Relevant Cost Analysis

Short-Run Decision Making: Relevant Costing

Practical applications to Relevant Costing:

• To take the jeep or take the taxi when going to school.

• To buy the required textbook or rent/borrow it from thesenior students.

• To buy lunch from Kolk’s Nook or Jollibee.

• To study or cheat for the exam.

• To go to Ayala or stay at home during the weekend.

• To buy a gown or rent the gown for the JS Prom next year.

What is your choice?

What is relevant cost analysis?

• Relevant cost analysis is also known as differentialanalysis or incremental analysis.

• Relevant costing is the use of cost and revenue datain making short-run decisions. It consists ofchoosing among alternatives with an immediate orlimited end in view.

• Although relevant costing decisions are short run innature, they often have long-run consequences,and although they are often small scale actions,they often serve a larger purposes.

What are relevant costs?

• Relevant costs

– They are future costs and they differ acrossalternatives. They are frequently (but not always)variable costs called flexible resources.

– The two bolded and underlined conditions MUSTBE MET in order for a cost to qualify as a relevantcost.

Decision making model/process:• A decision making model is a formal method of making a choice,

often involving both quantitative and qualitative analysis. It detailsspecific set of procedures that can be used to structure thedecision makers’ thinking and organize information to make gooddecisions.

• Steps in the decision making process:– Recognize, define, and clarify the problem.– Identify a decision criteria.– Identify alternatives as possible solutions to the problem and eliminate

alternatives that clearly are not feasible.– Identify the costs and benefits associated with each feasible alternative.– Classify costs and benefits as relevant or irrelevant, and eliminate

irrelevant ones from consideration.– Estimate the relevant costs and benefits for each alternative.– Assess qualitative factors.– Make the decision by selecting the alternative with the greatest overall

net benefit.

Quantitative versus Qualitative Analysis

• Quantitative

– Factors in a decision problem that is expressed innumerical terms.

• Qualitative

– Factors in a decision problem that cannot beexpressed effectively in numerical terms.

Usefulness of information is determined by its:

• Relevance– Information is pertinent to a decision problem.

– Relevant information is different under competing coursesof action, it relates to the future, provides a balancebetween accuracy and timeliness, and may consist of bothquantitative and qualitative information.

• Accuracy– Information is reasonably precise.

• Timeliness– Information is available in time for a decision to be made.

Interrelationship between budgeting and relevant costing

• Recall: Budgeting involves the acquisition andallocation of scarce resources over a specified timeperiod.

• In relevant costing, two or more alternatives arepresented and are evaluated quantitatively andqualitatively. The alternative that presents thehighest return or least cost is chosen. Relevantcosting strives to allocate resources in the best waypossible to increase profitability of the company,and ultimately, to increase shareholder value.

Relevant Costs versus Irrelevant Costs

• Relevant costs are future costs that differ amongalternatives while irrelevant costs are costs that donot differ among alternatives and/or costs thatalready occurred in the past.

• Importance of identifying relevant information:

– By focusing on only the relevant information, themanagerial accountant can simplify and shorten thedata-gathering process.

– By routinely providing only relevant information, themanagerial accountant can reduce the possibility ofinformation overload.

Relevant Costs versus Irrelevant Costs

• What costs are relevant?– Differential costs– Incremental costs– Opportunity costs– Avoidable costs– Out of pocket costs

• What costs are irrelevant?– Sunk costs– Committed costs– Non-cash costs– Unavoidable costs– Future costs that do not differ between alternatives.

Identifying if costs are relevant or not:Darlene is trying to decide whether it would be less expensive to drive or take the busto Santander. By car, it is 230 kilometers to her friend’s apartment. Her car costsP2,400,000 and is expected to have a 5 year remaining life with a P1,000,000 salvagevalue. The straight line method of depreciation is used. Price of gas per gallon is P160and her car can run 32 kilometers per gallon of gas. Annual cost of auto insurance andlicense is P138,000. Maintenance and repairs costs P6.50 per kilometer. The parkingfee at school is fixed at P4,500 a month. Darlene attends school only 8 months out ofthe year.

The reduction in resale value of car when the car is used is P2.60 per kilometer.Round-trip bus ticket fare is P10,400. The parking fee in Santander is estimated to beP2,500 per day, and she plans to stay in Santander for two days. The cost of puttingDarlene’s dog in the kennel during her absence is P4,000. Furthermore, Darlenebelieves that if she takes the bus rather than drive her car, she would have the benefitof relaxing. If she drives her car, it would give her more convenience, although there isalso the hassle of parking her car in Santander. (base this on 10k miles driven/ year).

Requirement 1: Identify the relevant costs of the two alternatives.

Requirement 2: Determine which decision should Darlene take?

Approaches in Relevant Cost Analysis

• Total Cost Approach

– All costs and benefits are included in thecomputation to identify which alternative is thebest.

• Incremental Cost Approach

– Only the costs and benefits that differ betweenalternatives are included in the computation toidentify which alternative is the best.

Sales 1,000,000

Less: variable expenses

Variable mfg. costs 240,000

Variable shipping costs 10,000

Commissions 150,000 400,000

Contribution margin 600,000

Less: fixed expenses

General factory overhead 120,000

Salary of line manager 180,000

Depreciation of equipment 100,000

Advertising - direct 200,000

Rent - factory space 140,000

General admin. expenses 60,000 800,000

Net loss (200,000)

Income Statement for 2012

Digital Musical Instruments

Exercise on the Approaches in Relevant Cost Analysis

General Factory Overhead and General Administrative Expenses are unavoidable costs.

Assume that the equipment used in manufacturing digital instruments has no resale value or

alternative use.

Exercise on the Approaches in Relevant Cost Analysis

• Required:

– Illustrate relevant cost analysis using the Total CostApproach

– Illustrate relevant cost analysis using the IncrementalCost Approach

Relevant Cost Decisions:• Make or buy? (Outsourcing)

• Adding a product line or segment? (Adoption of newproducts)

• Keeping or dropping a product line or segment?(Discontinuance of products)

• Lease or operate?

• Sell as is or process further?

• Shutdown or continue operations?

• Accept or reject a special order?

• Equipment replacement decisions.

• Utilization of scarce resources (Optimizing product mix)

• Financing versus investing decisions.

MAKE OR BUY

Make or Buy (Outsourcing)

• What is it?– It is a choice between producing a product internally/using in-

house service versus sourcing the product or service from anoutside supplier.

• When does this decision issue arise?– If the firm has the capability to produce its own

products/services (vertical integration) and it wants to decidewhether it is more cost effective to producing a product orservice or to outsource it from an outside supplier.

• What is the decision rule/guideline?– Compare internal production costs and opportunity costs to

external purchase costs. Choose the alternative with the lowestrelevant (incremental) cost.

Make or Buy (Outsourcing)

• Common relevant information in a make or buy decision:– Variable manufacturing costs that will be saved– Fixed manufacturing costs that can be eliminated– Purchase price– Opportunity costs

• Other important factors to consider:– Is the quality of the manufactured component superior to the

quality of the purchased component?– Will there be timeliness in the part of the supplier if one decides

to buy or outsource the needed materials/parts?– Will purchasing the component result in more timely availability

of the component?– Would a relationship with the potential supplier benefit the

company in any way?– Are there any worker productivity issues that affect this decision?

Make or Buy Sample Problem 1Granger Inc. purchased boards from an outside supplier at the cost of P100each. The company uses 50,000 units of boards a year. Management requeststhat an analysis be made to determine the profitability of producing theboards internally.

The raw materials required to manufacture each board cost P15 per board. Toprocess the raw materials includes a direct labor cost of P20 per board. Thecompany would also have to lease a board press costing P2,000,000 for a four-year lease. Presently, there is adequate space in to manufacture 20,000boards per year.

If the company were to produce all of its boards internally, it would benecessary to cease its manufacture of its other products and to purchase theseoutside, resulting in an additional P2,500,000 cost. Also, a machine used tocreate its other products costing P800,000 with a P400,000 book value wouldhave to be scrapped without a salvage value.

Required: Should Granger buy all 50k boards inside, 20k boards inside and30k boards outside, or buy all 50k boards outside?

Make or Buy Sample Problem 2Tremolo Inc. is considering whether to continue to make a component or to buy itfrom an outside supplier. The company uses 17,000 of the components each year. Theunit product cost of the component according to the company's cost accountingsystem is given as follows:

Direct materials P 8.20Direct labor 8.30Variable manufacturing overhead 1.20Fixed manufacturing overhead 4.30Unit product cost P22.00

Assume that direct labor is a variable cost. Of the fixed manufacturing overhead, 70%is avoidable if the component were bought from the outside supplier. In addition,making the component uses 2 minutes on the machine that is the company's currentconstraint. If the component were bought, this machine time would be freed up foruse on another product that requires 4 minutes on the constraining machine and thathas a contribution margin of P7.00 per unit.

When deciding whether to make or buy the component, what are the relevant costs tomake the component

Make or Buy Sample Problem 3Best Corp is working at full capacity producing 10,000 units ofProduct XYZ. Manufacturing costs per unit for XYZ follow:

Direct material P 2Direct manufacturing labor 3Manufacturing overhead 5

P 10

The unit manufacturing overhead cost is based on a variable cost perunit of P2 and fixed costs of P30,000 (at full capacity of 10,000 units).The non-manufacturing costs, all variable, are P4 per unit, and theselling price is P20 per unit. A customer, Hue Inc. has asked Best toproduce 2,000 units of a modification of XYZ to be called ABC. ABCwould require the same manufacturing processes as XYZ and Hue hasoffered to share equally the non-manufacturing costs with Best. ABCwill sell at P15 per unit.

Make or Buy Sample Problem 3

Required:

a. Assume that no overtime is worked, what is theopportunity cost to Best of producing the 2,000 unitsof ABC?

b. A supplier, Jonny Co. has offered to produce 2,000units of XYZ for Best, so Best can accept Hue’s offer.Jonny would charge Best P14 per unit for the XYZ.Should Best accept the offer of Jonny?

c. Suppose Best had been working at less than fullcapacity producing 8,000 units of XYZ at the time theABC offer was made. What is the minimum price Bestshould accept for ABC under these conditions(ignoring the P15 price mentioned previously)?

ADDING A

PRODUCT

LINE OR

SEGMENT

Adding a Product Line or Segment

• What is it?– It is a choice of whether the company should include

another product line or segment in its businessoperations.

• When does this decision issue arise?– When the company feels that it is ready to expand its

operations.

• What is the decision rule/guideline?– Choose the alternative that gives you the highest

profitability.

Adding a Product Line or Segment

• Common relevant information in adding a product line orsegment:– Externalities– Additional fixed costs incurred– Impact of additional contribution margin

• Other important factors to be considered:– Will the new product line or segment cannibalize the sales of existing

product lines or segments of the company?– If existing workers are transferred from their present position to the

new position that serves customers of the new product line or segment,will there be any productivity issues? Do they have the requisite skills?

– Will the firm have enough equipment/materials needed to produce thenew product?

– If there are resource constraints and the number of existing productsdecline due to the constraints, how will the customers of existingproducts react?

Adding a Product Line or Segment Sample Problem

Shure Inc.’s contribution margin statement is shown below:

Sales (20,000 units x P500) P 10,000,000Variable cost (3,000,000)Contribution margin P 7,000,000Fixed cost (2,000,000)Operating income P 5,000,000

The company is contemplating on adding another segment which willresult to a contribution margin of P500,000. Moreover, the companyforesees that adding another segment will not result to anyadditional incurrence of fixed cost. However, the new segment isexpected to detrimentally affect the number of units sold of existingproducts by 5%. If you were Shure, would you add the newsegment? Why or why not?

KEEPING OR DROPPING A

PRODUCT LINE OR

SEGMENT

Keeping or Dropping a Product Line or Segment

• What is it?– It is a choice of whether it is more profitable to keep a

product line or segment (that usually results in an operatingloss) or to drop that product line or segment.

• When does this decision issue arise?– When a product line or segment is deemed unprofitable to

the company as a whole, the company may want to considerdropping that product line or segment.

• What is the decision rule/guideline?– Keep, if Lost CM > Fixed cost savings or avoidable fixed costs.

– Drop, if Lost CM < Fixed costs savings or avoidable fixedcosts.

Keeping or Dropping a Product Line or Segment

• Common relevant information in keeping or dropping aproduct line or segment:– Variable costs that drive the contribution, if any, produced by the

segment.– Contribution margin produced by the segment– Disposition of the segment’s fixed expenses.

• Other important factors to be considered:– What will be the effect on the customers of a particular segment if

it is eliminated? What is the effect on the company’s reputation? – What will be the effect on the employees of a segment if it is

eliminated? Can any of them be reassigned to other divisions?– What will be the effect on the community where a particular

segment is located if the decision is made to drop that segment– What will be the effect on the morale of the employees of the

remaining divisions?

Keeping or Dropping a Product Line or Segment Sample Problem 1

ABC Company produces three versions of baseball bats: wood, aluminum, and hardrubber. A condensed segmented income statement for a recent period follows:

Wood Aluminum Hard Rubber Total

Sales P500,000 P200,000 P 65,000 P765,000

Variable expenses 325,000 140,000 58,000 523,000

Contrib. margin P175,000 P 60,000 P 7,000 P242,000

Fixed expenses 75,000 35,000 22,000 132,000

Net income (loss) P100,000 P 25,000 P (15,000) P110,000

Requirement 1: Assume that none of the fixed expenses for the hard rubber areavoidable. What will be the total net income if the line is dropped? What should beABC’s decision?

Requirement 2: Assume that all of the fixed expenses for the hard rubber line areavoidable. What will be the total net income if that line is dropped? What should beABC’s decision?

Requirement 3: If the total net income after dropping the hard rubber line is P105,000,what is the amount of avoidable fixed expenses for hard rubber line?

Keeping or Dropping a Product Line or Segment Sample Problem 2

Parity Company has three product lines in its retail stores: books, videos, andmusic. The allocated fixed costs are based on units sold and are unavoidable.Demand of individual products is not affected by changes in other productlines. Results of the fourth quarter are presented below:

Books Music Videos Total

Units sold 1,000 2,000 2,000 5,000

Revenue P24,000 P48,000 P32,000 P104,000

Variable departmental costs 15,000 22,000 23,000 60,000

Direct fixed costs P 3,000 P 6,000 P 4,000 P 13,000

Allocated fixed costs 4,400 8,800 8,800 22,000

Net income (loss) P 1,600 P11,200 P(3,800) P 9,000

Requirement 1: Should Parity drop the Video product line? Why or why not?

Requirement 2: If 40% of fixed costs are avoidable, should Parity drop theVideo product line? Why or why not?

LEASE OR OPERATE

Lease or Operate

• What is it?– Decisions may either be in the point of view of the lessee or the lessor.– Point of view of lessee: Decisions that need to be made when a firm is

deciding on whether to lease equipment or to operate its ownequipment in pursuance of organizational goals.

– Point of view of lessor: Decisions that need to be made when a firm isdeciding what to do with its equipment – whether it will sell theequipment or let the equipment be leased.

• When does this decision issue arise?– When a company is into manufacturing and the cost of the equipment

is considerable.

• What is the decision rule/guideline?– Identify the costs for leasing and operating and choose the alternative

that will give you the highest returns or the lowest costs.

Lease or Operate

• Common relevant information in the decision to leaseor operate:– Lease payments.– Foreseeable repairs and maintenance expenses.– Opportunity costs.

• Other important factors to be considered:– Are there any terms that the lessor and lessee have agreed

upon as to who will shoulder the repairs and maintenancecost of the machine?

– Do the current employees know how to operate the leasedequipment?

– Are there any worker productivity issues that will affect thisdecision?

Lease or Operate [Lessor] Sample Problem 1

Vina Inc. has bought a new machine and is decidingwhat to do with the old one. The cost of the oldmachine was originally P60,000 and has beendepreciated P45,000. The company has receivedtwo offers that it must consider. One offer wasmade to purchase the machine outright for P18,500less a 5% sales commission. The other offer was tolease the machine for P7,000 for the next five yearsbut the company will be required to providemaintenance and insurance totaling P3,000 peryear. What offer should Vina accept?

Lease or Operate [Lessor] Sample Problem 2

Homia Inc. owns a building but uses only half of thebuilding and is considering two options. First option isthat Yasui would purchase the half of the building that isnot being used for P550,000. A 7% commission wouldhave to be paid at the time of purchase. The secondoption is that Chongbeng would lease the half of thebuilding for the next 5 years at P100,000 each year.Homia would have to continue paying P9,000 of propertytaxes each year and P1,000 of yearly insurance on theproperty, according to the proposed lease agreement.

Requirement 1: Determine the differential income or lossfrom each of the options.Requirement 2: Which option must Homia take?

Lease or Operate [Lessee] Sample Problem

• Mike Osmeña Inc. is expanding, and is looking for suitable office space for its operations. It is evaluating between two proposals.

• It can buy the property directly for P25 million, and must pay a 7% commission to its broker. The company estimates that the building accounts for 70% of the property value.

• It can lease the property for ten years, paying P3 million in rent. Although the title remains with the landlord, the lease contract stipulates that Mike is responsible for maintenance and association dues amounting to P150,000 per year.

• What should the company do? Its policy is to depreciate buildings using the straight line method over 10 years, and has a 30% income tax rate.

SELL AS IS

OR

PROCESS

FURTHER

Sell as is or process further

• What is it?– Decisions regarding joint products that need to be made

when a firm is deciding on whether to sell products at agiven point in the production cycle or continuing toprocess with the expectation of selling them at a laterpoint at a higher price.

• When does this decision issue arise?– When a company has joint products and it is able to sell

these either in their rawer form or in their processed form.

• What is the decision rule/guideline?– Process further, if Incremental Revenue after split-off point

> Incremental Cost after split-off point– Sell as is, if Incremental Revenue after split-off point <

Incremental Cost after split-off point


Joint

Input

Common

Production

Process

Separate

Processing

Separate

Processing

Final

Sale

Final

Sale

Final

Sale

Split-Off

Point

Joint

Costs

Separate

Product

Costs

Oil

Gasoline

Chemicals


• Common relevant information in the decision to sell asis or process further:– Incremental processing costs.

• Other important factors to be considered:– Is there a good demand for joint products that are processed

further? If not, is it still profitable for the firm to sell thejoint products as is?

– Do the employees have the knowhow to continue processingthe joint products?

– Does the firm have the necessary equipment to process thejoint products?

– Can the firm procure enough materials needed to processthe joint product further?

Sell as is or process further sample problem 1

Hudson Inc. sells unfinished wood planks at a price ofP15.00 per wood plank. The current profit margin isP5.00 per wood plank. The company is consideringtaking individual orders and customizing them forsale. To finish the wood planks, the company wouldhave to pay (per plank) additional labor of P3.00,additional materials costing an average of P4.00, andfixed costs would increase by P1,500. The companyestimates that it can sell 600 finished planks for P25each month. Should Hudson sell the planks as is orshould it process the planks further? Why?

Sell as is or process further sample problem 2

RD Company manufactures three chemicals (AB, CD, and EF) from ajoint process. The three chemicals are in industrial grade form at thesplit-off point. They can either be sold at that point or processedfurther into premium grade. Costs related to each batch of thischemical process is as follows:

AB CD EFSales value at split-off point P16,000 P12,000 P5,000Allocated joint costs P6,000 P6,000 P6,000Sales value after further proc. P20,000 P18,000 P9,000Cost of further processing P5,000 P3,000 P2,000

For which product(s) above would it be more profitable for RD to sellat the split-off point rather than process further?

SHUT DOWN OR

CONTINUE OPERATIONS

Shutdown or continue operations

• What is it?– Choice a company makes if it is essential for a firm to

shut down temporarily or to continue operations.

• When does this decision issue arise?– When a firm is highly seasonal/cyclical and is expected

to experience cyclical lows during foreseeable periods.

• What is the decision rule/guideline?– Continue operations, if sales > shut down point.

– Shut down temporarily, if sales < shut down point.

*shut down point = (fixed costs – shut down costs) / unitcontribution margin.

Shutdown or continue operations

• Relevant information in the decision to shutdown orcontinue operations:– Avoidable fixed costs.

– Shutdown costs.

• Other important factors to be considered:– Will the decision to shut down operations temporarily affect

employee morale?

– Will the ‘valuable employees’ seek employment elsewherewhile the firm is shut down temporarily?

– Will shutting down operations temporarily send a negativesignal to the firm’s customers, and will it adversely affect thesales of the firm even during “supposedly profitableperiods”?

Shutdown or continue operations sample problem

XYZ Corporation had been experiencing a slowdown in business activities in March, April, andMay, and is considering temporarily shutting down its operations during those months. Theaccounting department has provided the following normal operating data for considerations:

Unit Sales Price P200 Monthly fixed OH P800,000Unit Variable Production Costs P80 Monthly fixed Expenses P500,000Unit Variable Marketing Costs P20 Regular Sales in Units 20,000/month

Estimated Sales in units during off peak months 5,000/month

If the company shuts down its operations, the following costs are expected to be incurred:Security and Safety P400,000/month Regular Fixed OH 40% of total is avoidableRe-start up costs P250,000/set-up Regular Fixed Expenses will be reduced by 60%

Requirement 1: How much is the total shutdown cost?Requirement 2: What is the shutdown point in three months?Requirement 3: Should the company shut down or continue operations?

ACCEPT OR REJECT A

SPECIAL ORDER

Accept or reject a special order

• What is it?– A choice a company makes whether it should

accommodate a one-time special order that is usuallydiscounted or at lower price.

• When does this decision issue arise?– When a company receives an order (usually at a

“special” price) that is not considered part of thecompany’s normal ongoing business.

• What is the decision rule/guideline?– Accept, if incremental revenue > incremental cost.– Reject, if incremental revenue < incremental cost.

Accept or reject a special order• Relevant information in the decision to accept or reject a special

order:– Expected additional revenues from the special order.– Expected additional costs from the special order.

• Other important factors to be considered:– Will the customer expect the same selling price per unit on future orders?– Will other regular customers be upset if they discover the lower selling price to

one of their competitors?– Will employee productivity change with the increase in production?– Given the increase in production, will the incremental costs remain as

predicted for this special order?– Are materials available from its supplier to meet the increase in production?– What is the effect on the company’s reputation of leaving orders from regular

customers unfilled, just to fill the special order?– Will any of the projected costs change if the company operates at 100%

capacity?– Are there any methods to increase capacity? What effects do these methods

have on employees and on the community?

Accept or reject a special order sample problem 1

Beulah Inc. incurs costs of P28 per unit (P18 variableand P10 fixed) to make a product that normally sellsfor P42. A customer approaches Beulah and offers tobuy 5,000 units at P25 each. Beulah will incuradditional shipping costs of P1 per unit. Assumingthat Beulah has excess operating capacity, shouldBeulah accept the special order?

Accept or reject a special order sample problem 2

Simba Company, when operating at full capacity, can produce one million units a year.The per unit and total costs for a unit when the company operates at full capacity areas follows:

Per Unit(in pesos) Total (in pesos)Direct materials 2.00 2,000,000Direct labor 0.75 750,000Variable manufacturing overhead 1.00 1,000,000Fixed manufacturing overhead 1.50 1,500,000Variable selling expenses 0.25 250,000Total 5.50 5,500,000

Nala Company expressed interest in purchasing 250,000 units. It offers to pay the unitcost for direct materials, direct labor, and variable manufacturing overhead costs. Inaddition, Nala has agreed to pay an additional P1 per unit to cover all other costs andprovide a profit . Presently, Simba is operating at 70% capacity and does not have anyother potential buyers of its products. If Simba accepts Nala’s offer, it will not incurany variable selling expenses related to this order.

Should Simba accept Nala’s offer? Why or why not?

EQUIPMENT

REPLACEMENT DECISIONS

Equipment replacement decision

• What is it?– A choice a company makes when deciding if it is more

beneficial for the company as a whole to keep using itsexisting equipment or would it be more beneficial to replaceits equipment.

• When does this decision issue arise?– When a company’s equipment is either not working at

optimal level or is becoming obsolete.

• What is the decision rule/guideline?– Choose the alternative (to replace the old equipment or to

keep the old equipment) that will give you the highestreturns or the lowest costs.

Equipment replacement decision

• Relevant information in the decision to keep or replace theold equipment:– Effects on variable costs.– Cost of the new equipment.– Any disposal value of the existing equipment.

• Other important factors to be considered:– If the company decides to use its existing equipment, is there a

risk that the equipment will fail? Are contingency plans put inplace in case the existing equipment fails?

– If the company decides to replace the equipment, do the currentemployees know how to operate the new equipment?

– Are there any worker productivity issues that will affect thisdecision?

Equipment replacement decision sample problem 1

Sonny Inc. is considering disposing of a machinewith a book value of P22,500 and an estimatedremaining life of three years. The old machine canbe sold for P6,250. A new machine with a purchaseprice of P68,750 is being considered as areplacement. It will have a useful life of three yearsand no residual value. It is estimated that variablemanufacturing costs will be reduced from P43,750to P20,000 if the new machine is purchased. Whatis the net differential increase or decrease in costfor the entire three years for the new equipment?

Equipment replacement decision sample problem 2

Taylor Inc. wants to replace an old machine with a new, more efficientmachine.

New machine:List price P 90,000Annual variable expenses 80,000Expected life in years 5 years

Old machine:Original cost P 72,000Remaining book value 60,000Disposal value now 15,000Annual variable expenses 100,000Remaining life in years 5 years

Taylor’s sales are P200,000 per year. Fixed expenses (other than amortization)are P70,000 per year. Should Taylor purchase the new machine?

UTILIZATION OF SCARCE

RESOURCES

Utilization of scarce resources (Optimizing product mix)

• What is it?– A decision in which a manufacturing firm needs to

determine which product must be prioritized. Itanswers the question “Which product(s) should beemphasized when capacity is limited?”

• When does this decision issue arise?– When resources are scarce, when capacity is limited,

and when the company manufactures two or moreproducts.

• What is the decision rule/guideline?– Prioritize the product which has the highest

contribution margin per unit of constrained resource.

Utilization of scarce resources (Optimizing product mix)

• Relevant information in the decision to determine howto utilize scarce resources and optimize product mix:– Constrained resource or bottleneck.

– Contribution margin.

• Other important factors to be considered:– Are there any fluctuations in demand that may force the

firm to change the unit selling price and changecontribution margin per unit of constrained resource?

– Will customers of products that are not prioritized beupset if the company does not produce enough of thatproduct to satisfy demand due to constrained resources?

Utilization of scarce resources (Optimizing product mix) sample problem

Browning Company makes four products in a single facility. These products have the followingunit product costs (in pesos)

Product A Product B Product C Product DDirect materials 10.60 7.90 6.10 3.80Direct labor 11.40 16.80 8.70 11.40Variable MOH 3.70 4.10 5.40 6.10Fixed MOH 24.60 34.40 21.50 19.30Unit product cost 50.30 63.20 41.70 40.60

Additional data concerning these products are listed below.

Prod. A Prod. B Prod. C Prod. DGrinding minutes/unit 2.60 1.80 2.50 1.40Selling price/unit P69.50 P74.80 P59.50 P59.60Variable selling cost/unit P 1.60 P 1.50 P 2.60 P 3.40Monthly demand in units 4,000 2,000 3,000 4,000

The grinding machines are potentially the constraint in the production facility. A total of 24,500minutes are available per month on these machines. Direct labor is a variable cost in thiscompany.

Utilization of scarce resources (Optimizing product mix) sample problem

Requirement 1: How many minutes of grinding timewould be required to satisfy demand for all fourproducts?

Requirement 2: Which product makes the least profitableuse of the grinding machines?

Requirement 3: Which product makes the most profitableuse of the grinding machines?

Requirement 4: Up to how much should the company bewilling to pay for one additional minute of grindingmachine time if the company has made the best use ofthe existing grinding machine capacity?

FINANCING VS.

INVESTING DECISIONS

Financing vs. investing decision (A review)

• What is it?– Investing: The determination of how to best allocate capital

to maximize their value.

– Financing: The determination of how to pay for investmentsand expenses. Eg: How much funding is needed (AFN), and achoice a company makes on how it should raise money.

• When does this decision issue arise?– When a company is wants to maximize its value.

• What is the decision rule/guideline?– Choose the alternative which will maximize shareholder

wealth or minimize cost of capital (WACC)


• Investing– Deals with how to spend money on assets that will gain the most

value. Companies would want to spend money on assets thatpotentially gives the highest return for the company. There mustbe a balance between short-term and long-term goals.

– 3 main criteria:• It must maximize the value of the firm after considering the amount of risk.• It must be financed appropriately.• If there is no appropriate investment opportunity, cash must be returned to

shareholders to maximize shareholder value.

• Financing– Deals with how to acquire money, and the most common ways to

do this is to use the company’s own money (retained earnings) orby raising money externally (debt, issuing stocks)


• Relevant information in financing decisions:– Amount of financing needed.

– WACC (and all the needed information to derive it)

• Other important factors to be considered:– Will the decision made send any signal (positive or

negative) to the existing/potential shareholders?

– Will the decision result to dilution of shares?

– Are there any debt covenants that would precludethe company from incurring additional debt?

Investing decision sample problem(Computation of expected returns – A review)

You have gathered information about two stocks, oneof which you are intending to invest in.

State of economy Probability Y Returns Z Returns

Recession 15% – 20% 24%

Slowdown 25% – 10% 15%

Average 20% 8% 6%

Upturn 25% 14% – 1%

Boom 15% 20% – 5%

Which stock should you invest in?

Financing decision sample problem(Financing Mix – A review)

Suppose, the risk-free rate for Vista Inc. is 6%, as is the marketrisk premium. The unlevered beta of the firm is 1.0. If the firmborrows P0, P250,000; P500,000; P750,000; P1,000,000, theircorresponding cost of debt would be 0%, 8%, 9%, 11.5%, and14.0%, respectively; and assume that the firm needs to financeP2,000,000.

Further assume that EBIT is P400,000, par value is P25 pershare, and that there should have been 80,000 sharesoutstanding if the firm uses 100% new equity financing. Allearnings are given out as dividends, and the firm experienceszero growth. Tax rate is 40%.

How should the Vista finance its needed funds of P2,000,000?

Nothing Follows…

Documents

Relevant Cost Analysis