1

2
 ABC Ltd is offered a special order of
Rs.13 per unit for 100,000 units.
Should ABC accept the order?
The first step is to gather relevant
information from ABC Ltds financial
statements.

3
 ABC Ltd
Income Statement
Year Ended December 31, 2002 (rs 000)
Sales (1,000,000 units) Rs.20,000
Less: Variable expenses
Manufacturing Rs.12,000
Selling 1,100 13,100
Contribution margin Rs. 6,900
4
 ABC Ltd
Income Statement
Year Ended December 31, 2002 (rs 000)
Contribution margin Rs.6,900
Less: Fixed expenses
Manufacturing Rs.3,000
Selling and administrative 2,900 5,900
Operating income Rs.1,000
5
 Only variable manufacturing costs are
affected by the particular order, at a rate
of Rs.12 per unit (Rs.12,000,000
1,000,000 units).
All other variable costs and all fixed costs
are unaffected and thus irrelevant.

6
Special order sales price/unit Rs.13
Increase in manufacturing costs/unit 12
Additional operating profit/unit Rs. 1

Based on the preceding analysis, should

ABC accept the order?

7
Decide to add or delete
a product line using
relevant information.

8
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.

9
Consider a discount department store that has
three major departments:

1 Groceries

General
2 merchandise

3 Drugs

10
 Department
General
(000) Groceries Mdse. Drugs Total
Sales Rs.1,000 Rs.800 Rs.100 Rs.1,900
Variable expenses 800 560 60 1,420
CM Rs. 200 Rs.240 Rs. 40 Rs. 480

11
 Department
General
(000) Groceries Mdse. Drugs Total
Contribution margin Rs.200 Rs.240 Rs.40 Rs.480
Fixed expenses:
Avoidable Rs.150 Rs.100 Rs.15 Rs.265
Unavoidable 60 100 20 180
Total Rs.210 Rs.200 Rs.35 Rs.445
Operating income Rs. (10) Rs. 40 Rs. 5 Rs. 35

12
 For this example, assume first that the
only alternatives to be considered are
dropping or continuing the grocery
department, which shows a loss of
Rs.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.
13
 Total Before Change
Sales Rs.1,900,000
Variable expenses 1,420,000
Contribution margin 480,000
Avoidable fixed expenses 265,000
Contribution to common
space and unavoidable costs Rs. 215,000
Unavoidable fixed expenses 180,000
Operating income Rs. 35,000
14
 Effect of Dropping Groceries
Sales Rs.1,000,000
Variable expenses 800,000
Contribution margin 200,000
Avoidable fixed expenses 150,000
Contribution to common
space and unavoidable cost Rs. 50,000

15
 Total After Change
Sales Rs.900,000
Variable expenses 620,000
Contribution margin 280,000
Avoidable fixed expenses 115,000
Contribution to common
space and unavoidable costs Rs.165,000
Unavoidable fixed expenses 180,000
Operating income Rs.(15,000)

16
Compute a measure of product
profitability when production
is constrained by a scarce
resource.

17
A limiting factor or scarce resource
restricts or constrains the production or
sale of a product or service.
The order to be accepted is the one that
makes the biggest total profit
contribution per unit of the limiting
factor.

18
 Assume that a company has two
products: a plain cellular phone and a
fancier cellular phone with many
special features.

19
Plant workers can make 3 plain phones
in one hour or 1 fancy phone.
Product
Plain Fancy
Per Unit Phone Phone
Selling price Rs.80 Rs.120
Variable costs 64 84
Contribution margin Rs.16 Rs. 36
Contribution margin ratio 20% 30%
20
Which product is more profitable?
If sales are restricted by demand for only
a limited number of phones, fancy
phones are more profitable.

Why?

21
The sale of a plain phone adds Rs.16 to profit.

The sale of a fancy phone adds Rs.36 to profit.

22
 Now suppose annual demand for phones
of both types is more than the company
can produce in the next year.
Productive capacity is the limiting factor
because only 10,000 hours of capacity
are available.

23
Which product should the company emphasize?
Plain phone:
Rs.16 contribution margin per unit 3 units per hour
= 48 per hour
Fancy phone:
Rs.36 contribution margin per unit 1 unit per hour
= Rs.36 per hour

24
 Relevant Information
and Decision Making:
Production Decisions

25
Use opportunity cost to
analyze the income
effects of a given
alternative.

26
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.

27
 Differential
cost and incremental cost are
defined as the difference in total cost
between two alternatives.

28
Decide whether to make or buy
certain parts or products.

29
 Thebasic make-or-buy question is
whether a company should make its own
parts to be used in its products or buy
them from vendors.

30
Qualitative Factors:
Control quality
Protect long-term relationships with suppliers

Quantitative Factors: Idle facilities or capacity

31
GE Company Cost of Making Part N900:
Total Cost for Cost
20,000 Units per Unit
Direct material $ 20,000 $ 1
Direct labor 80,000 4
Variable overhead 40,000 2
Fixed overhead 80,000 4
Total costs $220,000 $11

32
 Another manufacturer offers to sell GE
the same part for $10.
The essential question is the difference in
expected future costs between the
alternatives.
Should GE make or buy the part?

33
 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
eliminated if the parts are bought instead
of made, the fixed costs that may be
avoided in the future are relevant.

34
 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
not making 20,000 10 0 0
Total relevant costs $160,000 $ 8 $200,000 $10
Difference in favor
of making $ 40,000 $ 2

35
36
Decide whether a joint product
should be processed beyond
the split-off point.

37
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.
38
Separable costs are any costs beyond the
split-off point.

Joint costs are the costs of manufacturing

joint products before the split-off point.

39
 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.

40
1 million liters of X at a
selling price of $.09 = $90,000 Joint-processing
cost is $100,000
500,000 liters of Y at a
selling price of $.06 = $30,000

Total sales value at split-off Split-off point

is $120,000
41
 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.

42
 Sell at Process
Split-off Further and
as Y Sell as YA Difference
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

43
Identify irrelevant information
in disposal of obsolete inventory
and equipment replacement
decisions.

44
 Two examples of past costs that we can
consider, to see why they are irrelevant to
decisions, are:
1 The cost of obsolete inventory
2 The book value of old equipment

45
 Suppose General Dynamics has 100
obsolete aircraft parts in its inventory.
The original manufacturing cost of these
parts was $100,000.

46
 General Dynamics can...
1 remachine the parts for $30,000 and then
sell them for $50,000, or
2 scrap them for $5,000.
Which should it do?

47
 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
*Irrelevant because it is unaffected by the decision.

48
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.

49
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.

50
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
Book value $ 4,000

51
 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
Disposal value in 4 years 0 0
Annual cash operating costs $ 5,000 $3,000
52
 What is a sunk cost?
A sunk cost is a cost that has already been
incurred and, therefore, is irrelevant to
the decision-making process.

53
 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
4 Cost of new equipment

54
 The book value of old equipment is
irrelevant because it is a past (historical)
cost.
Therefore, depreciation on old
equipment is irrelevant.

55
 Thedisposal value of old equipment is
relevant (ordinarily) because it is an
expected future inflow that usually differs
among alternatives.

56
 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).
It is best to think of each separately.

57
 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 relevant.

58
 Four Years Together
Keep Replace Difference
Cash operating costs $20,000 $12,000 $ 8,000
Disposal value (2,500) 2,500
New machine
acquisition cost 8,000 (8,000)
Total costs $20,000 $17,500 $ 2,500

59
Explain how unit costs
can be misleading.

60
 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 the same volume basis

61
 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?

62
 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
Unit relevant costs $1.50 $1.20

63
 Itappears 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.

64
 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
Unit relevant costs $1.50 $1.6667

65
Discuss how performance
measures can affect
decision making.

66
 Tomotivate managers to make the right
choices, the method used to evaluate
performance should be consistent with
the decision model.

67
 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 compared with that in years
2, 3, and 4.
68
 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
against revenue $6,000 $6,500 $6,000 $5,000

69
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.

70