Future revenues A$ A$6 500 Deduct future costs Operating income A$8 500 A$6 500

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1 Chapter 8 DECISION MAKING AND RELEVANT INFORMATION 8-16 (20 min.) Disposal of assets 1. This is an unfortunate situation, yet the A$ costs are irrelevant regarding the decision to re-machine or sold as scrap. 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 maximised (or losses minimised). The difference in favour of re-machining is A$2000: (a) Re-machine (b) sold as scrap Future revenues A$ A$6 500 Deduct future costs Operating income A$8 500 A$6 500 Difference in favour of re-machining A$ This, too, is an unfortunate situation. But the A$ original cost is irrelevant to this decision. The difference in relevant costs in favour of replacing is A$3500 as follows: (a) Replace (b) Rebuild New truck A$ Deduct current disposal price of existing truck Rebuild existing truck A$ A$ A$ Difference in favour of replacing A$3 500 Note, here, that the current disposal price of A$ is relevant, but the original cost (or carrying amount, if the truck were not brand new) is irrelevant. 1 P a g e

2 8-17 (20 min.) Relevant and irrelevant costs 1. Make Buy Relevant costs Variable costs A$190 Avoidable fixed costs 10 Purchase price A$260 Unit relevant cost A$200 A$260 Hughes Computers should reject Peach s offer. The fixed costs of $80 are irrelevant because they will be incurred regardless of this decision. When comparing relevant costs between the choices, Peach s offer price is higher than the cost to continue to produce. 2. Keep Replace Difference Cash operating costs (3 years) A$ A$ A$6000 Current disposal value of old machine (2 200) Cost of new machine (9 000) Total relevant costs A$ A$ A$(800) AP Manufacturing should keep the old machine. The cost savings are less than the cost to purchase the new machine (15 min.) Multiple choices 1. Special order price per unit A$6.00 Variable manufacturing cost per unit A$4.50 Contribution margin per unit A$1.50 Effect on operating profit = A$ units = A$ increase From the above calculation, the best answer is (b). 2. Costs of purchases, units A$60 A$ Total relevant costs of making: Variable manufacturing costs, A$64 A$16 =A$48 Fixed costs eliminated 9 Costs saved by not making parts A$57 Total costs saved (A$ ) Extra costs of purchasing outside Minimum overall savings for Wizz Necessary relevant costs that would have to be saved in manufacturing of Part No. 575 A$ From the above calculation, the best answer is (b). 2 P a g e

3 8-21 (10 min.) Inventory decision, opportunity costs 1. Unit cost, orders of A$7.00 Unit cost, order of (0.98 A$7.00) A$6.86 Alternatives under consideration: (a) Buy units at start of year. (b) Buy units at start of each month. Average investment in inventory: (a) ( A$6.86) 2 A$ (b) ( A$7.00) Difference in average investment A$ Opportunity cost of interest forgone from unit purchase at start of year = A$ = A$ No. The A$ is an opportunity cost rather than an incremental or outlay cost. No actual transaction records the A$ as an entry in the accounting system. 3. The following table presents the two alternatives: Alternative A: Purchase spark plugs at beginning of year (1) Alternative B: Purchase spark plugs at beginning of each month (2) Difference (3) = (1) (2) Annual purchase-order costs (1 A$260; 12 A$260) Annual purchase (incremental) costs ( A$6.86; A$7) Annual interest income that could be earned if investment in inventory were invested (opportunity cost) (10% A$ ; 10% A$77 000) Relevant costs A$ A$ A$ A$ A$(2 860) (36 960) A$ Column (3) indicates that purchasing spark plugs at the beginning of each month is preferred relative to purchasing spark plugs at the beginning of the year because the opportunity cost of holding larger inventory exceeds the lower purchasing and ordering costs. If other incremental benefits of holding lower inventory such as lower insurance, materials handling, storage, obsolescence, and breakage costs were considered, the costs under Alternative A would have been higher, and Alternative B would be preferred even more. 3 P a g e

4 8-22(20 25 min.) Relevant costs, contribution margin, product emphasis 1. Flavoured milk Natural Orange Juice Cola Lemonade Selling price A$18.80 A$20.00 A$27.10 A$39.20 Deduct variable cost per case Contribution margin per case A$4.60 A$3.90 A$6.40 A$ The argument fails to recognise that shelf space is the constraining factor. There are only 12 metres of front shelf space to be devoted to drinks. Pratt should aim to get the highest daily contribution margin per metre of front shelf space: Flavoured milk Natural Orange Juice Cola Lemonade Contribution margin per case A$ 4.60 A$ 3.90 A$ 6.40 A$ 9.00 Sales (number of cases) per metre off shelf space per day Daily contribution per metre of front shelf space A$ A$93.60 A$25.60 A$ The allocation that maximises the daily contribution from drink sales is: Metres of Shelf Space Daily Contribution per Metre of Front Shelf Space Total Contribution Margin per Day Cola 6 A$ A$ Lemonade Natural orange juice Flavoured milk A$ The maximum of six metres of front shelf space will be devoted to Cola because it has the highest contribution margin per unit of the constraining factor. Four metres of front shelf space will be devoted to Lemonade, which has the second highest contribution margin per unit of the constraining factor. No more shelf space can be devoted to Lemonade since each of the remaining two products, Natural orange juice and Flavoured milk (that have the second lowest and lowest contribution margins per unit of the constraining factor) must each be given at least one metre of front shelf space. 4 P a g e

5 8-23 (10 min.) Selection of most profitable product Only Model 14 should be produced. The key to this problem is the relationship of manufacturing overhead to each product. Note that it takes twice as long to produce Model 9; machine-hours for Model 9 are twice that for Model 14. Management should choose the product mix that maximises operating profit for a given production capacity (the scarce resource in this situation). In this case, Model 14 will yield an A$14.25 contribution to fixed costs per machine hour, and Model 9 will yield A$13.50: Model 9 Model 14 Selling price Variable costs per unit (total cost FMOH) Contribution margin per unit Relative use of machine-hours per unit of product Contribution margin per machine hour A$ A$ A$ A$ A$ A$ P a g e