‘’CHAPTER 4: DECISION MAKING AND RELEVANT INFORMATION

- Theories: understanding relevant and non-relevant information

- One time only special order
- Insourcing vs Outsourcing
- Opportunity cost approach
- Carrying cost inventory
- Product mix decision
- Bottlenecks, theory of constraints
- Dropping customers & adding customers
- Closing or adding branch offices
- Decision making and performance evaluation
 These are among the short run decision making

Theories: Understanding Relevant & Non-relevant information

A decision model is a formal method of making a choice that often involves both quantitative
and qualitative analyses.
The concept of relevance information:
- Relevant cost: are expected future costs that differ among the alternative courses of
action being considered.
- Relevant revenues: are expected future revenues that differ among the alternative
courses of action being considered.
- Costs and revenues that are not relevant are called irrelevant.

Opportunity cost: is the contribution to operating income that is forgone by not using a limited
resource in its next-best alternative use.

Studying accounting at the university Income sacrificed by not

working
(Tuition fees, food, hostel, etc – relevant cost) (Opportunity cost)

Sunk Cost
- Past costs (historical costs) are never relevant and are also called sunk costs
- Costs that have already occurred and cannot be changed are classified as sunk costs.
- Sunk costs are excluded because they cannot be changed by future actions.
-
Qualitative and Quantitative Relevant Information
Quantitative factors are the outcomes that can be measured in financial terms
Qualitative factors are the outcomes that can’t be measured in financial terms (e.g. employee
morale).

Terms we need to know before we do the decision making:

• Incremental cost—the additional total cost incurred for an activity.
• Differential cost—the difference in total cost between two alternatives.
• Incremental revenue—the additional total revenue from an activity.
• Differential revenue—the difference in total revenue between two alternatives.

Managers should avoid two potential problems in relevant–cost analysis:

1. Avoid incorrect general assumptions such as that “All variable costs are
relevant and all fixed costs are irrelevant.” Even in our simple example, we
had irrelevant, variable marketing costs.
2. Be aware that unit-fixed-cost data can potentially mislead managers in two
ways.

(a) Fixed unit costs might include irrelevant costs; costs that will not change whether
or not the one-time only order is accepted or not.
(b) If using the same unit fixed costs at different output levels, managers may reach
erroneous conclusions. Total fixed costs should be used.

Example: Determining Relevant Revenues and Relevant Costs for Sport Style Company
Whether to reorganize the schedule for operation or not
All revenues and costs Relevant revenues and costs
Alternative 1: Alternative Alternative 1: Alternative
Do not 2: Do not 2:
organize Reorganize organize Reorganize
$ $ $ $
Revenues 6,250,000 6,250,000 - -
Costs:
Direct materials 1,250,000 1,250,000 - -
Manufacturing labor 640,000 480,000 640,000 480,000
Manufacturing 750,000 750,000 - -
overhead
Marketing 2,000,000 2,000,000 - -
Reschedule costs - 90,000 - 90,000
Total costs 4,640,000 4,570,000 640,000 570,000
Operating income 1,610,000 1,680,000 (640,000) (570,000)
$70,000 difference $70,000 difference
Note: Other costs are irrelevant because these cost will remain the same whether company
reorganize or not organize. Sport Style should do the re-organization, because it helps to reduce
the manufacturing labor up to $160,000 ($640,000 – $480,000). Although the reschedule cost
is $90,000, Sport Style still make higher operating income by doing the re-organization.
Example: Disposal of asset
A company has an inventory of 1,300 assorted parts for a line of automobiles that has been
discontinued. The inventory cost is $71,000. The parts can be either (a) remachined at total
additional costs of $27,500 and then sold for $31,500 or (b) sold as scrap for $6,000. Which
action is more profitable? Show your calculations.
Solution:

The $71,000 of inventory costs are irrelevant regarding the decision to remachine or scrap
because it is a historical cost. The only relevant factors are the future revenues and future costs.
By ignoring the accumulated costs and deciding on the basis of expected future costs, operating
income will be maximized (or losses minimized). The difference in favor of selling as scrap is
$2,000:

Remachine Scrap

Future revenues $31,500 $6,000

Deduct future costs $27,500 -

Operating income $4,000 $6,000

Difference in favour of scrap $2,000

Example: Relevant / Irrelevant Information
Razak Computers makes 5,700 units of powerbanks, at a cost of $230 each. Variable cost
per unit is $180 and fixed cost per unit is $50. Ahmad Electronics offers to supply 5,700
units of powerbank for $210. If Razak buys from Ahmad, it will be able to save $20 per unit
in fixed costs but continue to incur the remaining $30 per unit. Should Razak accept Ahmad’s
offer? Explain. (make or buy decision).

Solution:
Make Buy
Relevant costs
Variable costs 180
Avoidable fixed costs 20
Purchased price 210
Unit relevant cost 200 210

Razak Computers should reject Ahmad’s offer. The $30 of fixed costs is irrelevant because it
will be incurred regardless of this decision. When comparing relevant costs between the
choices, Ahmad’s offer price is higher than the cost to continue to produce.
Example: Rara Manufacturing is deciding whether to keep or replace an old machine. It
obtains the following information:

Old Machine New Machine

Original cost $10,800 $8,800
Useful life 9 years 5 years
Current age 4 years 0 years
Remaining useful life 5 years 5 years
Accumulated depreciation $4,800 Not acquired yet
Book value $6,000 Not acquired yet
Current disposal value (in cash) $2,800 Not acquired yet
Terminal disposal value (5 years from now) $0 $0
Annual cash operating costs $18,000 $15,000

Rara Manufacturing uses straight-line depreciation. Ignore the time value of money and income
taxes. Should Rara Manufacturing replace the old machine? Explain.

Solution
Keep Replace Difference
Cash operating costs (5 years) $90,000 $75,000 $15,000
Current disposal value of old machine (2,800) 2,800
Cost of new machine 8,800 (8,800)
Total relevant costs $90,000 $81,000 $9,000

Rara Manufacturing should replace the old machine. The cost to purchase the new machine
are less than the cost to keep and operate the old machine.

ONE TIME ONLY SPECIAL ORDER

- Situation where it involves accepting or rejecting special orders when there is idle production
capacity and the special orders have no long-run implications.
Example: BEES BLANKET
Bees Blanket manufactures high quality blanket at its highly automated plant in Durham, UK.
The plant has a production capacity of 45,000 blankets each month. Current production is
30,000 blankets. Retail department stores account for all existing sales. Table 1 shows the
expected results for the coming month (August). These amounts are prediction based on past
data. We assume that in the short run all costs can be classified as either fixed or variable for
a single cost driver (units of output).
Amanda Hotel is a luxury hotel chain that purchases blankets from Owl Blanket Corporation.
The workers at Owl Blanket are on strike, so Amanda Hotel must find a new supplier. In August,
Amanda Hotel contacts Bees Blanket and offers to buy 5,000 blankets from them at $11 per
blanket. Based on the following facts, should Bees Blanket’s managers accept Amanda Hotel’s
offer?
The management accountant gathers the following additional information:
- No subsequent sales to Amanda Hotel are anticipated.
- Fixed manufacturing costs are based on 45,000-blanket production capacity. That is, fixed
manufacturing costs relate to the production capacity available and not the actual capacity used.
If Bee Blanket accepts the special order, it will use existing idle capacity to produce the 5,000
blankets and fixed manufacturing costs will not change.
- No marketing costs will be necessary for the 5,000-unit one-time-only special order.
- Accepting this special order is not expected to affect the selling price or the quantity of blanket
sold to regular customers.

Table 1: Budgeted Income Statement for August for Bees Blanket Corporation
Total Per Unit
Units sold 30,000

Revenues $600,000 $20.00

Cost of good sold (manufacturing costs)
Variable manufacturing costs 225,000 7.50b
Fixed manufacturing costs 135,000 4.50c
Total cost of good sold 360,000 12.00
a
Marketing costs
Variable marketing costs 150,000 5.00
Fixed marketing costs 60,000 2.00
Total marketing costs 210,000 7.00
Full cost of the product 570,000 19.00
Operating income 30,000 1.00
a
Bees Blanket incurs no R&D, product design, distribution or customer-service costs
b
Variable manufacturing cost per unit = Direct material cost per unit + Variable direct
manufacturing labor cost per unit + Variable manufacturing overhead cost per unit
= $6.00 + $0.50 + $1.00 = $7.50
c
Fixed manufacturing cost per unit = Fixed direct manufacturing labor cost per unit +
Fixed manufacturing overhead cost per unit
= $1.50 + $3.00 = $4.50
 One-time only special order decision for Bees Blanket Corporation: Comparative
Contribution Income Statements
Without special order: 30,000 With the Difference:
units to be sold special order: Relevant
($) 35,000 units to Amounts for the
be sold 5000 units
($) special order
($)
Per unit ($) Total ($) Total ($) ($)
(1) (2) = (1) x (3) (4) = (3) - (2)
30,000
Revenues 20 600,000 655,000 55,000a
Variable costs:
Manufacturing 7.5 225,000 262,500 37,500b
Marketing 5.00 150,000 150,000 0
Total variable 12.50 375,000 412,500 37,500
costs
Contribution 7.50 225,000 242,500 17,500
margin
Fixed costs:
Manufacturing 4.50 135,000 135,000 0
Marketing 2.00 60,000 60,000 0
Total fixed 6.50 195,000 195,000 0
costs
Operating income $1.00 $30,000 $47,500 $17,500
a
5,000 units x $11.00 per unit = $55,000.
b
5,000 units x $7.50 per unit = $37,500
No variable marketing costs would be incurred for the 5,000-unit-one-time only special
order
Fixed manufacturing costs and fixed marketing costs would be irrelevant cost by this
special order. Bees Blanket should accept the order from Amanda Hotel because it will
increase the operating income by $17,500, fixed cost will not be changed, and it has higher
contribution margin.
Example:
The Great Window Company manufactures windows. Its manufacturing plant has the capacity
to produce 12,000 windows each month. Current production and sales are 10,000 windows per
month. The company normally charges $250 per window. Cost information for the current
activity level is as follows:
Variable costs that vary with number of units produced
Direct materials $600,000
Direct manufacturing labor $700,000
Variable costs (for set ups, materials handling, quality control, and so on) that
vary with number of batches, 100 batches x $1,500 per batch
Fixed manufacturing costs 250,000
Fixed marketing costs 400,000
Total costs $2,100,000
The Great Window Company has just received a special one-time-only order for 2,000
windows at $225 per window. Accepting the special order would not affect the company’s
regular business or its fixed costs. The Great Window Company makes windows for its existing
customers in batch sizes of 100 windows (100 batches  100 windows per batch = 10,000
windows). The special order requires The Great Window Company to make the windows in 25
batches of 80 windows. Should this company accept this special order? Show your calculations.
SOLUTION
Direct materials cost per unit ($600,000  10,000 units) = $60 per unit
Direct manufacturing labor cost per unit ($700,000  10,000 units) = $70 per unit
Variable cost per batch = $1,500 per batch
The Great Window’s operating income under the alternatives of accepting/rejecting the special
order are:
Without One-Time Only With One-Time Only Difference
Special Order Special Order 2,000
10,000 Units 12,000 Units Units
Revenues $2,500,000 $2,950,000 $450,000
Variable costs:
1
Direct materials 600,000 720,000 120,000
2
Direct 700,000 840,000 140,000
manufacturing labor
3
Batch 150,000 187,500 37,500
manufacturing cost
Fixed costs:
Fixed 250,000 250,000 ––
manufacturing costs
Fixed marketing 400,000 400,000 ––
costs
Total cost 2,100,000 2,397,500 297,500

Operating income $ 400,000 $ 552,500 $152,500

1
$600,000 + ($60  2,000 units) 2
$700,000 + ($70  2,000 units) 3
$150,000 + ($1,500
 25 batches)

The Great Window should accept the one-time-only special order if it has no long-term
implications because accepting the order increases The Great Window’s operating income by
$152,500.
If, however, accepting the special order would cause the regular customers to be
dissatisfied or to demand lower prices, then the Great Window will have to trade off the
$152,500 gain from accepting the special order against the operating income it might lose from
regular customers.

INSOURCING-VERSUS-OUTSOURCING AND MAKE-OR-BUY DECISIONS

Outsourcing and Idle Facilities

- Outsourcing is purchasing goods and services from outside vendors rather than insourcing,
producing the same goods or providing the same services within an organization.
- Decisions about whether a producer of goods or services will insource or outsource are
called make-or-buy decisions.

- Factors that managers need to consider in a make-or-buy decision: quality, dependability

of suppliers to deliver according to a schedule, costs, and sometimes qualitative factors
dominate management’s make or buy decision.

Example:
The Xeno Company manufactures a two-in-one video system consisting of a DVD player and
a digital media receiver (that download movies and video from internet sites such as Netflix).
Columns 1 and 2 of the following table show the expected total and per-unit costs for
manufacturing the DVD player. The Xeno plans to manufacture the 250,000 units in 2,000
batches of 125 units each. Variable batch-level costs of $625 per batch vary with the number
of batches, not the total units produced.

Bobo Incorporation, a manufacturer of DVD players, offers to sell Xeno 250,000 DVD players
next year for $64 per unit on Xeno’s preferred delivery schedule. Assume that financial factors
will be the basis of this make-or-buy decision. Should Xeno’s managers make or buy the DVD
player?
 Expected Total Costs of Expected
Producing 250,000 units in Cost per
2,000 Batches Next Year Unit
(1) (2) = (1) /
$ 250,000
$
Direct materials ($36 per unit x 250,000 9,000,000 36.00
units)
Variable direct manufacturing labor ($10 per 2,500,000 10.00
unit x 250,000 units)
Variable manufacturing overhead costs of 1,500,000 6.00
power and utilities ($6 per unit x 250,000
units)
Mixed (variable and fixed) batch-level 2,000,000 8.00
manufacturing overhead costs of material
handling and setup [$750,000 + ($625 per
batch x 2,000 batches)]
Fixed manufacturing overhead costs of plant 3,000,000 12.00
lease, insurance and administration
Total manufacturing cost $18,000,000 $72.00

Relevant (Incremental) Items for Make-or-Buy Decision for DVD Players at Xeno Company

Total Relevant Costs Relevant Cost

Per Unit
Relevant Items Make Buy Make Buy
$ $ $ $
Outside purchase of parts ($64 x 250,000 16,000,000 64
units)
Direct materials 9,000,000 36
Direct manufacturing labor 2,500,000 10
Variable manufacturing overhead 1,500,000 6
Mixed (variable and fixed) materials - 2,000,000 8
handling and setup overhead
Total relevant costs $15,000,000 $16,000,000 $60 $64

So, Xeno should make rather than buy. The total relevant cost is cheaper when Xeno make it
rather than buy.
Product-Mix Decisions with Capacity Constrains
- Product-mix decision: decisions managers make about which products to sell and in
what quantities.
Example: Power Equipment assembles two machine, that is Machine A and Machine B, at
its Pasir Gudang, Johor, factory. The following table shows the selling prices, costs, and
contribution margins of these two machine.
Machine A Machine B
Selling price $800 $1,000
Variable cost per unit 560 625
Contribution margin per unit 240 375
Contribution-margin 30% 37.5%
percentage

Only 600 machine-hours are available daily for assembling machines. Additional capacity
cannot be obtained in the short run. Power Equipment can sell as many machine as it produces.
The constraining resource, then, is machine-hours. It takes two machine-hours to produce
Machine A and five machine-hours to produce one Machine B. What product mix should
Power equipment’s managers choose to maximize operating income?
SOLUTION
- if we look at the contribution margin per unit, and contribution margin percentage, we can
see that the Machine B are more profitable than machine A.
- Nevertheless, that is not the only determination for us to choose the product mix.
- Managers should choose the product with the highest contribution margin per unit of the
constraining resource (factor). That’s the resource that restricts or limits the production or sale
of products.
Machine A Machine B
Contribution margin per unit $240 $375
Machine-hours required to produce one unit 2 machine hours 5 machine hours
Contribution margin per machine hour
$240 per unit / 2 machine-hours/ unit $120/ machine-
hour
$375 per unit / 5 machine-hours/ unit $75/ machine
hour
Total contribution margin for 600 machine-hours
$120/ machine hour x 600 machine-hours $72,000
$75/ machine-hour x 600 machine-hours $45,000
- the number of machine hours is the constraining resource in this example, and Machine A
earn more contribution margin per machine-hour ($120/ machine-hour) compared with
Machine B ($75/ machine-hour).
- Therefore, choosing to produce and sell Machine A maximizes total contribution margin
($72,000 vs $45,000 from producing and selling Machine B) and operating income.
Bottlenecks, Theory of Constraints and Throughput-Margin Analysis
- Theory of constraints (TOC) describes methods to maximize operating income when faced
with some bottleneck and some non-bottleneck operations.
To implement TOC, three measures will be used:
1. Throughput margin = revenues - the direct material costs of the goods sold. Which means,
it only consider direct material cost only when calculating margin, while normally in
contribution margin we calculate as = revenue – variable costs.
2. Investments = the sum of (a) material costs in the direct materials, work-in-process and
finished good inventories; (b) R&D costs, and (c) capital costs of equipment and buildings.
3. Operating costs = all costs of operations (other than direct materials) incurred to earn
throughput margin. Operating costs include costs such as salaries and wages, rent, utilities and
depreciation.
The objective of TOC is to increase throughput margin while decreasing investments and
operating costs.
TOC focuses on managing bottleneck operations.
*A bottleneck is a phenomenon where the performance or capacity of an entire system is
limited by a single or limited number of components or resources.

Bottleneck is a department in a manufacturing that is often need longer hours than other
department. Or situation where other departments already completed their part, but it seems in
certain department can’t deliver, so that department is bottleneck. The existence of bottleneck
slower the whole process of manufacturing.
(Draw the picture of a bottle)

Example:
The Classy Cabinet Corporation manufactures clothing cabinets in two operations: machining
and finishing. It provides the following information:
Machining Finishing
Annual capacity 120,000 units 100,000 units
Annual production 100,000 units 100,000 units
Fixed operating costs (excluding direct material) $600,000 $300,000
Fixed operating costs per unit produced $6 per unit $3 per unit
($600,000/ 100,000; $300,000/100,000)
Each cabinet sells for $75 and has direct material costs of $35 incurred at the start of the
machining operation. Classy Cabinet has no other variable costs. Classy Cabinet can sell
whatever output it produces. The following requirements refer only to the preceding data. There
is no connection between the requirements.

(Personal note: if we look at this table, the capacity for machining is 120,000, but the firms
operation is constraint by the finishing department with only 100,000 capacity. So, finishing is
bottleneck given that machining actually have no problem to deliver 120,000 but finishing can’t
cope for it. So TOC aims to focus on handling the finishing department).

Required:
1. Classy Cabinet is considering using some modern jigs and tools in the finishing operation
that would increase annual finishing output by 1,150 units. The annual cost of these jigs
and tools is $35,000. Should Classy Cabinet acquire these tools? Show your calculations.
2. The production manager of the Machining Department has submitted a proposal to do faster
setups that would increase the annual capacity of the Machining Department by 9,000 units
and would cost $20,000 per year. Should Classy Cabinet implement the change? Show your
calculations.
3. An outside contractor offers to do the finishing operation for 10,000 units at $9 per unit,
triple the $3 per unit that it costs Classy Cabinet to do the finishing in-house. Should Classy
Cabinet accept the subcontractor’s offer? Show your calculations.
4. The Hammond Corporation offers to machine 5,000 units at $3 per unit, half the $6 per unit
that it costs Classy Cabinet to do the machining in-house. Should Classy Cabinet accept
Hammond’s offer? Show your calculations.
5. Classy Cabinet produces 2,000 defective units at the machining operation. What is the cost
to Classy Cabinet of the defective items produced? Explain your answer briefly.
6. Classy Cabinet produces 2,000 defective units at the finishing operation. What is the cost
to Classy Cabinet of the defective items produced? Explain your answer briefly.

Solution
1. Finishing is a bottleneck operation. Therefore, producing 1,150 more units will
generate additional contribution (throughput) margin and operating income.

Increaseincontribution(throughput)margin($75–$35)1,150
Incrementalcostsofthejigsandtools
Increaseinoperatingincomeinvestinginjigsandtools

Classy Cabinet should invest in the modern jigs and tools because the benefit of higher
contribution (throughput) margin of $46,000 exceeds the cost of $35,000.

2. The Machining Department has excess capacity and is not a bottleneck operation.
Increasing its capacity further will not increase contribution (throughput) margin. There is,
therefore, no benefit from spending $20,000 to increase the Machining Department's capacity
by 9,000 units. Classy Cabinet should not implement the change to do setups faster.
3. Finishing is a bottleneck operation. Therefore, getting an outside contractor to
produce 10,000 units will increase contribution (throughput) margin.

Increase in contribution (throughput) margin ($75-$35) x 10,000 $400,000

Incremental contracting costs $9 x 10,000 $90,000
Increase in operating income by contracting 10,000 units of finishing $310,000
Classy Cabinet should contract with an outside contractor to do 10,000 units of finishing at $9
per unit because the benefit of higher throughput margin of $400,000 exceeds the cost of
$90,000. The fact that the cost of $9 per unit is three times Classy Cabinet's finishing cost of
$3 per unit is irrelevant.

4. Operating costs in the Machining Department of $600,000, or $6 per unit, are fixed
costs. Classy Cabinet will not save any of these costs by subcontracting machining of 5,000
units to Hammond Corporation. Total costs will be greater by $15,000 ($3 per unit  5,000
units) under the subcontracting alternative. Machining more filing cabinets will not increase
contribution (throughput) margin, which is constrained by the finishing capacity. Classy
Cabinet should not accept Hammond’s offer. The fact that Hammond’s costs of machining per
unit are half of what it costs Classy Cabinet in-house is irrelevant.

5. The cost of 2,000 defective units in the Machining Operation is $35 per unit  2,000
units = $70,000. Because the Machining Operation has a capacity of 120,000 units, it can still
produce and transfer 100,000 good units to the Finishing Operation. There is, therefore, no
opportunity cost of producing defective units in the Machining Operation.

6. The cost of 2,000 defective units in the Finishing Operation is:

Cost of direct materials used in the defective units of $35 per unit x 2,000 units $70,000
Opportunity cost, lost contribution (throughput) margin $40 per unit x 2,000 $80,000
units
Total cost of defective units in the Finishing Operation $150,000

Alternatively, the cost of 2,000 defective units in the Finishing Operation equals the revenues
lost by selling 2,000 fewer units = $75 per unit  2,000 units = $150,000. The cost of the
defective unit at a bottleneck operation is much higher than at a non-bottleneck operation
because of the opportunity cost of lost contribution margin at the bottleneck operation.\
OPPORTUNITY COST
The Wild Orchid Corporation is working at full production capacity producing 13,000 units of
a unique orchid variance, Ever. Manufacturing cost per unit for Ever is:

Direct materials $10

Variable direct manufacturing labor 2
Manufacturing overhead 14
Total manufacturing cost $26
Manufacturing overhead cost per unit is based on variable cost per unit of $8 and fixed costs
of $78,000 (at full capacity of 13,000 units). Marketing cost per unit, all variable, is $4, and
the selling price is $52.

A customer, the Tulips Company, has asked Wild Orchid to produce 3,500 units of Forever,
a modification of Ever. Forever would require the same manufacturing processes as Ever.
Tulips has offered to pay Wild Orchid $40 for a unit of Forever and share half of the marketing
cost per unit.
Required:
1. What is the opportunity cost to Wild Orchid of producing the 3,500 units of Forever?
(Assume that no overtime is worked.)
2. The Carnation Corporation has offered to produce 3,500 units of Ever for Wild Orchid so
that Wild Orchid may accept the Tulips offer. That is, if Wild Orchid accepts the Carnation
offer, Wild Orchid would manufacture 9,500 units of Ever and 3,500 units of Forever and
purchase 3,500 units of Ever from Carnation. Carnation would charge Wild Orchid $36 per
unit to manufacture Ever. On the basis of financial considerations alone, should Wild
Orchid accept the Carnation offer? Show your calculations.
3. Suppose Wild Orchid had been working at less than full capacity, producing 9,500 units of
Ever, at the time the Tulips offer was made. Calculate the minimum price Wild Orchid
should accept for Forever under these conditions. (Ignore the previous $40 selling price.)

SOLUTION
1. The opportunity cost to Wild Orchid of producing the 3,500 units of Forever is the
contribution margin lost on the 3,500 units of Ever that would have to be forgone,
as computed below:
Selling price $52
Variable costs per unit:
Direct materials $10
Direct manufacturing labor $2
Variable manufacturing overhead $8
Variable marketing costs $4 $24
Contribution margin per unit $28
Contribution margin for 3,500 units ($28 x 3,500 units) $98,000
The opportunity cost is $98,000. Opportunity cost is the maximum contribution to
operating income that is forgone (rejected) by not using a limited resource in its next-best
alternative use.
 2. Contribution margin from manufacturing 3,500 units of Forever and purchasing 3,500
units of Ever from Carnation is $105,000, as follows:
Manufacture Purchase Total
Forever Ever
Selling Price 40 52
Variable costs per unit:
Purchase cost - 36
Direct materials 10
Direct manufacturing labor 2
Variable manufacturing costs 8
Variable marketing overhead 2 4
Variable cost per unit 22 40
Contribution margin per unit 18 12
Contribution margin from selling 3,500 units of 63,000 42,000 105,000
Forever and 3,500 units of Ever
($18 x 3,500; $12 x 3,500)
As calculated in requirement 1, Wild Orchid’s contribution margin from continuing to
manufacture 3,500 units of Ever is $98,000. Accepting the Tulips Company and Carnation
offer will benefit Wild Orchid by $7,000 ($105,000 – $98,000). Hence, Wild Orchid should
accept the Tulips Company and Carnation Corporation’s offers.

3. The minimum price would be any price greater than $22, the sum of the incremental
costs of manufacturing and marketing Forever as computed in requirement 2. This follows
because, if Wild Orchid has surplus capacity, the opportunity cost = $0. For the short-run
decision of whether to accept Tulips’s offer, fixed costs of Wild Orchid are irrelevant. Only
the incremental costs need to be covered for it to be worthwhile for Wild Orchid to accept the
Tulip’s offer.
Customer Profitability and Relevant Costs
- Sometimes, managers also need to make decision whether to add or drop customers
(analogous to a product line) or a branch office (analogous to a business segment or division)
- This is the example of relevant-revenue and relevant-cost analysis for these decisions using
customers rather than products as the cost object.

Relevant-Revenue and Relevant-Cost analysis of Dropping/ Adding a Customer

Newbury Printers operates a printing press with a monthly capacity of 3,200 machine-hours.
Newbury has two main customers: Wallace Corporation and Kimberly Corporation. Data on
each customer for January are:

Wallace Corporation Kimberly Corporation Total

Revenues 240,000 160,000 400,000
Variable costs 129,600 112,000 241,600
Contribution margin 110,400 48,000 158,400
Fixed costs (allocated) 75,000 50,000 125,000
Operating income 35,400 2,000 33,400
Machine-hours required 2,400 hours 800 hours 3,200
hours

Kimberly Corporation indicates that it wants Newbury to do an additional $160,000 worth of

printing jobs during February. These jobs are identical to the existing business Newbury did
for Kimberly in January in terms of variable costs and machine-hours required. Newbury
anticipates that the business from Wallace Corporation in February will be the same as that in
January. Newbury can choose to accept as much of the Wallace and Kimberly business for
February as its capacity allows. Assume that total machine-hours and fixed costs for February
will be the same as in January.

What action should Newbury take to maximize its operating income? Show your calculations.
What other factors should Newbury consider before making a decision?
SOLUTION
If Newbury accepts the additional business from Kimberly, it would take an additional 800
machine-hours. If Newbury accepts all of Kimberly’s and Wallace’s business for February, it
would require 4,000 machine-hours (2,400 hours for Wallace and 1,600 hours for Kimberly).
Newbury has only 3,200 hours of machine capacity. It must, therefore, choose how much of
the Wallace or Kimberly business to accept.
To maximize operating income, Newbury should maximize contribution margin per
unit of the constrained resource. (Fixed costs will remain unchanged at $125,000 regardless of
the business Newbury chooses to accept in February and are, therefore, irrelevant.) The
contribution margin per unit of the constrained resource for each customer in January is:

Wallace Corporation Kimberly Corporation

Contribution margin per $110,400/ 2,400 = $46 $48,000/800 = $60
machine-hour

Because the $160,000 of additional Kimberly business in February is identical to jobs

done in January, it will also have a contribution margin of $60 per machine-hour, which is
greater than the contribution margin of $46 per machine-hour from Wallace. To maximize
operating income, Newbury should first allocate all the capacity needed to take the Kimberly
Corporation business (1,600 machine-hours) and then allocate the remaining 1,600 (3,200 –
1,600) machine-hours to Wallace.
Wallace Corporation Kimberly Total
Corporation
Contribution margin 46 60
per machine-hour
Machine-hours to be X 1,600 X 1,600
worked
Contribution margin $73,600 $96,000 $169,000
Fixed costs 125,000
Operating income $44,600

An alternative approach is to use the opportunity cost approach. The opportunity cost
of giving up 800 machine-hours for the Wallace Corporation jobs is the contribution margin
forgone of $46 per machine-hour  800 machine-hours equal to $36,800. The contribution
margin gained from using the 800 machine-hours for the Kimberly Corporation business is the
contribution margin per machine-hour of $60  800 machine-hours equal to $48,000.
The net benefit is:
Contribution margin from Kimberly Corporation business $48,000
Less: Opportunity cost (of giving up Wallace Corporation (36,800)
business)

Net benefit $11,200

Although taking the Kimberly Corporation business over the Wallace Corporation business
will maximize Newbury’s profits in the short run, Newbury’s managers must also consider the
long-run effects of this decision. Will Kimberly Corporation continue to demand the same level
of business going forward? Will turning down the Wallace business affect customer
satisfaction? If Newbury turns down the Wallace business, will Wallace continue to place
orders with Newbury or seek alternative suppliers? Newbury’s managers need to consider these
long-run effects and then decide whether it should accept Kimberly’s business at the cost of
Wallace’s. In other words, choosing customers is a strategic decision. If it sees long-run benefit
in working with Wallace, Newbury’s managers must also look for ways to increase the
profitability of the business it does with Wallace by increasing prices or reducing costs.

Relevant-Revenue and Relevant-Cost Analysis of Closing or Adding Branch Offices or

Business Divisions
- Company periodically confront decisions about closing or adding branch offices or
business decisions.
Example:
Sanchez Corporation runs two convenience stores, one in Connecticut and one in Rhode Island.
Operating income for each store in 2017 is as follows:

Connecticut Rhode Island

Revenues $1,070,000 $860,000
Operating costs
Cost of good sold 750,000 660,000
Lease rent (renewable each year) 90,000 75,000
Labor costs (paid on an hourly basis) 42,000 42,000
Depreciation of equipment 25,000 22,000
Utilities (electricity, heating) 43,000 46,000
Allocated corporate overhead 50,000 40,000
Total operating costs 1,000,000 885,000
Operating income (loss) $70,000 $(25,000)

The equipment has a zero disposal value. In a senior management meeting, Maria Lopez, the
management accountant at Sanchez Corporation, makes the following comment, “Sanchez can
increase its profitability by closing down the Rhode Island store or by adding another store like
it.”
Required:
1. By closing down the Rhode Island store, Sanchez can reduce overall corporate
overhead costs by $44,000. Calculate Sanchez’s operating income if it closes the
Rhode Island store. Is Maria Lopez’s statement about the effect of closing the
Rhode Island store correct? Explain.

2. Calculate Sanchez’s operating income if it keeps the Rhode Island store open and opens
another store with revenues and costs identical to the Rhode Island store (including a cost of
$22,000 to acquire equipment with a one-year useful life and zero disposal value). Opening
this store will increase corporate overhead costs by $4,000. Is Maria Lopez’s statement about
the effect of adding another store like the Rhode Island store correct? Explain.

SOLUTION
1. Solution Exhibit 11-30, Column 1, presents the relevant loss in revenues and the
relevant savings in costs from closing the Rhode Island store. Lopez is correct that Sanchez
Corporation’s operating income would increase by $7,000 if it closes down the Rhode Island
store. Closing down the Rhode Island store results in a loss of revenues of $860,000 but cost
savings of $867,000 (from cost of goods sold, rent, labor, utilities, and corporate costs). Note
that by closing down the Rhode Island store, Sanchez Corporation will save none of the
equipment-related costs because this is a past cost. Also note that the relevant corporate
overhead costs are the actual corporate overhead costs $44,000 that Sanchez expects to save
by closing the Rhode Island store. The corporate overhead of $40,000 allocated to the Rhode
Island store is irrelevant to the analysis.
2. Solution Exhibit 11-30, Column 2, presents the relevant revenues and relevant costs of
opening another store like the Rhode Island store. Lopez is correct that opening such a store
would increase Sanchez Corporation’s operating income by $11,000. Incremental revenues of
$860,000 exceed the incremental costs of $849,000 (from higher cost of goods sold, rent, labor,
utilities, and some additional corporate costs). Note that the cost of equipment written off as
depreciation is relevant because it is an expected future cost that Sanchez will incur only if it
opens the new store. Also note that the relevant corporate overhead costs are the $4,000 of
actual corporate overhead costs that Sanchez expects to incur as a result of opening the new
store. Sanchez may, in fact, allocate more than $4,000 of corporate overhead to the new store,
but this allocation is irrelevant to the analysis.

The key reason that Sanchez’s operating income increases either if it closes down the Rhode
Island store or if it opens another store like it is the behavior of corporate overhead costs. By
closing down the Rhode Island store, Sanchez can significantly reduce corporate overhead
costs presumably by reducing the corporate staff that oversees the Rhode Island operation.
On the other hand, adding another store like Rhode Island does not increase actual corporate
costs by much, presumably because the existing corporate staff will be able to oversee the
new store as well.
Relevant-Revenue and Relevant-Cost Analysis of Closing Rhode Island Store and
Opening Another Store Like It
(Loss in Revenues) and Incremental Revenues and
savings in costs from (Incremental Costs) of
closing Rhode Island opening new store like
Store Rhode Island Store
(1) (2)
Revenues ($860,000) $860,000
Cost of goods sold 660,000 (660,000)
Lease rent 75,000 (75,000)
Labor costs 42,000 (42,000)
Depreciation of equipment 0 (22,000)
Utilities (electricity, 46,000 (46,000)
heating)
Corporate overhead costs 44,000 (4,000)
Total costs 867,000 849,000
Effect on operating income $7,000 $11,000
(loss)
Irrelevant of Past Costs and Equipment-Replacement Decision
- Historical cost or sunk cost are irrelevant to decision making because all of this cost is
already happened, and a decision making will not change anything on the cost that
had occurred.
- Similarly, the book value – that is the original cost minus accumulated depreciation –
of existing equipment is a past cost that is irrelevant.
Example:
Janet’s Bakery is thinking about replacing the convection oven with a new, more energy-
efficient model. Information related to the old and new ovens follows:
Old oven New Oven
Original cost $21,000 IR $40,000 R
Accumulated depreciation $6,000 IR Not acquired yet
Book value $15,000 IR Not acquired yet
Current disposal value $10,000 R Not acquired yet
Installation cost Not $2,000 R
applicable
Annual operating cost $12,000 R $5,000 R
Useful life 7 years 5 years
Current age 2 years 0 years
Remaining useful life 5 years 5 years
Terminal disposal value (in 5 years) $0 $0
Ignore the effect of income taxes and the time value of money.

Required:
1. Which of the costs and benefits above are relevant to the decision to replace the oven?
2. What information is irrelevant? Why is it irrelevant?
3. Should Janet’s Bakery purchase the new oven? Provide support for your answer.
4. Is there any conflict between the decision model and the incentives of the manager who has
purchased the “old” oven and is considering replacing it only two years later?
5. At what purchase price would Janet’s Bakery be indifferent between purchasing the new
oven and continuing to use the old oven?

SOLUTION
1. The current market value and annual operating costs of the old oven, and the purchase
price, installation cost, and annual operating costs of the new oven are relevant when deciding
whether to replace the oven because these are future costs that would differ between the
alternatives of keeping or replacing the old oven.
2. The original cost and book value of the old oven are irrelevant because they are
variations of the same past (sunk) cost. All past costs are irrelevant because past costs will be
the same whether Janet’s Bakery keeps or replaces the oven. No decision can change what has
already been incurred in the past.

3. Janet’s Bakery should purchase the new oven, based on the following calculations:

Keep the old oven Replace the old oven

Current market value of old oven $ 10,000
Purchase price of the new oven (40,000)
Installation cost of the new oven (2,000)
Operating costs for 5 years Operating costs for 5 years
($12,000 × 5)
$(60,000) ($5,000 × 5) (25,000)
Cost of keeping the old oven $(60,000) Net cost of the new oven $(57,000)

The cost of replacing the old oven is $57,000, while the cost of continuing to operate the old
oven is $60,000.

4. The manager may be reluctant to replace because it might reflect badly on him for
having purchased the old oven in the first place if the new oven was available a year earlier.
Additionally, the new oven’s annual operating costs are substantially less than the old oven,
calling into question the possibility that the old oven wasn’t the best choice when it was
purchased.

5. At a purchase price of $43,000, Janet’s Bakery would be indifferent between purchasing the
new oven and continuing to use the old oven ($40,000 current purchase price + $3,000 savings
above). Note that a cost of $43,000, the cost of replacing the old oven would be $60,000, equal
to the cost of keeping the old oven.
Example:
(A.Spero, adapted) The TechGuide Company produces and sells 7,500 modular computer
desks per year at a selling price of $750 each. Its current production equipment,
purchased for $1,800,000 and with a five-year useful life, is only two years old. It
has a terminal disposal value of $0 and is depreciated on a straight-line basis. The
equipment has a current disposal price of $450,000. However, the emergence of a
new molding technology has led TechGuide to consider either upgrading or
replacing the production equipment. The following table presents data for the two
alternatives:

Upgrade Replace
One-time equipment costs $3,000,000 $4,800,000
Variable manufacturing cost $150 $75
per desk
Remaining useful life of 3 3
equipment (in years)
Terminal disposal value of $0 $0
equipment

All equipment costs will continue to be depreciated on a straight-line basis. For simplicity,
ignore income taxes and the time value of money.

Required:
1. Should TechGuide upgrade its production line or replace it? Show your calculations.
2. Assume that all data are as given in the original exercise. Dan Doria is TechGuide’s
manager, and his bonus is based on operating income. Because he is likely to relocate after
about a year, his current bonus is his primary concern. Which alternative would Doria
choose? Explain.
SOLUTION
1. 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 favour

of Replace
Comparing Relevant Costs of Upgrade Replace (3) = (1) – (2)
upgrade and replace alternatives (1) (2)
Cash operating costs
($150 x 7,500 desks per year x 3 years) $3,375,000 $1,687,500 $1,687,500
($75 x 7,500 desks per year x 3 years)
Current disposal price (450,000) 450,000
One time capital costs, written of 3,000,000 4,800,000 (1,800,000)
periodically as depreciation
Total relevant costs $6,375,000 $6,037,500 $337,500

3
Note that the book value of the current machine, $1,800,000  = $1,080,000 would either
5
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.

2. Operating income for the first year under the upgrade and replace alternatives are shown
below:

Year 1
Upgrade Replace
(1) (2)
Revenues (7,500 x $750) $5,625,000 $5,625,000
Cash operating costs 1,125,000 562,500
($150 x 7,500 desks per year)
($75 x 7,500 desks per year)
Depreciation 1,360,000 1,600,000
a
($1,080,000 + $3,000,000)/
3
($4,800,000 / 3)
Loss of disposal of old 0 630,000
equipment
(0)
($1,080,000 - $450,000)
Total costs 2,485,000 2,792,500
Operating income $3,140,000 $2,832,500
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.

Year 1
Upgrade Replace
(1) (2)
Revenues (750*7500 5625000 5625000
Cash operating costs 1125000 75*7500
150*7500) 562500
Depreciation 1,360,000 1,600,000
(1800,000/5=360,000)
(3,000,000/3=1,000,000)
Loss of disposal of old - 630,000
equipment
(book value–disposal value
=1,080,000-450,000

Total costs 2,485,000 2,792,500

Operating income 3,140,000 2,532,500

Decision and Performance Evaluation

• Despite the quantitative nature of some aspects of decision making, not all
managers will choose the best alternative for the firm.
• Managers will consider how the company will judge his or her performance after
the decision is implemented.
• Many managers consider it unethical to take actions that make their own
performance look good when these actions are not in the best interests of the firm.
• The decision model analysis (step 4) can dictate one decision but in the real
world, would the manager want to follow it?
• Managers frequently find it difficult to resolve the conflict between the decision
model and the performance-evaluation model. In theory, resolving the difficulty
seems obvious: managers should design models that are consistent.
Example
Susan Smith manages the Wexford plant of Sanchez Manufacturing. A representative of
Darnell Engineering approaches Smith about replacing a large piece of manufacturing
equipment that Sanchez uses in its process with a more efficient model. While the
representative made some compelling arguments in favor of replacing the 3-year-old
equipment, Smith is hesitant. Smith is hoping to be promoted next year to manager of the larger
Detroit plant, and she knows that the accrual-basis net operating income of the Wexford plant
will be evaluated closely as part of the promotion decision. The following information is
available concerning the equipment-replacement decision:

Old Machine New Machine

Original cost $900,000 $540,000
Useful life 5 years 2 years
Current age 3 years 0 years
Remaining useful life 2 years 2 years
Accumulated depreciation $540,000 Not acquired yet
Book value $360,000 Not acquired yet
Current disposal value (in cash $216,000 $0
2 years from now)
Annual operating costs $995,000 $800,000
(maintenance, energy, repairs,
coolants, and so on)
Sanchez uses straight-line depreciation on all equipment. Annual depreciation expense for the
old machine is $180,000 and will be $270,000 on the new machine if it is acquired. For
simplicity, ignore income taxes and the time value of money.

Required:
1. Assume that Smith’s priority is to receive the promotion and she makes the equipment-
replacement decision based on the next one year’s accrual-based net operating income.
Which alternative would she choose? Show your calculations.
2. What are the relevant factors in the decision? Which alternative is in the best interest of the
company over the next 2 years? Show your calculations.
3. At what cost would Smith be willing to purchase the new equipment? Explain.
SOLUTION
1. Operating income for the first year under the keep and replace alternatives are
shown below.

Year 1
Replace with new Keep old Cost difference by
machine machine replacing
(1) (2) (3) = (1) – (2)
Cash operating $800,000 $995,000 $(195,000)
costs
Depreciation 270,000 180,000 90,000
($540,000/2)
($900,000/5)
Loss on disposal of 144,000 0 144,000
old machine
($360,000 -
$216,000)
$0
Total costs $1,214,000 $1,175,000 $39,000

First-year costs are lower by $39,000 under the keep machine alternative, and Susan Smith,
with her one-year horizon and operating income-based bonus, will choose to keep the machine.

3. Based on the analysis in the table below, Sanchez Manufacturing will be better off by
$66,000 over two years if it replaces the current equipment.

Over 2 Years Cash Outflow

Comparing Relevant Costs of Replace Keep By Replacing
Replace and Keep Alternatives (1) (2) (3) = (1) – (2)
Cash operating costs $1,600,000 $1,990,000 $(390,000)
Current disposal price (216,000) 0 (216,000)
One time capital costs, written off
periodically as depreciation 540,000 0 540,000
Total relevant cashflow $1,924,000 $1,990,000 $ (66,,000)

Note that the book value of the current machine ($360,000) would either be written off as
depreciation over two years under the keep 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
$360,000 over two years; hence, it is irrelevant in this analysis.
 This problem illustrates the conflict between the decision model and the performance
evaluation model. From the perspective of Sanchez Manufacturing, the old machine should be
replaced. Over the longer two-year horizon, replacing the old machine with the new equipment
saves Sanchez Manufacturing $66,000. From a performance evaluation perspective, Susan
Smith prefers to keep the old machine because operating income in the first year will be
$39,000 higher if she keeps rather than replaces the old machine. Chapter 23 describes methods
that companies use to reduce the conflict between the decision model and the performance
evaluation model.

3. Smith would be willing to purchase the new equipment if the effect on operating income
in the first year would be zero or positive, that is, if the cost of operating the new equipment in
the first year were equal to or lower than the cost of operating the old machine.
From requirement 1, the cost difference in the first year from replacing the old machine
needs to be reduced by $39,000. This means that depreciation on the new equipment must be
$39,000 less than it is, so $270,000 – $39,000 = $231,000.
The new equipment is being depreciated over a two-year period with zero residual value
so the cost of the equipment equals $231,000  2 = $462,000. If the new equipment can be
purchased for $462,000 or less, Susan Smith will be willing to purchase it because the
performance evaluation model would be consistent with the decision model.
Note that over the two-year period, Sanchez Manufacturing will be better off
purchasing the new equipment for $462,000 by $144,000, as the following presentation of the
analysis done in requirement 2 shows:

Cash
Outflow
by Replacing

Cash operating costs –$390,000

Current disposal price –$216,000
One-time capital costs, written off periodically as depreciation +$462,000
Total relevant cash flow –$144,000