costs
Learning Objective 3
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.
16
Learning Objective 4
  • Choose whether to add
  • or delete a product line
  • using relevant information.

17
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.
18
Department Store Example
Consider a discount department store that has
three major departments
Groceries
General merchandise
Drugs
19
Department Store Example
Departments (000)
Groceries
General Mdse.
Drugs
Total
Sales 1,000 800 100 1,900 Variable
expenses 800 560 60
1,420 Contribution margin 200 240
40 480 Fixed expenses Avoidable
150 100 15 265 Unavoidable
60 100 20 180 Total fixed
expenses 210 200 35 445 Operating
income (10) 40 5 35
20
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.
21
Department Store Example
Store as a Whole (000)
Total Before Change
Effect of Dropping Groceries
Total After Change
Sales 1,900 1,000 900 Variable
expenses 1,420 800
620 Contribution margin 480
200 280 Avoidable fixed expenses 265
150 115 Profit contribution to common
space and other unavoidable costs 215
50 165 Unavoidable expenses 180
0 180 Operating income 35
50 (15)
22
Optimal Use of Limited Resources
Learning Objective 4
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.
23
Optimal Use of Limited Resources
24
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.
Why?
25
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.
26
Optimal Use of Limited Resources
Suppose that demand for either shoe would fill
the plants capacity. Now, capacity is the
limiting factor.
Which is more profitable?
If the limiting factor is capacity, the more
profitable product is Air Court.
Why?
27
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
28
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).
29
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
30
Joint Product Costs
Learning Objective 5
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.
31
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.
32
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.
Should Dow sell the products at the split-off
point or process them further?
33
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
34
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.
35
Illustration of Sell or Process Further
Sell at Split-off as Y
Process Further and Sell as YA
Difference
Revenues 30,000 80,000 50,000 Separable
costs beyond split-off _at_ .08
40,000 40,000 Income effects 30,000 40
,000 10,000
36
Equipment Replacement
Learning Objective 6
The book value of equipment is not a relevant
consideration in deciding whether to replace the
equipment.
Why?
Because it is a past, not a future cost.
37
Book Value of Old Equipment
Depreciation is the periodic allocation of the
cost of equipment.
The equipments book value (or net book value) is
the original cost less accumulated depreciation.
38
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 10,000
  • Accumulated depreciation (6 1,000)
    6,000
  • Book value 4,000

39
Keep or Replace the Old Machine?
40
Relevance of Equipment Data
A sunk cost is a cost already incurred and is
irrelevant to the decision-making process.
4 commonly encountered items
  • Book value of old equipment
  • Disposal value of old equipment
  • Gain or loss on disposal
  • Cost of new equipment

41
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.
42
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.
43
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.
44
Cost of New Equipment
The cost of new equipment is relevant because it
is an expected future outflow that will differ
among alternatives.
45
Cost Comparison
46
Irrelevant or Misspecified Costs
Learning Objective 7
The ability to recognize irrelevant costs is
important to decision makers.
Cost of obsolete inventory
Book value of old equipment
47
Irrelevant or Misspecified 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.
48
Irrelevant or Misspecified Costs
Remachine
Difference
Scrap
  • 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
  • Irrelevant because it is unaffected by the
    decision.

49
Irrelevant or Misspecified 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?
50
Irrelevant or Misspecified Costs
New Machine
Old Machine
Units 100,000 100,000 Variable cost
150,000 100,000 Straight-line
depreciation 0 20,000 Total
relevant costs 45,000 120,000 Unit
relevant costs 1.50 1.20
51
Irrelevant or Misspecified 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.
52
Irrelevant or Misspecified Costs
Old Machine
New Machine
Units 30,000 30,000 Variable
costs 45,000 30,000 Straight-line
depreciation 0 20,000 Total relevant
costs 45,000 50,000 Unit relevant costs
1.50 1.6667
53
Decision Making and Performance Evaluation
Learning Objective 8
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.
54
Decision Making and Performance Evaluation
Years 2, 3, and 4
Year 1
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 against revenue 6,000 6,500
6,000 5,000
55
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.
56
The End
End of Chapter 6
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