CHAPTER TWO

2. RELEVANT INFORMATION AND SPECIAL DECISIONS

After studying the chapter you are expected to:
 Explain the role of the managerial accounting decision making
 Understand the steps in decision making process
 Understand the characteristics of relevant information.
 Distinguish relevant costs and benefits from irrelevant costs and benefits.
 Analyze situations that involve special decisions.
Introduction
The need for a decision arises in business because a manager is faced with a problem and
alterative courses of action are available in solving that problem in deciding which option
to choose from the available alternatives he or she will need all the information which is
relevant to his/her decision; and he/she must have some criterion on the basis of which
he/she can choose the best alternative.
2.1. Meaning of Relevant information
Making correct decisions is one of the most important tasks of a successful manager.
Every decision involves a choice between at least two alternatives The decision process
may be complicated by volumes of data, irrelevant data, incomplete information, an
unlimited array of alternatives, etc. The role of the managerial accountant in this process
is usually that of a gatherer and summarizer of relevant information and not that of
ultimate decision maker.
The costs and benefits of the alternatives need to be compared and contrasted before
making a decision the decision should be based only on relevant information. Relevant
information includes the predicted future costs and revenues that differ among the
alternatives.
Relevant costs are often teemed avoidable costs, costs that can be eliminated by taking a
specific course of action Any cost or benefit that does not differ between alternatives is
irrelevant and can be ignored in a decision sunk costs (costs already irrevocably incurred)
are always irrelevant because the past cannot be changed; they will be the same for any
alternative Remember that current decisions affect the future not the past All future costs
that donot differ between the alternatives are also irrelevant. To summarize, to affect a
decision a cost must be;

Future; past costs are irrelevant, as we cannot affect them by current decision and they
are common to all alterative that we may choose
Incremental; Meaning expenditure which will be incurred or avoided as a result of
making a decision Any costs which would be incurred whether or not the decision is
made are not said to de incremental to the decision In other word, information that does
not differ among alternatives is irrelevant for decision making.

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In the following example a firm must chose whether it should make its product using
method one or method two in either case products the same product which sells for the
same price In this case total revenue is not relevant to the decision because it is the same
under either alternative both the fixed costs and variable costs are, however, relevant
because they differ.

Method One Method Two

Units produced 40,000 40,000
Selling price Br 7 Br 7
Variable cost/unit Br 2 Br 1
Total Fixed costs Br 6,000 Br 9,000

Should the past be totally ignored? Should we completely ignore the past? Not
really. Since relevant information involves future events, the managerial accountant
must predict the amount of relevant costs and benefits based on historical data so as
to pave the way for decisions. Thus, a study of the past may be of paramount
importance to a firm. There is an important and subtle issue to underline here.
Relevant information must involve costs and benefits that are anticipated to take place
in the future. The accountant’s predictions of those costs and benefits often are based
on data from the past, yet past may be a good predictor of what the future will hold in
store, indeed. The bottom line is that historical data aids in the prediction of the
possible state of business affairs in the future, though it is not relevant to a decision
situation by itself. Historical data have no direct bearing on a decision but such data
can have an indirect bearing on a decision because they may help in predicting the
future. That past figure are irrelevant to the decision itself because the decision cannot
affect past data Decisions affect the future and nothing can alter what has already
happened.
Irrelevant costs and Benefits
The following broad categories of costs and benefits are irrelevant:
Sunk Costs
A sunk cost is a cost that has already been incurred in the past and that cannot be
avoided irrespective of what course of action a manager decides to take. Sunk costs
are always the same no matter what alternatives are being considered and are,
therefore, always irrelevant and should be ignored from the analysis in making
decisions. sunk costs do not affect any future cost and cannot be changed by any
current or future action. An example of a sunk cost is the book value of an asset-plant
asset or inventory, among others. Sunk costs are often used 25 synonyms to historical
costs or past costs. A common behavior tendency is to give undue importance to book
values in decisions that involves replacing an asset or disposing of obsolete inventory.
It is a serious mistake to think that a current or future action can influence the long-

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 run impact of a past outlay. All past costs are down the drain. Nothing can change
what has already happened. The irrelevance of past costs for decisions does not mean
that knowledge of the cost is useless. As stated earlier, past costs do help predict
future costs and affect future payment for income taxes. The past cost in itself is not
relevant, yet. The only relevant cost is the predict future cost. People often seek to
justify their past decisions by refusing to dispose of an asset, if a better alternative has
been identified. The moral: Ignore sunk costs.
1. Future Costs and benefits that do not differ 0939710732
Future costs and benefits that are identical across all decision alternatives are not
relevant and therefore, they can be ignored when making decisions. Recall that future
costs and benefits are irrelevant if they fail to meet the second criterion (i.e.,
difference among alternatives) at same time.
Activity:
Differentiate b/n relevant and irrelevant costs?
As has been said earlier management decision involve predictions of costs and revenues
only future costs and revenues that will differ among alternative actions are relevant to
the decision However, even if sunk costs are past cost and not relevant to a decision, keep
in mind that a study of the past may prove beneficial for a firm since relevant information
involves future events, the managerial accountant is often asked to provide various
predictions-revenues, costs, cash flows, and the like-before a decision is made in making
these predictions, the accountant frequently turns to the past to analyze historical data
Although this may seem confusing, there is an important and subtle issue to be
recognized here.
Relevant information must involve costs and benefits that will take place in the future
Yet, in making predictions of these costs and benefits past may be a good predictor of
what the future will hold Therefore, the role of historical data is to aid the prediction of
future data They may not be relevant to the management decision itself.
2.2. Summary of Terminology Relating To Decision-Making
1. Relevant costs are future costs that differ among alternatives and appropriate to
aiding the making of specific management decisions.
2. Sunk cost is a cost that has already been incurred and that cannot be avoided
regardless of which course of action a manager may decide to take it is also called
past costs and is not relevant for decision making e.g. cost of dedicated fixed
assets,
3. Committed costs are costs which are future in nature but which arise from past
decisions. E.g. contract already entered into which cannot be altered.
4. Common costs are costs which will be identical for all alternatives. They are
irrelevant
5. An avoidable cost is a cost that can be eliminated (in whole or in part) as a result
of choosing one alternative over another. Any cost that is avoidable is potentially
relevant. Avoidable costs are frequently called relevant costs as they represent

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 future that differs among alternatives. In brief, costs that will be incurred or
avoided as a result of make a decision are avoidable costs.
6. Unavoidable costs
Costs that do not differ between alternatives are not avoidable and, therefore, are not
relevant in making decisions. These are costs that would continue to be incurred no
matter why alternative is selected and, therefore, are irrelevant in decision-making
situation. In brief, costs that would be incurred whether or not a decision is made are
unavoidable costs.
7. Differential costs
These represent difference in cost between two alternatives. As explain that avoidable
cost, differential cost, incremental cost, and relevant cost are often used interchangeably.
8. Differential Revenues
These stand for difference in revenue between any two alternatives. Relevant revenues
are expected future revenues that differ between the alternatives under consideration.
When deciding between two alternative business opportunities, a manager selects the
alternative that produces the highest revenue relative to its associated costs. If the two
alternatives are expected to produce the same revenue relative to cost, revenue is not
relevant because it would not make a difference in the amount of net income that could
be obtained in the future.
9. Opportunity Costs
These represent a potential benefit given up when the choice of one action precludes a
different action. Although people tend to overlook or underestimate the importance of
opportunity costs, they are just as relevant as out –of- pocket costs in evaluating decision
alternatives. It is a common mistake for people to overlook or underweight opportunity
costs and, therefore, such costs deserve particular attention.
People tend to overlook opportunity costs, or to treat such costs as less important than
out-off-pocket costs. Yet opportunity costs are just as real and important to making a
correct decision, as are out-of pocket costs. The moral: pay special attention to
identifying and including opportunity costs in a decision analysis.
Suppose that you pay $ 30 to acquire a ticket for admission to Addis Ababa stadium to
watch a football match. Just before entering the stadium, someone offers to buy your
ticket for $ 60. If you refuse the offer, how much will it cost you to attend the event?
From the perspective of managerial accounting, the answer is $ 60. The $ 30 original
purchase price is a sunk cost and is not relevant to the decision at hand. The decision
involves a choice between attending and not attending the football match. The $ 60 offer
differs between the alternatives and is future oriented and, therefore, it is relevant. If you
enter the stadium, you give up the opportunity to obtain $ 60 cash. That is why the
sacrifice of a potential benefit associated with a lost opportunity called an opportunities
cost.
Suppose that you turn down the first offer to sell your ticket for $ 60. A few minutes
later, another person offers you $ 100 for the ticket. If you refuse the second offer, does

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this mean that you opportunity cost has risen to $ 160 (the first $ 60 offer plus the second
$ 100 offer)? The answer is no as opportunity costs are not cumulative. If you had
accepted the first offer, you could not have accepted the second one. You may have many
opportunities, but the acceptance of one of the alternatives eliminates the possibility of
accepting the others. Normally, the opportunity cost is considered to be the highest value
of the available alternative courses of action. In this case, the opportunity cost of
attending the football match is $ 100.
Opportunity costs are not recorded in the financial accounting records, but they represent
an information factor used in decision-making. The reason is that opportunity costs
represent economic benefits forgone as a result of pursuing some course of action rather
than actual birr outlays. Remember that financial accounting is historically based, but
opportunity costs are future oriented-they affect the decisions that managers make. The
financial results of those decisions appear in the financial statements, but the information
used to make the decisions does not. The fact that opportunity costs are not recorded does
not negate their importance, although they are not a part of the financial accounting
system, they are an integral part of management accounting. You would not report the $
100 opportunity cost as an expense on the income statement, but it will certainly affect
your decision regarding whether you attend the football event. Opportunity costs are
relevant costs, indeed.
2. 3. Different Costs for Different Purposes

It seems at this juncture, to make it clear that costs that are relevant in one decision
situation are not necessarily relevant in another. Stated differently, the manager needs
different costs for different purposes. For one purpose, a particular group of costs may be
relevant and, for another purpose, and entirely different group of costs may be relevant.
Thus, in each decision situation, the manager must examine the data at hand and isolate
the relevant costs. Otherwise, the manager runs the risk of being misled by irrelevant
data. The ability to recognize relevant costs and benefits is just as important to a decision
maker as using relevant costs and benefits. How do we know that past costs, although
sometimes good predictors of the future are irrelevant in decision-making?
Now, you will see what information is relevant and what is irrelevant by the help of
numerical illustrations is the remaining part of this section.
Key point
Irrelevance of Future Costs and Benefits
Some people have difficulty accepting the principle that future costs and benefits that do
not differ between alternatives are never relevant in a decision. But the reality is that
future costs and benefits that remain the same under all feasible alternatives are irrelevant
and, therefore, can be safety ignored or eliminated from the analysis in making
decisions. Numerical examples will help
I illustrate how such future costs and benefits should be handled.

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To illustrate, assume that semen printing press is contemplating the purchase of a new
laborsaving machine that will cost $ 40,000 and have a 10- year useful life, Data
concerning the company’s annual sales and costs with and without the new machine
(current situation) are shown below:
Current Situation with
Situation the new Machine
Units produced and sold ------------------- 8,000---------------- -------------- 8,000
Selling price per unit ----------------------- $ 50 -------------------------------- $ 50
Direct materials cost per unit ------------- 20 ------------------------------ 20
Direct labor cost per unit ------------------ 11 ------------------------------- - 8
Variable overhead cost per unit ---------- 3 -------------------------------- 3
Fixed costs, other -------------------------- 90,000-------------------------------90,000
Fixed costs, new machine ------------------------------------------------------------ 4,000
Should the company buy the new laborsaving machine? To answer this question let’s first
consider all the data given irrespective of whether they are relevant or irrelevant.
Carefully observe the comparative income statement shown on the next page under
current situation and situation with the new Machine. Notice that the analysis considers
only the annual sales and cost data as then in the illustration. As the new laborsaving
machine has a useful life of 10 years, you can imply the figures in the above analysis by
10 to obtain the overall result for the coming 10 years. the case, however, the ultimate
decision is the same.
Given our analysis, it can be said that Semen Printing Press should buy the new
laborsaving machine because it results in an increase in the net operating income by $
20,000 annually (i.e., $58,000 -$38,000) over its useful life of 10 years.

8000 units produced and sold

Current New Differential
Situation Machine (costs) and benefits
Sales ($ 50x 8000 units) ----------- $ 400,000 $400,000 $0
Variable Expenses:
Direct Materials
($20x8000 units) --------- ----160,000 160,000 0
Direct labor (DL per unit
X 8000 units) ------------- --- 88,000 64,000 24,000
Variable overhead ($3
X 8000 units) ------------- 24,000 24,000 0
Total variable expenses 272,000 248,000 24,000
Contribution margin -------------- 128,000 152,000 24,000
Less fixed expenses:
Other ---------------------------- -- 90,000 90,000 0
New machine -------------------------0 4,000 (4,000)

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Total fixed expenses 90,000 94,000
Net annual operating income $38,000 $58,000 $20,000
Notice that, in our analysis, both relevant and irrelevant data are mingled together. The
analysis, however, could have ignored the irrelevant data to arrive at the same decisions
already made above. If you carefully observe the original date in the illustration, the new
laborsaving machine promises a saving of $ 3 per unit in direct labor costs (i.e., $ 11-$8),
but it will increase fixed costs by $ 4,000 per year. All other costs and the total number of
units produced and sold will remain the same under both alternatives. Consequently, we
have to eliminate the irrelevant data as follows:
1. Eliminate the sunk costs. Observe that there are no sunk costs, like those you have
seen in our previous illustrations, included in this example.
1. Eliminating the future costs and benefits that do not differ between the alternatives
under consideration. These include the following:
a. The selling price per unit and the number of units sold do not differ between
the alternatives. Therefore, total future sales revenue is not relevant, as it will
not differ between the alternatives.
b. The direct material cost per unit, the variable overhead cost per unit, and the
number of units produced do not differ between the alternatives. Therefore,
total future direct material costs and variable overhead costs are not relevant,
as they will not differ between the alternatives.
c. The fixed costs designated “other” do not differ between the alternatives and,
therefore, are not relevant.
The only relevant costs are the direct labor costs and the fixed costs associated with the
new machine. Consequently, considering only the relevant data, the analysis could be as
follows:
Saving in direct labor costs [$ 11 - $ 8) x 8000 units] ----------------- $ 24,000
Less increase in fixed costs ---------------------------------------------- 4,000
Net annual cost savings promised by the new machine ------------- $ 20,000
Thus, the net advantage in favor of buying the new laborsaving machine is $ 20,000
manually, which is the same as our earlier analysis.
To sum up, future costs and benefits that do not differ between alternatives are indeed
irrelevant in the decision-making process and can be safety eliminated from the analysis.
To enable you attach significant importance to the irrelevance of future costs and benefits
that will not differ between alternatives, the following additional example is given to you.

2.4. Types of Relevant Cost Decisions

There are a substantial number of relevant cost decisions such as:

1. Adding and Dropping product Lines and Other Segments

2. Make or buy or outsourcing product components or services.

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 3. Special Orders
4. Sell or Process further Decisions
5. Equipment replacement decisions

2.4.1Adding or Dropping a Segment

Decision relating to adding and dropping business unit are among the most difficult that a
manager makes. The term ‘business unit’ may refer to a product, a market territory, a
department, a warehouse, and just about any other business segment imaginable. Products
that were formerly profitable may be loosing market share to newer goods. A company
may undertake an aggressive expansion, starting to serve new geographic regions. An
existing market may have become increasingly competitive, forcing an entity to scale
back efforts and rethink its strategy. Or, an organization that has done a credible job in
building a business may entertain and accept an offer to sell off one of its product lines.
No doubt there are numerous other decisions that would fit under this caption.

1. Compare contribution margins and fixed costs

To make the correct decision regarding dropping a product line, we need to compare
lost contribution margin with avoidable fixed costs. A segment should be added only
if the increase in total contribution margin is greater than the increase in fixed costs.
A segment should e dropped only if the decease in total contribution margin is less
than the decrease in fixed costs.
2. Compare Total Net Incomes. A second approach is to calculate the total net income
under each alternative (That is, calculate the total net income before dropping and
after drop-in) the alternative with the highest net income is preferred This approach
requires more information than the first approach since costs and revenues that don’t
differ between the alternatives must be included in the analysis when the net incomes
are compared.
3. Beware of allocated common costs. I warn you to beware of allocated common
costs, Common fixed costs are fixed costs that support the operation of more than one
segment, but are not traceable in whole or in part to any one segment Thus they
continue even when the product line is dropped Allocate common costs can make a
segment look unprofitable even though dropping the segment might result in a
decrease in overall company net operating income. Allocated costs that would not be
affected by a decision are irrelevant and should be ignored in a decision relating to
adding or dropping a segment.
Example
Abebe Retailer operates three segments around Markato. Income statement for the
segment is shown below:-

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 A B C

Sales ………………………………80,000………140,000….100,000
CGS………………………………. 35,000 ……….90,000…..32,000
Contribution Margin ………………45,000………..50,000…...68,000
Fixed Costs:
Avoidable …………………….10,000…………30,000…..20,000
Unavoidable …………………15,000 …………25,000…..15,000
Net Income……………………….20,000................. (5,000)……33,000

Ato Abebe is considering closing segment B as it is operating at a recurring loss. Should

the owner eliminate this unprofitable segment?
This question will be answered by preparing comparative income statement for the
company as a whole under two alternatives:1) with the retention of segment B, and 2)
with elimination of this segment.

With Segment B without Segment B

Sales……………………………..320,000 180,000
CGS …………………………….157,000 67,000
Contribution Margin……………..163,000 113,000
Fixed Costs
Avoidable…………………….60,000 30,000
Unavoidable ……………….. 55,000 55,000
Net Income………………………….48,000 28,000

Note that our emphasis is on total net income of the Company With Segment B the total
profit is Br 48,000 whereas if this segment is to be eliminated the total profit of the
company will be reduced to Br 28,000 Thus it is better to operate this segment even if it
is operating at loss.
A quick answer to such type of elimination decision is to compare the unavoidable fixed
costs with the segment’s loss. As a decision rule if the unavoidable cost is lower than the
amount of loss, it is better to eliminate or close the segment and if the unavoidable cost is
greater than the amount of loss it is better not to close the segment. Accordingly, since
the unavoidable cost is greater than the loss (25,000>5,000) the segment should not be
closed the unavoidable cost exceeds the loss by Br 20,000 Note also that the difference in
total net income at these two alternatives is also Br 20,000 ;( 48,000-28,000)
2.4.2. The Make or Buy Decision
A make or buy decision is concerned with whether an item should be made internally or
purchased from an external supplier. Such consideration will arise when the company has

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the capacity to produce some items it needs internally and such items are at the same time
available in the outside market, the acquisition of goods and services from an outside
provider or supplier is termed as outsourcing.
The make-or-buy-or outsourcing decision is often part of a company’s long-term strategy.
Some companies choose to integrate vertically in an effort to control activities that lead to
the final product; others prefer to rely on outsiders for some inputs and specialize in only
certain steps of the total process.
1. Advantages of making an item internally.
 Producing a part internally reduces dependence on suppliers and may ensure a
smoother flow of parts and material for production.
 Quality control may be easier when parts are produce internally.
 Profits can be realized on the parts and materials.

2. Advantages of buying an item from an external supplier.

 By pooling the requirements of a number of users, a supplier can realize
economies of scale and may be able to move more quickly up the learning curve.
 A specialized supplier may be able to respond more quickly and at less cost to
changing future needs.
 Changing technology may make producing one’s own parts riskier than
purchasing from the outside.

Fixed costs; the key in such decision is the proper handling of fixed costs since the per-
unit cost of a product includes a portion of fixed costs (i.e., fixed costs that may continue
even if the product is purchased elsewhere at a lower price), the information should be
presented to emphasize that total costs will not change with the number of units
produced.

Opportunity cost. Opportunity costs should be considered in decisions there is no

opportunity cost involved in using a resource that has excess capacity. However, if the
resource is a constraint (i.e., there is no excess capacity) then there is an opportunity cost.
Normally if the items are purchased from outside, the released facilities could be used for
other profitable purposes. Thus, the management should take into account the opportunity
cost of making the item internally in stead of buying them from outside.

Example:
A Company makes four components, A, B, C, and D with expected costs for the coming
year as follows:

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 A B C D
Production (units) 2,000 4,000 8,000 6,000
Unit Variable Costs (Br)
Direct materials 8 10 7 8
Direct labor 16 18 10 12
Variable FOH 4 6 3 4
28 34 24 24

Direct fixed costs per year and committed fixed costs are as follows:

Incurred as a direct consequence of making A 2,000

Incurred as a direct consequence of making B 10,000
Incurred as a direct consequence of making C 12,000
Incurred as a direct consequence of making D 16,000
Other committed fixed costs 60,000
Total 100,0000

The company is often faced with the decision as to whether it should manufacture a
component or buy it outside. A subcontractor has offered to supply units A, B, C, and D
for Br 24, Br 42, Br 20 and Br 28, respectively.

Required: Decide whether the Company should make or buy the components.

A B C D
Cost of Making
Annual requirements in units 2,000 4,000 8,000 6,000
Unit variable cost of making 28 34 20 24
Total variable cost of making 56,000 136,000 160,000 144,000
Avoidable fixed Cost 2,000 10,000 12,000 16,000
Total Cost of Making 58,000 146,000 172,000 160,000
Cost of Buying
Annual requirements in units 2,000 4,000 8,000 6,000
Purchase price 24 42 20 28
Total Cost of Buying 48,000 168,000 160,000 168,000
Total Cost Saved by Buying 10,000 (22,000) 12,000 (8,000)

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Solution and discussion

a. The relevant costs are the differential costs between making and buying. They
consist of differences in unit variable costs plus differences in directly attributable
fixed costs. Subcontracting will result in some savings on fixed cost.
b. The company would save Br 10,000/annum by sub-contracting component A, and Br
12,000/annum by sub-contracting component C
c. In this example, relevant costs ate the variable costs of in-house manufacture, the
variable costs of sub-contracted units, and the saving in fixed costs.
d. Other important considerations are as follows:

 If components A and C are sub-contracted, the company will have spare capacity
how should that spare capacity be profitable used? Are there hidden benefits tofu
be obtained from sub-contracting? Will there be resentment from the workforce?
 Would the sub-contractor e reliable with delivery times, and is the quality the
same as those manufactured internally?
 Does the company wish to be flexible and maintain better control over operations
by making every ting itself?
 Are the estimates of fixed costs savings reliable? In the case of product A, buying
is clearly cheaper than making in-house. However, for product C, the decision to
buy rather than make would only be financially attractive if the fixed cost savings
of 12,000 could be delivered by management. In practice, this may not materialize
2.4.3. Special Order
Management sometimes faces the decision off accepting or rejecting one-time-only
special order for a price different from the normal selling price. Accepting the special
order will increase revenues and costs, wile rejecting the order will leave revenues and
costs unchanged. There are also qualitative factors to be considered like possible will
from rejecting the proposed customer order for instance if company rejects a special
order from a customer .It risks losing future sales to this customer and, in the long-run it
can lose other customers if it gets reputation for being unwilling to negotiate prices or
large orders.
It will also come from other customers whose orders are delayed if the special order is
accepted or from who receive less favorable prices than the price given to the special
order customers. The profit from a social order equals the incremental revenue less the
incremental costs As long as the incremental revenue exceeds the incremental costs, and
present sales are unaffected, the order should be accepted if there is no idle capacity,
opportunity costs should be included as part of the incremental costs as the special orders
will affect a company’s normal sales. Two basic situations are considered to analyze data
in this type of decision.
A. Excess (Idle) Capacity

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The company may operate below capacity at the time when the order is received. For
example, the company’s capacity is to manufacture and sell 10,000 units per year and the
current annual demand is only 8,000 units (i.e., it is operating at 80% capacity). In such
case if the special order is for units less 2,000 only variable costs associated with the
special order are relevant. Fixed costs are usually irrelevant.

B. No Excess Capacity

The company may not have sufficient idle capacity to accept the order. For instance
in the above example if the order is for 3,000 units, accepting the order will affect the
normal sales. In such cases the opportunity cost of the lost contribution margin from
regular sales and variable costs associated with the special offer are relevant.

Example

Date textile makes blankets that it markets through a variety of department stores in
Addis Ababa. It manufactures the blankets in batch and each batch represents 200 units
The Company has the capacity to produce 5000 blankets per month currently the
company sells 4000 units per month at its normal selling price of Br 250 per unit. The
cost of producing the blanket is summarized as follows.

Variable cost
Direct material cost ……………………Br 30 per unit
Direct labor …………………………….Br 80 per unit
Manufacturing Overhead………………Br 6 per unit
Set-up Cost……………………………..Br 8,000 per batch
Fixed Costs…………………………………...Br 90,000 per month

Delta Hotel has offered to buy 1,000 blankets for Br 160 each. Production of these
blankets requires two batches at 500 units per batch.

Required;

1. Should Date Textile accept this special order?

2. What if the special order is for 1,500 blankets?

Solution

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Remember that in making special decision, the key considerations are identification of
relevant costs and opportunity costs if there is no excess capacity.
Without Special Effect of the with Special
Order special Order Order

Sales ……………………………1,000,000 160,000 1,160, 000

Material Cost……………………..120,000 30,000 150,000
Labor Cost………………………320,000 80,000 400,000
MOH Cost………………………..24,000 6,000 30,000
Set-Up Costs…………………….60,000 16,000 176,000
Total Variable Cost………………624,000 132,000 756,000
Contribution Margin…………..3 76,000 28,000 404, 000
Fixed Costs………………………..90,000 - 90,000
Net Income…………………… 286,000 28,000 314,000

Activity: Attempt the second requirement._____________________________________

Sell-or-Process Further Decision

In some manufacturing processes, several intermediate products are products are

produced from a single input. Such end products are known as joint products. The split-
off point is the point in the process at which the products are distinguishable from one
another is called split-off point. All manufacturing costs incurred associated with making
these products up to split-off point are called joint costs Joint costs are usually allocated
to each product based on relative sales value methods or output method.

A decision often must be made about selling a joint product at split off point or
processing it fudge the key in the decision is considering only the increase in process
costs after split-off point (called separable processing cost) and comparing it to the
increase in revenue the extra processing brings.

It is profitable to continue processing a joint product after the split-off point so long as
the incremental revenue from such processing exceeds the incremental processing costs.
In such decisions, the joint product costs incurred before the split-off point are irrelevant
and should be ignored They would be relevant in a decision to shut down the joint
process altogether, but they are irrelevant in any decision about what to do with the joint
products once they have reached the split-off point.

The pitfalls of allocation: Joint product costs are really common costs that are incurred
to simultaneously produce a variety of end products. Unfortunately, these common costs

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are routinely allocated to the joint products. Allocated joint product costs are often
misinterpreted as costs that could be avoided by producing less of one of the joint
products. However, joint product costs can only be avoided by producing less of all of the
joint products simultaneously. If any of the joint products is made, then all of the joint
product costs up to the split-off point will have to be incurred.

Example:
Afro chemicals produces three chemicals, Ch1, Ch2, and Ch3 through a joint process the
cost up to the split-off point amount to Br 40,000 per month At split-off point Afro can
sell Ch l at Br 10, Ch2 at Br 5, and Ch3 at Br 15. These three products can be further
processed and sold. Further processing cost per unit are Br 4, Br 7 and Br 9, respectively.
After further processed they can be sold for Br 16, Br 14 and Br 20 each, respectively.

Required:
When should Afro Chemical sell its three chemicals?
Solution
We should compare the cost of further processing and the additional revenue we get from
further processing.

Product cost of further processing additional revenue from further processing difference
Ch1 Br. 4 Br. 6 = (16-10) Br.2
Ch2 7 9 = (14-5) 2
Ch3 9 5 = (20-15) (4)

Decision product Ch1 and Ch2 should be process further but product Ch3 should not be
processed further and be sold at split-off

5.4.5. Equipment Replacement Decisions

Equipment may become technologically deficient long before it deteriorates physically.
Accordingly, equipment decisions should be determined on the basis of profitability
analysis rather than physical deterioration.
It has been previously state, “Sunk costs are not relevant costs.” One of the most difficult
conceptual lessons that managers have to learn is that sunk costs are never relevant in
decision. The temptation to include sunken costa in the analysis is especially strong in the
case of book value of old equipments and machineries. Due attention will be given to the
book value of old depreciable plant assets and cost of absolute inventory on hand here in
this section of the chapter. Other types of sunk costs will be taken account of in other
parts of the chapter. The key point to always remember is that sunk costs are not
avoidable and, therefore, they should be ignored in decisions.
To illustrate, porno Engineering gathered the following information concerning the old
machine and the proposed new machine:

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 Old Machine
Original cost ………………………………. $ 190,000
Remaining book value …………………….150, 000
Remaining life …………………………….4 years
Disposal value (salvage value) now ……….110, 000
Disposal value (salvage value) in four years…0
Annual variable operating expenses ………..370,000*
Annual revenue form sales …………………600,000

Proposed New Machine

List price (cost) now …………………………$215,000
Expected life ………………………………… 4 years
Disposal value in four years …………………… 0
Annual variable operating expenses ………… 310,000*
Annual revenue from sales …………………….600, 000

* Include labor, maintenance, gasoline, power, etc.

You are required to decide as to whether to continue with the old machine or buy the
proposed new machine. That is, should porno engineering dispose off (sale) the old
machine now and purchase the new machine? Before we go to the answer, let’s open a
stage for argument by first computing the loss if the old machine is sold now as follows

Old Machine:
Remaining book value ----------------------------------- $ 150,000
Disposal value now ------------------------------------- 110,000
Loss from disposal --------------------------------------- $ 40,000

The manager of Porno Engineering may reason, given this potential loss of $ 740,000 if
the old machine I s sold now, “We have already made an investment in the old machine,
so now we have no choice but to use this old machine until our investment has been fully
recovered”. The manager may tend to think this way even though the new machine I s
clearly more efficient than the old machine and highly profitable in terms of quantitative
analysis. Notice, however, that an error made in the past cannot be corrected by simply
continuing to use this old machine. The investment that has been made in the old machine
is a sunk cost because this equipment is purchased in the past and the cost has already
been incurred. The portion of this investment that remains on the company’s books (i.e.,
the book value of $ 150,000) should not be considered in decision about whether to buy
the new machine.

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The following analysis, therefore, verifies the irrelevance of the book value of the old
machine and helps us arrive at the final decision

Total costs and Revenues-Four years

Keep old Purchase New Differential
Machine Machine (costs) and Benefits
Sales (Annual revenue x 4 years).,, $2,400,000 $2,400,000 $0
Variable expenses (Annual variable
Expenses x4 years) …………….. (1,480,000) (1,240,000) 240,000
Cost (depreciation) of new machine-- 0 (215,000) (215,000)
Depreciation of old Machine or Book
Value write-off ………………….. (150,000) (150,000)* 0
0 110,000* 110,000
Total net operating income over
Four Years ………………… $770,000 $905,000 $135,000

For external reporting purposes, the $ 150,000 remaining book value of the old machine
and the $ 110,000 disposal value would be netted together and deducted as a single $
40,000 loss figure.

Looking at all four years together, notice that the firm will be $ 135,000 better off by
purchasing the new machine now. Thus, the final decision is the old machine should be
sold now and the new machine purchased. To arrive at the correct equipment replacement
decision of this type, you have two possible ways stated below:

Compare the total net operating income for four years for the two alternatives (i.e.,
$770,000 and $905,000) and select the alternative with the largest net operating income
figure, or concentrate on the total differential costs and benefits for four years and select
the second terminative if the figure for total differential costs and benefits is positive as in
our case.
Notice that the $ 150,000 book value of the old machine had no effect on the outcome of
the analysis. Since this book value is a sunk cost, it must be absorbed by the firm
regardless of whether the old machine is kept and used for four years or sold now. If the
old machine is kept and used, then the $ 150,000 book value is deducted in the form of
depreciation over the machine remaining life of 4 years. If the old machine is sold now,
then the $ 150,000 book value is deducted in the form of a lump-sum write-off. Either
way, the company bears the same $ 150,000 cost and the differential cost is Zero. The
only difference in the treatment of the $ 150,000 book value of the old machine is one of
timing.
In our analysis, both relevant and irrelevant costs and benefits are mingled together. we
could, however, arrive at the same decision by emphasizing only on the relevant data.

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Looking the data for porno engineering, we should eliminate the following irrelevant data
from the analysis:
1. The sunk cost: This includes only the remaining book value of the old machine
(i.e., 150,000).
2. The future costs and benefits that do not differ between the alternatives at h and
including,
a. The sales revenue of $ 600,000 per year
b. The variable expenses to the extent of $ 310,000 per year.
The only relevant data in this question are the following:
1. The variable expenses to the extent of $ 60,000 per year.
2. Cost of the new machine, $215,000.
3. Disposal value of old machine now,$110,000
Using only the relevant costs and benefits, we have the following analysis that product
the same result:
Differential (costs) and
Benefits Four years
Reduction in variable expenses if the new Machine is
Purchased ($60,000*per year x 4 years) -----------------. $ 240,000
Cost of the new machine ----------------------------------- (215,000)
Disposal value of old machine ---------------------------- 110,000
Net advantage of the new machine ----------------------- $135,000
* $ 370,000 - $ 310,000= $ 60,000.
Note that the items above are the same as those in the last column of the earlier analysis
and represent those predicated future costs and benefits that differ between the two
alternatives. To conclude, the new machine should be purchased and the old machine
disposed off now.

We could also use another method that considers the opportunity cost concept to arrive at
the same answer by first identifying relevant costs and benefits associated with the two
machines. The following relevant and irrelevant information pertain to the old machine:
1. The original cost of $ 190,000, the book value of $ 150,000 and the accumulated
depreciation of $40,000 (i.e., $ 190,000 - $ 150,000) are different measures of a
cost that was incurred in prior period. As such, they represent sunk costs that are
not relevant costs.
2. The $110.000 disposal value of the old machine now represents the current
sacrifice that must be made to use the old machine for the remaining 4 years of its
life. In other words, if Mesfin Engineering does not use the machine, it can sell it
now at market value of $ 110,000 from and economic perspective, forgoing the
opportunity to sell the old machine is the same thing as buying it. Accordingly,
the opportunity cost is relevant cost to the replacement decision.

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 3. The $ 370,000 annual variable operating expense will be incurred if the old
machine is kept and used but can be avoided if it is replaced by the new machine.
Accordingly, the variable operating expenses are relevant costs.
4. The annual revenue from sales of $ 600,000 is irrelevant benefit because, though
it is predicted revenue, it is the same (doesn’t differ) as the future revenue
if the new machine is chased.
The following relevant and irrelevant information pertain to the proposed new
Machine:
1. The cost of the new machine (i.e., $ 215,000) represents a future economic
sacrifice that must be incurred if the new machine I s purchased. Accordingly it is
relevant cost. Moreover, depreciation on new machine is relevant cost.
2. The $ 310,000 annual variable operating expenses will be incurred if the new
machine is purchased, and it can be avoided if the new machine is not purchased.
Accordingly, the variable operating expenses are relevant costs.
3. The annual revenue from sales of $ 600,000 is irrelevant benefit as it is the same
as expected annual revenue if the old machine is kept and used.
The relevant information for the two machines is summarized here:
Total Costs and (Benefits)-Four years
Keep Purchase
Old machine New machine

Cost:
Opportunity Cost ---------------------- $ 110,000
Acquisition Cost ---------------------------------------------- $215,000
Operating Expenses ------------------- $1,480,000 $1,240,000
Total ------------------------------------ $1,590,000 $1,455,000

Difference in favor of
New machine ----------------------------------------------------$135,000

As the proposed new machine produces the lowest relevant cost of $ 1,455,000 porno
Engineering should acquire it. Stated differently, the $ 1,590,000 cost of using the old
machine can be avoided by incurring the $1,455,000 cost necessary to acquire and use the
new machine during the four-year period, the company would save $ 135,000 by
purchasing the new machine Thus, our analysis favors the “replacement” option.

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