Prof. McDermott’s Substitute for Chapter 11
Decision-Making and Relevant Information

Earlier this semester we talked about the difference between data and information. Data are numbers that we record and manipulate. Information is data that is useful for decision-making.

When we study the difference between data and information, we often use the term relevant cost.

A relevant cost is a cost that is useful for a particular decision. There are a couple of things we need to remember about relevant costs: (1)they always occur in the future, and (2) they always differ between two or more courses of action.

Let me illustrate. Let’s assume you have inherited a manufacturing plant from your grandfather. This plant has the capability of manufacturing either motorcycles or bicycles.

Which product should you manufacture? This is dependent on the alternative that will make you the most money. In making this decision,you will of course focus on the price you can charge for each product. You will also focus on the cost. Put another way, how much more (or less) will you make if you manufacture motorcyclesinstead of bicycles?

To answer this question, we only need to look at relevant revenues and relevant costs—those revenues and costs that will differ if we manufacture bicycles rather than motorcycles.

Let me illustrate by classifying the costs incurred in manufacturing either product into relevant or non-relevant costs.

The cost of mowing the lawn of the factory will not differ whether we manufactured bicycles or motorcycles. Therefore this cost is not relevant and should not be considered in making the final decision.

Direct labor costs do vary, one alternative to the next, and are therefore relevant costs.

We will come back to this in a moment, but first let’s define a couple of other terms we will be use. A sunk cost is a cost: (1) that was incurred in the past and (2) is non-recoverable. Sunk costs are neverrelevant..

Let me give an example of sunk costs and why they are never relevant.Many years ago Lockheed designed an aircraft known as the L–1011. This was a wide-body jet, similar to the DC-10. Lockheed spent something like $200,000,000 designing this aircraft. Before it went into production, however, the market had changed and the company realized that it could not be profitable.The variable cost of producing the aircraft would exceed the price.

The Board of Directors should have written off the cost and abandoned the project. It was emotionally difficult, however, to write off $200,000,000, and so the Boarddecided to manufacture the productanyway, throwing good money after bad. The $200,000,000 was a sunk cost and should not have been considered in the decision.

Let’s define another term – opportunity cost. An opportunity cost is a cost that is given up when one option is chosen over another. If you decide to go to school rather than work full time, there is a short term opportunity cost (the salary you are giving up to get your degree).

If you don’t go to school but decide to get a job right out of high school, the opportunity cost is the difference between the salary you could have earned with a college degree versus the salary you will earn with a high school degree. Opportunity costs are never shown in the general ledger. Opportunity, however, costs are relevant costs.

In this chapter we will use relevant costs and relevant revenues in making five types of decisions:

  1. The decision to make or buy a product
  2. The decision to keep or shut down an unprofitable business segment
  3. The decision tokeep or replacean existing piece of equipment
  4. The decision of which of several products to manufacture when there is a limited production resource (such as labor, materials or the output of an essential piece of machinery
  5. The decision to sell a product at less than full cost

We will illustrate each of these below. The questions you see on the test will be similar to those illustrated.

The Decision To Make Or Buy A Product

Sometimes a manufacturer makes a product that is a component of another product. For example, the manufacture of Toyota automobiles might make door locks that are used in their cars.

Sometimes in this situation, an outside manufacturer proposes to sellthe same component for a price that is less than the full cost of manufacturing the product internally.

For those not acquainted with the concept of relevant costs, a knee-jerk reaction might be to go with the “lower cost” and outsource the product.

What managers sometimes fail to understand, however, is that the fixed costs incurred in the manufacture of the product might not go away if the product is outsourced.

Again, it is helpful to illustrate a principle with an example.

McDermott Manufacturing makes integrated circuits for its PC computers. One of the integrated circuits used in its computer is the ML–140. McDermott Manufacturing’s full cost to manufacture this product is shown in the two tables below.

Cincinnati Manufacturing approaches McDermott Manufacturing and proposes to sell the unit for $112.00per unit. Should McDermott accept this offer and discontinue manufacturing the ML-140 internally?

At first glance, this looks like a good deal. The $112.00 to purchase the unit is cheaper than the cost of $164.50 to make it internally.

However, not all of the costs included in the $164.50 figure are relevant.That is to say, not all of these costs will differ, one alternative to another. Put still another way, not all of $164.50 will cost will go away if the item is outsourced.

In this example we will assume that only $10.00 of the variable administrative and marketing expense will be eliminated (by firing some administrative personnel); $10.00 will still remain. In additionlet’s assume that only $250,000 of the fixed overhead costs will go away (the salaries of the supervisor of manufacturing and her staff). Should the president of McDermott Manufacturing accept the proposal to outsource the ML-140?

To make this decision we need to examine relevant costs.

Direct labor, direct materials, and variable overhead costs will all go away of if we outsource. Therefore, these costs are relevant. Also, $250,000 of fixed overhead will go away if we outsource the product, so these are also relevant. In addition, $12.00 of variable administrative and marketing expense will go awayandso these costs are also relevant.

Since the fixed administrative and marketing expense of $20.00 per unit will not be different regardless of whether we manufacture or outsource, this cost is not relevant.

In comparing the impact of outsourcing versus manufacturing the ML-140, we should prepare a schedule that looks something like the following:

From this analysis we conclude the companywill incur a net loss of $7.50 per unit if it purchaes the ML–140 from Cincinnati Manufacturing rather than manufacturing it internally.

The Decision to Keep or Shut down an Unprofitable Business Segment

Lambert Manufacturing makes five electronic products at its Columbus Ohio plant. These products are sold to distributors. A product income statement for 2012 is shown below.

The president wants to discontinue the KC–90 product line because it is unprofitable (it has a loss of $46,900 a year). He reasons that discontinuing this product line will increase the company’s total profits by $46,900. By focusing on total costs, rather than relevant costs, however, he is wrong.

The controller does a more detailed analysis and discovers that if the company discontinues manufacturing the KC-90, total fixed factory overhead will remain unchanged as this is an allocated cost.

The controller also discovers that the company’s total fixed marketing and administrative expense will only decrease by $100,000—the company can only fire part of their sales staff.

What, therefore, will be the impact on the bottom line if the president has his way and discontinues the KC-90 product line? This is shown in the schedule below.

The president was wrong! If he discontinues the unprofitable product line the company will incur a loss of $983,100. A bad decision!

The Decision to Keep or Replace an Existing Piece of Equipment

Aldrich Industries uses a manual piece of equipment to manufacture its primary product. This equipmentoriginally cost $3,000,000 and has accumulated depreciation of $1,500,000, giving it a book value of $1,500,000.It has a remaining life of five years. If the equipment is sold now, it will have a residual value of $500,000. If sold at the end of its useful life, it will have a scrap value of $25,000.

The company is considering replacing this equipment with a computerized model at a cost of $2,500,000. The computerized model would have an estimated life of five years and would be depreciated on a straight-line basis. The computerized model would generate an annual labor savings of $625,000.

The president is skeptical about purchasing the new equipment as he would have to write off the $1,500,000 remaining book value of the old machine (he doesn’t realize this is a sunk cost and therefore is not relevant).

He also recognizes that the residual value of the existing machine would decrease from $500,000 to $25,000. The $475,000 is relevant.

What would be the impact on the company’s profit of buying the new machine? As demonstrated in the table below, the company would earn an additional profit of $150,000 over a five year period if it buys the new machine.

The Decision of Which of Several Products to Manufacture
When there is a Limited Production Resource

Normally when deciding which product to manufacture from a range of two or more choices, one would choose the product with the highest contribution margin per unit. Remember the contribution margin per unit is the price per unit minus the total variable cost per unit. The total variable costs include variable administrative and selling costs as well as direct labor, direct materials and variable overhead.

There is one exception to this rule, however. When there is a constraint on one of the resources of production. Resources of production include machinery, materials, and direct labor. When there is a constraint on a resource (i.e. when there is a limited amount of one of these resources) the rule changes. In this case one should first produce the product that has the highest contribution margin per unit of scarce resource. Let’s illustrate:

Remington Incorporated makes two products: Product A and Product B. Revenues and expenses for both of these products (on a per unit basis) are shown below.

The contribution margin per unitis shown below.

Assume there are no scarce resources, and an unlimited demand exists for each product. Which product should the company produce?

The answer of course is the product with the highest contribution margin per unit which is Product B.

Now assume that both products use a rare mineral of which there is a limited quantity. Product A uses one pound of the scarce direct material per unit, while Product B uses two pounds. Which product should the company produce first?

The answer is the product with the highest contribution margin per unit of scarce resource. The company should produce Product Afirst as it has the highest contribution margin per unit of scarce resource, as shown below. After satisfying the demand for product A, if there is any excess direct material, then the company can produce Product B.

The Decision to Sell a Product at Less Than Full Cost

There is a school of thought (disputed by some) that states believes that a company can sometimes sell their products for less than full cost, and still make a profit. In textbooks, this discussion is usually included under the subheading of Short-Term Pricing Decisions.

This school of thought believes that relevant costs in the short run are different from relevant costs in the long run. Specifically it states that fixed costs are not relevant in the short run, and do not therefore need to be taken into considerationwhen establishing a short-term price.The belief, therefore, is that a short term price need only cover variable costs.

This philosophy can sometimes be dangerous. In the long run, a company's price must cover both fixed and variable costs. Also, the long run is of course made up of nothing more than a series of short runs.

When do the advocates of this school of thought say that a company can make money by selling products at below full cost?

  1. When the company can separate fixed and variable costs. Not all companies are able to do this, however. Also, as we have learned in ABC cost accounting, many costs are variable but do not vary based on units produced. Instead, they vary based on other factors including the number of setups, maintenance hours, the number of product lines, and so on.
  1. When the company can segregate its market. What this means is that the company can charge different customers different prices,and get away with it. A good example is the airline industry. Suppose that you are flying to Chicago to interview for a new job. If you were to survey all of the passengers on your plane, you would find that they had paid a variety of prices for their tickets. Airlines can segregate their markets by charging a different price for business fliers than they do for recreation fliers.
  1. When the sale produces a positive contribution margin.Remember, the total contribution margin is calculated by subtracting variable costs from revenue.
  1. When the company has excess capacity, or can charge the new customer for the opportunity cost of lost sales to existing customers.If a company does not have excess capacity (if it is selling all of its capacity at a price that covers full costs), it would be foolish (in most situations) to discount its price.

If a company with limited capacity is willing to sell its product to a new customer at a reduced price,however,(perhaps to open a new market), then it must charge the new customer an amount equal to the contribution margin it loses by taking sales away from existing customers. This will make more sense once we see an example.

All of the above conditions must be metfor the principle we are discussing to work. Let me illustrate this principle with two examples.

Example One

Bellevue Manufacturing makes a product, the CM-12. The company sells this product for $125.00 to local customers. Its full cost of production and distribution are shown below.

A distributor from Hong Kong wishes to purchase 10,000 units at a cost of $85.00. The president of Bellevue Manufacturingis reluctant to accept this sale, as the proposed price of $85.00 is below the $99.00 total cost of manufacturing the product.

Assuming the four criteria listed above are met, how much would the company make or lose if it accepts this proposal?

Assume in this example that none of the company’s production costs would change as a result of the sale. Also assume that the company has the excess capacity to produce the additional units.

To calculate the answer, we need only consider relevant costs. Since fixed costs are not relevant in the short run, we only need to look at revenues minus variable. Put another way, we need only a positive contribution margin to accept the sale.

The contribution margin per unit for the Hong Kong customer is shown below.

By accepting this order, Bellevue Manufacturing will earn an additional contribution margin of $10.00 per unit. All of this will go to the bottom line. The company will therefore increase its income by 10,000 units × $10.00 = $100,000.

Again, one must be careful. If the present customers of Bellevue Manufacturing find out that the CM-12 isbeing sold for less elsewhere, they may demand the same price. This of course would put the company out of business as they would no longer be able to cover their fixed costs.

Example Two

Okay, now let’s make the problem a little more complex.

In the above problem, none of the company’sexisting variable costs would change if they sold to the Hong Kong customer. Let’s now assumethat Bellevue Manufacturingwould not have to pay sales commissions. Their variable and selling expenses would decrease from $8.00 per unit to $4.00.

Let’s also assume that the manufacturing capacity of the company is 100,000 units per year, and the company is currently selling 95,000 units to existing customers. They can’t fill the new 10,000 unit order without giving up sales to existing customers.

What this means is there is now an opportunity cost of 5,000 units (100,000 units manufacturing capacity minus 95,000 units of existing demandminus 10,000 units to be sold to Hong Kong equals 5,000 unit shortfall).

What is the opportunity cost in dollars if Bellevue Manufacturing decides to take the order from Hong Kong?

This is calculated by multiplying the opportunity cost (in units) by the contribution margin (per unit)of sales to existing customers.

Students please note: we do not use the contribution margin for the new customer in this calculation, but the contribution margin for existing customers. That is because we are calculating the contribution margin given up to make the new sales. This is an error that some students make on examinations.

First let’s calculate the contribution margin for our existing customers. This calculation is shown below.