Decision Making and Relevant Information. JOIN KHALID AZIZ FRESH CLASSES OF ICMAP STAGE 1...

Decision Making and Decision Making and Relevant InformationRelevant Information

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FRESH CLASSES OF ICMAP STAGE 1 FRESH CLASSES OF ICMAP STAGE 1 FUNDAMENTALS OF FA & FUNDAMENTALS OF FA & ECONOMICS.ECONOMICS.

STAGE 2 FUNDAMENTALS OF COST STAGE 2 FUNDAMENTALS OF COST ACCOUNTING.ACCOUNTING.

STAGE 3 FA & APPRAISAL.STAGE 3 FA & APPRAISAL.

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FRESH CLASSES OF PIPFAFRESH CLASSES OF PIPFAFOUNDATIONFOUNDATION INTERMEDIATEINTERMEDIATEFINALFINAL0322-33857520322-3385752

JOIN KHALID AZIZJOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS,

B.COM.B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4

ICAP MODULE B, B.COM, BBA, MBA & PIPFA.ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP

MODULE D, BBA, MBA & PIPFA.MODULE D, BBA, MBA & PIPFA.

CONTACT:CONTACT:0322-33857520322-3385752R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA,

KARACHI, PAKISTAN.KARACHI, PAKISTAN.

IntroductionIntroductionThis presentation explores the This presentation explores the

decision-making process.decision-making process. It focuses on specific decisions such It focuses on specific decisions such

as accepting or rejecting a one-time-as accepting or rejecting a one-time-only special order, insourcing or only special order, insourcing or outsourcing products or services, and outsourcing products or services, and replacing or keeping equipment.replacing or keeping equipment.

Learning ObjectivesLearning Objectives1 Use the five-step decision process to Use the five-step decision process to

make decisionsmake decisions2 Differentiate relevant costs and Differentiate relevant costs and

revenues from irrelevant costs and revenues from irrelevant costs and revenues in any decision situationrevenues in any decision situation

3 Distinguish between quantitative Distinguish between quantitative factors and qualitative factors in factors and qualitative factors in decisionsdecisions

Learning ObjectivesLearning Objectives4 Identify two potential problems that Identify two potential problems that

should be avoided in relevant-cost should be avoided in relevant-cost analysisanalysis

5 Describe the opportunity cost concept Describe the opportunity cost concept and explain why it is used in decision and explain why it is used in decision makingmaking

6 Describe the key concept in choosing Describe the key concept in choosing which among multiple products to which among multiple products to produce when there are capacity produce when there are capacity constraintsconstraints

Learning ObjectivesLearning Objectives7 Discuss the key factor managers must Discuss the key factor managers must

consider when adding or dropping customers consider when adding or dropping customers and segmentsand segments

8 Explain why the book value of equipment is Explain why the book value of equipment is irrelevant in equipment-replacement decisionsirrelevant in equipment-replacement decisions

9 Explain how conflicts can arise between the Explain how conflicts can arise between the decision model used by a manager and the decision model used by a manager and the performance model used to evaluate the performance model used to evaluate the managermanager

Learning Objective 1Learning Objective 1

Use the five-step Use the five-step decision process to decision process to

make decisionsmake decisions

Information and the Information and the Decision ProcessDecision Process

A decision model is a formal method A decision model is a formal method for making a choice, often involving for making a choice, often involving quantitative and qualitative analysis.quantitative and qualitative analysis.

Five-Step Decision ProcessFive-Step Decision Process1 Gathering informationGathering information2 Making predictionsMaking predictions3 Choosing an alternativeChoosing an alternative4 Implementing the decisionImplementing the decision5 Evaluating performanceEvaluating performance


Differentiate relevant Differentiate relevant costs and revenues costs and revenues from irrelevant costs from irrelevant costs and revenues in any and revenues in any

decision situationdecision situation

The Meaning of RelevanceThe Meaning of RelevanceRelevant costs and relevant Relevant costs and relevant

revenues are expected future costs revenues are expected future costs and revenues that differ among and revenues that differ among alternative courses of action.alternative courses of action.

The Meaning of RelevanceThe Meaning of RelevanceHistorical costs are irrelevant to a Historical costs are irrelevant to a

decision but are used as a basis for decision but are used as a basis for predicting future costs.predicting future costs.

Sunk costs are past costs which are Sunk costs are past costs which are unavoidable.unavoidable.

The Meaning of RelevanceThe Meaning of RelevanceDifferential income (net relevant Differential income (net relevant

income) is the difference in total income) is the difference in total operating income when choosing operating income when choosing between two alternatives.between two alternatives.

Differential costs (net relevant costs) Differential costs (net relevant costs) are the difference in total costs are the difference in total costs between two alternatives.between two alternatives.


Distinguish between Distinguish between quantitative factors and quantitative factors and

qualitative factors in qualitative factors in decisionsdecisions

Quantitative and Qualitative Quantitative and Qualitative Relevant InformationRelevant Information

Quantitative factors are outcomes Quantitative factors are outcomes that are measured in numerical that are measured in numerical terms:terms:

– FinancialFinancial– NonfinancialNonfinancialQualitative factors are outcomes that Qualitative factors are outcomes that

cannot be measured in numerical cannot be measured in numerical terms.terms.

One-Time-Only Special OrderOne-Time-Only Special Order

Gabriela & Co. manufactures fancy bath Gabriela & Co. manufactures fancy bath towels in Boone, North Carolina.towels in Boone, North Carolina.

The plant has a production capacity of The plant has a production capacity of 44,000 towels each month.44,000 towels each month.

Current monthly production is 30,000 Current monthly production is 30,000 towels.towels.

The assumption is made that costs can be The assumption is made that costs can be classified as either variable with respect to classified as either variable with respect to units of output or fixed.units of output or fixed.

One-Time-Only Special OrderOne-Time-Only Special Order

Variable Fixed Variable Fixed Costs Costs Costs Costs Per UnitPer Unit Per Unit Per Unit Direct materialsDirect materialsRs6.50Rs6.50 Rs -0- Direct laborRs -0- Direct labor

.50 .50 1.50 1.50 Manufacturing costsManufacturing costs 1.50 1.50 3.50 3.50 TotalTotal Rs8.50Rs8.50 Rs5.00Rs5.00

One-Time-Only Special OrderOne-Time-Only Special OrderTotal fixed direct manufacturing Total fixed direct manufacturing

labor amounts to Rs45,000.labor amounts to Rs45,000.Total fixed overhead is Rs105,000.Total fixed overhead is Rs105,000.Marketing costs per unit are Rs7 (Rs5 Marketing costs per unit are Rs7 (Rs5

of which is variable).of which is variable).What is the full cost per towel?What is the full cost per towel?

One-Time-Only Special OrderOne-Time-Only Special OrderVariable (Rs8.50 + Rs5.00):Variable (Rs8.50 + Rs5.00):

Rs13.50Rs13.50Fixed:Fixed: 7.00 7.00 TotalTotal

Rs20.50Rs20.50A hotel in Puerto Rico has offered to A hotel in Puerto Rico has offered to

buy 5,000 towels from Gabriela & Co. buy 5,000 towels from Gabriela & Co. at Rs11.50 per towel for a total of at Rs11.50 per towel for a total of Rs57,500.Rs57,500.

One-Time-Only Special OrderOne-Time-Only Special OrderNo marketing costs will be incurred No marketing costs will be incurred

for this one-time-only special order.for this one-time-only special order.Should Gabriela & Co. accept this Should Gabriela & Co. accept this

order?order?Yes!Yes!Why?Why?

One-Time-Only Special OrderOne-Time-Only Special OrderThe relevant costs of making the The relevant costs of making the

towels are Rs42,500.towels are Rs42,500.Rs8.50 × 5,000 = Rs42,500 Rs8.50 × 5,000 = Rs42,500

incremental costsincremental costsRs57,500 – Rs42,500 = Rs15,000 Rs57,500 – Rs42,500 = Rs15,000

incremental revenuesincremental revenuesRs11.50 – Rs8.50 = Rs3.00 Rs11.50 – Rs8.50 = Rs3.00

contribution margin per towelcontribution margin per towel

One-Time-Only Special OrderOne-Time-Only Special OrderDecision criteria: Decision criteria: Accept the order if the revenue Accept the order if the revenue

differential is greater than the cost differential is greater than the cost differential.differential.


Identify two potential Identify two potential problems that should problems that should

be avoided in relevant-be avoided in relevant-cost analysiscost analysis

Potential Problems in Potential Problems in Relevant-Cost AnalysisRelevant-Cost Analysis

General assumptions:General assumptions:– Do not assume that all variable costs Do not assume that all variable costs

are relevant.are relevant.– Do not assume that all fixed costs Do not assume that all fixed costs

are irrelevant.are irrelevant.

Potential Problems in Potential Problems in Relevant-Cost AnalysisRelevant-Cost Analysis

Unit-cost data can potentially Unit-cost data can potentially mislead decision makers:mislead decision makers:

– Irrelevant costs are included.Irrelevant costs are included.– The same unit costs are used at The same unit costs are used at

different output levels.different output levels.

Insourcing versus Insourcing versus OutsourcingOutsourcing

OutsourcingOutsourcing is the process of is the process of purchasing goods and services from purchasing goods and services from outside vendors rather than outside vendors rather than producing goods or providing producing goods or providing services within the organization, services within the organization, which is called which is called insourcinginsourcing..

Make-or-Buy DecisionsMake-or-Buy DecisionsDecisions about whether to Decisions about whether to

outsource or produce within the outsource or produce within the organization are often called make-organization are often called make-or-buy decisions.or-buy decisions.

The most important factors in the The most important factors in the make-or-buy decision are quality, make-or-buy decision are quality, dependability of supplies, and costs.dependability of supplies, and costs.

Make-or-Buy DecisionsMake-or-Buy DecisionsGabriela & Co. also manufactures Gabriela & Co. also manufactures

bath accessories.bath accessories.Management is considering Management is considering

producing a part it needs (#2) or producing a part it needs (#2) or using a part produced by Alec using a part produced by Alec Enterprises.Enterprises.

Make-or-Buy DecisionsMake-or-Buy DecisionsGabriela & Co. has the following Gabriela & Co. has the following

costs for 150,000 units of Part #2:costs for 150,000 units of Part #2:Direct materialsDirect materials Rs 28,000 Rs 28,000

Direct labor Direct labor 18,500 18,500 Mixed overheadMixed overhead 29,000 29,000 Variable overhead Variable overhead 15,000 15,000 Fixed overhead Fixed overhead 30,00030,000 TotalTotalRs120,500Rs120,500

Make-or-Buy DecisionsMake-or-Buy DecisionsMixed overhead consists of material Mixed overhead consists of material

handling and setup costs.handling and setup costs.Gabriela & Co. produces the 150,000 Gabriela & Co. produces the 150,000

units in 100 batches of 1,500 units units in 100 batches of 1,500 units each.each.

Total material handling and setup Total material handling and setup costs equal fixed costs of Rs9,000 costs equal fixed costs of Rs9,000 plus variable costs of Rs200 per plus variable costs of Rs200 per batch.batch.

Make-or-Buy DecisionsMake-or-Buy DecisionsWhat is the cost per unit for Part #2?What is the cost per unit for Part #2?Rs120,500 ÷ 150,000 units = Rs120,500 ÷ 150,000 units =

Rs0.8033/unitRs0.8033/unitAlec Enterprises offers to sell the Alec Enterprises offers to sell the

same part for Rs0.55.same part for Rs0.55.Should Gabriela & Co. manufacture Should Gabriela & Co. manufacture

the part or buy it from Alec the part or buy it from Alec Enterprises?Enterprises?

Make-or-Buy DecisionsMake-or-Buy DecisionsThe answer depends on the The answer depends on the

difference in expected future costs difference in expected future costs between the alternatives.between the alternatives.

Gabriela & Co. anticipates that next Gabriela & Co. anticipates that next year the 150,000 units of Part #2 year the 150,000 units of Part #2 expected to be sold will be expected to be sold will be manufactured in 150 batches of manufactured in 150 batches of 1,000 units each.1,000 units each.

Make-or-Buy DecisionsMake-or-Buy DecisionsVariable costs per batch are Variable costs per batch are

expected to decrease to Rs100. expected to decrease to Rs100. Gabriela & Co. plans to continue to Gabriela & Co. plans to continue to

produce 150,000 next year at the produce 150,000 next year at the same variable manufacturing costs same variable manufacturing costs per unit as this year.per unit as this year.

Fixed costs are expected to remain Fixed costs are expected to remain the same as this year.the same as this year.

Make-or-Buy DecisionsMake-or-Buy DecisionsWhat is the variable manufacturing What is the variable manufacturing

cost per unit?cost per unit?Direct materialDirect material Rs28,000 Rs28,000

Direct labor Direct labor 18,500 18,500 Variable overheadVariable overhead 15,000 15,000 Total Total Rs61,500Rs61,500

Rs61,500 ÷ 150,000 = Rs0.41 per Rs61,500 ÷ 150,000 = Rs0.41 per unitunit

Make-or-Buy DecisionsMake-or-Buy Decisions

Expected relevant cost to make Part #2:Expected relevant cost to make Part #2:ManufacturingManufacturing Rs61,500 Rs61,500

Material handling and setupsMaterial handling and setups 15,000 15,000* * Total relevant cost to makeTotal relevant cost to makeRs76,500 *150 × Rs100 = Rs15,000Rs76,500 *150 × Rs100 = Rs15,000

Cost to buy: (150,000 × Rs0.55)Cost to buy: (150,000 × Rs0.55)Rs82,500Rs82,500

Gabriela & Co. will save Rs6,000 by making Gabriela & Co. will save Rs6,000 by making the part.the part.

Make-or-Buy DecisionsMake-or-Buy DecisionsNow assume that the Rs9,000 in Now assume that the Rs9,000 in

fixed clerical salaries to support fixed clerical salaries to support material handling and setup will not material handling and setup will not be incurred if Part #2 is purchased be incurred if Part #2 is purchased from Alec Enterprises.from Alec Enterprises.

Should Gabriela & Co. buy the part or Should Gabriela & Co. buy the part or make the part?make the part?

Make-or-Buy DecisionsMake-or-Buy DecisionsRelevant cost to make:Relevant cost to make:VariableVariable Rs76,500 Rs76,500

Fixed Fixed 9,000 9,000 Total Total Rs85,500Rs85,500

Cost to buy:Cost to buy: Rs82,500Rs82,500Gabriela would save Rs3,000 by Gabriela would save Rs3,000 by

buying the part.buying the part.


Describe the Describe the opportunity cost opportunity cost

concept and explain concept and explain why it is used in why it is used in decision makingdecision making

Opportunity Costs, Opportunity Costs, Outsourcing, and Outsourcing, and

ConstraintsConstraintsAssume that if Gabriela buys the part Assume that if Gabriela buys the part

from Alec Enterprises, it can use the from Alec Enterprises, it can use the facilities previously used to facilities previously used to manufacture Part #2 to produce Part manufacture Part #2 to produce Part #3 for Krysta’s Company.#3 for Krysta’s Company.

The expected additional future The expected additional future operating income is Rs18,000.operating income is Rs18,000.

What should Gabriela & Co. do?What should Gabriela & Co. do?


ConstraintsConstraintsGabriela & Co. has three options:Gabriela & Co. has three options:1 Make Part #2 and do not make Part Make Part #2 and do not make Part

#3 for Krysta.#3 for Krysta.2 Buy Part #2 and do not make Part Buy Part #2 and do not make Part

#3 for Krysta.#3 for Krysta.3 Buy the part and use the facilities to Buy the part and use the facilities to

produce Part #3 for Krysta.produce Part #3 for Krysta.


ConstraintsConstraints

Expected cost of obtaining 150,000 Expected cost of obtaining 150,000 parts:parts:

Buy Part #2Buy Part #2 Buy Part #2Buy Part #2 and do not and do not and makeand make

Make Make make Part #3make Part #3Part #3Part #3 Part #2 Part #2 Rs82,500 Rs82,500

Rs64,500*Rs64,500* Rs76,500Rs76,500*Rs82,500 – Rs18,000 = Rs64,500*Rs82,500 – Rs18,000 = Rs64,500


ConstraintsConstraintsOpportunity cost is the contribution Opportunity cost is the contribution

to income that is foregone (rejected) to income that is foregone (rejected) by not using a limited resource in its by not using a limited resource in its next-best alternative use.next-best alternative use.


ConstraintsConstraintsOpportunity costs are not recorded in Opportunity costs are not recorded in

formal accounting records since they formal accounting records since they do not generate cash outlays. do not generate cash outlays.

These costs also are not ordinarily These costs also are not ordinarily incorporated into formal reports.incorporated into formal reports.


ConstraintsConstraintsThe opportunity cost of holding The opportunity cost of holding

inventory is the income forgone from inventory is the income forgone from tying up money in inventory and not tying up money in inventory and not investing it elsewhere.investing it elsewhere.


ConstraintsConstraintsCarrying costs of inventory can be a Carrying costs of inventory can be a

significant opportunity cost and significant opportunity cost and should be incorporated into decisions should be incorporated into decisions regarding lot purchase sizes for regarding lot purchase sizes for materials.materials.


ConstraintsConstraintsAssume that annual estimated Part Assume that annual estimated Part

#2 requirements for next year is #2 requirements for next year is 150,000.150,000.

Cost per purchase order is Rs40.Cost per purchase order is Rs40.Cost per unit when each purchase is Cost per unit when each purchase is

of 1,500 units = Rs0.55. of 1,500 units = Rs0.55. Cost per unit when each purchase is Cost per unit when each purchase is

equal to or greater than 150,000 = equal to or greater than 150,000 = Rs0.54.Rs0.54.


ConstraintsConstraintsAverage investment in inventory is Average investment in inventory is

either:either:(1,500 x .55) ÷ 2 = Rs412.50 or(1,500 x .55) ÷ 2 = Rs412.50 or(150,000 x Rs0.54) = Rs40,500(150,000 x Rs0.54) = Rs40,500Annual interest rate for investment in Annual interest rate for investment in

government bonds is 6%.government bonds is 6%.Rs412.50 × .06 = Rs24.75Rs412.50 × .06 = Rs24.75Rs40,500 × .06 = Rs2,430Rs40,500 × .06 = Rs2,430



Option A: Make 100 purchases of 1,500 units:Option A: Make 100 purchases of 1,500 units:Purchase order costs: (100 × Rs40)Purchase order costs: (100 × Rs40) Rs Rs

4,000.004,000.00Purchase costs: (150,000 × Rs0.55)Purchase costs: (150,000 × Rs0.55)

82,500.0082,500.00Annual interest income Annual interest income

that could be earned:that could be earned: 24.75 24.75Relevant costsRelevant costs Rs86,524.75Rs86,524.75



Option B: Make 1 purchase of 150,000 units:Option B: Make 1 purchase of 150,000 units:Purchase order costs: (1 × Rs40)Purchase order costs: (1 × Rs40) Rs Rs

40 40Purchase costs: (150,000 × Rs0.54)Purchase costs: (150,000 × Rs0.54)

81,00081,000Annual interest income Annual interest income

that could be earned: that could be earned: 2,430 2,430Relevant costs:Relevant costs: Rs83,470Rs83,470


ConstraintsConstraints In this case purchasing all 150,000 In this case purchasing all 150,000

units at the beginning of the units at the beginning of the year is preferred.year is preferred.

Why?Why?The higher purchase and ordering The higher purchase and ordering

costs exceeds the lower opportunity costs exceeds the lower opportunity cost of holding smaller inventory.cost of holding smaller inventory.


Describe the key Describe the key concept in choosing concept in choosing

which among multiple which among multiple products to produce products to produce

when there are capacity when there are capacity constraintsconstraints

Product-Mix Decisions Product-Mix Decisions Under Capacity ConstraintsUnder Capacity Constraints

What product should be emphasized What product should be emphasized to maximize operating income in the to maximize operating income in the face of capacity constraints?face of capacity constraints?

Gabriela & Co. produces Product #2 Gabriela & Co. produces Product #2 and Product #3.and Product #3.

The company has 3,000 machine The company has 3,000 machine hours available to produce these hours available to produce these products.products.


Decision criteria:Decision criteria: Aim for the highest contribution Aim for the highest contribution margin per unit of the constraining margin per unit of the constraining factor.factor.

When multiple constraints exist, When multiple constraints exist, optimization techniques such as optimization techniques such as linear programming can be used in linear programming can be used in making decisions.making decisions.


Per unitPer unit Product #2Product #2 Product #3 Product #3 Sales priceSales priceRs2.11Rs2.11 Rs14.50 Variable expensesRs14.50 Variable expenses

0.41 0.41 13.90 13.90 Contribution Contribution marginmargin Rs1.70Rs1.70 Rs 0.60Rs 0.60

Contribution margin ratio 81% Contribution margin ratio 81% 4% 4%


One unit of Prod. #2 requires 7 One unit of Prod. #2 requires 7 machine hours.machine hours.

One unit of Prod. #3 requires 2 One unit of Prod. #3 requires 2 machine hours.machine hours.

What is the contribution of each What is the contribution of each product per machine hour?product per machine hour?

Product #2: Rs1.70 ÷ 7 = Rs0.24Product #2: Rs1.70 ÷ 7 = Rs0.24Product #3: Rs0.60 ÷ 2 = Rs0.30Product #3: Rs0.60 ÷ 2 = Rs0.30


Which product should be Which product should be emphasized?emphasized?

The product with the highest The product with the highest contribution margin per unit of the contribution margin per unit of the constraining resource.constraining resource.


Discuss the key factor Discuss the key factor managers must managers must

consider when adding consider when adding or dropping customers or dropping customers

and segmentsand segments

Profitability, Activity-Based Profitability, Activity-Based Costing, and Relevant CostsCosting, and Relevant Costs

Companies must often make Companies must often make decisions about adding or decisions about adding or discontinuing a product line, branch, discontinuing a product line, branch, or business segment.or business segment.

Companies must also make decisions Companies must also make decisions about adding or dropping customers.about adding or dropping customers.


Blowing Rock Furniture supplies Blowing Rock Furniture supplies specialized furniture to two local specialized furniture to two local retailers – Stevens and Cohen.retailers – Stevens and Cohen.

Blowing Rock Furniture has a Blowing Rock Furniture has a monthly capacity of 3,000 machine monthly capacity of 3,000 machine hours.hours.

Fixed costs are allocated on the basis Fixed costs are allocated on the basis of revenues.of revenues.


StevensStevens Cohen Cohen Revenues RevenuesRs200,000Rs200,000 Rs100,000 Variable Rs100,000 Variable costscosts 70,000 70,000 60,000 60,000 Fixed costs Fixed costs 100,000 100,000 50,00050,000 Total operating costs Total operating costsRs170,000Rs170,000 Rs110,000 Rs110,000 Operating income Operating income Rs 30,000Rs 30,000Rs (10,000) Machine-hours Rs (10,000) Machine-hours requiredrequired 2,000 2,000 1,000 1,000


Total Total Revenues Revenues

Rs300,000 Rs300,000 Variable costsVariable costs 130,000 130,000 Fixed costs Fixed costs 150,000150,000 Total operating Total operating costscosts Rs280,000 Operating Rs280,000 Operating incomeincome Rs 20,000 Rs 20,000 Machine-hours required 3,000Machine-hours required 3,000


Should Blowing Rock Furniture drop Should Blowing Rock Furniture drop the Cohen business, assuming that the Cohen business, assuming that dropping Cohen would decrease its dropping Cohen would decrease its total fixed costs by 10%?total fixed costs by 10%?

New fixed costs would be: New fixed costs would be: Rs150,000 – Rs15,000 = Rs135,000Rs150,000 – Rs15,000 = Rs135,000

Profitability, Activity-Based Profitability, Activity-Based Costing, and Relevant CostsCosting, and Relevant Costs Stevens Stevens Alone Alone Revenues RevenuesRs200,000 Variable costsRs200,000 Variable costs

70,000 Fixed 70,000 Fixed costscosts 135,000 135,000 Total operating costsTotal operating costs Rs205,000 Rs205,000 Operating incomeOperating income Rs (5,000) Rs (5,000) Machine-hours required Machine-hours required 3,0003,000


Cohen’s business is providing a Cohen’s business is providing a contribution margin of Rs40,000.contribution margin of Rs40,000.

Rs40,000 decrease in contribution Rs40,000 decrease in contribution margin – Rs15,000 decrease in fixed margin – Rs15,000 decrease in fixed costs = Rs25,000 decrease in costs = Rs25,000 decrease in operating income.operating income.


Assume that if Blowing Rock Assume that if Blowing Rock Furniture drops Cohen’s business it Furniture drops Cohen’s business it can lease the excess capacity to the can lease the excess capacity to the Perez Corporation for Rs50,000.Perez Corporation for Rs50,000.

Fixed costs would not decrease.Fixed costs would not decrease.Should Blowing Rock Furniture lease Should Blowing Rock Furniture lease

to Perez?to Perez?


Rs50,000 would be Blowing Rock Rs50,000 would be Blowing Rock Furniture’s opportunity cost of Furniture’s opportunity cost of continuing serving Cohen.continuing serving Cohen.

The Rs50,000 offsets the Rs40,000 The Rs50,000 offsets the Rs40,000 contribution of Cohen’s business.contribution of Cohen’s business.


Explain why the book Explain why the book value of equipment is value of equipment is

irrelevant in irrelevant in equipment-replacement equipment-replacement

decisionsdecisions

Equipment-Replacement Equipment-Replacement DecisionsDecisions

Assume that Gabriela & Co. is Assume that Gabriela & Co. is considering replacing a cutting considering replacing a cutting machine with a newer model.machine with a newer model.

The new machine is more efficient The new machine is more efficient than the old machine.than the old machine.

Revenues will be unaffected.Revenues will be unaffected.


Existing Existing ReplacementReplacement MachineMachine MachineMachine Original cost Original cost Rs80,000 Rs80,000 Rs105,000 Useful life Rs105,000 Useful life 4 4 years 4 years Accumulated years 4 years Accumulated depreciation Rs50,000 Book depreciation Rs50,000 Book valuevalue Rs30,000 Rs30,000 Disposal priceDisposal price Rs14,000 Rs14,000 Annual costs Annual costs Rs46,000 Rs 10,000 Rs46,000 Rs 10,000


Ignoring the time value of money and Ignoring the time value of money and income taxes, should Gabriela income taxes, should Gabriela replace the existing machine?replace the existing machine?

Yes!Yes!The cost savings per year are The cost savings per year are

Rs36,000.Rs36,000.The cost savings over a 4-year period The cost savings over a 4-year period

will be Rs36,000 × 4 = Rs144,000.will be Rs36,000 × 4 = Rs144,000.


Investment = Rs105,000 – Rs14,000 Investment = Rs105,000 – Rs14,000 = Rs91,000 = Rs91,000

Rs144,000 – Rs91,000 = Rs53,000 Rs144,000 – Rs91,000 = Rs53,000 advantage of the replacement advantage of the replacement machine.machine.

Irrelevance of Past CostsIrrelevance of Past CostsThe book value of existing equipment The book value of existing equipment

is irrelevant since it is neither a is irrelevant since it is neither a future cost nor does it differ among future cost nor does it differ among any alternatives (sunk costs never any alternatives (sunk costs never differ).differ).

Irrelevance of Past CostsIrrelevance of Past CostsThe disposal price of old equipment The disposal price of old equipment

and the purchase cost of new and the purchase cost of new equipment are relevant costs and equipment are relevant costs and revenues because...revenues because...

– they are future costs or revenues they are future costs or revenues that differ between alternatives to be that differ between alternatives to be decided upon.decided upon.


Explain how conflicts Explain how conflicts can arise between the can arise between the

decision model used by decision model used by a manager and the a manager and the

performance model used performance model used to evaluate the managerto evaluate the manager

Decisions and Performance Decisions and Performance EvaluationEvaluation

What is the journal entry to sell the What is the journal entry to sell the existing machine?existing machine?

CashCash 14,000 14,000 Accumulated Accumulated Depreciation Depreciation 50,000 50,000 Loss on disposal Loss on disposal 16,000 16,000 Machine Machine 80,000 80,000


In the real world would the manager In the real world would the manager replace the machine?replace the machine?

An important factor in replacement An important factor in replacement decisions is the manager’s decisions is the manager’s perceptions of whether the decision perceptions of whether the decision model is consistent with how the model is consistent with how the manager’s performance is judged.manager’s performance is judged.


Managers often behave consistent Managers often behave consistent with their short-run interests and with their short-run interests and favor the alternative that yields best favor the alternative that yields best performance measures in the short performance measures in the short run.run.

When conflicting decisions are When conflicting decisions are generated, managers tend to favor generated, managers tend to favor the performance evaluation model.the performance evaluation model.


Top management faces a challenge – Top management faces a challenge – that is, making sure that the that is, making sure that the performance-evaluation model of performance-evaluation model of subordinate managers is consistent subordinate managers is consistent with the decision model.with the decision model.

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