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Chapter ThirteenShort-Run Decision Making:
Relevant Costing
Chapter ThirteenShort-Run Decision Making:
Relevant Costing
COPYRIGHT © 2012 Nelson Education Ltd.
COPYRIGHT © 2012 Nelson Education Ltd.
Learning ObjectivesLearning Objectives
1. Describe the short-run decision-making model, and explain how cost behaviour affects the information used to make decisions
2. Apply relevant costing and decision-making concepts in a variety of business situations
3. Choose the optimal product mix when faced with one constrained resource
4. Explain the impact of cost on pricing decisions
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OBJECTIVE OBJECTIVE 11
Describe the short-run decision-making model, and explain how cost behaviour affects the information used
to make decisions
COPYRIGHT © 2012 Nelson Education Ltd.
Short-Run DecisionsShort-Run Decisions
• Small-scale actions that serve a larger purpose
• Decisions are made using a decision model– Used to structure the thinking process– Organizes information
• Consists of choosing among alternatives with an immediate or limited end in view
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COPYRIGHT © 2012 Nelson Education Ltd.
Decision-Making ModelDecision-Making Model
1. Recognize and define the problem
2. Identify the alternatives
3. Identify the costs and benefits associated with each feasible alternative
4. Estimate the relevant costs and benefits for each alternative
5. Assess the qualitative factors
6. Select alternative with the greatest net benefit
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COPYRIGHT © 2012 Nelson Education Ltd.
Relevant CostsRelevant Costs
• Can consist of both variable and fixed costs• Changes in supply and demand for resources
must be considered• Also known as differential or incremental costs• Practical interpretation
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OBJECTIVE OBJECTIVE 22
Apply relevant costing decision-making
concepts in a variety of business situations
COPYRIGHT © 2012 Nelson Education Ltd.
Make-or-Buy DecisionsMake-or-Buy Decisions
• Decisions involving a choice between internal and external production
• Decision process:– Identify feasible alternatives– Identify which costs are relevant– Compare total relevant costs of manufacturing with
cost of buying– Make a choice
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COPYRIGHT © 2012 Nelson Education Ltd.
Example: Cornerstone 13-1Example: Cornerstone 13-1
Information:
Direct materials
Direct labour
Variable overhead
Fixed overhead
Unit CostTotal Cost
$10,000 $1.00
20,000 2.00
8,000 0.80
44,000 4.40
Total $82,000 $8.20
Determine if it would be cheaper to make 10,000 units of a component in-house or to purchase them from an outside supplier for $4.75 each
HOW TO Structure a Make-or-Buy Problem
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Information continued:Fixed overhead will continue whether the component is produced internally or externally. No additional costs of purchasing will be incurred beyond the purchase price
1. What are the alternatives?2. List the relevant cost(s) of internal production and of
external purchase3. Which alternative is more cost effective and by how much? 4. Now assume that the fixed overhead includes $10,000 of
avoidable cost (if the component is purchased externally) Which alternative is more cost effective and by how much?
Required:
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
1. Alternatives:• Make the component in-house, or• Purchase the component from an outside supplier
2. Relevant costs:• Producing in-house
‒ Direct Materials‒ Direct Labour‒ Variable Overhead
• Purchasing the component externally‒ Purchase Price
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Differential Cost to Make
Direct materials
Direct labour
Variable overhead
Purchase cost
BuyMake
$10,000 $10,000
20,000
8,000
Alternatives
----
----
----
20,000
8,000
Fixed overhead is not included in the analysis.It will remain the same under either alternative
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Differential Cost to Make
Direct materials
Direct labour
Variable overhead
Purchase cost
BuyMake
$10,000 $10,000
20,000
8,000
Alternatives
----
----
----
20,000
8,000
The only cost under the “buy” alternative is the purchase cost
$47,500----
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Differential Cost to Make
Direct materials
Direct labour
Variable overhead
Purchase cost
BuyMake
$10,000 $10,000
20,000
8,000
Alternatives
----
----
----
20,000
8,000
If they buy the component, they will incur $47,500 in additional costs
$47,500---- (47,500)
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Differential Cost to Make
Direct materials
Direct labour
Variable overhead
Purchase cost
BuyMake
$10,000 $10,000
20,000
8,000
Alternatives
----
----
----
20,000
8,000$47,500---- (47,500)
Total $47,500$38,000 $(9,500)
It is cheaper to make the component in-house This alternative is better by $9,500
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Differential Cost to Make
Direct materials
Direct labour
Variable overhead
Avoidable fixed overhead
BuyMake
$10,000 $10,000
20,000
8,000
Alternatives
----
----
----
20,000
8,000
Part 4: $10,000 of avoidable fixed overhead
If they make the component, fixed costs will increase by $10,000. If they buy it, the $10,000 in fixed costs will be avoided.
----10,000 10,000
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Differential Cost to Make
Direct materials
Direct labour
Variable overhead
Avoidable fixed overhead
BuyMake
$10,000 $10,000
20,000
8,000
Alternatives
----
----
----
20,000
8,000
Part 4: $10,000 of avoidable fixed overhead
----10,000 10,000
$48,000Total $47,500
$47,500 (47,500)
$ 500
Now it is cheaper to purchase the component. This alternative is better by $500
Purchase cost ----
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COPYRIGHT © 2012 Nelson Education Ltd.
Special Order DecisionsSpecial Order Decisions
• Focus on whether a specially priced order should be accepted or rejected
• Orders can be attractive– Especially when firm is operating below maximum
productive capacity
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COPYRIGHT © 2012 Nelson Education Ltd.
Example: Cornerstone 13-2Example: Cornerstone 13-2
• A new customer has offered to purchase 20,000 units of model TR8 @ $9 each
• New customer is geographically separated from company’s other customers
• Existing sales not affected• Normal production is 100,000 units per year
– Company plans to produce and sell 75,000 in the coming year
• Normal sales price is $14 per unit
Information:
HOW TO Structure a Special-Order Problem
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Information continued:
Direct materialsDirect labourVariable overheadFixed overhead
Unit Cost$3.00
2.801.502.00
Total $9.30
1. What are the relevant costs and benefits of the two alternatives (accept or reject the special order)?
2. By how much will operating income increase or decrease if the order is accepted?
Required:
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
1. Relevant cost and benefits:• Accept the order
• Sales price of $9 (Benefit)• Direct materials (Cost)• Direct labour (Cost)• Variable overhead (Cost)
• Reject the order:• There are no relevant costs or benefits
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Accept Reject
Differential Benefit to
Accept
Price
Direct Materials
Direct Labour
Variable Overhead
$9.00 $ --- $9.00
(3.00) --- (3.00)
(2.80) --- (2.80)
(1.50) (1.50) ---
Increase in operating income $1.70 $ 0 $1.70
Operating income will increase by $34,000 ($1.70 × 20,000 units) if the special order is accepted.
Per Unit:
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COPYRIGHT © 2012 Nelson Education Ltd.
Keep-or-Drop DecisionsKeep-or-Drop Decisions
• Decision to keep or drop a segment such as a product line
• Variable costing segment financial reports provide information– Contribution margin– Segment margin
• Relevant costing provides structure to decision making
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COPYRIGHT © 2012 Nelson Education Ltd.
Example: Cornerstone 13-3Example: Cornerstone 13-3
• Roofing tile line has a contribution margin of $10,000 (sales of $150,000 less total variable costs of $140,000)
• All variable costs are relevant• Relevant fixed costs associated with this line include:
– Advertising $10,000– Supervision $35,000
Information:
HOW TO Structure a Keep-or-Drop Product Line Problem
1. List the alternatives being considered2. List the relevant benefits and costs for each alternative3. Which alternative is more cost effective? By how much?
Required:
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
1. Alternatives:• Keep roofing tile line OR Drop roofing tile line
2. Relevant costs and benefits:• Keep the order
• Sales of $150,000 (Benefit)• Variable costs of $140,000 (Cost)• Advertising $10,000 (Cost)• Supervision $35,000 (Cost)
• Reject the order:• None of the relevant costs or benefits will occur if
line is dropped
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Keep Drop
Differential Amount to
Keep
SalesLess: Variable Expenses
Contribution MarginLess: Advertising
$150,000 $ --- $150,000140,000 --- 140,000
$ 10,000 --- $ 10,000(10,000) (10,000) ---
Cost of supervision
$ 0 $(35,000)
The difference is $35,000 in favour of dropping the roofing tile line
(35,000) --- (35,000)
Total relevant benefit (loss) $(35,000)
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COPYRIGHT © 2012 Nelson Education Ltd.
HOW TO Structure a Keep-or-Drop Line Problem with Complementary Effects
Example: Cornerstone 13-4Example: Cornerstone 13-4
Information: Blocks BricksSalesLess: Variable Expenses
Contribution MarginLess direct fixed expenses:
$500 $800250 480
$250 $320
(10) (10)Advertising
(40)(37) (40)
Segment margin $150
(53)Salaries
Depreciation
$230
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
• Dropping the roofing tile product line reduces:– Sales of blocks by 10%– Sales of bricks by 8%
• All other information remains the same
Information continued:
1. If the roofing tile line is dropped, what is the contribution margin: For the block line? For the brick line?
2. Which alternative (keep or drop the roofing tile line) is now more cost effective and by how much?
Required:
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Sales $500,000
Before dropping line
After dropping line
$450,000
Blocks
Less: Variable expenses 250,000 225,000Contribution Margin $250,000 $225,000
10% reduction in Block sales = $500,000 – 10% ($500,000) = $450,000
Variable expenses are also reduced by 10%, resulting in a 10% decrease in Contribution Margin
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Sales $500,000
Before dropping line
After dropping line
$450,000
Blocks
Less: Variable expenses 250,000 225,000
Contribution Margin $250,000 $225,000
Sales $800,000 $736,000
Bricks
Less: Variable expenses 480,000 441,600
Contribution Margin $320,000 $294,400
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Keep Drop
Differential Amount to
Keep
Contribution Margin $580,000 $519,400
Blocks $225,000 + Bricks $294,400
Blocks $250,000 + Bricks $320,000 + Tile $10,000
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Keep Drop
Differential Amount to
Keep
Contribution Margin
Less: Advertising
Cost of supervision
$580,000 $519,400 $60,600
(30,000) (20,000) (10,000)
(112,000) (77,000) (35,000)
$15,600
Now the difference is $15,600 in favour of keeping tile line
Total $438,000 $422,400
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COPYRIGHT © 2012 Nelson Education Ltd.
Further Processing of Joint ProductsFurther Processing of Joint Products
• Joint products– Include both common processes and costs up to
split-off point
• Split-off point– The point at which separate products become
distinguishable
• Common costs are not relevant to the decision making
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COPYRIGHT © 2012 Nelson Education Ltd.
Example: Cornerstone 13-5Example: Cornerstone 13-5
• Appletime must decide between– Selling the Grade B apples at split-off
• 120 two-kilogram bags• Selling price is $1.25 per bag
– If processed into apple pie filling• Generates 500 cans of filling• $0.24 additional cost to process• Selling price will be $0.90 per can
Information:
HOW TO Structure the Sell-or-Process-Further Decision
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
1. What is the contribution to income from selling the Grade B apples in two-kilogram bags?
2. What is the contribution to income from processing the Grade B applies into pie filling?
3. Should Appletime continue to sell the Grade B apples in bags or process them further into pie filling?
Required:
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
1. Contribution to income from selling apples in bags
120 bags x $1.25 selling price
$150 revenue from selling apples in bags
There are no additional costs, so all the additional revenue is additional profit
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
2. Contribution to income from processing into pie filling…
Sales of the pie filling will bring in additional revenue
500 cans x $0.90 selling price = $450 revenue
But processing the apples, will add additional costs:
$0.24 per can x 500 cans = $120
$450 - $120 = $330 Income
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Selling the apples in two-kilogram bags would bring in an additional $150 in
revenue with no additional costs
Processing the apples into pie filling would contribute $330 in additional income
Appletime should process the apples into pie filling because it generates
the most income
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OBJECTIVE OBJECTIVE 33
Choose the optimal product mix when faced with one
constrained resource
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COPYRIGHT © 2012 Nelson Education Ltd.
Product Mix DecisionsProduct Mix Decisions
• Organizations have wide flexibility in choosing their product mix– Mix has significant impact on profitability
• Maximizing total profit is the goal– Fixed cost will not change with mix, therefore not
relevant• Focus should be on maximizing total
contribution margin• Limitations on resources are called
“constraints”
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COPYRIGHT © 2012 Nelson Education Ltd.
HOW TO Determine the Optimal Product Mix with One Constrained Resource
Example: Cornerstone 13-6Example: Cornerstone 13-6
• Jorgenson Company produces two types of gears:X: Unit contribution margin of $25Requires 2 hours of machine time
Y: Unit contribution margin of $10Requires 0.5 hours of machine time
• Eight machines provide 40,000 machine hours per year
Information:
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
1. What is the contribution per hour of machine time for each gear?
2. What is the optimal mix of gears?
3. What is the total contribution margin earned for the optimal mix?
Required:
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Gear X Gear Y
Contribution margin per unit
Machine hours required per gear
Contribution margin per machine hour
$ 25 $ 10
÷ 2
$12.50 $20
÷ 0.5
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Since Gear Y yields $20 of contribution margin per machine hour…..
ALL the machine time should be devoted to the production of Gear Y
40,000 machine hours / 0.5 hours per Gear Y = 80,000 units
Optimal mix
Gear Y = 80,000 units and Gear X = 0 units
Contribution Margin of Optimal Mix80,000 units × $10 = $800,000
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COPYRIGHT © 2012 Nelson Education Ltd.
HOW TO Determine the Optimal Product Mix with One Constrained Resource and a Sales Constraint
Example: Cornerstone 13-7Example: Cornerstone 13-7
• Jorgenson Company produces two types of gears:– X provides unit contribution margin $25, requires two
hours of machine time– Y provides unit contribution margin of $25, requires 0.5
hours of machine time• Eight machines provide 40,000 machine hours per year• Maximum sales of 60,000 units of each gear can be sold
Information:
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
1. What is the contribution per hour of machine time for each gear?
2. What is the optimal mix of gears?
3. What is the total contribution margin earned for the optimal mix?
Required:
13-46
COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Gear X Gear Y
Contribution margin per unit
Machine hours required per gear
Contribution margin per machine hour
$ 25 $ 10÷ 2
$12.50 $20
÷ 0.5
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Since Gear Y yields $20 of contribution margin per machine hour…..
First priority is to produce ALL of Gear Y that the market will take
60,000 units × 0.5 hours = 30,000 hours
60,000 is the maximum sales for any gear. 60,000 units use 30,000 machine hours.
This leaves 10,000 hours of production time.
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Since Gear Y yields $20 of contribution margin per machine hour…..
First priority is to produce ALL of Gear Y that the market will take
60,000 units x 0.5 hours = 30,000 hours
10,000 hours will produce 5,000 units of Gear X
10,000 hours ÷ 2 hours per Gear X = 5,000 units
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Since Gear Y yields $20 of contribution margin per machine hour…..
First priority is to produce ALL of Gear Y that the market will take
60,000 units × 0.5 hours = 30,000 hours
10,000 hours ÷ 2 hours per Gear X = 5,000 units
Optimal mix: Gear Y = 60,000 units Gear X = 5,000 units
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Optimal mix
Gear Y = 60,000 units and Gear X = 5,000 units
Contribution Margin of Optimal Mix
60,000 units Gear Y × $10 = $600,000
5,000 units Gear X × $25 = $125,000
Contribution Margin $725,000
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OBJECTIVE OBJECTIVE 44
Explain the impact of cost on pricing decisions
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COPYRIGHT © 2012 Nelson Education Ltd.
Cost-Based PricingCost-Based Pricing
• Most companies start with cost to determine price
• Formula:Price = Product cost + Markup
Markup is percentage of base cost• Includes costs not in base cost & desired profit
• Advantage – Ease of use
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COPYRIGHT © 2012 Nelson Education Ltd.
HOW TO Calculate Price by Applying a Markup Percentage to Cost
Example: Cornerstone 13-8Example: Cornerstone 13-8
• Elvin Company assembles and installs computers to customer specifications
• Jobs are priced at the cost of direct materials and direct labour plus 20%
• Job for a local vocational-technical school includes:– direct materials $65,000 – direct labour $4,000
Information:
Calculate the price charged by Elvin Company to the schoolRequired:
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Price = Cost + 20% (Cost)
Cost = Direct Materials + Direct Labour
Cost = $65,000 + $4,000
Cost = $69,000
Price = $69,000 + 20% ($69,000)
Price = $82,800
Price = $69,000 +$13,800
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COPYRIGHT © 2012 Nelson Education Ltd.
Target Costing and PricingTarget Costing and Pricing
• Determining price based on what customers are willing to pay
• Company then must design and develop product– Cost must be low enough to allow for desired profit
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COPYRIGHT © 2012 Nelson Education Ltd.
Example: Cornerstone 13-9Example: Cornerstone 13-9
• Digitime’s new wristwatch plus PDA has a target price of $200
• Management requires a 15% profit on new products
Information:
Required:
1. Calculate the amount of desired profit2. Calculate the target cost
HOW TO Calculate a Target Cost
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COPYRIGHT © 2012 Nelson Education Ltd.
ExampleExample
Desired Profit
0.15 × Target Price
0.15 × $200
$30
Target Cost
Target Price – Desired Profit
$200 – $30
$170
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