9 - 1 © 2005 Accounting 1/e, Terrell/Terrell Using Relevant Information for Internal Operations Chapter 9

9 - 9 - 11© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell

Using Relevant Using Relevant

Information for Internal Information for Internal

OperationsOperations

Chapter 9Chapter 9


Learning Objective 1Learning Objective 1

Determine the fixed and Determine the fixed and

variable components ofvariable components of

a cost element using thea cost element using the

high-low method andhigh-low method and

results of regression results of regression

analysis.analysis.


Fixed and Variable Fixed and Variable Components of a Cost Components of a Cost

ElementElement

Understanding the company’s costUnderstanding the company’s costcomponents and determiningcomponents and determining

cost formulas are a basic analysiscost formulas are a basic analysistechniques for planning and budgeting.techniques for planning and budgeting.


Using the High-Low Method Using the High-Low Method to Find the Total Cost to Find the Total Cost

FormulaFormula

TC = FC + (UVC × V)TC = FC + (UVC × V)

Total Cost =Total Cost =Fixed costs + (Unit variable cost × Volume)Fixed costs + (Unit variable cost × Volume)

The high-low method is a model thatThe high-low method is a model thatseparates the fixed and variableseparates the fixed and variablecomponents of a cost element.components of a cost element.


Bicycle Shop ExampleBicycle Shop Example

1998199819991999200020002001200120022002

5,4005,4005,2005,2005,0005,0006,0006,0006,4006,400

$432,000$432,000 416,000416,000 400,000400,000 480,000480,000 512,000512,000

$30,000$30,000 33,00033,000 32,00032,000 35,00035,000 38,00038,000

YearYearUnitsUnitssoldsold

Cost ofCost ofgoods soldgoods sold

StoreStoresuppliessupplies

Low

High



HighHigh LowLow DifferenceDifference

6,4006,4005,0005,0001,4001,400

$512,000$512,000 400,000400,000$112,000$112,000

UnitsUnitssoldsold

Cost ofCost ofgoods soldgoods soldStep 1:Step 1:

Step 2: $112,000 ÷ 1,400 =Step 2: $112,000 ÷ 1,400 =$80 variable cost per unit sold$80 variable cost per unit sold



HighHigh LowLow DifferenceDifference

6,4006,4005,0005,0001,4001,400

$38,000$38,000 32,00032,000$ 6,000$ 6,000

UnitsUnitssoldsold

Cost ofCost ofgoods soldgoods soldStep 1:Step 1:

Step 2: $6,000 ÷ 1,400 =Step 2: $6,000 ÷ 1,400 =$4.2857 variable cost per unit sold$4.2857 variable cost per unit sold



TC = $22,571.52 +TC = $22,571.52 +($84.2857 × Units sold)($84.2857 × Units sold)

Fixed costFixed cost

RentRentCost of goods soldCost of goods soldStore suppliesStore suppliesTotalTotal

$12,000.00$12,000.00 0.000.00 10,571.5210,571.52$22,571.52$22,571.52

$ 0.0000$ 0.0000 80.000080.0000 4.28574.2857$84.2857$84.2857

UnitUnitvariablevariable

costcostExpenseExpense



If management predicts it will sellIf management predicts it will sell5,800 units in 200X, what would5,800 units in 200X, what would

the formula predict the cost to be?the formula predict the cost to be?

TC = $22,571.52 + ($84.2857 × 5,800)TC = $22,571.52 + ($84.2857 × 5,800)

RentRent $ 12,000.00$ 12,000.00Cost of goods soldCost of goods sold 464,000.00 464,000.00Store suppliesStore supplies 35,428.58 35,428.58

Total costsTotal costs $511,428.58$511,428.58


Learning Objectives 2 Learning Objectives 2 and 3and 3

Identify the characteristics Identify the characteristics ofof

a relevant cost or revenue.a relevant cost or revenue.Demonstrate why sunk Demonstrate why sunk

costscostsand costs that do not differand costs that do not differbetween alternatives arebetween alternatives are

irrelevant costs.irrelevant costs.


Relevant versusRelevant versusIrrelevant ConceptsIrrelevant Concepts

Relevant costing is the process of determiningRelevant costing is the process of determiningwhich dollar inflows and outflows pertainwhich dollar inflows and outflows pertain

to a particular management decision.to a particular management decision.

Sunk costs are past costs that cannot beSunk costs are past costs that cannot bechanged by current or future actions.changed by current or future actions.

A relevant cost is a future cost that isA relevant cost is a future cost that ispertinent to a particular decision andpertinent to a particular decision anddiffers between decision alternatives.differs between decision alternatives.


Relevant versusRelevant versusIrrelevant ConceptsIrrelevant Concepts

A relevant cost must differ between alternatives.A relevant cost must differ between alternatives.

If a cost remains the same regardless of theIf a cost remains the same regardless of thedecision alternative, it is irrelevant.decision alternative, it is irrelevant.

A relevant revenue is a future revenueA relevant revenue is a future revenuethat differs between alternatives.that differs between alternatives.

Relevant costs and revenues are Relevant costs and revenues are quantitativequantitativefactorsfactors that affect business decisions.that affect business decisions.


Decision Model to Decision Model to Determine Relevant Costs Determine Relevant Costs

and Revenuesand RevenuesIs the item a futureIs the item a futurecost or revenue?cost or revenue?

Does the cost or revenueDoes the cost or revenuediffer betweendiffer between

decision alternatives?decision alternatives?

YesYes

The cost or revenueThe cost or revenueISIS relevant. relevant.

YesYes

The cost or revenueThe cost or revenueis is NOT NOT relevant.relevant.

NoNo

The cost or revenueThe cost or revenueis is NOT NOT relevant.relevant.

NoNo



Discuss several majorDiscuss several major

qualitative factors that qualitative factors that

shouldshould

be considered when makingbe considered when making

a business decision.a business decision.


Qualitative FactorsQualitative Factors

These are non-numerical attributesThese are non-numerical attributesthat will affect decision alternatives.that will affect decision alternatives.

Product qualityProduct quality

Employee moraleEmployee morale Customer perceptionsCustomer perceptions

Customer satisfactionCustomer satisfaction



Use accounting information Use accounting information

toto

determine the relevant costdetermine the relevant cost

of various decisions.of various decisions.


Equipment Replacement –Equipment Replacement –Gather all Decision Gather all Decision

InformationInformation

Elevation Sports, Inc.’s productionElevation Sports, Inc.’s productionequipment is three years old.equipment is three years old.

Its cost was $75,000 with a residualIts cost was $75,000 with a residualvalue of $15,000 and an estimatedvalue of $15,000 and an estimated

remaining life of five years.remaining life of five years.

Operators expenses are $50,000 per year.Operators expenses are $50,000 per year.

Maintenance is $3,000 per year.Maintenance is $3,000 per year.


Equipment Replacement –Equipment Replacement –Gather all Decision Gather all Decision

InformationInformation

The new equipment will cost $100,000.The new equipment will cost $100,000.

It has an estimated useful life of fiveIt has an estimated useful life of fiveyears with a $10,000 residual value.years with a $10,000 residual value.

Expenses for one operator are $30,000 perExpenses for one operator are $30,000 peryear and maintenance is $1,500 per year.year and maintenance is $1,500 per year.

Equipment can be sold now for $20,000.Equipment can be sold now for $20,000.


Replacement Cost SummaryReplacement Cost Summary

OldOldequipmentequipment

NewNewequipmentequipment

Start-up costs:Start-up costs:Cost of equipmentCost of equipment $ 75,000$ 75,000 $100,000$100,000Operating costs:Operating costs:Annual depreciationAnnual depreciation $ 12,000$ 12,000 $ 18,000$ 18,000Total depreciation – 5 yearsTotal depreciation – 5 years 60,000 60,000 90,000 90,000Annual labor costAnnual labor cost 50,000 50,000 30,000 30,000Total labor cost – 5 yearsTotal labor cost – 5 years 250,000 250,000 150,000 150,000Annual maintenance costAnnual maintenance cost 3,000 3,000 1,500 1,500Total maintenance cost – 5 yearsTotal maintenance cost – 5 years 15,000 15,000 10,000 10,000Shutdown costs:Shutdown costs:Residual value of equipmentResidual value of equipment $ 15,000$ 15,000 $ 10,000$ 10,000Current sale price old equipment Current sale price old equipment 20,000 20,000


Relevant Cost of Each Relevant Cost of Each AlternativeAlternative

Relevant:Relevant:Total labor costTotal labor cost $250,000$250,000

MaintenanceMaintenance $ 15,000$ 15,000Residual valueResidual value $ 15,000$ 15,000Current sale priceCurrent sale price $ 20,000$ 20,000

Irrelevant:Irrelevant:Cost of systemCost of system $ 75,000$ 75,000DepreciationDepreciation $ 60,000$ 60,000


Relevant Cost of Each Relevant Cost of Each AlternativeAlternative

Relevant:Relevant:Cost of equipmentCost of equipment $100,000$100,000

Total labor costTotal labor cost $150,000$150,000MaintenanceMaintenance $ 7,500$ 7,500Residual valueResidual value $ 10,000$ 10,000

Irrelevant:Irrelevant:DepreciationDepreciation $ 90,000$ 90,000


Replacement Cost Replacement Cost ComparisonComparison

$22,500 in favor of$22,500 in favor ofbuyingbuying the new equipment the new equipment

Start-up costs:Start-up costs:Cost of new equipmentCost of new equipment $(100,000)$(100,000)Operating costs:Operating costs:Labor cost:Labor cost: $(250,000)$(250,000) (150,000) (150,000) Maintenance cost:Maintenance cost: (15,000) (15,000) ( 7,500) ( 7,500)Shutdown costs:Shutdown costs:Residual value of old equipmentResidual value of old equipment 15,000 15,000Sale price of old equipment sold nowSale price of old equipment sold now 20,000 20,000Residual value of new equipmentResidual value of new equipment 10,000 10,000Total relevant costsTotal relevant costs $(250,000)$(250,000) $(227,500)$(227,500)

Keep oldKeep oldequipmentequipment

Replace oldReplace oldequipmentequipment


Special OrdersSpecial Orders

A special order is outside theA special order is outside thenormal scope of business activity.normal scope of business activity.

A representative of a Swiss ski resort approachesA representative of a Swiss ski resort approachesElevation Sports, Inc., with a proposition toElevation Sports, Inc., with a proposition topurchase 2,000 snowboards for $70 each.purchase 2,000 snowboards for $70 each.

The normal wholesale price is $95 per board.The normal wholesale price is $95 per board.

Should Elevation Sports, Inc., accept this order?Should Elevation Sports, Inc., accept this order?


Gather Relevant InformationGather Relevant Information

Expected wholesale sales (5,000 units @ $95 each)Expected wholesale sales (5,000 units @ $95 each) $475,000$475,000Less: Cost of goods soldLess: Cost of goods sold 350,000 350,000Expected gross marginExpected gross margin $125,000$125,000

Number of unitsNumber of units 1 1 5,000 5,000Direct material costsDirect material costs $10$10 $ 50,000$ 50,000Direct labor costsDirect labor costs 25 25 125,000 125,000Variable production costsVariable production costs 15 15 75,000 75,000Fixed production costsFixed production costs 20 20 100,000 100,000Total cost of goods soldTotal cost of goods sold $70$70 $350,000$350,000

Per unitPer unit TotalTotalDetailed calculation forDetailed calculation for

cost of goods soldcost of goods sold



Sales from special orderSales from special order $70$70 $140,000$140,000

Direct material costsDirect material costs $10$10 $ 20,000$ 20,000Direct labor costsDirect labor costs 25 25 50,000 50,000Variable production costsVariable production costs 15 15 30,000 30,000Total relevant production costsTotal relevant production costs $50$50 $100,000$100,000

Total increase in incomeTotal increase in income $20$20 $ 20,000$ 20,000

Per unitPer unit TotalTotalRelevant costs for specialRelevant costs for specialorder of 2,000 snowboardsorder of 2,000 snowboards


Make or Buy DecisionsMake or Buy Decisions

Outsourcing is buying services, products,Outsourcing is buying services, products,or components of products from outsideor components of products from outside

vendors instead of producing them.vendors instead of producing them.

Elevation Sports, Inc., has alwaysElevation Sports, Inc., has alwayspurchased its binding from a vendor.purchased its binding from a vendor.

The vendor has now indicated that the priceThe vendor has now indicated that the pricewill increase from $5.00 each to $7.00.will increase from $5.00 each to $7.00.

Is it cheaper to manufacture the binding?Is it cheaper to manufacture the binding?



Direct materialDirect material $3.00$3.00 $30,000$30,000Direct laborDirect labor 1.00 1.00 10,000 10,000

Variable overheadVariable overhead 0.50 0.50 5,000 5,000Fixed overheadFixed overhead 0.40 0.40 4,000 4,000Total costsTotal costs $4.90$4.90 $49,000$49,000

CostCostper unitper unit

Total cost forTotal cost for10,000 units10,000 units


Selecting Relevant CostsSelecting Relevant Costs

Direct laborDirect labor yesyes yesyes yesyes

VariableVariablemanufacturingmanufacturing

overheadoverheadyesyes yesyes yesyes

FixedFixedoverhead:overhead:

new machinenew machineyesyes yesyes yesyes

Direct materialDirect material yesyes yesyes yesyes

Future?Future? Differs?Differs? Relevant?Relevant?


Relevant Cost of Make orRelevant Cost of Make orBuy Decisions for BindingsBuy Decisions for Bindings

$21,000 in favor ofmaking the bindings

Cost to purchase (10,000 × $7)Cost to purchase (10,000 × $7) $70,000$70,000Direct materialDirect material $30,000$30,000Direct laborDirect labor 10,000 10,000Variable overheadVariable overhead 5,000 5,000Fixed overheadFixed overhead 4,000 4,000Total relevant costsTotal relevant costs $49,000$49,000 $70,000$70,000

Make Buy



$21,000 in favor ofmaking the bindings

Cost to purchase (10,000 × $7)Cost to purchase (10,000 × $7) $70,000$70,000Direct materialDirect material $30,000$30,000Direct laborDirect labor 10,000 10,000Variable overheadVariable overhead 5,000 5,000Additional fixed overheadAdditional fixed overhead 4,000 4,000Fixed overheadFixed overhead 15,000 15,000 15,000 15,000Total relevant costsTotal relevant costs $64,000$64,000 $85,000$85,000

Make Buy



Interpret the effects of Interpret the effects of

fixedfixed

costs and opportunity costscosts and opportunity costs

on various decisions.on various decisions.


Special Relevant Cost Special Relevant Cost Considerations for Fixed Considerations for Fixed

CostsCosts

Fixed costs normally are irrelevantFixed costs normally are irrelevantin make or by decisions.in make or by decisions.

Costs whichCosts whichcancan change change

Costs whichCosts whichcannotcannot change change


Decision to Outsource Decision to Outsource ServicesServices

Fast Track Delivery Service operatesFast Track Delivery Service operatesa small auto repair facility.a small auto repair facility.

Fast Track is considering using a localFast Track is considering using a localCPA firm to prepare the weekly payroll.CPA firm to prepare the weekly payroll.

It currently pays $1,500 per week plusIt currently pays $1,500 per week plusbenefits and payroll taxes of $525 per week.benefits and payroll taxes of $525 per week.

Weekly administrative costs ofWeekly administrative costs of$1,000 per week will not change.$1,000 per week will not change.


Decision to Outsource Decision to Outsource ServicesServices

The CPA firm has offered to provideThe CPA firm has offered to providethe services for $2,000 per week.the services for $2,000 per week.

If Fast Track accepts the offer, theyIf Fast Track accepts the offer, theycould reduce the weekly wages bycould reduce the weekly wages by$1,250, benefits by $450, and save$1,250, benefits by $450, and save

supplies costs of $125 per week.supplies costs of $125 per week.


Relevant Costs forRelevant Costs forEach AlternativeEach Alternative

Salary costsSalary costs $1,500$1,500 $ 250$ 250Benefits and payroll taxesBenefits and payroll taxes 525 525 2,000 2,000Costs of CPA firmCosts of CPA firm 125 125 0 0Total relevant costsTotal relevant costs $2,150$2,150 $2,325$2,325

ContinueContinuein-housein-house OutsourceOutsource


Decision to Add orDecision to Add orClose DivisionsClose Divisions

When a firm has excess capacity, expandingWhen a firm has excess capacity, expandingto produce new product lines or adding newto produce new product lines or adding new

divisions can be profitable because thedivisions can be profitable because thefirm does not have to add fixed costs.firm does not have to add fixed costs.

As long as a product or division isAs long as a product or division isproducing contribution marginproducing contribution margin

toward unavoidable fixed costs, it istoward unavoidable fixed costs, it isusually more profitable to continue.usually more profitable to continue.


Decision to Add orDecision to Add orClose DivisionsClose Divisions

Austin Products has three product lines,Austin Products has three product lines,A, B, and C that it considers losers.A, B, and C that it considers losers.

UnavoidableUnavoidablefixed costsfixed costs $130,000$130,000 $ 50,000$ 50,000 $250,000$250,000

DecisionDecisionchoicechoice ContinueContinue Close Close ContinueContinue

Current lossCurrent loss $110,000$110,000 $ 130,000$ 130,000$100,000$100,000


Mountain Boards ExampleMountain Boards Example

Elevation Sports, Inc. is consideringElevation Sports, Inc. is consideringmanufacturing and selling mountain boards.manufacturing and selling mountain boards.

Potential sales price per unit:Potential sales price per unit:WholesaleWholesale $120$120RetailRetail 200 200


Mountain Boards ExampleMountain Boards Example

Variable costs per unit:Variable costs per unit: MaterialsMaterials $30$30 LaborLabor 20 20 Variable overheadVariable overhead 30 30Total variable cost per unitTotal variable cost per unit $80$80Allocated unavoidable fixed costsAllocated unavoidable fixed costs (part of current fixed costs)(part of current fixed costs) 20,00020,000Added new fixed costsAdded new fixed costs 3,000 3,000


Mountain Boards Example: Mountain Boards Example: AssumptionsAssumptions

Retail sales:Retail sales:

(1)(1) BEBEUnitsUnits ==FCFC

UCMUCM== 192 units192 units==$23,000$23,000

$200 – $80$200 – $80



$200 – $80$200 – $80


Mountain Boards Example: Mountain Boards Example: AssumptionsAssumptions

Wholesale sales:Wholesale sales:



$120 – $80$120 – $80



$120 – $80$120 – $80


Mountain Boards Example: Mountain Boards Example: ScheduleSchedule

(A) $120 wholesale price × 576 units = $69,120(A) $120 wholesale price × 576 units = $69,120(B) $200 retail price × units = $5,000(B) $200 retail price × units = $5,000

Added sales (A) (B)Added sales (A) (B) $69,120$69,120 $5,000$5,000Additional variable costsAdditional variable costs 46,080 46,080 2,000 2,000Additional contribution marginAdditional contribution margin $23,040$23,040 $3,000$3,000Added fixed costsAdded fixed costs 3,000 3,000 3,000 3,000Addition to net incomeAddition to net income $20,040$20,040 $ -0-$ -0-

WorstWorstcasecase

BestBestcasecase


Considering Opportunity Considering Opportunity CostsCosts

An opportunity cost is the value of what is given upAn opportunity cost is the value of what is given upbecause of choosing one alternative over another.because of choosing one alternative over another.

Assume that Elevation Sports, Inc., can use itsAssume that Elevation Sports, Inc., can use itsexcess capacity to make the bindings orexcess capacity to make the bindings orproduce mountain boards, but not both.produce mountain boards, but not both.

The officers believe that they canThe officers believe that they cansell at least 200 mountain boards.sell at least 200 mountain boards.


Considering Opportunity Considering Opportunity CostsCosts

Sales ($200 × 200)Sales ($200 × 200) $40,000$40,000Less:Less: Variable costs ($80 × 200)Variable costs ($80 × 200) (16,000) (16,000)

Added Fixed CostsAdded Fixed Costs (3,000) (3,000)Net Contribution MarginNet Contribution Margin $21,000$21,000

What is the contribution margin ofWhat is the contribution margin ofthe 200 boards at retail prices?the 200 boards at retail prices?



Difference = $0

Cost to purchase (10,000 × $7)Cost to purchase (10,000 × $7) $70,000$70,000Direct materialDirect material $30,000$30,000Direct laborDirect labor 10,000 10,000Variable overheadVariable overhead 5,000 5,000Fixed overheadFixed overhead 4,000 4,000Opportunity costsOpportunity costs 21,000 21,000Total relevant costsTotal relevant costs $70,000$70,000 $70,000$70,000

Make Buy


AppendixAppendix

Regression analysisRegression analysis is a mathematical model is a mathematical modelthat uses all the items in the data set tothat uses all the items in the data set to

compute a least-squares regressioncompute a least-squares regressionline that equals the total cost formula.line that equals the total cost formula.

Y = total costsY = total costsa = fixed costsa = fixed costs

bb = unit variable cost= unit variable costX = the activity levelX = the activity level


End of Chapter 9End of Chapter 9

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9 - 1 © 2005 Accounting 1/e, Terrell/Terrell Using Relevant Information for Internal Operations Chapter 9