17 Activity Resource Usage Model & Tactical Decision Making

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1 Relevant Costing By Dr. Michael Constas Page 1 17 Activity Resource Usage Model & Tactical Decision Making In making decisions, the following steps are taken: Define the problem; Identify the feasible alternatives; Identify the costs of each feasible alternative; Compare the relevant costs and benefits; and Select the alternative with the greatest net benefit. The key part of this analysis is to consider only the information that is relevant to the decision being made. Relevant Costs & Benefits Relevant costs and benefits are costs and benefits that are different between the alternatives being considered. Costs that are the same, regardless of which alternative is chosen, have no impact on the decision making process. How can they? Their impact on each alternative is exactly the same. For example, assume that you rent a boat for $1,000 a month. Also assume that you can operate either a harbor tour business or a fishing business using that boat. The following revenues and costs would be generated from the alternative uses of the boat: Fishing Tour Difference Revenue $8,000 $10,000 -$2,000 Expenses -1,000-4,000 3,000 Rent -1,000-1,000 0 Profit $6,000 $5,000 $1,000 You will generate $1,000 more profit if you choose the Fishing Business alternative. Your decision to operate a Fishing business would remain unchanged if you had not considered the rent: Fishing Tour Difference Revenue $8,000 $10,000 -$2,000 Expenses -1,000-4,000 3,000 Profit $7,000 $6,000 $1,000 With either calculation, the Fishing business produces a profit that is $1,000 higher than the Tour business. If a particular cost is the same under both alternatives (e.g., rent), that cost is not relevant to the decision of which alternative to choose. Including such a cost in your analysis might cause you to make the wrong decision. The purpose of this analysis is to make a decision as to which alternative to choose. The bottom line profit/cost that appears in the table is not important to our analysis, and it does not have

2 Relevant Costing By Dr. Michael Constas Page 2 to reflect all of the revenues and costs associated with each alternative. The difference between the two columns is the key to this analysis (e.g., Fishing produces $1,000 more in Operating Profits). Another term used for relevant costs is differential costs, and this subject matter is often referred to as Relevant Costing or Differential Costing. Relevant costs do not include sunk or historical costs. Sunk costs are costs that we have already spent, and that we cannot recover. Because they are already spent, sunk costs are the same (not different) for each alternative. In order to be relevant, costs and benefits must be future costs and benefits. For example, assume that you bought an original oil painting by Leroy Neiman for your home. The Sunk Cost painting is huge, and filled an entire wall of your living room. At the time, you paid $10,000 for the painting. You are now downsizing your lifestyle (and living accommodations), and the painting is too large to be appropriately displayed in your new trailer park accommodations. You have decided to sell the painting, but the only offer that you have received is $8,000. The fact that you originally paid $10,000 for the painting is not relevant to whether you should accept or reject this offer. The original price that you paid for the painting is a sunk cost. Although, you may not like the idea of selling the painting for less than you paid for it, you should be attempting to liquidate your investment in the painting in a manner that will produce the highest net benefit to you. This could involve selling the painting at a loss, if that is the best deal that you can obtain. Other revenue generating operations that are available if only one of the alternatives is selected is relevant to your decision. These are Opportunity Costs. For example, assume that you have rented retail space, and you are trying to decide whether to use it to operate a CD store or a Comic Book store. Assume that if you elect to operate a Comic Book store, then you will also be able to sublease part of your space to vending machine operators for an additional $200 a month. There is not sufficient space to permit such a sublease if you choose to operate a CD store. The lost revenue from the vending machines ($200) is viewed as an Opportunity Cost if the CD store alternative is chosen, and it is added to the other costs of the CD store.

3 Relevant Costing By Dr. Michael Constas Page 3 CD Store Comic Book Store Difference Revenue $10,000 $7,000 -$3,000 Expenses -5,000-2,000-3,000 Sublease Profit $4,800 $5,000 -$200 In this chapter we will focus on a quantitative analysis, but qualitative factors are also relevant. For example, assume you are trying to decide whether you should produce a product internally, or outsource its production. While we will focus on which alternative provides you with the maximum economic net benefit; in real life, qualitative factors would play an important role in your decision. For example, you would be concerned with such qualitative factors as the reliability of the supplier; your ability to control the quality of the outsourced products; the impact on the morale of your workforce if you downsize your manufacturing operations; whether you decision would change with a change in circumstances, and the ability for you to resume production of the product if circumstances change. Another factor that is very relevant to decision making is the time-value of money. For simplicity, we will not consider it in this chapter. Relevant Cost Example Assume that Titanic, Inc. owns a ship that takes passengers on day-long cruises from Long Beach to Catalina and back again. The ship was purchased for $4,000,000, and has a 20-year life. The ship is depreciated using the straight-line method over its useful life with no salvage value. This produces a depreciation expense of $200,000 a year. Only half of the ship is used for the Catalina cruises. Titanic is very pleased with its cruise business, which generates an Operating Profit of $500,000 each year. Titanic is also on the verge of signing a contract with the Boy Scouts in which Titanic will be engaged to transport the Scouts on a regular basis to Catalina for camping trips. This contract is expected to bring in an additional net profit of $15,000 each year. Titanic is considering two alternate uses of the unused portion of the ship. The first alternative is to carry freight to Catalina. Titanic estimates that it a freight business would produce an annual revenue of $70,000 and annual expenses of $10,000 (not including the depreciation attributable to the half of the ship used for the freight, which would be $100,000).

4 Relevant Costing By Dr. Michael Constas Page 4 The second alternative is to rent the space to a company that will use the space to operate a floating disco. Titanic projects that a disco rental will generate annual rents of $90,000, but it will also increase expenses by $20,000 (not including the $100,000 depreciation expense). The Boy Scouts have told Titanic, however, that they will not patronize a ship that is used as a disco. We would analyze the two alternatives in the following manner: Freight Disco Difference Revenue $70,000 $90,000 -$20,000 Cash Expenses -$10,000 -$20,000 10,000 Opportunity Cost -$15,000 15,000 Operating Profit $60,000 $55,000 $5,000 The Operating Profit from the cruise operation is irrelevant to our decision. We will operate the cruise regardless of which alternative we choose. (It is not different between our alternatives.) The depreciation on the ship is also irrelevant. The depreciation expense is based on the original cost of the ship, and it represents a sunk cost. The loss ticket sales to the Boy Scouts are an Opportunity Cost for the Disco alternative. Special Orders Special Orders are a classic area in which Relevant Costing is used. In these problems, you have a business that is approached by a potential customer. The customer is in an area that your business does not normally serve. The potential customer offers to buy your product or service at a price below the cost to provide the product or service (the special order). The caveat about the area not normally served is often put into these problems to avoid the issue of whether the special order will result in any cannibalization of your existing sales when existing customers demand the same low price. The caveat, in effect, states that the special order has no relationship to or impact on our regular business. The caveat is also included because price discrimination between similar customers is illegal under antitrust laws. In these problems, the overall cost to provide the product or service is irrelevant. You are already in the business. You are trying to decide if accepting the special order will increase your Operating Profit. Your focus should be on whether the incremental revenue produced by the special order is higher than the added expenses and costs incurred by the special order. We know from our discussion of cost behavior that the increased production to meet a special order will increase our Variable Costs. We also need to examine whether we can produce the units needed for the special order with our existing capacity (Fixed Costs) or whether additional capacity will be needed.

5 Relevant Costing By Dr. Michael Constas Page 5 For example, assume: You normally have Revenue of $A, and the special order will produce additional Revenue of $a. You normally have Variable Costs of $B, and the special order will produce additional Variable Costs of $b. You normally have Fixed Costs of $C, and whether the special order will require additional capacity at a cost of $c has to be determined. Don t Take Special Order Take Special Order Difference Revenue: A (A + a) a Variable Costs: -B -(B+b) -b Fixed Costs -C -(C+c?) -c? Incremental Profit A (B+C) (A+a)-(B+c+C+c?) a-(b+c?) Because A, B, & C are the same for both alternatives, you can ignore them and focus only on the incremental revenue and costs from the special order. The Fixed Costs do not change if you have sufficient excess capacity to do the special order. You also have to be careful about whether some Variable Costs will be different when producing the special order. For example, maybe you will not need to pay a sales commission or it will be a reduced sales commission. Assume that you run a small airline that takes passengers to a resort island, which has a deluxe conference center. Although tourists go to this island, they find your rate of $700 per passenger too high, and they prefer to take the 4 hour ferry ride to the island, which only costs $50 per passenger. Your clientele are business people, who attend meetings at the conference center. The business people are willing to pay your rates in order to get to the island in 20 minutes. A one-way trip to/from the island costs you $3,000, and your jet can carry ten passengers. It, therefore, costs you $300 per passenger to operate your business. On a typical trip, you sell 6 seats, and 4 seats remain empty. Motel 6½ offers to purchase, on a stand-by basis, any unsold tickets on your jet. They agree that the tickets will only be resold to their customers, who are tourists. The business travelers stay at the luxury hotel at the conference center (not the Motel 6½). The manager of the Motel 6½ offers to pay you $100 a ticket. The fact that it costs you $300 per passenger to fly to the island is irrelevant. You are already in the airline business, and you make on average $1,200 on each flight ($4,200

6 Relevant Costing By Dr. Michael Constas Page 6 - $3,000). You should be considering whether the sale of the tickets to the tourists will hurt your existing airline business. Assuming that it will not, you should then ask whether the accepting the special order will increase your Operating Profits: Take Special Order Don t Take Special Order Difference Incremental Revenue $400 $0 $400 Incremental Expenses Marginal Profit $400 $0 $400 Accepting the special order will increase your Operating Profits by $400 per trip. Per Unit Fixed Manufacturing Overhead Application Rates Managers often complain that, despite the fact that: (i) they have excess capacity, and (ii) their Fixed Manufacturing Overhead will not increase if they accept a special order, their firm will still charge the special order for Fixed Manufacturing Overhead. These managers are forgetting to include the Fixed Manufacturing Overhead Variance in their analysis of the situation. An overhead variance is ultimately used to adjust the amount of overhead applied to the units produced to the actual overhead cost incurred. If your overhead is over-applied, then adding additional overhead to the special order will just increase the amount that the overhead is over-applied. The amount by which the overhead is over-applied will ultimately be credited to Cost of Goods Sold, thereby reducing the amount of overhead in Cost of Goods Sold to the actual overhead cost and canceling out that application of overhead to the special order. Assume: Over-applied O/H=$100,000 & Special Order O/H = $10,000 Don t Accept Accept Added to Special Order $10,000 Added to COGS at Year End -$100,000 -$110,000 Net Affect -$100,000 $100,000 If your overhead is under-applied, then the Cost of Goods Sold will be increased by the amount that the overhead is under-applied at the end of the year. If you apply more overhead to the special order, you will also reduce the amount that Cost of Goods Sold will be increased at the end of the year by that same amount. You would have added that overhead to the Cost of Goods Sold anyway, you just shifted it to the special order away from the end of the year adjustment.

7 Relevant Costing By Dr. Michael Constas Page 7 Operating Profits will not be affected by the overhead applied to the special order. Assume: Under-applied O/H=$100,000 & Special Order O/H = $10,000 Don t Accept Accept Added to Special Order $10,000 Added to COGS at Year End $100,000 $90,000 Net Affect $100,000 $100,000 When the year end variance adjustment to Cost of Goods Sold is considered, the Fixed Manufacturing Overhead applied to a special order ultimately does not lower your Operating Profits. Dropping A Division or Product Product Line-Up Another area in which Relevant Costing is used is whether to drop a division or product. Companies often prepare income statements for their divisions or products. These income statements include all of the costs of the products and divisions. Some Fixed Costs, however, are not relevant to this decision, and their inclusion can mislead managers when deciding whether to discontinue a division or product. In this area, the only relevant Fixed Costs are the costs that will disappear if the product or division is discontinued. (If Fixed Costs do not disappear, then they are not different, and thereby not relevant.) Consider Green Toys, a prominent toy manufacturer, whose line-up of toys includes three action figures: Gumby, Barbie and GI Joe. Green releases internal income statements that show that Green is losing money on the Gumby action figure. Based on these financial statements, Green is considering discontinuing production of the Gumby action figure: Barbie GI Joe Gumby Total Revenue $600,000 $350,000 $250,000 $1,200,000 Variable Costs -200, , , ,000 Fixed Costs -300, , , ,000 Operating Profit $100,000 $50,000 -$50,000 $100,000 The presentation of this income statement leads the reader to assume that Green s Operating Profit will increase by $50,000 if the $50,000 loss on the Gumby sales can be eliminated by discontinuing the action figure. This conclusion, however, may not be accurate.

8 Relevant Costing By Dr. Michael Constas Page 8 We know that the revenue produced by sale of the action figure will disappear if Gumby is discontinued. We also know that the Gumby Variable Costs, by definition, will drop to zero if the product is dropped. Without knowing more, we cannot be sure that the Fixed Costs attributable to the Gumby action figure will disappear if the action figure is discontinued. Some Fixed Costs disappear if a product is dropped. These Fixed Costs are tied to the product. They are called Direct Fixed Costs. An example of a Direct Fixed Cost would be the salary of the product manager, who will be laid off if the product is discontinued. If the Gumby action figure is dropped, the salary paid to the product manager will drop to zero. On the other hand, some Fixed Costs are not tied to the product, but are generated by the factory or company as a whole. These are called Common Fixed Costs. Common Fixed Costs are allocated to a product, but they are not reduced if you drop the product to which they are assigned. Instead, they are reassigned to another product. An example of a Common Fixed Cost would be the factory rent allocated to the Gumby action figure. It is likely that the rent on the factory will not be decreased if we drop the Gumby action figure. Instead, it will be reassigned to the Gumby and Pokey action figures. Assume that the factory rent is $450,000, and it is allocated to the three action figures based on the factory floor space dedicated to their respective production lines. The remaining Fixed Costs are the salaries of the product managers, who will be laid off if their product is discontinued: Barbie GI Joe Gumby Total Revenue $600,000 $350,000 $250,000 $1,200,000 Variable Costs -200, , , ,000 Manager Salary -100,000-50,000-50, ,000 Rent -200, , , ,000 Operating Profit $100,000 $50,000 -$50,000 $100,000 Now that the rent has been separated from the product managers salaries, we can analyze the situation: Don t Drop Gumby Drop Gumby Difference Revenue $250,000 $0 $250,000 Variable Costs -150, ,000 Manager Salary -50, ,000 Operating Profit $50,000 $0 $50,000 The factory rent will not change if you drop the Gumby action figure. It is not a relevant cost. Green will make $50,000 more if it does not drop the Gumby action figure rather than dropping the figure. There is nothing wrong with allocating rent to the Gumby

9 Relevant Costing By Dr. Michael Constas Page 9 action figure. Green is, in fact, losing $50,000 on the Gumby action figure. The profitability of the Gumby action figure is not the issue. The issue is whether Green s Operating Profit will be higher or lower if it drops the action figure. Assume that Green dropped the Gumby action figure, and that all other revenue and costs remain unchanged (other than reassigning the factory rent to the remaining products). Revising Green s income statement to reflect the discontinuance of the Gumby action figure shows that Green s Operating Profit will go down by $50,000 as predicted above: Barbie GI Joe Total Revenue $600,000 $350,000 $950,000 Variable Costs -200, , ,000 Fixed Costs -100,000-50, ,000 Rent -257, , ,000 Operating Profit $42,857 $7,143 $50,000 You can prepare an income statement that treats Common Fixed Costs in a manner that will not mislead managers into making the wrong decision regarding whether to retain or drop a product or division. With this format, the Common Fixed Costs, such as rent, are shown under a total column and not allocated to an individual product: Barbie GI Joe Gumby Total Revenue $600,000 $350,000 $250,000 $1,200,000 Variable Costs -200, , , ,000 Manager Salary -100,000-50,000-50, ,000 Product Profit $300,000 $200,000 $50,000 Rent -450,000 Operating Profit $100,000 With this format, it is clear that the sales of the Gumby action figure contribute $50,000 to Green s Operating Profits. We will discuss this area more fully when we discuss Variable Costing. Make or Buy Relevant Costing is also very useful in when deciding whether you should outsource a product. In these problems, you can either make an item that you use in your business or you can purchase it from an outside supplier. When calculating the cost of each alternative, you have to be careful to accurately reflect what manufacturing costs will disappear if you purchase a product rather than manufacturing it. Also, Opportunity Costs often appear in this area.

10 Relevant Costing By Dr. Michael Constas Page 10 Assume that the National Parks Service runs a restaurant on Liberty Island that offers a limited gourmet menu to discriminating tourists visiting the Statue of Liberty. The meals that are served at the restaurant are prepared by the National Parks Service at a nearby kitchen facility located in the New York City (not on Liberty Island). The meals are then delivered to the restaurant. During a month, the National Parks Service prepares 12,000 meals. The National Parks Service is not interested in relinquishing control of its restaurant. It is interested, however, in subcontracting the preparation of the meals that are served at the restaurant. McDonald s Corporation wishes to enter the gourmet catering market, and offers to cater the meals served at the Liberty Island restaurant. Each meal costs the National Parks Service $35 as shown below: Direct Materials $ 5 Direct Labor 15 Variable Overhead 10 Fixed Overhead 5 $35 McDonald s Corporation has offered to provide each meal for $37. If the National Parks Service accepts the offer, its kitchen facility can be rented out for $40,000. However, $3 of the Fixed Manufacturing Overhead currently being applied to each meal would have to be reassigned to the restaurant operation. It represents a portion of the salaries of the restaurant personnel who will continue to work at the restaurant. The National Parks Service would consider the following Relevant Costs of each alternative: Buy Meals Make Meals Difference Direct Materials: 0 $60,000 (5x12,000) -$60,000 Direct Labor: 0 180,000 (15x12,000) -180,000 Variable Overhead: 0 120,000 (10x12,000) -120,000 Fixed Overhead: $36,000 (3x12,000) 60,000 (5x12,000) -24,000 Opportunity Cost 0 40,000-40,000 Purchase Price: 444,000 (37x12,000) 444,000 Total Cost: $480,000 $460,000 $20,000 It is cheaper for the National Parks Service to continue to make the meals served at the restaurant.

11 Relevant Costing By Dr. Michael Constas Page 11 Most books treat the $40,000 rental as an Opportunity Cost as shown above. You could also place it in the Buy column as a reduction of cost. Regardless of how you treat these items, the $20,000 difference in cost will remain: Buy Meals Make Meals Difference Direct Materials: $60,000 (5x12,000) -$60,000 Direct Labor: 180,000 (15x12,000) -180,000 Variable Overhead: 120,000 (10x12,000) -120,000 Fixed Overhead: $36,000 (3x12,000) 60,000 (5x12,000) -24,000 Sublease -40, ,000 Purchase Price: 444,000 (37x12,000) 0 444,000 Total Cost: $440,000 $420,000 $20 Sell or Process Further Another area in which Relevant Costing is traditionally used is when you produce a product in a raw or semi-finished state. There is a market for your raw product, but you could process the product further and sell the processed product at a higher price. For example, assume that you own oil wells. You could either sell the crude oil to a refiner or refine it yourself. Assume that Bond Inc. owns a diamond mine. It produces two grades of diamonds: Grade A and Grade B. Currently, Bond sells its diamonds to DeBeers. DeBeers pays $700 a carat for Grade A diamonds and $500 a carat for Grade B diamonds. Alternatively, Bond could process the Grade A and/or Grade B diamonds further and then sell them directly to American jewelers for $900 and $1,200, respectively. Additional processing and marketing costs of $100 for Grade A diamonds and $750 for Grade B diamonds would be incurred in the event of a direct sale to American jewelers. You would analyze the situation as follows: Grade A Diamonds: USA Sale DeBeers Sale Difference Revenue: $900 $700 $200 Additional Marketing Costs: Operating Profit: $800 $700 $100 Bond makes $100 more in profits if it processes the Grade A Diamonds and then sells them directly to American jewelers.

12 Relevant Costing By Dr. Michael Constas Page 12 Grade B Diamonds: DeBeers Sale USA Sale Difference Revenue: $500 $1, Additional Marketing Costs: Operating Profit: $500 $450 $50 Bond makes $50 more in profits if it sells the Grade B diamonds to DeBeers. E-1. Opportunity costs are: A) not used for decision making. B) the same as variable costs. C) the same as historical costs. D) relevant to decision making. PROBLEMS E-2. Freestone Company is considering renting Machine Y to replace Machine X. It is expected that Y will waste less direct materials than does X. If Y is rented, X will be sold on the open market. For this decision, which of the following factors is (are) relevant? I. Cost of direct materials used II. Resale value of Machine X A) Only I B) Only II C) Both I and II D) Neither I nor II E-3. In a sell or process further decision, which of the following costs are relevant? I. A variable production cost incurred prior to the split-off point. II. An avoidable fixed production cost incurred after the split-off point. A) Only I. B) Only II. C) Both I and II. D) Neither I nor II. Use the following to answer questions E-4 through E-6: The Tingey Company has 500 obsolete microcomputers that are carried in inventory at a total cost of $720,000. If these microcomputers are upgraded at a total cost of $100,000, they can be sold for a total of $160,000. As an alternative, the microcomputers can be sold in their present condition for $50,000.

13 Relevant Costing By Dr. Michael Constas Page 13 E-4. The sunk cost in this situation is: A) $720,000. B) $160,000. C) $ 50,000. D) $100,000. E-5. What is the net advantage or disadvantage to the company from upgrading the computers rather than selling them in their present condition? A) $110,000 advantage. B) $660,000 disadvantage. C) $ 10,000 advantage. D) $ 60,000 advantage. E-6. Suppose the selling price of the upgraded computers has not been set. At what selling price per unit would the company be as well off upgrading the computers as if it just sold the computers in their present condition? A) $100. B) $770. C) $300. D) $210. Use the following to answer questions 7-8: Meacham Company has traditionally made a subcomponent of its major product. Annual production of 20,000 subcomponents result in the following costs: Direct materials... $200,000 Direct labor... $180,000 Variable overhead... $150,000 Fixed overhead... $100,000 Meacham has received an offer from an outside supplier who is willing to provide 20,000 units of this subcomponent each year at a price of $28 per subcomponent. Meacham knows that the facilities now being used to make the subcomponent would be rented to another company for $75,000 per year if the subcomponent were purchased from the outside supplier. Otherwise, the fixed overhead would be unaffected. E-7. If Meacham decides to purchase the subcomponent from the outside supplier, how much higher or lower will operating income be than if Meacham continued to make the subcomponent? A) $45,000 higher. B) $70,000 higher. C) $30,000 lower. D) $70,000 lower.

14 Relevant Costing By Dr. Michael Constas Page 14 E-8. Suppose the price for the subcomponent has not been set. At what price per unit charged by the outside supplier would Meacham be economically indifferent between making the subcomponent or buying it from the outside? A) $ B) $ C) $ D) $ Use the following to answer questions E-9 through E-10: The Melville Company produces a single product called a Pong. Melville has the capacity to produce 60,000 Pongs each year. If Melville produces at capacity, the per unit costs to produce and sell one Pong are as follows: Direct materials... $15 Direct labor Variable manufacturing overhead... 8 Fixed manufacturing overhead... 9 Variable selling expense... 8 Fixed selling expense... 3 The regular selling price for one Pong is $80. A special order has been received by Melville from Mowen Company to purchase 6,000 Pongs next year. If this special order is accepted, the variable selling expense will be reduced by 75%. However, Melville will have to purchase a specialized machine to engrave the Mowen name on each Pong in the special order. This machine will cost $9,000 and it will have no use after the special order is filled. The total fixed manufacturing overhead and selling expenses would be unaffected by this special order. E-9. Assume Melville anticipates selling only 50,000 units of Pong to regular customers next year. If Mowen Company offers to buy the special order units at $65 per unit, the effect of accepting the special order on Melville's operating income for next year should be a: A) $60,000 increase. B) $90,000 decrease. C) $159,000 increase. D) $36,000 increase.

15 Relevant Costing By Dr. Michael Constas Page 15 E-10. Assume Melville anticipates selling only 50,000 units of Pong to regular customers next year. At what selling price for the 6,000 special order units would Melville be economically indifferent between accepting or rejecting the special order from Mowen? A) $ B) $ C) $ D) $ P-1 Keep or Drop. Audio Mart is a retailer of radios, stereos, and televisions. The store carries two portable sound systems that have radios, tape players, and speakers. System A, of slightly higher quality than System B, costs $20 more. It also sells headsets. Variable-costing income statements for the three products are shown below. System A System B Headset Sales $45,000 $32,500 $8,000 Less: Variable Expenses -20,000-25,500-3,200 Contribution Margin $25,000 $ 7,000 $4,800 Less: Fixed Costs* -10,000-18,000-2,700 Operating Profit $15,000 -$11,000 $2,100 * Fixed Costs include $11,000 of common fixed costs, which are allocated $5,000 to A; $5,000 to B; and $1,000 to the Headset. The owner of the store is concerned about the profit performance of System B and is considering dropping it. What are the relevant costs? Should any product be dropped?

16 Relevant Costing By Dr. Michael Constas Page 16 P-2 Make or Buy. Powell Dentistry Services is part of an HMO that operates in a large metropolitan area. Currently, Powell has its own dental laboratory to produce porcelain and gold crowns. The unit costs to produce the crowns are as follows: Porcelain Gold Raw Materials: $ 55 $ 94 Direct Labor: Variable Manufacturing Overhead: 5 5 Fixed Manufacturing Overhead: Total: $107 $146 Fixed overhead is detailed as follows: Salary (supervisor) $24,000 Depreciation 5,000 Rent (lab facility 26,000 A local dental laboratory has offered to supply Powell all the crowns it needs. Its price is $100 for porcelain crowns and $132 for gold crowns; however, the offer is conditioned on supplying both types of crowns--it will not supply just one type for the price indicated. If the offer is accepted, the equipment used by Powell's laboratory would be scrapped (it is old and has no market value), and the lab facility would be closed. The lab facility is rented on a month-to-month basis (there are no leases to deal with). Powell uses 1,500 porcelain crowns and 1,000 gold crowns per year REQUIRED: 1. Should Powell continue to make its own crowns or should they be purchased from the external supplier? What is the dollar effect of purchasing? 2. What qualitative factors should Powell consider in making this decision? 3. Suppose that the lab facility is owned rather than rented and that the $26,000 is depreciation rather than rent. What effect does this have on the analysis in Requirement 1? 4. What would your answer in #3 be if you could rent the lab facility for $15, Refer to the original data. Assume that the volume of crowns is 3,000 porcelain and 2,000 gold. Should Powell make or buy the crowns? Explain the outcome.

17 Relevant Costing By Dr. Michael Constas Page 17 P-3 Sell or Process Further. Rudolph Drug Corporation buys three chemicals that are processed to produce 2 types of analgesics used as ingredients for popular overthe-counter drugs. The purchased chemicals are blended for 2 to 3 hours and then heated for 15 minutes. The results of the process are 2 separate analgesics, Tyl and Buff, which are sent to a drying room until their moisture content is reduced to 6 to 8 percent. For every 1,100 pounds of chemicals used, 500 pounds of Tyl and 500 pounds of Buff are produced. After drying, Tyl and Buff are sold to companies that process them into their final form. The selling prices are $10 per pound for Tyl and $25 per pound for Buff. The costs to produce 500 pounds of each analgesic are as follows: Chemicals $5,500 Direct Labor 4,500 Manufacturing Overhead 3,500 The analgesics are packaged in 25-pound bags and shipped. The cost of each bag is $0.75. Shipping costs $0.10 per pound. Rudolph Company could process Tyl further by grinding it into a fine powder and then molding the powder into tablets. The tablets can be sold directly to retail drug stores as a generic brand. If this route is taken, the revenue received per bottle of tablets would be $3.00, with 5 bottles produced by every pound of tyl. The costs of grinding and tableting total $2.50 per pound of Tyl. Bottles cost $0.20 each. Bottles are shipped in boxes that hold 25 at a shipping cost of $1.23 per box. REQUIRED: 1. Should Rudolph sell Tyl at split-off or should Tyl be processed and sold as tablets? 2. If Rudolph normally sells 265,000 pounds of Tyl per year, what will be the difference in profits if Tyl is processed further?

18 Relevant Costing By Dr. Michael Constas Page 18 P-4 Special Order. Kevin McBride, manager of an electronics division was considering an offer by Ellen Antle, manager of a sister division. Ellen's division was operating below capacity and had just been given an opportunity to produce 10,000 units of one of its products for a customer in a market not normally served. Ellen still will have excess capacity even if she accepts the special order. The opportunity involves a product that uses an electrical component produced by Kevin's division. Each unit that Ellen's department produces requires one of Kevin s components. However, the price the customer is willing to pay is well below the price usually charged. To make a reasonable profit on the order, Ellen needed a price concession from Kevin's division. Ellen had offered to pay full manufacturing cost for the parts. So that Kevin would know that everything was above board, Ellen had supplied the following unit-cost and price information concerning the special order, excluding the cost of the electrical component: Selling price $32.00 Less costs: Direct Materials Direct Labor 7.00 Variable Manufacturing Overhead 2.00 Fixed Manufacturing Overhead 3.00 Kevin s Component 3.20 Total Costs: Gross Profit: -20 The normal selling price of Kevin s component is $3.20 per unit. Its full manufacturing cost is $2.50 ($2.10 variable and 40 fixed). Ellen had argued that paying $3.20 per component would wipe out the gross profit and result in her division showing a loss. Kevin was interested in the offer because his division was also operating below capacity (the order would not use all the excess capacity). REQUIRED: 1. Should Kevin accept the order at a selling price of $2.50 per unit? By how much will his division's profits be changed if the order is accepted? 2. Suppose that Kevin refuses Ellen's offer. Should Ellen still accept the special order?

19 Relevant Costing By Dr. Michael Constas Page 19 P-5. Light Company has received an offer from a potential customer to purchase 1,000 units of its lamps at $14 per unit. Light normally sells its lamps for $19 per unit. Light s decision to accept the special order would not interfere with any of its current sales. Light Company is operating at capacity at the moment. In order to manufacture the units for the special order, Light must rent additional factory space for $6,000. When this cost is added to Light s other fixed costs, the average fixed cost per unit will increase to $3 for all of the units produced by Light. The standard cost per unit of producing its lamps is show below: Direct Materials $ 4.00 Direct Labor: 3.00 Variable Overhead 2.00 Fixed Overhead Total Production Cost $11.50 Should Light Company accept the special order? How much incremental income (loss) will Light Company make (or lose) on the special order? E-1 The answer is d. SOLUTIONS E-2 The answer is c. The cost savings is relevant. The money you get from selling the old machine makes your investment in the new machine less. (It is an opportunity cost.) E-3 The answer is b. The costs up to the split off point are the same regardless of whether you sell or process further. Because they are not different, those costs are not relevant. Only the direct fixed costs (avoidable) after split off are relevant because they will go away if you sell the product rather than processing it further. E-4 The answer is a. The original cost is the sunk cost. It is not relevant to this decision. E-5 The answer is c. Sell Process Further Revenue $50,000 $160,000 Upgrade Cost ,000 $50,000 $60,000

20 Relevant Costing By Dr. Michael Constas Page 20 E-6 The answer is c. You would be indifferent if the Upgrade Option produced a net benefit of $50,000. This means that the sales price must be $150,000. Divide it by 500 computers, and you get a sales price per unit of $300. E-7 The answer is a. The rental income from the sublease would be an opportunity cost of the Make option. Make Buy Direct Materials $200,000 $ 0 Direct Labor 180,000 0 Variable Overhead 150,000 0 Opportunity Cost 75,000 Purchase Cost 560,000 $28 x 20,000 $605,000 $560,000 E-8 The answer is a. You would be indifferent if the Upgrade Option cost $605,000. This means that the sales price must be $605,000. Divide it by 20,000 units, and you get a sales price per unit of $ E-9 The answer is c. Take Don t Take Purchase Price $390,000 $ 0 ($65 x 6,000) Direct Materials -90,000 0 ($15 x 6,000) Direct Labor -72,000 0 ($12 x 6,000) Variable Overhead -48,000 0 ($8 x 6,000) Machine -9,000 0 Variable Selling -12,000 0 $2 x 6,000 $159,000 $0 E-10 The answer is d. Melville would be indifferent if it had no profit from the sale. To do this you would reduce the sales price by $159,000. This would mean sales revenue of $231,000, which means a sales price of $38.50 ($231,000/6,000) P-1 The common fixed costs are irrelevant to the decision making. The following income statement isolates these irrelevant costs: System A System B Headset Total Sales: $45,000 $32,500 $8,000 $85,500

21 Relevant Costing By Dr. Michael Constas Page 21 Less: Variable Expenses: -20,000-25,500-3,200-48,700 Contribution Margin: $25,000 $ 7,000 $4,800 $36,800 Less: Direct Fixed Costs: -5,000-13,000-1,700-19,700 Divisional Margin: $20,000 -$ 6,000 $3,100 $17,100 Common Fixed Costs: -11,000 Operating Profit: $ 6,100 We can now see that System B is reducing our Operating Profit by $6,000, and if we drop System B, then our Operating Profit should increase to $12,100. If you drop System B: System A Headset Total Sales: $45,000 $8,000 $55,500 Less: Variable Expenses: -20,000-3,200-23,200 Contribution Margin: $25,000 $4,800 $29,800 Less: Direct Fixed Costs: -5,000-1,700-6,700 Divisional Margin: $20,000 $3,100 $23,100 Common Fixed Costs: -11,000 Operating Profit: $12,100 P-2 (1) Make Buy Raw Materials: $176,500 (55 x 1500)+(94 x 1000) $ 0 Direct Labor: 55,000 (22 x 2500) 0 Variable Manufacturing O/H: 12,500 (5 x 2500) 0 Fixed Manufacturing O/H: 50,000 (24, ,000) 0 Purchase Cost: 0 (100x1500)+(132x1000) $282,000 Total Cost: $294,000 $282,000 You ignore the depreciation expense because it is a sunk cost. The equipment is going to be scraped it has no other value, its cost (the depreciation) has already been spent. (2) Qualitative Factors include (i) quality control on the purchased crowns, (ii) reliability of supplier, (iii) effect of a reduction in work force on labor relations, (iv) eliminates the ability to later produce their own crowns at a later date. (3)

22 Relevant Costing By Dr. Michael Constas Page 22 Make Buy Raw Materials: $176,500 (55 x 1500)+(94 x 1000) $ 0 Direct Labor: 55,000 (22 x 2500) 0 Variable Manufacturing Overhead: 12,500 (5 x 2500) 0 Fixed Manufacturing Overhead: 24,000 (24,000) 0 Purchase Cost: 0 (100X1500)+(132X1000) $282,000 Total Cost: $268,000 $282,000 You ignore the depreciation expense because it is a sunk cost. We have no information of alternative use of the space being vacated by the lab. (4) Make Buy Raw Materials: $176,500 (55 x 1500)+(94 x 1000) $ 0 Direct Labor: 55,000 (22 x 2500) 0 Var. Manufacturing Overhead: 12,500 (5 x 2500) 0 Fixed Manufacturing Overhead: 24,000 (24,000) 0 Purchase Cost:: 0 (100X1500)+(132X1000) $282,000 Rental Income: 0-15,000 Total Cost:: $268,000 $267,000 Rather than showing the rental income as an opportunity cost which is added to the cost of the Make alternative, we treated the rental income as a reduction of the cost of the Buy alternative. (5) Make Buy Raw Materials: $353,000 (55 x 3000)+(94 x 2000) $ 0 Direct Labor: 110,000 (22 x 5000) 0 Variable Manufacturing Overhead: 25,000 (5 x 5000) 0 Fixed Manufacturing Overhead: 50,000 (24,000+26,000) 0 Purchase Cost:: 0 (100X3000)+(132X2000) $564,000 Total Cost:: $538,000 $564,000 We assumed that the Fixed Manufacturing Overhead Costs didn t change. This alternative shows that the decision can change if the circumstances change. You decision making must take this into account. P-3 (1)

23 Relevant Costing By Dr. Michael Constas Page 23 Process 1 costs are incurred whether or not you sell Tyl or process it further and sell Tylenol. So the Process 1 costs are not relevant to our decision. The revenue and costs from selling Buff is also not relevant to our decision. Process 2 costs are incurred only if you process the Tyl into Tylenol, so they are relevant. Sell Process Revenue: $5,000 $ 7,500 Bag Cost: -15 (.75 x(500/25)) 0 Shipping Cost: -50 ((2500/25)x1.23) -123 (.1 x 500) Grinding & Tableting 0 (2.5 x 500) Bottling Cost: 0 (.20 x 2500) -500 Operating Profit (Per 500lb) $ 4,935 $ 5,627 For each 500 pound lot of Tyl, you make $692 more by processing the Tyl rather than selling it in its raw state. We sell 265,000/500 = 530 lots of Tyl. Therefore we can make $692 x 530 = $366,760 more by processing the Tyl further. P-4 (1) Kevin has excess capacity (he has capacity that he is not using). Therefore his fixed cost does not go up if he makes more units. Because the fixed costs are the same whether or not he takes the special order, the fixed costs are not relevant to the decision. You only have to consider the incremental revenue and costs: Kevin's Decision: Don't Take Order Take Order Revenue: 0 $25,000 (10,000 x $2.50) Variable Costs 0-21,000 (10,000 x $2.10) Fixed Costs: 0-0 Operating Profit: 0 $ 4,000

24 Relevant Costing By Dr. Michael Constas Page 24 Even though Ellen thinks that Kevin is breaking even on the special order, Kevin is actually making a profit from the special order. (2) Ellen's Decision: Don't Take Order Take Order Revenue: 0 $320,000 (10,000 x $32) Variable Costs 0-260,000 (10,000 x26) Kevin's Components: -32,000 (10,000 x $3.20) Fixed Costs: 0-0 Operating Profit: 0 $ 28,000 Even if Ellen doesn't get here price concession from Kevin, she will still make a profit on the special order. P-5. The key fact here is that Light is operating at capacity, and to complete the special order Light hast to spend $6,000 for additional office space. Take Per Unit Take-1000 units Don t Take Revenue $14 $14,000 $0 Costs: Direct Materials $ Direct Labor: Variable Overhead Variable Costs $9.00 -$9,000 0 Fixed Overhead -6,000 0 Net Revenue -$1,000 $0 Light Company should not accept the special order. They would lose $1,000 if they took the special order.