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CHAPTER 11
DECISION MAKING AND RELEVANT INFORMATION
11-1 The five steps in the decision process outlined in Exhibit 11-1 of the text are
1. Identify the problem and uncertainties.
2. Obtain information.
3. Make predictions about the future.
4. Make decisions by choosing among alternatives.
5. Implement the decision, evaluate performance, and learn.
11-2 Relevant costs are expected future costs that differ among the alternative courses of action
being considered. Historical costs are irrelevant because they are past costs and, therefore, cannot
differ among alternative future courses of action.
11-3 No. Relevant costs are defined as those expected future costs that differ among alternative
courses of action being considered. Thus, future costs that do not differ among the alternatives are
irrelevant to deciding which alternative to choose.
11-4 Quantitative factors are outcomes that are measured in numerical terms. Some quantitative
factors are financial––that is, they can be easily expressed in monetary terms. Direct materials are
an example of a quantitative financial factor. Other quantitative nonfinancial factors, such as on–
time flight arrivals, cannot be easily expressed in monetary terms. Qualitative factors are outcomes
that are difficult to measure accurately in numerical terms. An example is employee morale.
11-5 Two potential problems that should be avoided in relevant cost analysis are
(i) Do not assume all variable costs are relevant and all fixed costs are irrelevant.
(ii) Do not use unit-cost data directly. It can mislead decision makers because
a. it may include irrelevant costs, and
b. comparisons of unit costs computed at different output levels lead to erroneous
conclusions.
11-6 No. Some variable costs may not differ among the alternatives under consideration and,
hence, will be irrelevant. Some fixed costs may differ among the alternatives and, hence, will be
relevant.
11-7 No. Some of the total manufacturing cost per unit of a product may be fixed and, hence,
will not differ between the make and buy alternatives. These fixed costs are irrelevant to the make-
or-buy decision. The key comparison is between purchase costs and the costs that will be saved if
the company purchases the component parts from outside plus the additional benefits of using the
resources freed up in the next best alternative use (opportunity cost). Furthermore, managers
should consider nonfinancial factors such as quality and timely delivery when making outsourcing
decisions.
11-8 Opportunity cost is the contribution to income that is forgone (rejected) by not using a
limited resource in its next-best alternative use.
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11-9 No. When deciding on the quantity of inventory to buy, managers must consider both the
purchase cost per unit and the opportunity cost of funds invested in the inventory. For example,
the purchase cost per unit may be low when the quantity of inventory purchased is large, but the
benefit of the lower cost may be more than offset by the high opportunity cost of the funds invested
in acquiring and holding inventory.
11-10 No. Managers should aim to get the highest contribution margin per unit of the constraining
(that is, scarce, limiting, or critical) factor. The constraining factor is what restricts or limits the
production or sale of a given product (for example, availability of machine–hours).
11-11 No. For example, if the revenues that will be lost exceed the costs that will be saved, the
branch or business segment should not be shut down. Shutting down will only increase the loss.
Allocated costs and fixed costs that will not be saved are irrelevant to the shut-down decision.
11-12 Cost written off as depreciation is irrelevant when it pertains to a past cost such as
equipment already purchased. But the purchase cost of new equipment to be acquired in the future
that will then be written off as depreciation is often relevant.
11-13 No. Managers often favor the alternative that makes their performance look best so they
focus on the measures used in the performance-evaluation model. If the performance-evaluation
model does not emphasize maximizing operating income or minimizing costs, managers will most
likely not choose the alternative that maximizes operating income or minimizes costs.
11-14 The three steps in solving a linear programming problem are
(i) Determine the objective function.
(ii) Specify the constraints.
(iii) Compute the optimal solution.
11-15 The text outlines two methods of determining the optimal solution to an LP problem:
(i) Trial-and-error approach
(ii) Graphic approach
Most LP applications in practice use standard software packages that rely on the simplex method
to compute the optimal solution.
11-16 (20 min.) Disposal of assets.
Answer the following questions.
1. A company has an inventory of 1,250 assorted parts for a line of missiles that has been
discontinued. The inventory cost is $76,000. The parts can be either (a) remachined at total
additional costs of $26,500 and then sold for $33,500 or (b) sold as scrap for $2,500. Which
action is more profitable? Show your calculations.
2. A truck, costing $100,500 and uninsured, is wrecked its first day in use. It can be either (a)
disposed of for $18,000 cash and replaced with a similar truck costing $103,000 or (b) rebuilt
for $88,500 and thus be brand-new as far as operating characteristics and looks are concerned.
Which action is less costly? Show your calculations.
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SOLUTION
1. This is an unfortunate situation, yet the $76,000 costs are irrelevant regarding the decision
to remachine or 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 maximized (or losses minimized). The difference in favor of remachining is $4,500:
(a) (b)
Remachine Scrap
Future revenues $33,500 $2,500
Deduct future costs 26,500 –
Operating income $ 7,000 $2,500
Difference in favor of remachining $4,500
2. This, too, is an unfortunate situation. But the $101,500 original cost is irrelevant to this
decision. The difference in relevant costs in favor of replacing is $3,500 as follows:
(a) (b)
Replace Rebuild
New truck $103,000 –
Deduct current disposal
price of existing truck 18,000 –
Rebuild existing truck – $88,500
$ 85,000 $88,500
Difference in favor of replacing $3,500
Note, here, that the current disposal price of $18,000 is relevant, but the original cost (or book
value, if the truck were not brand new) is irrelevant.
11-17 (20 min.) Relevant and irrelevant costs.
Answer the following questions.
1. DeCesare Computers makes 5,200 units of a circuit board, CB76, at a cost of $280 each.
Variable cost per unit is $190 and fixed cost per unit is $90. Peach Electronics offers to supply
5,200 units of CB76 for $260. If DeCesare buys from Peach it will be able to save $10 per unit
in fixed costs but continue to incur the remaining $80 per unit. Should DeCesare accept Peach’s
offer? Explain.
2. LN Manufacturing is deciding whether to keep or replace an old machine. It obtains the
following information:
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LN Manufacturing uses straight-line depreciation. Ignore the time value of money and income
taxes. Should LN Manufacturing replace the old machine? Explain.
SOLUTION
1.
Make
Buy
Relevant costs
Variable costs
$190
Avoidable fixed costs
10
Purchase price
____
$260
Unit relevant cost
$200
$260
DeCesare Computers should reject Peach’s offer. The $80 of fixed costs is irrelevant because it
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
Difference
Cash operating costs (3 years)
$52,500
$6,000
Current disposal value of old machine
2,200
Cost of new machine
_ _____
(9,000)
Total relevant costs
$52,500
$ (800)
LN Manufacturing should keep the old machine. The cost savings are less than the cost to purchase
the new machine.
11-18 (15 min.) Multiple choice.
(CPA) Choose the best answer.
1. The Dalton Company manufactures slippers and sells them at $12 a pair. Variable
manufacturing cost is $5.00 a pair, and allocated fixed manufacturing cost is $1.25 a pair. It
has enough idle capacity available to accept a one-time–only special order of 5,000 pairs of
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slippers at $6.25 a pair. Dalton will not incur any marketing costs as a result of the special
order. What would the effect on operating income be if the special order could be accepted
without affecting normal sales: (a) $0, (b) $6,250 increase, (c) $28,750 increase, or (d) $31,250
increase? Show your calculations.
2. The Sacramento Company manufactures Part No. 498 for use in its production line. The
manufacturing cost per unit for 30,000 units of Part No. 498 is as follows:
The Counter Company has offered to sell 30,000 units of Part No. 498 to Sacramento for $47 per
unit. Sacramento will make the decision to buy the part from Counter if there is an overall savings
of at least $30,000 for Sacramento. If Sacramento accepts Counter’s offer, $8 per unit of the fixed
overhead allocated would be eliminated. Furthermore, Sacramento has determined that the
released facilities could be used to save relevant costs in the manufacture of Part No. 575. For
Sacramento to achieve an overall savings of $30,000, the amount of relevant costs that would have
to be saved by using the released facilities in the manufacture of Part No. 575 would be which of
the following: (a) $90,000, (b) $150,000, (c) $180,000, or (d) $210,000? Show your calculations.
What other factors might Sacramento consider before outsourcing to Counter?
SOLUTION
1. (b) Special order price per unit $6.25
Variable manufacturing cost per unit 5.00
Contribution margin per unit $1.25
Effect on operating income = $1.25 5,000 units
= $6,250 increase
2. (b) Costs of purchases, 30,000 units $47 $1,410,000
Total relevant costs of making:
Variable manufacturing costs, $5 + $22 + $8 $35
Fixed costs eliminated 8
Costs saved by not making $43
Multiply by 30,000 units, so total
costs saved are $43 30,000 1,290,000
Extra costs of purchasing outside 120,000
Minimum overall savings for Sacramento 30,000
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Necessary relevant costs that would have
to be saved in manufacturing Part No. 575 $ 150,000
Before outsourcing to Counter, Sacramento must consider the consequence of increasing its
dependence on Counter. Sacramento would want to be sure about the quality of Counter’s product
and the reliability of its delivery schedules over a long-run period. Sacramento would also want
Counter to continuously reduce costs. To achieve all these goals, Sacramento may want to build
close partnerships and alliances with Counter.
11-19 (30 min.) Special order, activity-based costing.
(CMA, adapted) The Gold Plus Company manufactures medals for winners of athletic events and
other contests. Its manufacturing plant has the capacity to produce 11,000 medals each month.
Current production and sales are 10,000 medals per month. The company normally charges $150
per medal. Cost information for the current activity level is as follows:
Gold Plus has just received a special one-time-only order for 1,000 medals at $100 per medal.
Accepting the special order would not affect the company’s regular business. Gold Plus makes
medals for its existing customers in batch sizes of 50 medals (200 batches × 50 medals per batch
= 10,000 medals). The special order requires Gold Plus to make the medals in 25 batches of 40
medals.
Required:
1. Should Gold Plus accept this special order? Show your calculations.
2. Suppose plant capacity were only 10,500 medals instead of 11,000 medals each month. The
special order must either be taken in full or be rejected completely. Should Gold Plus accept
the special order? Show your calculations.
3. As in requirement 1, assume that monthly capacity is 11,000 medals. Gold Plus is concerned
that if it accepts the special order, its existing customers will immediately demand a price
discount of $10 in the month in which the special order is being filled. They would argue that
Gold Plus’s capacity costs are now being spread over more units and that existing customers
should get the benefit of these lower costs. Should Gold Plus accept the special order under
these conditions? Show your calculations.
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SOLUTION
1. Direct materials cost per unit ($350,000 10,000 units) = $35 per unit
Direct manufacturing labor cost per unit ($375,000 10,000 units) = $37.50 per unit
Variable cost per batch = $500 per batch
Gold Plus’ operating income under the alternatives of accepting/rejecting the special order
are:
Without One-
Time Only
Special Order
10,000 Units
With One–
Time Only
Special Order
11,000 Units
Difference
1,000 Units
Revenues $1,500,000 $1,600,000 $100,000
Variable costs:
Direct materials 350,000 385,0001 35,000
Direct manufacturing labor 375,000 412,5002 37,500
Batch manufacturing costs 100,000 112,5003 12,500
Fixed costs:
Fixed manufacturing costs 300,000 300,000 ––
Fixed marketing costs 275,000 275,000 ––
Total costs 1,400,000 1,485,000 85,000
Operating income $ 100,000 $ 115,000 $ 15,000
1$350,000 + ($35 1,000 units) 2$375,000 + ($37.50 1,000 units) 3$100,000 + ($500 25 batches)
Alternatively, we could calculate the incremental revenue and the incremental costs of the
additional 1,000 units as follows:
Incremental revenue $100 1,000 $100,000
Incremental direct manufacturing costs $35 1,000 units 35,000
Incremental direct manufacturing costs $37.50 1,000 units 37,500
Incremental batch manufacturing costs $500 25 batches 12,500
Total incremental costs 85,000
Total incremental operating income from
accepting the special order $ 15,000
Gold Plus should accept the one-time–only special order if it has no long-term implications because
accepting the order increases Gold Plus’ operating income by $15,000.
If, however, accepting the special order would cause the regular customers to be
dissatisfied or to demand lower prices, then Gold Plus will have to trade off the $15,000 gain from
accepting the special order against the operating income it might lose from regular customers.
2. Gold Plus has a capacity of 10,500 medals. Therefore, if it accepts the special one-time
order of 1,000 medals, it can sell only 9,500 medals instead of the 10,000 medals that it currently
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sells to existing customers. That is, by accepting the special order, Gold Plus must forgo sales of
500 medals to its regular customers. Alternatively, Gold Plus can reject the special order and
continue to sell 9,500 medals to its regular customers.
Gold Plus’ operating income from selling 9,500 medals to regular customers and 1,000
medals under one-time special order follow:
Revenues (9,500 $150) + (1,000 $100) $1,525,000
Direct materials (9,500 $35) + (1,000 $35) 367,500
Direct manufacturing labor (9,500 $37.50) + (1,000 $37.50) 393,750
Batch manufacturing costs (1901 $500) + (25 $500) 107,500
Fixed manufacturing costs 300,000
Fixed marketing costs 275,000
Total costs 1,443,750
Operating income $ 81,250
1Gold Plus makes regular medals in batch sizes of 50. To produce 9,500 medals requires 190 (9,500 ÷ 50) batches.
Accepting the special order will result in a decrease in operating income of $18,750
($100,000 – $81,250). The special order should, therefore, be rejected.
A more direct approach would be to focus on the incremental effects––the benefits of
accepting the special order of 1,000 units versus the costs of selling 500 fewer units to regular
customers. Increase in operating income from the 1,000-unit special order equals $15,000
(requirement 1). The loss in operating income from selling 500 fewer units to regular customers
equals:
Lost revenue, $150 500 $(75,000)
Savings in direct materials costs, $35 500 17,500
Savings in direct manufacturing labor costs, $37.50 500 18,750
Savings in batch manufacturing costs, $500 10 5,000
Operating income lost $(33,750)
Accepting the special order will result in a decrease in operating income of $18,750 ($15,000 –
$33,750). The special order should, therefore, be rejected.
Even if operating income had increased by accepting the special order, Gold Plus should
consider the effect on its regular customers of accepting the special order. For example, would
selling 1,000 fewer medals to its regular customers cause these customers to find new suppliers
that might adversely impact Gold Plus’s business in the long run.
3. Gold Plus should not accept the special order.
Increase in operating income by selling 1,000 units
under the special order (requirement 1) $ 15,000
Operating income lost from existing customers ($10 10,000) (100,000)
Net effect on operating income of accepting special order $ (85,000)
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The special order should, therefore, be rejected.
11-20 (30 min.) Make versus buy, activity-based costing.
The Svenson Corporation manufactures cellular modems. It manufactures its own cellular modem
circuit boards (CMCB), an important part of the cellular modem. It reports the following cost
information about the costs of making CMCBs in 2014 and the expected costs in 2015:
Svenson manufactured 8,000 CMCBs in 2014 in 40 batches of 200 each. In 2015, Svenson
anticipates needing 10,000 CMCBs. The CMCBs would be produced in 80 batches of 125 each.
The Minton Corporation has approached Svenson about supplying CMCBs to Svenson in 2015
at $300 per CMCB on whatever delivery schedule Svenson wants.
Required:
1. Calculate the total expected manufacturing cost per unit of making CMCBs in 2015.
2. Suppose the capacity currently used to make CMCBs will become idle if Svenson purchases
CMCBs from Minton. On the basis of financial considerations alone, should Svenson make
CMCBs or buy them from Minton? Show your calculations.
3. Now suppose that if Svenson purchases CMCBs from Minton, its best alternative use of the
capacity currently used for CMCBs is to make and sell special circuit boards (CB3s) to the
Essex Corporation. Svenson estimates the following incremental revenues and costs from
CB3s:
On the basis of financial considerations alone, should Svenson make CMCBs or buy them from
Minton? Show your calculations.
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SOLUTION
1. The expected manufacturing cost per unit of CMCBs in 2015 is as follows:
Total
Manufacturing
Costs of CMCB
(1)
Manufacturing
Cost per Unit
(2) = (1) ÷ 10,000
Direct materials, $170 10,000
Direct manufacturing labor, $45 10,000
Variable batch manufacturing costs, $1,500 80
Fixed manufacturing costs
Avoidable fixed manufacturing costs
Unavoidable fixed manufacturing costs
Total manufacturing costs
$1,700,000
450,000
120,000
320,000
800,000
$3,390,000
$170
45
12
32
80
$339
2. The following table identifies the incremental costs in 2015 if Svenson (a) made CMCBs
and (b) purchased CMCBs from Minton.
Total
Incremental Costs
Per-Unit
Incremental Costs
Incremental Items
Make
Buy
Make
Buy
Cost of purchasing CMCBs from Minton
Direct materials
Direct manufacturing labor
Variable batch manufacturing costs
Avoidable fixed manufacturing costs
Total incremental costs
$1,700,000
450,000
120,000
320,000
$2,590,000
$3,000,000
$3,000,000
$170
45
12
32
$259
$300
$300
Difference in favor of making
$410,000
$41
Note that the opportunity cost of using capacity to make CMCBs is zero because Svenson would
keep this capacity idle if it purchases CMCBs from Minton.
Svenson should continue to manufacture the CMCBs internally because the incremental
costs to manufacture are $259 per unit compared to the $300 per unit that Minton has quoted. Note
that the unavoidable fixed manufacturing costs of $800,000 ($80 per unit) will continue to be
incurred whether Svenson makes or buys CMCBs. These are not incremental costs under either
the make or the buy alternative and, hence, are irrelevant.
3. Svenson should continue to make CMCBs. The simplest way to analyze this problem is to
recognize that Svenson would prefer to keep any excess capacity idle rather than use it to make
CB3s. Why? Because expected incremental future revenues from CB3s, $2,000,000, are less than
expected incremental future costs, $2,150,000. If Svenson keeps its capacity idle, we know from
requirement 2 that it should make CMCBs rather than buy them.
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An important point to note is that, because Svenson forgoes no contribution by not being
able to make and sell CB3s, the opportunity cost of using its facilities to make CMCBs is zero. It
is, therefore, not forgoing any profits by using the capacity to manufacture CMCBs. If it does not
manufacture CMCBs, rather than lose money on CB3s, Svenson will keep capacity idle.
A longer and more detailed approach is to use the total alternatives or opportunity cost
analyses shown in Exhibit 11-7 of the chapter.
Choices for Svenson
Relevant Items
Make CMCBs
and Do Not
Make CB3s
Buy CMCBs
and Make
CB3s, if Profitable
TOTAL-ALTERNATIVES APPROACH TO MAKE-OR-BUY DECISIONS
Total incremental costs of
making/buying CMCBs (from
requirement 2)
Because incremental future costs
exceed incremental future revenues
from CB3s, Svenson will make zero
CB3s even if it buys CMCBs from
Minton
Total relevant costs
$2,590,000
0
$2,590,000
$3,000,000
0
$3,000,000
Svenson will minimize manufacturing costs and maximize operating income by making CMCBs.
OPPORTUNITY-COST APPROACH TO MAKE-OR-BUY DECISIONS
Total incremental costs of
making/buying CMCBs (from
requirement 2)
$2,590,000
$3,000,000
Opportunity cost: profit contribution
forgone because capacity will not
be used to make CB3s
0*
0
Total relevant costs
$2,590,000
$3,000,000
*Opportunity cost is zero because Svenson does not give up anything by not making CB3s. Svenson is best off leaving
the capacity idle (rather than manufacturing and selling CB3s).