Chapter 6
Relevant Information for Decision Making with a Focus on Operational
Decisions
Opportunity, Outlay, and Differential Costs
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Differential cost: is the difference in total cost between two alternatives.
Differential revenue: is the difference in total revenue between two
alternatives.
Incremental costs: 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.
An incremental analysis: is an analysis of the additional costs and benefits of
a proposed alternative.
An opportunity cost: applies to a resource that the company already owns or
committed or buy , so it's the maximum available contribution to profit
forgone (or passed up) by using limited resources for a particular
purpose…(2nd best alternative).
An outlay cost: requires a cash disbursement.
Example:
Nantucket Nectars has a machine for which it paid $100,000 and it is sitting idle.
Nantucket Nectars has three alternatives:
1. Increase production of Peach juice with contribution margin of $ 60,000.
2. Sell the machine for $50,000.
3. Produce a new drink Papaya Mango with projected sales of $ 500,000.
Required:
Q1: What is the opportunity cost to Nantucket Nectars for producing papaya
mango?
Answer:
An Opportunity cost is the amount that the company would have gained if the
resource had been used in their best alternatives.
The opportunity cost to Nantucket Nectars for producing papaya mango is $ 60,000.
1
Q2: show a tabulation of the net income effects of producing papaya mango ?
Revenue
$500,000
Costs:
Outlay Costs
400,000
Financial benefit before opportunity costs
$100,000
Opportunity cost of machine
60,000
Net financial benefit
$40,000
6-28
1.
Independent
Practice
Employee
Operating revenues
$340,000
$110,000
$230,000
Operating expenses
220,000
--
220,000
$120,000
$110,000
$ 10,000
Income effects per year
Difference
Choose Independent Practice
Revenues
$340,000
Expenses:
Outlay costs
$220,000
Opportunity cost of employee compensation
Income effects per year
110,000
330,000
$ 10,000
Each tabulation produces the key difference of $10,000. As a
general rule, we favor using the first tabulation. It offers a
straightforward presentation of inflows and outflows under
sharply stated alternatives.
2
2.
Choice as Employee
Revenue
$ 110,000
Expenses:
Outlay costs
$
0
Opportunity cost of accounting practice
120,000
Income effects per year
120,000
$ (10,000)
If the employee alternative is selected, the key difference in favor
of becoming a sole practitioner is again $10,000. Bridgeman is
sacrificing $10,000 to avoid the risks of an independent practice.
Make-or-Buy decisions
(Insourcing and outsourcing)
6-33
Nantucket Nectars should make the bottles.
_______Make______
________Buy_____
Total
Total
Per Bottle
$250,000
$.250
Per Bottle
Purchase cost
Direct materials
$80,000
$.080
Direct labor
30,000
.030
Variable overhead
60,000
.060
Avoidable fixed overhead
_ 60,000
.060
_______
____
Total relevant costs
$230,000
$.230
$250,000
$.250
Difference in favor of making
$20,000
$.020
3
6-34
Buy and
Leave
Facilities
Idle
Make
Contribution from other
activities
Buy and
Use
Facilities
for Other
Activities
$
Buy and
Rent Out
Facilities
75
Rent revenue
$
55
Relevant cost of bottles
$(230)
$(250)
_(250)
_(250)
Net relevant costs
$(230)
$(250)
$(175)
$(195)
Nantucket Nectars should buy the bottles and use the facilities for other
activities.
6-B1
1.
Make
Total
Buy
Per Unit
Total
€10,000,000
Purchase cost
€5,500,000
€27.5
Direct labor
1,900,000
9.5
Factory overhead, variable
1,100,000
5.5
Direct material
Per Unit
€50
Factory overhead, fixed
avoided 750,000
3.75
Total relevant costs
€9,250,000
€46.25
Difference in favor of making
€ 750,000
€ 3.75
€10,000,000
The numerical difference in favor of making is €750,000 or €3.75 per unit. The
relevant fixed costs are €750,000, not €2,500,000.
4
€50
2.
Buy and Leave
Make
Capacity Idle
Buy and
Rent
--
--
€ 1,250,000
Obtaining of components
€(9,250,000)
€(10,000,000)
€(10,000,000)
Net relevant costs
€(9,250,000)
€(10,000,000)
€ (8,750,000)
Rent revenue
The final column indicates that buying the components and renting the
vacated capacity will yield the best results in this case. The favorable
difference is €9,250,000 - €8,750,000 = €500,000.
Deletion of products, services, departments
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.
Example:
Consider a discount department store that has three major departments: Groceries,
General merchandise, Drugs:
1. Assume that the only alternatives to be considered are dropping or continuing the
grocery department, which has consistently shown an operating loss.
Solution:
5
So it's better not to drop the grocery department.
2. Assume that the store could use the space made available by the dropping of
groceries to expand the general merchandise department. And this will
increase sales by $50,000, generate a 30% contribution-margin, and have
avoidable fixed costs of $70,000.
Solution:
3. Prepare a tabular analysis of the (favorable F and unfavorable U) differences for
dropping grocery department. And expanding the merchandise department.
Solution:
1000
(800)
200
Expanding
merchandise
500
(350)
150
(150)
(70)
80F
50
80
30F
Dropping grocery
sales
-VC
CM
-FC
Avoidable
unavoidable
OI
6
difference
500U
450F
50U
Optimal Use of Limited Resources
1. The company will prefer producing the product with the highest CMU, if
there are no limiting factors other than units of sale.
Example:
A company has 2 products: air max shoes and air court shoes…
Q1: Which is more profitable? Why?
Max is more profitable (as it's the product with the higher CMU)…and the
limiting factor is only the units of sale.
2. The company will prefer producing the product with the highest CM per
unit of limiting factor.
Q2: suppose for the previous example that only 10,000 of capacity are available and
the machine can make either 3 air shoes or 1 max shoe on one hour.
Air shoe
Max shoe
Units per hour
3
1
Cmu
20
36
Cm per hour
60
36
Cm for10,000 hours
600,000
360,000
The air is more profitable (because it is the higher CM per unit of limiting factor).
3. The case of inventory turnover:
(The number of times the average inventory is sold per year).
In retails stores, the limiting factor is often floor space. The focus is on products
taking up less space or on faster inventory turnover.
Example: 2 department stores have the same product:
Department A
Department B
Sp = 4
sp = 3.5
Vcu =3
vcu = 3
7
Department A has lower inventory turnover and sells 10,000 units per year ,
while department B sell 22,000 units per year.
Q : which department makes more profitable use of the product?
A
Department b makes a more profitable use of the product.
8
B