Chapter 6

Relevant Information and Decision

Making:
Production Decisions

LEARNING OBJECTIVES:
When your students have finished studying this chapter, they should be
able to:

1. Use opportunity cost to analyze the income effects of a given

alternative.

2. Decide whether to make or buy certain parts or products.

3. Decide whether a joint product should be processed beyond the

split-off point.

4. Identify irrelevant information in disposal of obsolete inventory and

equipment replacement decisions.

5. Explain how unit costs can be misleading.

6. Discuss how performance measures can affect decision-

making.

7. Construct Absorption and Contribution format income statements

and identify which is better for decision making.

1
CHAPTER 6: OVERVIEW
This chapter concludes a two-chapter sequence on relevant information
and its use in decision making.

Section One: Defines opportunity, outlay, and differential costs.

Section Two: Illustrates the determination of relevant costs in a

make-or-buy decision. Typically, direct materials, direct
labor, variable overhead, avoidable fixed costs, the
purchase price of the parts and opportunity costs of
making parts or components of final products must be
considered.

Section Three: Examines joint products and the decision of whether to

process them beyond the split-off point. Differential
revenues and further processing costs are useful in
making these decisions, while the joint costs represent a
sunk cost that is irrelevant for making the decision.

Section Four: Addresses the irrelevance of such past costs as

obsolete inventories and the book value of old equipment.

Section Five: Indicates that future costs that do not differ among
alternatives are irrelevant for managerial decision making.

Section Six: Beware of unit costs and the volume levels for which they
are being reported.

Section Seven:Examines the conflicts between performance evaluation

and decision making. Often, the pressure to report short-
run profits biases decision-makers against taking actions
that are in the long-run economic interests of a firm.

Section Eight: Two approaches to costs on Income Statements are

presented. The absorption approach and the contribution

2
approach differ in their treatments of fixed factory-
overhead costs and in their emphasis on a functional or
behavioral categorization of costs.

3
CHAPTER 6: ASSIGNMENTS

COGNITIVE EXERCISES

23 Measurement of Opportunity Cost

24 Outsourcing Decisions
25 Historical Costs and Inventory Decisions
26 Income Statements and Sales Managers

EXERCISES

27 Opportunity Costs
28 Opportunity Cost of Home Ownership
29 Hospital Opportunity Cost
30 Make or Buy
31 Sell or Process Further
32 Joint Products, Multiple Choice
33 Obsolete Inventory
34 Replacement of Old Equipment
35 Unit Costs
36 Relevant Investment
37 Weak Division
38 Opportunity Cost
39 Straightforward Absorption Statement
40 Straightforward Contribution Income Statement
41 Straightforward Absorption and Contribution
Statement
42 Absorption Statement
43 Contribution Income Statement

4
PROBLEMS

44 Hotel Rooms and Opportunity Costs

45 Extension of Preceding Problem
46 Make or Buy
47 Relevant-Cost Analysis
48 Hotel Pricing and Use of Capacity
49 Special Air Fares
50 Joint Costs and Incremental Analysis
51 Relevant Cost
52 New Machine
53 Conceptual Approach
54 Book Value of Old Equipment
55 Decision and Performance Models
56 Review of Relevant Costs
57 Make or Buy, Opportunity Costs, and Ethics
58 Irrelevance of Past Costs at Starbucks

CASES

59 Make or Buy
60 Make or Buy
61 Analysis with Contribution Income Statement

COLLABORATIVE EXERCISE

62 Outsourcing
63 Internet Exercise - Green Mountain Coffee
Company

5
CHAPTER 6: OUTLINE
0. Opportunity, Outlay, and Differential Costs {L. O.
1}
Opportunity Cost - maximum available contribution to profit
forgone (i.e., rejected) by using limited resources for a particular
purpose. Outlay Cost - requires a cash disbursement sooner or
later and is the typical cost recorded by accountants.

Presenting revenues, costs, and income of two alternatives and the

differences in those revenues, costs, and incomes is referred to as
differential analysis. Differential Costs (or Incremental Costs)
- the difference in costs between two alternatives. Examples
provided include an employee quitting her job to go into business
for herself and changing the production level of automobiles. It is
important to consider opportunity costs when evaluating
alternative courses of action.

0. Make-or-Buy Decisions {L. O. 2}

0. Basic Make or Buy and Idle Facilities

Manufacturers have to decide whether to make or buy parts

and subassemblies that go into their final products. Some
companies make all their own parts and subassemblies in
order to assure product quality, while others buy most of
theirs to protect mutually-advantageous long-run
relationships with suppliers. Many companies only make
parts if their facilities cannot be used to better advantage.

When idle facilities exist, quantitative factors bearing on the

decision typically include the direct material, direct labor,
variable overhead, fixed overhead that may be avoided if the
part is purchased, and the purchase cost of buying the parts.
A make-or-buy decision for GENERAL ELECTRIC COMPANY
is presented. The key to make-or-buy decisions is identifying
the additional costs for making (or the costs avoided by
buying) a part or component. Using activity analysis can help
in identifying these costs.

0. Make or Buy and the Use of Facilities

6
The alternative uses for the facilities that would be occupied
if the part was made should be considered. The previous
example is expanded to include the possible renting out of
the space used to make the parts, and the possibility of
producing other products in that space. In all cases,
companies should relate these decisions to the long-run
policies for the use of capacity.

7
 TEACHING TIP: Outsourcing - Have students read the
boxed insert on outsourcing and discuss the advantages and
disadvantages in class.

0.0 Joint Product Costs

0. Nature of Joint Products

Joint Products - two manufactured products have relatively

significant sales values, and are not separately identifiable as
individual products until their split-off point (e.g., chemicals,
lumber, flour, and the products of petroleum refining and
meatpacking). Split-Off Point - time in manufacturing
where the joint products become individually identifiable.
Separable Costs - any costs beyond the split-off point due
to not being part of the joint process and can be exclusively
identified with individual products. Joint Costs - costs of
manufacturing joint products before the split-off point.

0. Sell or Process Further {L. O. 3}

Decisions on whether to sell joint products at the split-off
point or to process some or all products further are frequently
made by managers. The essence of the decision whether or
not to process further is to compare the difference between
incremental revenues and costs with the opportunity cost of
selling the product at the split-off point.

See EXHIBIT 6-2 for an example of a sell or process further

analysis. See EXHIBIT 6-3 for another presentation of the
sell or process further for the entire firm. The joint costs are
included in the analysis along with the revenues generated
from the sale of the other joint product. These items are not
differential revenues or costs, and thus they do not affect the
decision. It is important to recognize that the joint costs do
not play a role in determining whether or not to process a
joint product further.

0.0 Irrelevance of Past Costs {L. O. 4}

Past costs are irrelevant for decision-making purposes. Two
examples, in addition to the joint costs discussed above which
represent past costs, are obsolete inventory and the book value of

8
old equipment.

9
0. Obsolete Inventory

The original historical cost of obsolete inventory is irrelevant

in deciding the best way of disposing of it. The differential
revenues and costs of remachining and selling parts should
be compared to the opportunity cost of the proceeds from
selling them as scrap. An example of General Dynamic's
decision regarding what to do with obsolete aircraft parts is
provided.

0. Book Value of Old Equipment

Depreciation - purchased equipment cost is spread over (or

charged to) the future periods in which the equipment is
expected to be used (i.e., a periodic cost). Book Value (or
net book value) - the original cost less accumulated
depreciation, which is the summation of depreciation charged
to past periods. Sunk Cost (historical or past cost) - a cost
that has already been incurred and is irrelevant in the
decision-making process. In making equipment replacement
decisions, the book value of old equipment is a sunk cost and
should therefore not be considered. The only relevant costs
in making this decision are the expected future costs (e.g.,
the disposal value of old equipment and the cost of new
equipment). The gain or loss on disposal and the book value
of the old equipment are irrelevant. However, tax
consequences of these items should be included in a keep-or-
replace decision. See EXHIBIT 6-4 for an analysis of a keep-
or-replace decision.

TEACHING TIP: Sunk Cost Examples - Discuss the various

sunk costs associated with buying a textbook, nonrefundable
airplane ticket to Fort Lauderdale during Spring Break, tuition,
opportunity cost of foregone wages while attending classes
(include a discussion of utility theory and cost-benefit
analysis).

0. Elimination of Alternatives over the Long Run

See EXHIBIT 6-4 for a time period in excess of one year in

analyzing the alternatives. This approach ensures that
peculiar nonrecurring items (such as loss on disposal) will not
obstruct the long-term view needed for many managerial
decisions. See EXHIBIT 6-5 for a presentation of the keep-

10
or-replace analysis while omitting the irrelevant items.

11
0.0 Irrelevance of Future Costs That Will Not Differ

In addition to past costs, future costs (whether fixed or variable),

that will be the same under all feasible solutions, are irrelevant in
making managerial decisions. Salaries of members of top
managers are given as an example of future costs that will not
differ in most decisions and are, therefore, irrelevant for those
decisions.

0. Beware of Unit Costs {L. O. 5}

This section provides an example of the pitfalls of using unit costs,
not total costs, for decisions. The illustration provided shows the
effect that the expected volume of activity may have on a decision
to replace an existing piece of equipment. If the expected volume
level is at the level used by an equipment salesman in claiming
that a cost reduction is possible, then no problem exists with the
analysis. On the other hand, if the expected volume level is much
lower than that used by the salesman in making his claim, a
different result may occur.

0. Conflicts Between Decision Making and Performance

Evaluation {L. O. 6}
To motivate people to make optimal decisions, performance
evaluation methods should be consistent with the decision
analysis. The equipment replacement decision is an example of
performance evaluation, based on annual income, resulting in a
bad decision. Since income in Year 1 would be less if the
replacement was made, managers may choose to retain the
existing equipment. The savings in Years 2, 3, and 4 are, therefore,
not realized. Failing to replace the existing equipment also allows
the manager to hide the potential "loss on disposal" as
depreciation expense over the remaining useful life of the old
equipment. Ideally, performance would be evaluated against
predictions made when making decisions. However, with the
complexity of modern organizations and the innumerable decisions
being made, this is not possible.

12
0.0 How Income Statements Influence Decision Making
{L. O. 7}
EXHIBIT 6-6 and EXHIBIT 6-7 provide schedules of factory
overhead, and selling and administrative expenses for Samson
Company

0. Absorption Approach (see EXHIBIT 4-8 for Absorption

Income Statement).

Absorption Costing - all factory overhead (both variable

and fixed) is treated as product cost that becomes an
expense in the form of manufacturing cost of goods sold only
as sales occur. GAAP accounting requires the use of
absorption costing. Gross Profit or Gross Margin is the
difference between sales and fully absorbed cost of goods
sold. Selling and Administrative expenses are treated as
period expenses and are deducted from gross profit to arrive
at operating income. Costs are classified according to the
three major functions (i.e., manufacturing, selling, and
administrative) of management under absorption costing.

0. Contribution Approach (see EXHIBIT 6-9 for contribution

income statement)

Contribution Approach - all variable costs (both

manufacturing and selling and administrative) are deducted
from sales to result in Contribution Margin. Fixed
expenses are deducted from the contribution margin to
arrive at Operating Income. Costs are classified according
to behavior (i.e., variable or fixed) under the contribution
approach to income determination.

13
CHAPTER 6: TRANSPARENCY MASTERS
The following exhibits are reproduced as transparency masters at the
end of this manual:

Exhibit 6-2 Illustration of Sell or Process Further

Exhibit 6-3 Sell or Process Further Analysis - Firm as a Whole

Exhibit 6-4 Cost Comparison - Replacement of Equipment

Including Relevant and Irrelevant Items

Exhibit 6-5 Cost Comparison - Replacement of Equipment,

Relevant Items Only

Exhibit 6-6 Schedules of Indirect Costs (Product Costs) for the

Year Ended December 31, 2001 (thousands of dollars) -
Samson Company.

Exhibit 6-7 Schedules of Selling and Administrative Expenses

(Period Costs) for the Year Ended December 31, 2001
(thousands of dollars) - Samson Company.

Exhibit 6-8 Absorption Income Statement for the Year Ended

December 31, 2001 (thousands of dollars) - Samson
Company.

Exhibit 6-9 Contribution Income Statement for the Year Ended

December 31, 2001 (thousands of dollars) - Samson
Company.

14
CHAPTER 6: Quiz/Demonstration
Exercises
Learning Objective 1

1. The extra sleep you could have rather than attending an 8 a.m.
class in college is an example of a

a. sunk cost.
b. outlay cost.
c. opportunity cost.
d. misplaced cost.

2. A cost that requires a cash disbursement sooner or later is referred

to as a(n) cost.

a. outlay
b. opportunity
c. immediate
d. differential

3. costs are irrelevant for decisions that affect the

future.

a. Sunk
b. Outlay
c. Opportunity
d. Differential

15
Learning Objective 2

4. ACE produces cars for both American and Japanese car companies.
It currently manufactures the transmissions that go into the cars.
SOY Corp. has offered to provide transmissions to ACE for $400
each. ACE produces 5,000 cars per month and has the following
costs for the manufacture of the transmissions:

Direct materials $150

Direct labor 50
Variable overhead 100
Fixed overhead 150
Total Cost $450

If the transmissions are purchased from SOY, $300,000 of fixed

overhead costs per month (supervisors salaries, insurance, etc.)
could be eliminated. Given that the quality of the SOY
transmissions is equivalent to that of ACE, it should

a. buy transmissions from SOY to save $200,000 per month.

b. make transmissions to save $200,000 over the cost of buying
them.
c. buy transmissions from SOY to save $250,000 per month.
d. make transmissions to save $250,000 over the cost of buying
them.

5. Qualitative factors that should be considered when evaluating a

make-or-buy decision is (are):

a. the quality of the outside suppliers product

b. can the outside supplier provide the needed quantities.
c. can the outside supplier provide the product when it is
needed.
d. all of the above

16
Learning Objective 3

6. Gizzard Company slaughters chickens and then sells the parts to

grocery stores, fast-food restaurants, and soup companies.
Currently it is selling the leg quarters (thigh and leg) to grocery
stores at 20/lb. Gizzard's has been asked to separate the thighs
and legs by a chain of fast-food restaurants. For a standard 100-
pound package of separated leg quarters, the chain will pay $28.
Gizzard's estimates that the additional labor and packaging cost
involved in further processing the leg quarters are 6/lb. Gizzard
Company should

a. continue selling leg quarters to the grocery stores at 20/lb.

b. sell the separate legs and thighs to the chain of fast-food
restaurants for an increased profit of 2/lb. for the leg
quarters.
c. sell the leg quarters to a soup company for 21/lb.
d. do none of these.

7. A joint product should be processed beyond split-off if:

a. additional revenue from further processing exceeds

joint costs.
b. additional revenue from further processing exceeds
allocated joint costs.
c. additional revenue from further processing exceeds
allocated joint costs and additional costs of further
processing.
d. additional revenue from further processing exceeds
additional costs of further processing.

Learning Objective 4

8. The original cost of inventory, which has been determined to be

obsolete, is

a. not relevant in deciding whether to alter the inventory for

another use because it is a sunk cost.
b. not relevant in deciding whether to alter the inventory for
another use because it represents an opportunity cost.
c. always very important in deciding whether to alter the
inventory for some other use.
d. sometimes important in deciding whether to alter the

17
inventory for some other use.

18
9. The book value of old equipment is irrelevant in replacement
decisions because

a. it will be capitalized if the equipment is kept.

b. it will be written off if the equipment is replaced.
c. it represents a future cost that will differ between the options
of replacing or keeping the equipment.
d. both a. and c. are correct.

10. In analyzing whether to replace or keep existing equipment,

depreciation on the existing equipment is

a. irrelevant because it is an historical cost.

b. relevant because depreciation is always relevant.
c. both a. and b.
d. neither a. nor b.

Learning Objective 5

11. A copying machine salesman has offered to sell DRAKE Corp. a new
copier for $3,500. He claims that with this new copier you can
make copies for 2.75 each compared with your current cost of 3
per copy. DRAKE purchases copy paper for 1 per page, which is
included in both your current cost and the 2.75 cost provided by
the salesman. If DRAKE estimates that this copier will make
100,000 copies, it should

a. buy it because the salesman knows more about copiers than

anyone at DRAKE.
b. buy it because a savings of $250 can be realized through
using it.
c. not buy it because the 2.75/copy quote is based on a
volume of 50,000 copies.
d. not buy it because the 2.75/copy quote is based on a
volume of 200,000 copies.

12. In general, a decision maker should be wary of:

a. unit variable costs.

b. unit sales prices.
c. unit fixed costs.
d. none of the above.

19
Learning Objective 6

13. A manager of a division of Clare Company is considering replacing

some manufacturing equipment. If the equipment is replaced,
income in the first year after purchase will be lowered, while the
following four years would show increased income due to lower
operating costs of the new equipment. Over the five-year life of
the new equipment, total income is expected to exceed what is
expected with the old equipment by $300,000. Unfortunately, due
to the write-off of the old equipment, the first year income with the
replacement is lower by $80,000. Managers at Clare are given
bonuses and promotions based on divisional income. The failure to
make the investment in the new equipment is an illustration of

a. far-sighted management.
b. long-term effects of myopia.
c. a conflict between decision making and performance
evaluation.
d. sound business judgment in the long-run best interest of the
firm.

14. Managers are least likely to make decisions based on the effects of:

a. their performance measures.

b. the companys performance measures.
c. their best friends performance measures.
d. the competitors performance measures.

Learning Objective 7

Items 15 and 16 are based on the following data:

In 2002, its first year of operations, Janice, Inc., manufactured 150,000

units of its single product, cakes. Variable manufacturing costs were $3
per unit of product. Fixed manufacturing costs were $60,000 and are
based on the production volume of 150,000 units. Janice sold 120,000
cakes during the year at an average selling price of $5. Variable selling
costs were 50 per pie and fixed selling and administrative costs were
$100,000.

15. Janice's operating income using the absorption approach for 2002
is:

a. $0 b. $10,000 c. $20,000 d.

20
$32,000

16. Janice's operating income using the contribution approach for 2002
is:

a. $0 b. $10,000 c. $20,000
d. $32,000

21
CHAPTER 6: Solutions to
Quiz/Demonstration Exercises

1. [c] 2. [a] 3. [a]

4. [b] The difference is $200,000 in favor of making. It is

easiest to see the difference in a total cost analysis, which
appears below.

Make Buy

Cost of purchasing $2,000,000

Direct materials cost $ 750,000 0
Direct labor cost 250,000 0
Variable overhead 500,000 0
Fixed overhead 750,000 450,000
Total cost $2,250,000 $2,450,000

5. [d]

6. [b] The additional revenues generated of 8/lb. are greater

than the further processing costs of 6/lb.

7. [d] 8. [a] 9. [b] 10.

[a]

11. [d] $3,500/200,000 copies is 1.75 per copy. Adding this to the
cost of copy paper gives the 2.75 quote given by the
salesman. If only 100,000 copies can be produced, the cost
per copy would be 4.5 each.

12. [c] 13. [c] 14. [d]

22
15. [d] Income under Absorption Approach

Sales (120,000 * $5) $600,000

COGS ((120,000 * ($3 + $.40)) (408,000)
Gross Profit 192,000
Selling and Administrative Expenses
(120,000 * 50) + $100,000 160,000
Operating income $ 32,000

16. [c] Income under Contribution Approach

Sales (120,000 * $5) $600,000

Variable costs:
Manufacturing (120,000 * $3) $360,000
Selling (120,000 * 50) 60,000 (200,000)
Contribution Margin $180,000
Fixed Expenses:
Manufacturing $ 60,000
Selling and Administrative 100,000 (160,000)
Operating Income $20,000

23
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24
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25