Chapter 13 Notes Page 1. The key part of this analysis is to consider only the information that is relevant to the decision being made.

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1 Chapter 13 Notes Page 1 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. Relevant Costing 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 Chapter 13 Notes 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 Chapter 13 Notes 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 Chapter 13 Notes 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 Chapter 13 Notes 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 Chapter 13 Notes 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 Chapter 13 Notes 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 Chapter 13 Notes 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 Chapter 13 Notes 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 Chapter 13 Notes 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 Chapter 13 Notes 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 Chapter 13 Notes 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.