Chapter 6Chapter 6Relevant Information and Decision- Relevant Information and Decision-

Making: Production DecisionsMaking: Production Decisions

Objective 1Objective 1Define Opportunity Cost Define Opportunity Cost and Use it to Analyze the and Use it to Analyze the Income Effects of a Given Income Effects of a Given

AlternativeAlternative

Opportunity,Opportunity, Outlays and Outlays and Differential CostsDifferential Costs

Opportunity,Opportunity, Outlays and Outlays and Differential CostsDifferential Costs

is the maximum available contribution to profit is the maximum available contribution to profit forgone (or passed up ) by using limited forgone (or passed up ) by using limited

resources for a particular purpose.resources for a particular purpose.

This definition indicates that opportunity cost is This definition indicates that opportunity cost is not the usual outlay cost recorded in accounting. not the usual outlay cost recorded in accounting.

Opportunity cost is the contribution of the best Opportunity cost is the contribution of the best alternative that is excluded .alternative that is excluded .

Opportunity costOpportunity cost

A cost that requires a cash disbursement. A cost that requires a cash disbursement. Outlay cost is the typical cost recorded by Outlay cost is the typical cost recorded by

accountaccount ..

Outlay costOutlay cost

Or incremental cost is the difference in total Or incremental cost is the difference in total cost between two alternatives .cost between two alternatives .

Differential costDifferential cost

The contribution to profit of best of the The contribution to profit of best of the rejected alternatives. ( contribution of the best rejected alternatives. ( contribution of the best

alternative is excluded from consideration.)alternative is excluded from consideration.)

The salary forgone by a person who The salary forgone by a person who quits a job to start a business.quits a job to start a business.

An exampleAn example

Opportunity CostOpportunity CostOpportunity CostOpportunity Cost

Alternatives under ConsiderationAlternatives under ConsiderationRemainRemain

asas

employeeemployee

OpenOpen

a newa new

business business

Difference Difference

RevenuesRevenues60,00060,000200,000200,000140,000140,000 Outlay costs Outlay costs --120,000120,000120,000120,000

Income effect per year Income effect per year 60,00060,00080,00080,00020,00020,000

The opportunity cost of the new business is 60,000 The opportunity cost of the new business is 60,000 the forgone annual salary.the forgone annual salary.

Alternative chosenAlternative chosen::

New businessNew business RevenuesRevenues200,000200,000 Expenses:Expenses:

Outlay costsOutlay costs120,000120,000 Opportunity cost of employee salary Opportunity cost of employee salary 60,00060,000

180,000180,000 Income effect per yearIncome effect per year20,00020,000

The first solution (tabulation) does not The first solution (tabulation) does not mention opportunity cost because the economic mention opportunity cost because the economic

impacts are individually measured for each of impacts are individually measured for each of the alternatives. Neither alternative has been the alternatives. Neither alternative has been

excluded from considerationexcluded from consideration

The second mention opportunity cost The second mention opportunity cost (60.000 salary, impact of the best excluded (60.000 salary, impact of the best excluded

alternative) as a cost of the chosen alternativealternative) as a cost of the chosen alternative

The failure to recognize opportunity cost in The failure to recognize opportunity cost in the second tabulation wile misstate the the second tabulation wile misstate the

difference between alternatives.difference between alternatives.

Alternative chosenAlternative chosen::

Remain as employeeRemain as employee RevenuesRevenues60,00060,000 Expenses:Expenses:

Outlay costsOutlay costs-- Opportunity cost of independent practice Opportunity cost of independent practice 80,00080,000

80,00080,000 Income effect per yearIncome effect per year(20,000)(20,000)

If the first alternatives is chosenIf the first alternatives is chosen

Objective 2Objective 2Analyze Given Data to Support Analyze Given Data to Support

a Decision to Make or Buy a Decision to Make or Buy Certain Parts or ProductsCertain Parts or Products

Companies often must decide whether to Companies often must decide whether to produce its own parts and subassemblies or buy produce its own parts and subassemblies or buy

them from an outside supplier.them from an outside supplier.

Sometimes quantitative factors dominate Sometimes quantitative factors dominate qualitative assessments of costs. Some qualitative assessments of costs. Some

manufactures always make parts because they manufactures always make parts because they want to control quality, others because they want to control quality, others because they

possess special know-how, usually skilled labor possess special know-how, usually skilled labor or rare raw materials needed for production. or rare raw materials needed for production.

Alternatively, some companies always purchase Alternatively, some companies always purchase parts to protect mutually advantageous long-run parts to protect mutually advantageous long-run

relationships with their suppliers.relationships with their suppliers.

Make or Buy and Idle FacilitiesMake or Buy and Idle FacilitiesMake or Buy and Idle FacilitiesMake or Buy and Idle Facilities

What quantitative factors are relevant to the What quantitative factors are relevant to the decision to make or buy ?decision to make or buy ?

A key Factor is whether there are idle A key Factor is whether there are idle facilities.facilities.

The key to make-or-buy decisions is The key to make-or-buy decisions is identifying the additional costs for identifying the additional costs for

making ( or the costs avoided by buying ) making ( or the costs avoided by buying ) a part or subcomponent.a part or subcomponent.

The relevant costs to this decision The relevant costs to this decision include the additional variable costs, and include the additional variable costs, and

the fixed costs that will be eliminated if the fixed costs that will be eliminated if the parts are bought instead of made the parts are bought instead of made

MakeMakeBuyBuy

TotalTotalPer Per unitunit

TotalTotalPer Per unitunit

Purchase cost :Purchase cost :200,000200,0001010

Direct materialDirect material20,00020,00011

Direct laborDirect labor80,00080,00044

Variable factory overheadVariable factory overhead40,00040,00022

Fixed factory overhead that Fixed factory overhead that can be avoided by not can be avoided by not making (supervisor’s salary)making (supervisor’s salary)20,00020,00011 Total relevant costsTotal relevant costs160,000160,00088200,000200,0001010

Difference in favor of Difference in favor of makingmaking40,00040,00022

Suppose the released facilities can be used in Suppose the released facilities can be used in some other manufacturing activity ( to produce a some other manufacturing activity ( to produce a contribution to profits of, say, L.E. 55.000) or can contribution to profits of, say, L.E. 55.000) or can

be rented out (say, for L.E. 35.000). be rented out (say, for L.E. 35.000).

Make or Buy : Use of FacilitiesMake or Buy : Use of Facilities

The choice in make- or- buy decisions is The choice in make- or- buy decisions is not only whether to make or buy, it is how not only whether to make or buy, it is how

best to use available facilities.best to use available facilities.

MakeMakeBuy & Buy & leave leave

facilities facilities idleidle

Buy &rent Buy &rent out out

facilitiesfacilities

Buy &use Buy &use facilities for facilities for

other other product product

Rent revenueRent revenue----3535--Contribution from other Contribution from other productsproducts

------5555

Obtaining of partsObtaining of parts(160)(160)(200)(200)(200)(200)(200)(200)

Net relevant costsNet relevant costs(160)(160)(200)(200)(165)(165)(145)(145)

The alternativesThe alternatives are:are:

1.1. Make the parts.Make the parts.2.2. Buy the part and leave facilities idle.Buy the part and leave facilities idle.

3.3. Buy and rent out facilities.Buy and rent out facilities.4.4. Buy and use facilities for other products.Buy and use facilities for other products.

ExampleExample

Electrical Electrical and and

Mechanical Mechanical ComponentsComponents

PlasticPlasticHousingHousing

IndustrialIndustrialDrillsDrills

Revenue100,000 unit,@ L.E. 100 Revenue100,000 unit,@ L.E. 100 10,000,00010,000,000

Variable costs :Variable costs :

Direct materialDirect material4,400,0004,400,000500,000500,0004,900,0004,900,000Direct laborDirect labor400,000400,000300,000300,000700,000700,000Variable factory overheadVariable factory overhead100,000100,000200,000200,000300,000300,000Other variable costsOther variable costs100,000100,000--100,000100,000

Sales commissions @ 10% of salesSales commissions @ 10% of sales1,000,0001,000,000--1,000,0001,000,000Total variable costsTotal variable costs6,000,0006,000,0001,000,0001,000,0007,000,0007,000,000Contribution marginContribution margin3,000,0003,000,000

Reparable fixed costsReparable fixed costs1,900,0001,900,000400,000400,0002,300,0002,300,000Common fixed costsCommon fixed costs320,000320,00080,00080,000400,000400,000Total fixed costsTotal fixed costs2,220,0002,220,000480,000480,0002,700,0002,700,000Operating income Operating income 300,000300,000

RequiredRequiredDuring the year a prospective customer in an During the year a prospective customer in an

unrelated market offered L.E. 82.000 for 1,000 drills. unrelated market offered L.E. 82.000 for 1,000 drills. The latter would be in addition to the 100,000 units The latter would be in addition to the 100,000 units

sold. The regular sales commission rate would have sold. The regular sales commission rate would have been paid. The president rejected the order because " been paid. The president rejected the order because "

it was below cur costs of L.E. 97 per unit " What it was below cur costs of L.E. 97 per unit " What would operating income have been if the order had would operating income have been if the order had

been accepted?been accepted?A supplier offered to manufacture the year's supply of A supplier offered to manufacture the year's supply of

100,000 plastic housings for L.E. 13.50 each. What 100,000 plastic housings for L.E. 13.50 each. What would be the effect on operating income if the Block would be the effect on operating income if the Block

Company purchased rather than made the housings? Company purchased rather than made the housings? Assume that L.E.350,000 of the separable fixed costs Assume that L.E.350,000 of the separable fixed costs assigned to housings would have been avoided if the assigned to housings would have been avoided if the

housings were purchased.housings were purchased.

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The company could have purchased the housings The company could have purchased the housings for L.E. 13.50 each and used the vacated space for for L.E. 13.50 each and used the vacated space for

the manufacture of a deluxe version of its drill. the manufacture of a deluxe version of its drill. Assume that 20,000 deluxe units could have been Assume that 20,000 deluxe units could have been made ( and sold in addition to the 100,000 regular made ( and sold in addition to the 100,000 regular

units) at a unit variable cost of L.E.90, exclusive of units) at a unit variable cost of L.E.90, exclusive of housings and exclusive of the 10% sales housings and exclusive of the 10% sales

commission. The 20,000 extra plastic housings commission. The 20,000 extra plastic housings could also be purchased for L.E. 13.50 each. The could also be purchased for L.E. 13.50 each. The sales price would have continued, because these sales price would have continued, because these

costs related primarily to the manufacturing costs related primarily to the manufacturing facilities used. What would operating income have facilities used. What would operating income have

been if Block had bought the housings and made been if Block had bought the housings and made and sold the deluxe units?and sold the deluxe units?

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The costs of filling the special order follow:The costs of filling the special order follow:

SolutionSolution

Direct materialDirect material49,00049,000Direct laborDirect labor7,0007,000Variable factory overheadVariable factory overhead3,0003,000Other variable costsOther variable costs1,0001,000 Sales commissions @ 10% of sales Sales commissions @ 10% of sales ×× 82,000 82,0008,2008,200Total variable costsTotal variable costs68,20068,200

Selling priceSelling price82,00082,000

Contribution marginContribution margin13,80013,800

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Operating income would have been L.E.300.000 + L.E. 13.800 or Operating income would have been L.E.300.000 + L.E. 13.800 or L.E. 313.800, if the order had been accepted. In a sense, the decision to L.E. 313.800, if the order had been accepted. In a sense, the decision to reject the offer implies that the Block Company is willing to invest L.E. reject the offer implies that the Block Company is willing to invest L.E.

13.800 in immediate gains forgone (an opportunity cost ) in order to 13.800 in immediate gains forgone (an opportunity cost ) in order to preserve the long – run selling- price structure.preserve the long – run selling- price structure.

Assuming that L.E. 350.000 of the fixed costs could Assuming that L.E. 350.000 of the fixed costs could have been avoided by not making the housings and have been avoided by not making the housings and

that the other fixed costs would have been continued, that the other fixed costs would have been continued, the alternatives can be summarized as follows:the alternatives can be summarized as follows:

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MakeMakeBuyBuyPurchase costPurchase cost1,350,0001,350,000

Variable costsVariable costs1,000,0001,000,000

Avoidable fixed costsAvoidable fixed costs350,000350,000

Total relevant costsTotal relevant costs 1,350,0001,350,0001,350,0001,350,000

If the facilities used for plastic housings became idle, If the facilities used for plastic housings became idle, the Block Company would be indifferent as to whether the Block Company would be indifferent as to whether

to make or buy. Operating income would be to make or buy. Operating income would be unaffected.unaffected.

The effect of purchasing the plastic housings and The effect of purchasing the plastic housings and using the vacated facilities for manufacture of a using the vacated facilities for manufacture of a

deluxe version of its drill is:deluxe version of its drill is:

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Sales Sales would increase by 20,000 units,@ L.E. 130would increase by 20,000 units,@ L.E. 1302,600,0002,600,000

Variable costs exclusive of parts would increase by Variable costs exclusive of parts would increase by 20,000 units,@ L.E. 9020,000 units,@ L.E. 90

1,800,0001,800,000

Plus: sales commission, 10% of L.E. 2, 600,000Plus: sales commission, 10% of L.E. 2, 600,000260,000260,0002.2.060,000060,000

Contribution margin on 20,000 unitsContribution margin on 20,000 units540,000540,000

Housing: 120,000 rather than 100,000 would be Housing: 120,000 rather than 100,000 would be NeededNeeded

Buy 120,000@ L.E. 13.50Buy 120,000@ L.E. 13.501,620,0001,620,000

Make 100,000 @ L.E. 10 (only the variable costs Make 100,000 @ L.E. 10 (only the variable costs Are relevant)Are relevant)

1,000,0001,000,000

Excess cost of outside purchaseExcess cost of outside purchase620,000620,000

Fixed costs, unchangedFixed costs, unchanged--

Disadvantage of making deluxe units Disadvantage of making deluxe units 80,00080,000

Operating income would decline to L.E. 220,000 Operating income would decline to L.E. 220,000 (L.E.300,000 - L.E. 80,000). The deluxe un bring (L.E.300,000 - L.E. 80,000). The deluxe un bring

in a contribution margin of L.E. 540,000, but the in a contribution margin of L.E. 540,000, but the additional costs of buying rather than making additional costs of buying rather than making

housings is L.E. 620,000, leading to a net housings is L.E. 620,000, leading to a net disadvantage of L.E. 80,000.disadvantage of L.E. 80,000.

Thank youThank you