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Relevant Information and Decision Making: Production Decisions

Chapter 6
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 6-1

Opportunity, Outlay, and Differential Costs


Differential cost (or revenue) is the difference in total cost (or revenue) between two alternatives.

Incremental cost includes all of the costs of the other alternative plus some additional costs.

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Opportunity, Outlay, and Differential Costs


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.

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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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.

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Make-or-Buy Example
Nantucket Nectars Company Cost of Making 12-ounce Bottles Total Cost for 1,000,000 bottles Direct material Direct labour Variable overhead Fixed overhead Total costs $ 60,000 20,000 40,000 80,000 $200,000 Cost per bottle $.06 .02 .04 .08 $.20
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2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Make-or-Buy Example
Another manufacturer offers to sell Nantucket the same part for $.18. If the company buys the part, $50,000 of fixed overhead would be eliminated. Should Nantucket make or buy the part?

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Relevant Cost Comparison


Make Total Purchase cost Direct material $ 60,000 Direct labour 20,000 Variable overhead 40,000 Fixed OH unavoidable 30,000 Fixed OH avoided by not making 50,000 Total costs $200,000 Difference in favour of making $ 10,000 Per Bottle Total $180,000 $.06 .02 .04 .03 .05 $.20 $.01

Buy
Per Bottle $.18

30,000 0 $210,000

.03 0 $.21

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Relevant Cost Comparison


Make Total Purchase cost Direct material Direct labour Variable overhead Fixed OH avoided by not making Total relevant costs Difference in favour of making Per Bottle Total $180,000 $ 60,000 20,000 40,000 $.06 .02 .04

Buy
Per Bottle $.18

50,000 $170,000 $ 10,000

.05 $.17 $.01

0 $180,000

0 $.18

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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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 $35,000.

What are the alternatives?

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Make or Buy and the Use of Facilities


Buy and leave facilities idle
$ (180) $(180)

(000) Rent revenue Contribution from other products Variable cost of bottles Net relevant costs

Make $ (170) $(170)

Buy and use Buy and facilities rent out for other facilities products
$ 35 $ 55 (180) $(125)

(180) $(145)

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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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.
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 6 - 11

Joint Products
Split-off point Product A

Joint costs

Product B

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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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.

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Joint Product Costs


Suppose Dow Chemical Company produces 2 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.
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 6 - 14

Joint Product Costs


1,000,000 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

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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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 sales price of YA would be $.16 per liter, a total of $80,000.
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 6 - 16

Joint Products Revenue


1,000,000 litres of X @ RM0.09 = X RM90,000 500,000 litres of Y @ RM0.06 = Y RM30,000

Revenue

Joint processing cost RM100,000

500,000 litres of YA @ RM0.16 = YA RM80,000 Processing costs: 500,000 litres of YA @ RM0.08 RM40,000
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2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Illustration of Sell or Process Further


Sell at Split-off as Y Process Further and Sell as YA Difference

Revenue - Y Separable costs beyond split-off @ $.08 Revenue X Joint processing Income effects

$30,000

$80,000

$50,000

(40,000) 90,000 90,000 (100,000) (100,000) 20,000 $30,000

(40,000) -___ $10,000


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2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Irrelevance of Past Costs


The ability to recognize and thereby ignore irrelevant costs is important to decision makers.

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Example of Irrelevance of Obsolete Inventory


Suppose General Dynamics has 100 obsolete aircraft parts in its inventory. The original manufacturing cost of these parts was $100,000.

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Example of Irrelevance of Obsolete Inventory


General Dynamics can...

remachine the parts for $30,000 and then sell them for $50,000, or
scrap them for $5,000. Which should it do?
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 6 - 21

Example of Irrelevance of Obsolete Inventory


Remachine
Expected future revenue Expected future costs Relevant excess of revenue over costs Accumulated historical inventory cost* Net loss on project $ 50,000 30,000 $ 20,000 100,000 $(80,000) $

Scrap
5,000 0 5,000

Difference
$45,000 30,000 $15,000 0 $15,000

100,000 $ (95,000)

* Irrelevant because it is unaffected by the decision.

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Book Value of Old Equipment


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.

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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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.

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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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


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2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Keep or Replace an Old Machine ?


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 $10,000 10 6 4 $ 6,000 $ 4,000 $ 2,500 0 $ 5,000 Replacement Machine $8,000 4 0 4 0 N/A N/A 0 $3,000

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Cost Comparison
4 Years Together Keep Replace Difference Cash operating costs $20,000 Old equipment (book value): Depreciation, or 4,000 Lump-sum write-off Disposal value New machine acquisition cost Total costs $24,000 $12,000 4,000 (2,500) 8,000 $21,500 $8,000 2,500 (8,000) $2,500

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Make or Buy: Another Example


Sunshine Fruit Company sells premium-quality oranges by mail order. Protecting the fruit during shipping is important, so the company has designed & produces shipping boxes. The annual cost to make 80,000 boxes is:
Materials Labour Indirect manufacturing costs fixed Total 120,000 20,000 60,000 216,000

Indirect manufacturing costs variable 16,000

Cost per box = RM2.70.


2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 6 - 34

Make or Buy: Another Example


Suppose an external supplier submits a bid to supply Sunshine with boxes for RM2.40 per box. Sunshine must give the supplier the box design specifications, and the boxes will be made according to those specs. Question

How much, if any, would Sunshine save by buying the boxes from the external supplier?

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Make or Buy: Another Example


The key to this question is what will happen to the fixed overhead costs if production of the boxes is discontinued. Assume that all RM60,000 of fixed costs will continue. Then, Sunshine will lose RM36,000 by purchasing the boxes from the supplier: Payment to supplier 80,000 x $2.40 Costs saved, variable costs Additional costs $192,000 156,000 $ 36,000

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Make or Buy: Another Example


Question What subjective factors should affect Sunshines decision whether to make or buy the boxes?
Some subjective factors are: Might the supplier raise prices if Sunshine closed down its box-making facility? Will sub-contracting the box production affect the quality of the boxes? Is a timely supply of boxes assured, even if the number needed changes? Does Sunshine State sacrifice proprietary information when disclosing the box specifications to the supplier?
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 6 - 37

Make or Buy: Another


Question Suppose all the fixed costs represent depreciation on equipment that was purchased for RM600,000 and is just about at the end of its 10-year life. New replacement equipment will cost RM1 million and is also expected to last 10 years. In this case, how much, if any, would Sunshine save by buying the boxes from the supplier?
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 6 - 38

Make or Buy: Another Example


In this case the fixed costs are relevant. However, it is not the depreciation on the old equipment that is relevant. It is the cost of the new equipment. Annual cost savings by not producing the boxes now will be:

Variable costs Investment avoided (annualized) Total saved

$156,000 100,000 $256,000

The payment to supplier is $256,000-$192,000 = $64,000 less than the savings, so Sunshine would be $64,000 better off subcontracting the production of the boxes.
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 6 - 39

Joint Products: Another Example


The Mussina Chemical Company produced 3 joint products at a joint cost of RM117,000. These products were processed further & sold as follows: Chemical product A B C Sales 230,000 330,000 175,000 Additional processing costs 190,000 300,000 100,000
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2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Joint Products: Another Example


The company has had an opportunity to sell at split-off directly to other processors. If that alternative had been selected, sales would have been A: RM54,000, B: RM28,000, C: RM54,000.
The company expects to operate at the same level of production and sales in the forthcoming year. Consider all the available information, and assume that all cost incurred after split-off are variable.
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 6 - 41

Joint Products: Another Example


Question 1. Could the company increase operating income by altering its processing decisions? 2. If so, what would be the expected overall operating income? 3. Which products should be processed further and which should be sold at split-off?
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 6 - 42

Joint Products: Another Example


A B C Total

Sell at splitoff:
Process further:
-Revenue -Additional

54,000

28,000

54,000

136,000

230,000 (190,000)

330,000 (300,000)

175,000 (100,000)

735,000 (590,000)

processing costs 40,000 30,000 75,000 145,000


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2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Joint Products: Another Example


A B C Total

Sell at splitoff:
Process further:
-Revenue -Additional

54,000

28,000

54,000

136,000

230,000 (190,000)

330,000 (300,000)

175,000 (100,000)

735,000 (590,000)

processing costs 40,000 ACTION Sell @ splitoff 30,000 Process further 75,000 Process further
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145,000

2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Joint Products: Another Example


Expected overall operating income:
A: 54,000 + B: 30,000 + C: 75,000 Joint costs 117,000 = RM42,000
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 6 - 45