Relevant Information For Decision Making: Learning Objectives

CHAPTER 10
Relevant information for

decision making
LEARNING OBJECTIVES
After studying this chapter, you T he provision of decision-relevant information is one important
function of the management accountant. In this chapter, we
focus on decisions such as accepting or rejecting a one-time-only
should be able to:
special order, insourcing or outsourcing products or services, and
l Describe a five-step sequence in
replacing or keeping equipment. We stress the importance of dis-
the decision process
tinguishing between relevant and irrelevant items in making these
l Differentiate relevant costs and
decisions.
revenues from irrelevant costs
and revenues
l Distinguish between quantitative
factors and qualitative factors in
decisions
l Identify two potential problems in
relevant-cost analysis
l Describe the opportunity cost
concept; explain why it is used in
decision making
l Describe the key concept in
choosing which among multiple
products to produce when there
are capacity constraints
l Explain why the book value of
equipment is irrelevant in
equipment-replacement
decisions
309
Chapter 10 Relevant information for decision making
Information and the decision process

Managers often adopt a personalised approach for deciding among different courses of
action. The approach may be highly stylised, informal and subjective. It will also draw
differentially on formally structured information. A decision model is here taken to sig-
nify a formal method for making a choice, frequently involving quantitative and
qualitative analyses. Accountants aim to supply managers with relevant data to guide
their decisions. This information is usually structured and acts as an input to decision
making which will rely also on other information forms.
Consider a decision that Home Appliances, a manufacturer of vacuum cleaners,
faces: should it rearrange a manufacturing assembly line to reduce manufacturing
labour costs? For simplicity, assume that the only alternatives are ‘do not rearrange’
and ‘rearrange’. The rearrangement will eliminate all manual handling of materials.
The current manufacturing line uses 20 workers – 15 workers operate machines, and 5
workers handle materials. Each worker puts in 2000 hours annually. The rearrange-
ment is predicted to cost €90 000. The predicted production output of 25 000 units for
the next year will be unaffected by the decision. Also unaffected by the decision are
the predicted selling price per unit of €250, direct materials costs per unit of €50, other
manufacturing overhead of €750 000, and marketing costs of €2 000 000. The cost
driver is units of production.
To make the decision, management may hypothetically proceed in a sequence of
steps. The first step is to gather more information about manufacturing labour costs.
The historical manufacturing labour rate of €14 per hour is the starting point for pre-
dicting total manufacturing labour costs under both alternatives. The manufacturing
labour rate is expected to increase to €16 per hour following a recently negotiated
increase in employee benefits.
The second step is to predict future costs under the two alternatives. Predicted man-
ufacturing labour costs under the ‘do not rearrange’ alternative are 20 workers × 2000
hours × €16 per hour = €640 000. Predicted manufacturing labour costs under the
‘rearrange’ alternative are 15 workers × 2000 hours × €16 per hour = €480 000.
Predicted costs of rearrangement are €90 000.
As the third step, Home Appliances’ management compares the predicted savings
from eliminating materials handling labour costs (5 workers × 2000 hours × €16 per
hour) = €160 000 to the costs of rearrangement of €90 000. It also takes into account
other qualitative considerations such as the effect that reducing the number of work-
ers will have on employee morale. After weighing the costs and benefits, management
chooses the ‘rearrange’ alternative. Management next implements the decision in the
fourth step by rearranging the manufacturing assembly line.
As the fifth and final step, management gathers information about the actual results
of the plant rearrangement to evaluate performance and to provide feedback. Actual
results show that the new manufacturing labour costs are €550 000 (due to, say, lower-
than-expected manufacturing labour productivity) rather than the predicted
€480 000. This feedback may lead to better implementation through, for example, a
change in supervisory behaviour, employee training or personnel so that the €480 000
target is achieved in subsequent periods. However, the feedback may convince the
decision maker that the prediction method, rather than the implementation, was
faulty. Perhaps the prediction method for similar decisions in the future should be
modified to allow for worker training or learning time.
Exhibit 10.1 summarises the five-step decision process that we just described: gath-
ering information, making predictions, choosing an alternative, implementing the
decision, and evaluating actual performance to provide feedback. The feedback, in
turn, might affect future predictions, the prediction method itself, the decision model
or the implementation.
310
The concept of relevance
Exhibit 10.1 Accounting information and the decision process
Five-step sequence An illustration
Step 1: Historical labour costs were €14 per hour. A recently

Gathering negotiated increase in employee benefits of €2 per hour will
information apply in the future. The rearrangement of the manufacturing
assembly line is expected to eliminate material handling costs.
Historical Other
costs information
Use the information from step 1 together with an assessment
Step 2: of probability as a basis for predicting the future labour costs of
Making €640 000 and €480 000 respectively for the ‘do not arrange’
predictions and ‘rearrange’ alternatives. The rearrangement is predicted
to cost €90 000.
Specific
predictions
Feedback
The predicted benefits of the different alternatives in step 2 are

Step 3:
compared and are related to the size of the required investment
Choosing an
alternative along with other considerations (such as likely effects on
employee morale). Management chooses the rearrange
alternative.
Step 4:
The manager implements the decision reached in step 3 by
Implementing
the decision rearranging the manufacturing assembly line.
Evaluation of performance of the decision implemented in step 4

provides the feedback as the five-step sequence is then repeated
Step 5:
Evaluating in whole or in part. New manufacturing labour costs are
performance €550 000 rather than the predicted €480 000. This historical
information can help managers in making subsequent predictions,
or improving implementation through, for example, employee
training.
The concept of relevance
Relevant costs and relevant revenues

The most important decision-making concepts in this chapter are relevant costs and
relevant revenues. Relevant costs are those expected future costs that differ among alter-
native courses of action. The two key aspects to this definition are that the costs must
occur in the future and that they must differ among the alternative courses of action.
We focus on the future because every decision deals with the future – nothing can be done
to alter the past. Also, the future costs must differ among the alternatives because if
they do not, there will be no difference in costs no matter what decision is made.
Likewise, relevant revenues are those expected future revenues that differ among alter-
native courses of action.
In Exhibit 10.2, the €640 000 and €480 000 manufacturing labour costs are relevant
costs – they are expected future costs that differ between the two alternatives. The past
manufacturing labour rate of €14 per hour and total past manufacturing labour costs
311
Exhibit 10.2 Determining relevant revenues and relevant costs for Home Appliances
All data Relevant data

–––––––––––––––––––––––––––––––––– –––––––––––––––––––––––––––––––––
Alternative 1: Alternative 2: Alternative 1: Alternative 2:
Do not Rearrange Do not Rearrange
rearrange rearrange
Revenues* €6 250 000 €6 250 000 – –

––––––––––––
– –
Costs
Direct materials† 1 250 000 1 250 000 – –
Manufacturing labour 640 000‡ 480 000§ €640 000‡ €480 000§
Manufacturing overhead 750 000 750 000 – –
Marketing 2 000 000 2 000 000 – –
Rearrangement costs – 90 000 – 90 000
–––––––––––– –––––––––––– –––––––––––– ––––––––––––
Total costs 4 640 000 4 570 000 640 000 570 000
–––––––––––– –––––––––––– –––––––––––– ––––––––––––
Operating profit €1 610 000 €1 680 000 €(640 000) €(570 000)
––––––––––––
–––––––––––– ––––––––––––
–––––––––––– ––––––––––––
–––––––––––– ––––––––––––
––––––––––––
€70 000 difference €70 000 difference
* 25 000 × €250 = €6 250 000.

† 25 000 × €50 = €1 250 000.
‡ 20 × 2000 × €16 = €640 000.
§ 15 × 2000 × €16 = €480 000.
of €560 000 (2000 hours × 20 workers × €14 per hour) are not relevant, even though
they may play a role in preparing the €640 000 and €480 000 labour cost predictions.
Although they may be a useful basis for making informed judgements for predicting
expected future costs, historical costs in themselves are irrelevant to a decision. Why?
Because they deal strictly with the past, not the future.
Exhibit 10.2 presents the quantitative data underlying the choice between the ‘do
not rearrange’ and the ‘rearrange’ alternatives. The first two columns present all data.
The last two columns present only relevant costs or revenues. The revenues, direct
materials, manufacturing overhead and marketing items can be ignored. Why?
Because although they are expected future costs, they do not differ between the alter-
natives. They are thus irrelevant. The data in Exhibit 10.2 indicate that rearranging
the production line will increase next year’s predicted operating profit by €70 000.
Note that we reach the same conclusion whether we use all data or include only the
relevant data in the analysis. By confining the analysis to only the relevant data, man-
agers can clear away related but irrelevant data that might confuse them.
The difference in total cost between two alternatives is a differential cost. The differ-
ential cost between alternatives 1 and 2 in Exhibit 10.2 is €70 000.
Qualitative factors can be relevant

We divide the consequences of alternatives into two broad categories: quantitative and
qualitative. Quantitative factors are outcomes that are measured in numerical terms.
Some quantitative factors are financial, that is, they can be easily expressed in financial
terms. Examples include the costs of direct materials, direct manufacturing labour and
312
An illustration of relevance: choosing output levels
marketing. Other quantitative factors are non-financial, that is, they can be measured
numerically, but they are not expressed in financial terms. Reduction in page download
time for an Internet company and the percentage of on-time flight arrivals for an airline
company are examples of quantitative, non-financial factors. Qualitative factors are out-
comes that cannot be measured in numerical terms. Employee morale is an example.
Cost analysis generally emphasises quantitative factors that can be expressed in
financial terms. But just because qualitative factors and non-financial quantita-
tive factors cannot be easily measured in financial terms does not make them unim-
portant. Managers must at times give more weight to qualitative or non-financial
quantitative factors. For example, Home Appliances may find that it can purchase a
part from an outside supplier at a price that is lower than what it costs to manufacture
the part in-house. Home Appliances may still choose to make the part in-house
because it feels that the supplier is unlikely to meet the demanding delivery schedule –
a quantitative non-financial factor – and because purchasing the part from outside
may adversely affect employee morale – a qualitative factor. Trading off non-financial
and financial considerations, however, is seldom easy.
An illustration of relevance: choosing output levels
Managers often make decisions that affect output levels. For example, managers must
choose whether to introduce a new product or sell more units of an existing product.
When changes in output levels occur, managers are interested in the effect it has on the
organisation and on operating profit. Why? Because maximising organisational objec-
tives (typically operating profit in our illustrations) also increases managers’ rewards.
One-off special orders

Management sometimes faces the decision of accepting or rejecting one-off special
orders when there is idle production capacity and where the order has no long-run
implications. We assume that all costs can be classified as either variable with respect
to a single driver (units of output) or fixed. The following example illustrates how
focusing on revenues, variable costs and contribution margins can provide key infor-
mation for decisions about the choice of output level. The example also indicates how
reliance on unit-cost numbers calculated after allocating fixed costs can mislead man-
agers about the effect that increasing output has on operating profit.
Example 10.1 Huber GmbH manufactures quality bath towels at its highly automated Heidelberg
plant. The plant has a production capacity of 48 000 towels each month. Current
monthly production is 30 000 towels. Retail department stores account for all existing
sales. Expected results for the coming month (August) are shown in Exhibit 10.3. (Note
that these amounts are predictions.) The manufacturing costs per unit of €12 consist of
direct materials €6 (all variable), direct manufacturing labour €2 (€0.50 of which is vari-
able), and manufacturing overhead €4 (€1 of which is variable). The marketing costs per
unit are €7 (€5 of which is variable). Huber GmbH has no R&D costs or product-design
costs. Marketing costs include distribution costs and customer-service costs.
A luxury hotel chain offers to buy 5000 towels per month at €11 a towel for each of
the next three months. No subsequent sales to this customer are anticipated. No mar-
keting costs will be necessary for the 5000-unit one-off special order. The acceptance
of this special order is not expected to affect the selling price or the quantity of towels
sold to regular customers. Should Huber GmbH accept the hotel chain’s offer?
313
Exhibit 10.3 Budgeted income statement for August, absorption-costing

format for Huber GmbH
Total Per unit
Sales (30 000 towels × €20) €600 000 €20

Cost of goods sold 360 000 12
–––––––––– ––––
Gross margin (gross profit) 240 000 8
Marketing costs 210 000 7
–––––––––– ––––
Operating profit €30 000 €1
––––––––––
–––––––––– ––––
––––
Exhibit 10.3 presents data in an absorption-costing format: fixed manufacturing

costs are included as product costs. The manufacturing cost per unit is €12 (€7.50 of
which is variable and €4.50 of which is fixed), which is above the €11 price offered by
the hotel chain. Using the €12 absorption cost as a guide in decision making, a man-
ager might reject the offer.
Exhibit 10.4 presents data in a contribution income statement format. The relevant
costs are the expected future costs that differ between the alternatives – the variable
manufacturing costs of €37 500 (€7.50 per unit × 5000 units). The fixed manufacturing
Exhibit 10.4 Comparative income statements for August, contribution

income statement format for Huber GmbH
Without one-off With one-off

special order, special order, Difference,
30 000 units 35 000 units 5000 units
––––––––––––––––––––––– –––––––––––––– –––––––––––––
Per unit Total Total Total
Sales €20.00 €600 000 €655 000 €55 000‡

–––––––– ––––––––– ––––––––– ––––––––
Variable costs
Manufacturing 7.50* 225 000 262 500 37 500§
Marketing 5.00 150 000 150 000 – ||
–––––––– ––––––––– ––––––––– ––––––––
Total variable
costs 12.50 375 000 412 500 37 500
–––––––– ––––––––– ––––––––– ––––––––
Contribution margin 7.50 225 000 242 500 17 500
–––––––– ––––––––– ––––––––– ––––––––
Fixed costs
Manufacturing 4.50† 135 000 135 000 –#
Marketing 2.00 60 000 60 000 –#
–––––––– ––––––––– ––––––––– ––––––––
Total fixed costs 6.50 195 000 195 000 –
–––––––– ––––––––– ––––––––– ––––––––
Operating profit €1.00 €30 000 €47 500 €17 500
––––––––
–––––––– –––––––––
––––––––– –––––––––
––––––––– ––––––––
––––––––
* Variable manufacturing costs = direct materials, €6 + direct manufacturing labour, €0.50 +
manufacturing overhead, €1 = €7.50.
† Fixed manufacturing costs = direct manufacturing labour, €1.50 + manufacturing overhead,
€3 = €4.50.
‡ 5000 × €11.00 = €55 000.
§ 5000 × €7.50 = €37 500.
|| No variable marketing costs would be incurred for the 5000-unit one-off special order.
# Fixed manufacturing costs and fixed marketing costs are also unaffected by the special order.
314
Outsourcing and make-or-buy decisions
costs and all marketing costs (including variable marketing costs) are irrelevant in this
case; they will not change in total whether or not the special order is accepted.
Therefore, the only relevant items here are sales revenues and variable manufacturing
costs. Given the €11 relevant revenue per unit (the special-order price) and the €7.50
relevant costs per unit, Huber would gain an additional €17 500 [(€11.00 – €7.50) ×
5000] in operating profit per month by accepting the special order. In this example,
comparisons based on either total amounts or relevant amounts (Exhibit 10.4) avoid
the misleading implication of the absorption cost per unit (Exhibit 10.3).
The additional costs of €7.50 per unit that Huber will incur if it accepts the special
order for 5000 towels are sometimes called incremental costs. Incremental costs are
additional costs to obtain an additional quantity, over and above existing or planned
quantities, of a cost object. Huber could avoid these costs if it did not accept the spe-
cial order. Huber incurs no incremental fixed manufacturing costs if it accepts the
special order; those costs will not change whether or not the special order is accepted.
Fixed manufacturing costs do not change because the analysis in Exhibit 10.4 assumes
that the 5000-towel special order will use already acquired capacity that will otherwise
remain idle for each of the next three months.
The assumption of no long-run or strategic implications is crucial in the analysis we
present for the one-off special order decision. Suppose, for example, that Huber is con-
cerned that the retail department stores (its regular customers) will demand a lower
price if it sells towels at €11 each to the luxury hotel chain. In this case, the analysis of
the luxury hotel chain order must be modified to consider both the short-term
benefits from accepting the order and the long-term consequences on Huber’s busi-
ness and profitability.
Potential problems in relevant-cost analysis

It is important in relevant-cost analysis not to assume that all variable costs are relevant.
In the Huber GmbH example, the marketing costs of €5 per unit are variable but not rele-
vant. Why? Because for the special-order decision, Huber incurs no extra marketing costs.
Similarly, it is important not to assume that all fixed costs are irrelevant. Consider
fixed manufacturing costs. In our example, we assume that the extra production of 5000
towels per month does not affect fixed manufacturing costs. That is, we assume that the
relevant range is at least between 30 000 and 35 000 towels per month. In some cases,
however, the extra 5000 towels might increase fixed manufacturing costs. Assume that
Huber would have to run three shifts of 16 000 towels per shift to achieve full capacity of
48 000 towels per month. Increasing the monthly production from 30 000 to 35 000
would require a partial third shift because two shifts alone could produce only 32 000
towels. This extra shift would probably increase fixed manufacturing costs, thereby
making any partial additional fixed manufacturing costs relevant for this decision.
The best way to avoid these problems is to require each item included in the analysis
both (1) to be an expected future revenue or cost, and (2) to differ among the alternatives.
Note also that unit-cost data mislead decision makers in two major ways: (a) when costs
that are irrelevant to a particular decision are included in unit costs, and (b) when unit
costs that are calculated at different output levels are used to choose among alternatives.
Unitised fixed costs are often erroneously interpreted as if they behave like unit variable
costs. Generally, use total costs rather than unit costs in relevant-cost analysis.

We now consider the strategic decision of whether a company should make a part or
buy it from a supplier. We again assume idle capacity.
315
Outsourcing and idle facilities

Outsourcing is the process of purchasing goods and services from outside vendors
rather than producing the same goods or providing the same services within the
organisation, which is called insourcing. Outsourcing is an increasingly common prac-
tice. Yahoo! uses Hewlett-Packard’s E-Services Division for sales, marketing, system
integration, and ongoing customer support. Toyota relies on outside suppliers to
supply some parts and components but chooses to manufacture other parts internally.
The BBC likewise outsources much of its accounting-based activities as does British
Airways. Saab, too, prefers an outside firm to undertake part of its finance function. In
making decisions about outsourcing and insourcing, cost is a major factor.
Decisions about whether a producer of goods or services will insource or outsource are
also called make-or-buy decisions. Often qualitative factors dictate management’s make-
or-buy decision. For example, Dell Computers must buy the Opteron chip for its
personal computers from AMD because it does not have the know-how and technology
to make the chip itself. Sometimes, a company may prefer to make the product in-house
to retain control of the product and technology. For example, in order to safeguard
Coca-Cola’s formula, the company does not outsource the manufacture of its concen-
trate. What are the most important factors in the make-or-buy decision? Surveys of
company practices indicate they are quality, dependability of supplies and cost. E-
commerce technologies facilitate outsourcing. It has been noted that many web-enabled
companies are ‘stripping out their physical assets and functions, flattening out their cor-
porate hierarchies, and connecting their operations to suppliers in increasingly intricate
shared networks and relationships’ (Rifkin, The Industry Standard Europe, 23 November
2000, p. 72). In part, outsourcing helps confront ‘being stuck with outdated plant, obso-
lete equipment, and antiquated business systems and processes’ (ibid.).
In the Brumaire SA example described here, assume that financial factors predomi-
nate in the make-or-buy decision. The question we address is: What financial factors
are relevant?
Brumaire SA manufactures thermostats for home and industrial use. Thermostats
consist of relays, switches and valves. Brumaire makes its own switches. Columns 1
and 2 of Exhibit 10.5 report the current costs for its heavy-duty switch (HDS) based on
an analysis of its various manufacturing activities.
Materials handling and set-up activities occur each time a batch of HDS is made.
Brumaire produces the 10 000 units of HDS in 25 batches of 400 units each. The cost
driver is the number of batches. Total materials handling and set-up consist of fixed
costs of €5000 plus variable costs of €500 per batch, amounting to €5000 + 25 × €500 =
€17 500. Brumaire only commences production after it receives a firm customer order.
Brumaire’s customers are pressuring the company to supply thermostats in smaller batch
sizes. Brumaire anticipates that next year, the 10 000 units of HDS will be manufactured
in 50 batches of 200 units each. Through continuous improvement, Brumaire expects to
reduce variable costs per batch for materials handling and set-up costs to €300 per batch.
No other changes in fixed costs or unit variable costs are anticipated.
Another manufacturer offers to sell Brumaire 10 000 units of HDS next year for €16
per unit on whatever delivery schedule Brumaire wants. Should Brumaire make or buy
the part?
Columns 3 and 4 of Exhibit 10.5 indicate the expected total costs and the expected
per unit cost of producing 10 000 units of HDS next year. Direct materials, direct manu-
facturing labour, and variable manufacturing overhead costs that vary with units
produced are not expected to change since Brumaire plans to continue to produce
10 000 units next year at the same variable costs per unit as this year. The costs of mat-
erials handling and set-ups are expected to increase even though there is no expected
change in the total production quantity. Why? Because these costs vary with the
number of batches started, not the quantity of production. Expected total materials
316
Exhibit 10.5 Financial data for HDS manufacturing at Brumaire SA
Expected
Total current Current total costs Expected
costs of cost of producing cost
producing per unit 10 000 units per unit
10 000 units (2) = (1) next year (4) = (3)
(1) ÷ 10 000 (3) ÷ 10 000
Direct materials €80 000 €8.00 €80 000 €8

Direct manufacturing
labour 10 000 1.00 10 000 1
Variable manufacturing
overhead costs for
power and utilities 40 000 4.00 40 000 4
Mixed overhead costs
of materials
handling and set-ups 17 500 1.75 20 000 2
Fixed overhead costs of
plant depreciation,
insurance and
administration 30 000 3.00 30 000 3
Total manufacturing –––––––––– ––––––– –––––––––– ––––
costs €177 500 €17.75 €180 000 €18
––––––––––
–––––––––– –––––––
––––––– ––––––––––
–––––––––– ––––
––––
handling and set-up costs = €5000 + 50 batches × the cost per batch of €300 = €5000 +
€15 000 = €20 000. Brumaire expects fixed overhead costs to remain the same. The
expected manufacturing cost per unit equals €18. At this cost, it seems that the com-
pany should buy HDS from the outside supplier because making the part appears to be
more costly than the €16 per unit to buy it. A make-or-buy decision, however, is rarely
obvious. A key question for management is: What is the difference in relevant costs
between the alternatives?
For the moment, suppose the capacity now used to make HDS will become idle if
HDS is purchased and that the €30 000 of fixed manufacturing overhead will continue
to be incurred next year, regardless of the decision made. Assume that the €5000 in
fixed clerical salaries to support set-up, receiving and purchasing will not be incurred if
the manufacture of HDS is completely shut down. Further suppose that the €30 000 in
plant depreciation, insurance and administration costs represent fixed manufacturing
overhead that will not vary regardless of the decision made.
Exhibit 10.6 presents the relevant cost calculations. Brumaire saves €10 000 by
making HDS rather than buying it from the outside supplier. Alternatively stated, pur-
chasing HDS costs €160 000 but saves only €150 000 in manufacturing costs. Making
HDS is thus the preferred alternative. Exhibit 10.6 excludes the €30 000 of plant depre-
ciation, insurance and administration costs under both the make and the buy
alternatives. Why? Because these costs are irrelevant; they do not differ between the
two alternatives. Alternatively, the €30 000 could be included under both alternatives
since the €30 000 will continue to be incurred whether HDS is bought or made.
Exhibit 10.6 includes the €20 000 of materials handling and set-up costs under the
make alternative but not under the buy alternative. Why? Because buying HDS and
not having to manufacture it saves both the variable costs per batch and the avoidable
fixed costs. The €20 000 of costs differ between the alternatives and hence are relevant
to the make-or-buy decision.
317
Exhibit 10.6 Relevant (incremental) items for make-or-buy decision for

HDS at Brumaire SA
Total Per unit

relevant costs relevant costs
–––––––––––––––––––– ––––––––––––––––––––
Relevant items Make Buy Make Buy
Outside purchase of parts €160 000 €16

Direct materials €80 000 €8
Direct manufacturing labour 10 000 1
Variable manufacturing
overhead 40 000 4
Mixed materials handling
and set-up overhead* 20 000 2
––––––––– ––––––––– ––––– –––––
Total relevant costs €150 000 €160 000 €15 €16
–––––––––
––––––––– –––––––––
––––––––– –––––
––––– –––––
–––––
Difference in favour of
making HDS
€10 000 €1
* Alternatively, the €30 000 of depreciation, plant insurance and plant administration costs could
be included under both alternatives. These are, however, irrelevant to the decision.
In Exhibit 10.6, the incremental cost of making HDS is the additional cost of
€150 000. Likewise, the incremental cost of buying HDS from an outside supplier is the
additional cost of €160 000. The differential cost between making and buying HDS is
€10 000. Note that, in practice, incremental and differential costs are often used inter-
changeably.
The figures in Exhibit 10.6 are valid only if the released facilities remain idle. If the
component part is bought from the outside supplier, the released facilities can poten-
tially be used for other, more profitable purposes. More generally, then, the choice in
our example is not fundamentally whether to make or buy, it is how best to use avail-
able facilities.
The use of otherwise idle resources can often increase profitability. For example,
consider the machine-repair plant of Beijing Engineering, where the decision was
whether to drop or keep a product. The China Daily noted that workers were ‘busy pro-
ducing electric plaster-spraying machines’ even though the unit cost exceeded the
selling price. According to the prevailing method of calculating its cost, each sprayer
costs 1230 yuan to make. However, each sprayer sells for only 985 yuan, resulting in a
loss of 245 yuan per sprayer. Still, to meet market demand, the plant continues to pro-
duce sprayers. Workers and machines would otherwise be idle, and the plant would
still have to pay 759 yuan even if no sprayers were made. In the short run, the produc-
tion of sprayers, even at a loss, actually helps cut the company’s operating loss.
Opportunity costs, outsourcing and capacity constraints

Reconsider the Brumaire SA example where we assumed that the capacity currently
used to make HDS became idle if the parts were purchased. Suppose instead that
Brumaire has alternative uses for the extra capacity. The best available alternative is for
Brumaire to use the capacity to produce 5000 units each year of a regular switch (RS)
that Ventôse SA wants. Charlotte de Calonne, the accountant at Brumaire, estimates
the following future revenues and future costs if RS is manufactured and sold:
318
Expected additional future revenues €80 000

Expected additional future costs
Direct materials €30 000
Direct manufacturing labour 5 000
Variable overhead (power, utilities) 15 000
Materials handling and set-up overheads 5 000
––––––––
Total expected additional future costs 55 000
––––––––
Expected additional operating profit €25 000
––––––––
––––––––
Since Brumaire cannot make both HDS and RS, the three alternatives available to
management are as follows:
1 Make HDS and do not make RS for Ventôse.
2 Buy HDS and do not make RS for Ventôse.
3 Buy HDS and use excess capacity to make and sell RS to Ventôse.
Exhibit 10.7, Panel A, summarises the ‘total-alternatives’ approach – the incremental
expected future costs and expected future revenues for all alternatives. Buying HDS
and using the excess capacity to make RS and sell it to Ventôse is the preferred alterna-
tive. The incremental costs of buying HDS from an outside supplier are more than the
incremental costs of making HDS in-house (€160 000 to buy versus €150 000 to make).
But the capacity freed up by buying HDS from the outside supplier enables Brumaire
to gain €25 000 in operating profit (expected additional future revenues of €80 000
minus expected additional future costs of €55 000) by making RS and selling
to Ventôse. The total relevant costs of buying HDS (and making and selling RS) are
€160 000 – €25 000 = €135 000.
Deciding to use a resource in a particular way causes a manager to give up the
opportunity to use the resource in alternative ways. The lost opportunity is a cost that
the manager must take into account when making a decision. Opportunity cost is the
contribution to income that is forgone (rejected) by not using a limited resource in its
next-best alternative use.
Exhibit 10.7, Panel B, displays the opportunity-costs approach for analysing the
alternatives faced by Brumaire. Management focuses on the two alternatives before it:
whether to make or buy HDS. It does not explicitly include RS in the analysis. Focus
first on the make HDS column and ask what are all the costs of choosing this alterna-
tive? Certainly, Brumaire incurs €150 000 of incremental costs to make HDS. But is
this the entire cost? No, because by using limited manufacturing resources to make
HDS, Brumaire gives up the opportunity to earn €25 000 from not using these
resources to make RS. Therefore, the relevant costs of making HDS are the incremen-
tal costs of €150 000 plus the opportunity cost of €25 000. Next consider the buy
alternative. The incremental costs are €160 000. The opportunity cost is zero because
choosing this alternative does not require the use of a limited resource – Brumaire’s
manufacturing capacity is still available to make and sell RS. Panel B leads manage-
ment to the same conclusion as Panel A does – buying HDS is the preferred
alternative by an amount of €15 000.
Panels A and B of Exhibit 10.7 describe two consistent approaches to decision
making with capacity constraints. The total-alternatives approach in Panel A includes
only incremental costs and benefits and no opportunity costs. Why? Because the
incremental benefit from making RS when HDS is bought is explicitly considered
under the alternatives. Panel B does not explicitly consider the incremental benefits
from selling RS. Instead, it factors in the forgone benefit as a cost of the make alterna-
tive. Panel B highlights the idea that when capacity is constrained, relevant costs
equal the incremental costs plus the opportunity cost.
319
Exhibit 10.7 Total-alternatives approach and opportunity-costs approach

to make-or-buy decisions for Brumaire
Panel A: Total-alternatives approach to make-or-buy decisions
Choices for Brumaire
–––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––
Make HDS and Buy HDS and Buy HDS and
Relevant items do not make RS do not make RS make RS
Total incremental costs of

making/buying HDS
(from Exhibit 10.6) €150 000 €160 000 €160 000
Excess of future revenues
over future costs from RS 0 0 (25 000)
–––––––––– –––––––––– ––––––––––
Total relevant costs €150 000 €160 000 €135 000
––––––––––
–––––––––– ––––––––––
–––––––––– ––––––––––
––––––––––
Panel B: Opportunity-costs approach to make-or-buy decisions

Choices for Brumaire
––––––––––––––––––––––––––––
Relevant items Make HDS Buy HDS
Total incremental costs of

making/buying HDS
(from Exhibit 10.6) €150 000 €160 000
Opportunity cost: Profit
contribution forgone
because capacity cannot
be used to make RS, the
next-best alternative 25 000 0
–––––––––– ––––––––––
Total relevant costs €175 000 €160 000
––––––––––
–––––––––– ––––––––––
––––––––––
Difference in favour of
buying HDS €15 000
Opportunity costs are seldom incorporated into formal financial accounting reports
because these costs do not entail cash receipts or disbursements. Accountants usually
confine their systematic recording to costs that require cash disbursements currently
or in the near future. Historical recordkeeping is limited to alternatives selected rather
than those rejected, because once rejected, there are no transactions to record. For
example, if Brumaire makes HDS, it would not make RS, and it would not record any
accounting entries for RS. Yet the opportunity cost of making HDS, which equals the
profit contribution that Brumaire forgoes by not making RS, is a crucial input into the
make-versus-buy decision. Consider again Exhibit 10.7, Panel B. On the basis of incre-
mental costs alone, the costs systematically recorded in the accounting system, it is
less costly for Brumaire to make rather than buy HDS. Recognising the opportunity
cost of €25 000 leads to a different conclusion. It is preferable to buy HDS.
Suppose Brumaire has sufficient excess capacity to make RS (and indeed any other
part) even if it makes HDS. Under this assumption, the opportunity cost of making
HDS is zero. Why? Because Brumaire gives up nothing even if it chooses to manufac-
ture HDS. It follows from Panel B (substituting opportunity costs equal to zero) that,
under these conditions, Brumaire would prefer to make HDS.
320
Our analysis emphasises purely quantitative considerations. The final decision,

however, should consider qualitative factors as well. For example, before deciding to
buy HDS from an outside supplier, Brumaire management will consider such qualita-
tive factors as the supplier’s reputation for quality and the supplier’s dependability for
on-time delivery.
Carrying costs of stock

The notion of opportunity cost can also be illustrated for a direct-materials purchase-
order decision. Suppose Nøkleby, AS, has enough cash to pay for whatever quantity of
direct materials it buys.
Annual estimated direct-materials requirements

for the year 120 000 kg
Cost per kg for purchase orders below 120 000 kg €10.00
Cost per kg for purchase orders equal to or
greater than 120 000 kg; €10.00 minus
2% discount €9.80
Alternatives under consideration:
A. Buy 120 000 kg at start of year
B. Buy 10 000 kg per month
Average investment in stock:
A. (120 000 kg × €9.80) ÷ 2* €588 000
B. (10 000 kg × €10.00) ÷ 2* €50 000
Annual interest rate for investment in
government bonds 6%
* The example assumes that the direct materials purchased will be used up uniformly at the
rate of 10 000 kg per month. If direct materials are purchased at the start of the year (month),
the average investment in stock during the year is the cost of the stock at the beginning of
the year (month) plus the cost of stock at the end of the year (month) divided by 2.
The following table presents the two alternatives.
Alternative A: Alternative B:
Purchase Purchase
120 000 kg 10 000 kg
at beginning at beginning of
of year each month Difference
(1) (2) (3) = (1) – (2)
Annual purchase (incremental)
costs (120 000 × €9.80;
120 000 × €10) €1 176 000 €1 200 000 €(24 000)
Annual interest income that
could be earned if investment
in stock were invested in
government bonds
(opportunity cost)(6% ×
€588 000; 6% × €50 000) 35 280 3 000 32 280
––––––––––– ––––––––––– –––––––––
Relevant costs €1 211 280 €1 203 000 €8 280
–––––––––––
––––––––––– –––––––––––
––––––––––– –––––––––
–––––––––
321
CONCEPTS IN ACTION
VW takes outsourcing to the limit
Volkwagen’s bus and truck plant in Resende, Brazil, is a virtual plant: VW has completely
outsourced manufacturing to a team of carefully selected supplier-partners in a radical
experiment in production operations. At Resende, VW is transformed from manufacturer
to general contractor, overseeing assembly operations performed by seven German, US,
Brazilian and Japanese components suppliers, with not one VW employee so much as
turning a screw. Only 200 of the total 1000 Resende workers are actual VW employees.
When designing the Resende plant, VW asked suppliers to bid for the opportunity
to own one of seven major modules required to build a car, such as axles and brakes or
engine and transmission. Suppliers have invested US$50 mil-
lion to build, equip and stock their areas. VW’s contract with
Source: © Reuter Raymond/Corbis Sygma
suppliers is for 10- to 15-year periods, with the conditions

that suppliers must achieve specified cost and performance
targets and maintain cutting-edge technologies.
The plant is divided into seven zones, demarcated by
yellow floor stripes. Within the boundaries of its zone, each
supplier assembles its component from subcomponents
sourced from 400 minor suppliers. In parallel with subcom-
ponent assembly, final assembly occurs as the chassis (the
vehicle platform) passes through the zones, and each com-
pany adds its respective component-module until the
finished VW rolls off the line. Following each vehicle through the line is a single VW
employee – a master craftsman assigned to track the vehicle and solve problems on
the spot. Suppliers are paid for each completed vehicle that passes final inspection.
Despite representing seven different companies, the suppliers operate as a tightly
integrated team, wearing the same uniforms and receiving the same pay. The assembly
line is highly cross-functional, with representatives from each supplier meeting each
morning to plan the day’s production and each evening to address issues and solve
any problems. Each supplier has visibility of the entire production process, which
stimulates ideas for simplification, streamlining, and product and process changes.
The specialisation and component knowledge of each supplier, combined with the
close interaction among suppliers, improves quality and efficiency. Locating the major
component and final assemblies together at the same plant improves production flow
and compresses total assembly time. It also simplifies logistics and reduces materials-
handling, production control, manufacturing engineering and coordination costs.
Although the plant has made some adjustments that make its operations more con-
ventional, preliminary results look promising. Resende employs 1500 manufacturing
workers, instead of 2500 at a comparable older VW plant. The time to assemble a truck
has been reduced from 52 to 35 hours. These improvements have enabled VW to
quickly earn more than a 20% share in the Brazilian truck and bus markets.
Sources: Schemo, D.J. (1996) ‘Is VW’s new plant lean, or just mean?’, New York Times, 19 November 1994; Friedland, J.
(1996) ‘VW puts suppliers on production lines’, The Wall Street Journal, 15 February 1996; Goering, L. (1997) ‘Revolution at
plant X’, Chicago Tribune, 13 April 1997; Sedgwick, D. (2000) ‘Just what does an automaker make?’, Automotive News
International, 1 September 2000; ‘Mercedes and VW fight from factory floor up’, Gazeta Mercantil Online, 4 April 2001; and
Arellano, J. (2006) ‘Is outsourcing bad for Volkswagen?’, www.autoblog.com/tag/outsourcing, 6 March 2006.
The opportunity cost of holding stock is the income forgone from not investing this
money elsewhere. These opportunity costs would not be recorded in the accounting
system because they are not incremental or outlay costs. Column 3 indicates that,
322
Product-mix decisions under capacity constraints
consistent with the trends towards holding smaller stocks as in just-in-time systems (see
Chapter 21), purchasing 10 000 kg per month is preferred to purchasing 120 000 kg at
the beginning of the year because the lower opportunity cost of holding smaller stock
exceeds the higher purchase cost. If other incremental benefits of holding lower stock
such as lower insurance, materials handling, storage, obsolescence and breakage costs
were considered, alternative B would be preferred even more.
Product-mix decisions under capacity constraints

Companies with capacity constraints, such as Brumaire, must also often decide which
products to make and in what quantities. When a multiple-product plant operates at
full capacity, managers must often make decisions regarding which products to
emphasise. These decisions frequently have a short-run focus. For example, BMW
must continually adapt the mix of its different models of cars to short-run fluctuations
in materials costs, selling prices and demand. Throughout this section, we assume that
as short-run changes in product mix occur, the only costs that change are those that
are variable with respect to the number of units produced (and sold).
Analysis of individual product contribution margins provides insight into the prod-
uct mix that maximises operating profit. Consider Tiilikainen, a company that
manufactures engines for a broad range of commercial and consumer products. At its
Helsinki plant, it assembles two engines: a snowmobile engine and a boat engine.
Information on these products is as follows:
Snowmobile Boat
engine engine
Selling price €800 €1000
Variable costs per unit 560 625
Contribution margin per unit €240 €375
––––– –––––
Contribution margin ratio 30% 37.5%
At first glance, boat engines appear more profitable than snowmobile engines. The
product to be emphasised, however, is not necessarily the product with the higher indi-
vidual contribution margin per unit or contribution margin percentage. Rather,
managers should aim for the highest contribution margin per unit of the constraining factor –
that is, the scarce, limiting or critical factor. The constraining factor restricts or limits the
production or sale of a given product. (See also Chapter 20 on the theory of constraints.)
Assume that only 600 machine-hours are available daily for assembling engines.
Additional capacity cannot be obtained in the short run. Tiilikainen can sell as many
engines as it produces. The constraining factor, then, is machine-hours. It takes
2 machine-hours to produce one snowmobile engine and 5 machine-hours to produce
one boat engine.
Snowmobile Boat
engine engine
Contribution margin per engine €240 €375
Machine-hours required to produce
one engine 2 machine-hours 5 machine-hours
Contribution margin per machine-hour
(240 ÷ 2; 375 ÷ 5) €120 €75
Total contribution margin for 600 machine-
hours (€120 × 600; €75 × 600) €72 000 €45 000
323
Producing snowmobile engines contributes more margin per machine-hour, which

is the constraining factor in this example. Therefore, choosing to emphasise snowmo-
bile engines is the correct decision. Other constraints in manufacturing settings can be
the availability of direct materials, components or skilled labour, as well as financial
and sales considerations. In a retail department store, the constraining factor may be
linear metres of display space. The greatest possible contribution margin per unit of
the constraining factor yields the maximum operating profit.
As you can imagine, in many cases a manufacturer or retailer must meet the chal-
lenge of trying to maximise total operating profit for a variety of products, each with
more than one constraining factor. The problem of formulating the most profitable
production schedules and the most profitable product mix is essentially that of max-
imising the total contribution margin in the face of many constraints. Optimisation
techniques, such as the linear-programming technique discussed in the appendix to
this chapter, help solve these complicated problems.
Customer profitability and relevant costs

In addition to making choices among products, companies must often decide whether
they should add some customers and drop others. This section illustrates relevant-
revenue and relevant-cost analysis when different cost drivers are identified for differ-
ent activities. The cost object in our example is customers. The analysis focuses on
customer profitability at Imbro-Glio, the Naples sales office of Papa-Geno Srl, a whole-
saler of specialised furniture.
Imbro-Glio supplies furniture to three local retailers, Lucrezia, Borgia and Rigo-
Letto. Exhibit 10.8 presents representative revenues and costs of Imbro-Glio by
customers for the coming year. Additional information on Imbro-Glio’s costs for dif-
ferent activities at various levels of the cost hierarchy is as follows:
1 Materials handling labour costs vary with the number of units of furniture shipped
to customers.
2 Different areas of the warehouse stock furniture for different customers. Materials
handling equipment in an area and depreciation costs on the equipment are
Exhibit 10.8 Analysis of Imbro-Glio customer profits
Lucrezia Borgia Rigo-Letto Total
Sales €500 000 €300 000 €400 000 €1 200 000

––––––––– ––––––––– ––––––––– –––––––––
Cost of goods sold 370 000 220 000 330 000 920 000
Materials handling labour 41 000 18 000 33 000 92 000
Materials handling equipment
cost written off as depreciation 10 000 6 000 8 000 24 000
Rent 14 000 8 000 14 000 36 000
Marketing support 11 000 9 000 10 000 30 000
Purchase orders and delivery
processing 13 000 7 000 12 000 32 000
General administration 20 000 12 000 16 000 48 000
––––––––– ––––––––– ––––––––– –––––––––
Total operating costs 479 000 280 000 423 000 1 182 000
––––––––– ––––––––– ––––––––– –––––––––
Operating profit €21 000 €20 000 €(23 000) €18 000
–––––––––
––––––––– –––––––––
––––––––– –––––––––
––––––––– –––––––––
–––––––––
324
Customer profitability and relevant costs
identified with individual customer accounts. Any equipment not used remains
idle. The equipment has a one-year useful life and zero disposal price.
3 Imbro-Glio allocates rent to each customer account on the basis of the amount of
warehouse space occupied by the products to be shipped to that customer.
4 Marketing costs vary with the number of sales visits made to customers.
5 Purchase-order costs vary with the number of purchase orders received; delivery-
processing costs vary with the number of shipments made.
6 Imbro-Glio allocates fixed general administration costs to customers on the basis of
euro sales made to each customer.
Relevant-cost analysis of dropping a customer

Exhibit 10.8 indicates a loss of €23 000 on sales to Rigo-Letto. Imbro-Glio’s manager
believes this loss occurred because Rigo-Letto places many low-volume orders with
Imbro-Glio, resulting in high purchase-order and delivery processing, and materials
handling and marketing activity. Imbro-Glio is considering several possible actions
with respect to the Rigo-Letto account – reducing its own costs of supporting Rigo-
Letto by becoming more efficient, cutting back on some of the services it offers
Rigo-Letto, charging Rigo-Letto higher prices, or dropping the Rigo-Letto account. The
following analysis focuses on the operating profit effect of dropping the Rigo-Letto
account. Exhibit 10.8 is essentially a customer profitability analysis (this management
accounting approach is further discussed in Chapter 12).
The key question is: What are the relevant costs and relevant revenues? The follow-
ing information about the effect of reducing various activities related to the Rigo-Letto
account is available.
1 Dropping the Rigo-Letto account will save cost of goods sold, materials handling
labour, marketing support, purchase-order and delivery processing costs incurred on
the Rigo-Letto account.
2 Dropping the Rigo-Letto account will mean that the warehouse space currently
occupied by products for Rigo-Letto and the materials handling equipment used to
move them will become idle.
3 Dropping the Rigo-Letto account will have no effect on fixed general administra-
tion costs.
Exhibit 10.9 presents the relevant-revenue and relevant-cost calculations. Imbro-Glio’s
operating profit will be €15 000 lower if it drops the Rigo-Letto account, so Imbro-Glio
decides to keep the Rigo-Letto account. The last column in Exhibit 10.9 shows that the
cost savings from dropping the Rigo-Letto account, €385 000, are not enough to offset
the loss of €400 000 in revenue. The key reason is that depreciation, rent and general
administration costs will not decrease if the Rigo-Letto account is dropped.
Now suppose that if Imbro-Glio drops the Rigo-Letto account, it could lease the
extra warehouse space to Nessun-Dorma, which has offered €20 000 per year for it.
Then the €20 000 that Imbro-Glio would receive would be the opportunity cost of con-
tinuing to use the warehouse to service Rigo-Letto. Imbro-Glio would gain €5000 by
dropping the Rigo-Letto account (€20 000 from lease revenue minus lost operating
profit of €15 000). Before reaching a final decision, however, Imbro-Glio must examine
whether Rigo-Letto can be made more profitable so that supplying products to Rigo-
Letto earns more than the €20 000 from leasing to Nessun-Dorma. Imbro-Glio must
also consider qualitative factors such as the effect of the decision on Imbro-Glio’s rep-
utation for developing stable, long-run business relationships.
325
Exhibit 10.9 Relevant-cost analysis for Imbro-Glio dropping the Rigo-Letto account
Difference:
incremental
(loss in revenue)
Amount of total revenues
and savings in
and total costs
costs from
Keep Rigo-Letto Drop Rigo-Letto dropping Rigo-
account account Letto account
Sales €1 200 000 €800 000 €(400 000)

––––––––––– ––––––––––– –––––––––––
Cost of goods sold 920 000 590 000 330 000
Materials handling labour 92 000 59 000 33 000
cost written off as depreciation 24 000 24 000 0
Rent 36 000 36 000 0
Marketing support 30 000 20 000 10 000
Purchase orders and delivery
processing 32 000 20 000 12 000
General administration 48 000 48 000 0
Total operating costs 1 18 200 797 000 385 000
––––––––––– ––––––––––– –––––––––––
Operating profit (loss) €18 000 €3 000 €(15 000)
–––––––––––
––––––––––– –––––––––––
––––––––––– –––––––––––
–––––––––––
Relevant-cost analysis of adding a customer

Suppose that in addition to Lucrezia, Borgia and Rigo-Letto, Imbro-Glio is evaluating
the profitability of adding a fourth customer, Bocca-Negra. Imbro-Glio is already
paying rent of €36 000 for the warehouse and is incurring general administration costs
of €48 000. These costs will not change if Bocca-Negra is added as a customer. Bocca-
Negra is a customer with a profile much like Rigo-Letto’s. Suppose Imbro-Glio predicts
other revenues and costs of doing business with Bocca-Negra to be the same as those
described under the Rigo-Letto column of Exhibit 10.8. Should Imbro-Glio add Bocca-
Negra as a customer? Exhibit 10.10 shows incremental revenues exceed incremental
costs by €7000. Imbro-Glio would prefer to add Bocca-Negra as a customer. Note that
both volume and non-volume factors drive costs. This is the principle underlying
activity-based costing which is further discussed in the next chapter. The key point is
that the cost of acquiring new equipment to support the Bocca-Negra order (written
off as depreciation of €8000 in Exhibit 10.10) is included as a relevant cost. Why?
Because this cost can be avoided if Imbro-Glio decides not to do business with Bocca-
Negra. Note the critical distinction here. Depreciation cost is irrelevant in deciding
whether to drop Rigo-Letto as a customer (because it is a past cost), but the purchase
cost of the new equipment that will then be written off as depreciation in the future is
relevant in deciding whether to add Bocca-Negra as a new customer.
Irrelevance of past costs and equipment-replacement

decisions
The illustrations in this chapter have shown that expected future costs that do not
differ among alternatives are irrelevant. Now we return to the idea that all past costs
are irrelevant.
326
Irrelevance of past costs and equipment-replacement decisions
Exhibit 10.10 Relevant-cost analysis for adding the Bocca-Negra account
Difference:
incremental
revenue and
Amount of total revenues
(incremental
and total costs
costs) from
Do not add Bocca- Add Bocca- adding Bocca-
Negra account Negra account Negro account
Sales €1 200 000 €1 600 000 €400 000

––––––––––– ––––––––––– –––––––––––
Cost of goods sold (variable) 920 000 1 250 000 (330 000)
Materials handling labour 92 000 125 000 (33 000)
cost written off as depreciation 24 000 32 000 (8 000)
Rent 36 000 36 000 0
Marketing support 30 000 40 000 (10 000)
Purchase orders and delivery processing 32 000 44 000 (12 000)
General administration 48 000 48 000 0
Total operating costs 1 182 000 1 575 000 393 000
––––––––––– ––––––––––– –––––––––––
Operating profit €18 000 €25 000 €7 000
–––––––––––
––––––––––– –––––––––––
––––––––––– –––––––––––
–––––––––––
Consider an example of equipment replacement. The irrelevant cost illustrated here

is the book value (original cost minus total depreciation) of the existing equipment.
Assume that Bjørnstjerne is considering replacing a metal-cutting machine for kitchen
parts with a more technically advanced model. The new machine has an automatic
quality-testing capability and is more efficient than the old machine. The new
machine, however, has a shorter life. Bjørnstjerne uses the straight-line depreciation
method. Sales from kitchen parts (€1.1 million per year) will be unaffected by the
replacement decision. Summary data on the existing machine and the replacement
machine are as follows:
Existing Replacement
machine machine
Original cost €1 000 000 €600 000
Useful life in years 5 years 2 years
Current age in years 3 years 0 years
Useful life remaining in years 2 years 2 years
Total depreciation €600 000 Not acquired yet
Book value €400 000 Not acquired yet
Current disposal price (in cash) €40 000 Not acquired yet
Terminal disposal price (in cash 2 years
from now) €0 €0
Annual operating costs (maintenance,
energy, repairs, coolants, and so on) €800 000 €460 000
To focus on the main concept of relevance, we ignore the time value of money in this
illustration.
Exhibit 10.11 presents a cost comparison of the two machines.
We can apply our definition of relevance to four important items in the equipment-
replacement decision facing Bjørnstjerne:
327
Exhibit 10.11 Cost comparison: replacement of machinery, including relevant and

irrelevant items for Bjørnstjerne
Two years together
Keep Replace Difference
Sales €2 200 000 €2 200 000 –

––––––––––– –––––––––––
Operating costs
Cash-operating costs 1 600 000 920 000 €680 000
Old machine book value
Periodic write-off as
depreciation or 400 000 – –
Lump-sum write-off – 400 000*
Current disposal price of
old machine – (40 000)* 40 000
New machine cost, written off
periodically as depreciation – 600 000 (600 000)
––––––––––– ––––––––––– –––––––––––
Total operating costs 2 000 000 1 880 000 120 000
––––––––––– ––––––––––– –––––––––––
Operating profit €200 000 €320 000 €(120 000)
–––––––––––
––––––––––– –––––––––––
––––––––––– –––––––––––
–––––––––––
* In a formal income statement, these two items would be combined as ‘loss on disposal of machine’ of €360 000.
1 Book value of old machine. Irrelevant, because it is a past (historical) cost. All past
costs are ‘down the drain’. Nothing can change what has already been spent or
what has already happened.
2 Current disposal price of old machine. Relevant, because it is an expected future cash
inflow that differs between alternatives.
3 Gain or loss on disposal. This is the algebraic difference between items 1 and 2. It is a
meaningless combination blurring the distinction between the irrelevant book
value and the relevant disposal price. Each item should be considered separately.
4 Cost of new machine. Relevant, because it is an expected future cash outflow that will
differ between alternatives.
Exhibit 10.11 should clarify these four assertions. The difference column in Exhibit 10.11
shows that the book value of the old machine is not an element of difference between
alternatives and could be completely ignored for decision-making purposes. No matter
what the timing of the charge against revenue, the amount charged is still €400 000
regardless of the alternative chosen because it is a past (historical) cost (note that the
advantage of replacing is €120 000 for the two years together). In contrast, the €600 000
cost of the new machine is relevant because it can be avoided by deciding not to replace.
Past costs that are unavoidable because they cannot be changed, no matter what
action is taken, are sometimes described as sunk costs. In our example, old equipment
has a book value of €400 000 and a current disposal price of €40 000. What are the
sunk costs in this case? The entire €400 000 is sunk and down the drain because it rep-
resents an outlay made in the past that cannot be changed. Thus, past costs and sunk
costs are synonyms.
Exhibit 10.12 concentrates on relevant items only. Note that the same answer (the
€120 000 net difference) will be obtained even though the book value is completely
omitted from the calculations. The only relevant items are the cash-operating costs,
the disposal price of the old machine and the cost of the new machine (represented as
depreciation in Exhibit 10.12).
328
Summary
Exhibit 10.12 Cost comparison – replacement of machinery, relevant items only for
Bjørnstjerne
Two years together
Keep Replace Difference
Cash-operating costs €1 600 000 €920 000 €680 000

Current disposal price of old
machine – (40 000) 40 000
New machine, written off
periodically as depreciation – 600 000 (600 000)
––––––––––– ––––––––––– –––––––––––
Total relevant costs €1 600 000 €1 480 000 €120 000
–––––––––––
––––––––––– –––––––––––
––––––––––– –––––––––––
–––––––––––
Summary
The following points are linked to the chapter’s learning objectives.

1 The five steps which managers might undertake in a decision process are:
(a) obtain information, (b) make predictions, (c) choose alternative courses of
action, (d) implement decisions, and (e) evaluate performance.
2 To be relevant to a particular decision, a revenue or cost must meet two criteria: (a)
it must be an expected future revenue or cost, and (b) it must differ among alterna-
tive courses of action.
3 The consequences of alternative actions can be quantitative and qualitative.
Quantitative factors are outcomes that are measured in numerical terms. Some
quantitative factors can be easily expressed in financial terms, others cannot.
Qualitative factors, such as employee morale, cannot be measured in numerical
terms. Due consideration must be given to both financial and non-financial factors
in making decisions.
4 There are two common problems in relevant-cost analysis: (a) assuming all variable
costs are relevant, and (b) assuming all fixed costs are irrelevant.
5 Opportunity cost is the maximum available contribution to income that is forgone
(rejected) by not using a limited resource in its next-best alternative use. The idea of
an opportunity cost arises when there are multiple uses for resources and some
alternatives are not selected. Opportunity cost is often included in decision making
because it represents the best alternative way in which an organisation may have
used its resources had it not made the decision it did.
6 In choosing among multiple products when resource capacity is constrained, man-
agers should emphasise the product that yields the highest contribution margin per
unit of the constraining or limiting factor.
7 Expected future revenues and costs are the only revenues and costs relevant in any
decision model. The book value of existing equipment in equipment-replacement
decisions represents past (historical) cost and therefore is irrelevant.
329
APPENDIX
Linear programming
Linear programming (LP) is an optimisation technique used to maximise total contri-

bution margin (the objective function), given multiple constraints. LP models
typically assume that all costs can be classified as either variable or fixed with respect
to a single driver (units of output). LP models also require certain other linear assump-
tions to hold. When these assumptions fail, other decision models should be con-
sidered. Such models are described in Eppen et al. (1998) and Nahmias (2001).
Consider the Tiilikainen example described earlier in the chapter. Suppose that both
the snowmobile and boat engines must be tested on a very expensive machine before
they are shipped to customers. The available testing-machine time is limited.
Production data are as follows:
Available Use of capacity in Daily maximum

daily hours per unit of product production in units
––––––––––––––––––––––––––––– –––––––––––––––––––––––
capacity Snowmobile Boat Snowmobile Boat
Department in hours engine engine engine engine
Assembly 600 machine-hours 2.0 5.0 300* 120
Testing 120 testing-hours 1.0 0.5 120 240
* For example, 600 machine-hours ÷ 2.0 machine-hours per snowmobile engine = 300, the maximum number of
snowmobile engines that the Assembly Department can make if it works exclusively on snowmobile engines.
Exhibit 10.13 summarises these and other relevant data. Note that snowmobile
engines have a contribution margin of €240 and that boat engines have a contribution
margin of €375. Material shortages for boat engines will limit production to 110 boat
engines per day. How many engines of each type should be produced daily to max-
imise operating profit?
Steps in solving an LP problem

We use the data in Exhibit 10.13 to illustrate the three steps in solving an LP problem.
Throughout this discussion, S equals the number of units of snowmobiles produced
and B equals the number of units of boat engines produced.
Exhibit 10.13 Operating data for Tiilikainen
Department capacity (per day)

in product units Variable Contribution
cost per margin per
Product Assembly Testing Selling price unit unit
Only snowmobile
engines 300 120 €800 €560 €240
Only boat engines 120 240 €1 000 €625 €375
330
Linear programming
Step 1: Determine the objective

The objective function of a linear program expresses the objective or goal to be max-
imised (for example, operating profit) or minimised (for example, operating costs). In
our example, the objective is to find the combination of products that maximises total
contribution margin in the short run. Fixed costs remain the same regardless of the
product mix chosen and are therefore irrelevant. The linear function expressing the
objective for the total contribution margin (TCM) is
TCM = €240S + €375B
Step 2: Specify the constraints

A constraint is a mathematical inequality or equality that must be satisfied by the vari-
ables in a mathematical model. The following linear inequalities depict the
relationships in our example:
Assembly Department constraint 2S + 5B ≤ 600

Testing Department constraint 1S + 0.5B ≤ 120
Material shortage constraint for boat engines B ≤ 110
Negative production is impossible S ≥ 0 and B ≥ 0
The coefficients of the constraints are often called technical coefficients. For example,
in the Assembly Department, the technical coefficient is 2 machine-hours for snow-
mobile engines and 5 machine-hours for boat engines.
The three solid lines on the graph in Exhibit 10.14 show the existing constraints for
Assembly and Testing and the material shortage constraint. The feasible alternatives
are those combinations of quantities of snowmobile engines and boat engines that
satisfy all the constraining factors. The shaded ‘area of feasible solutions’ in Exhibit
10.14 shows the boundaries of those product combinations that are feasible, or techni-
cally possible.
Exhibit 10.14 Linear programming – graphic solution for Tiilikainen
250
Testing
Department
constraint
200
Boat engines (units)
Material shortage constraint

150 for boat engines
100 Optimal corner Equal

(75, 90) contribution
Area margin lines
of feasible
solutions Assembly
50
Department
constraint
0
0 50 100 150 200 250 300
Snowmobile engines (units)
331
As an example of how the lines are plotted in Exhibit 10.14, use equal signs instead
of inequality signs and assume for the Assembly Department that B = 0; then S = 300
(600 machine-hours ÷ 2 machine-hours per snowmobile engine). Assume that S = 0;
then B = 120 (600 machine-hours ÷ 5 machine-hours per boat engine). Connect those
two points with a straight line.
Step 3: Calculate the optimal solution

We present two approaches for finding the optimal solution: the trial-and-error
approach and the graphic approach. These approaches are easy to use in our example
because there are only two variables in the objective function and a small number of
constraints. An understanding of these two approaches provides insight into LP mod-
elling. In most real-world LP applications, however, managers use computer software
packages to calculate the optimal solution.
Although the trial-and-error and graphic approaches can be useful for two or poss-
ibly three variables, they are impractical when many variables exist. Standard
computer software packages rely on the simplex method. The simplex method is an iter-
ative step-by-step procedure for determining the optimal solution to an LP problem. It
starts with a specific feasible solution and then tests it by substitution to see whether
the result can be improved. These substitutions continue until no further improve-
ment is possible and the optimal solution is obtained.
Trial-and-error approach The optimal solution can be found by trial and error, by
working with coordinates of the corners of the area of feasible solutions. The approach
is simple.
First, select any set of corner points and calculate the total contribution margin. Five
corner points appear in Exhibit 10.14. It is helpful to use simultaneous equations to
obtain the exact graph coordinates. To illustrate, the point (S = 75; B = 90) can be
derived by solving the two pertinent constraint inequalities as simultaneous equations:
2S +5B = 600 (1)
1S + 0.5B = 120 (2)
Multiplying (2) by 2, we get 2S + 1B = 240 (3)
Subtracting (3) from (1): 4B = 360
Therefore, B = 360 ÷ 4 = 90
Substituting for B in (2): 1S + 0.5(90) = 120
S = 120 – 45 = 75
Given S = 75 and B = 90,
TCM = €240(75) + €375(90)
= €51 750
Second, move from corner point to corner point, computing the total contri-
bution margin at each corner point. The total contribution margin, at each corner
point is as follows:
Corner Snowmobile Boat
point engines engines
Trial (S, B) (S) (B) Total contribution margin
1 (0, 0) 0 0 €240(0) + €375(0) = €0
2 (0, 110) 0 110 €240(0) + €375(110) = 41 250
3 (25, 110) 25 110 €240(25) + €375(110) = 47 250
4 (75, 90) 75 90 €240(75) + €375(90) = 51 750*
5 (120, 0) 120 0 €240(120) + €375(0) = 28 800
* Indicates the optimal solution.
332
Linear programming
The optimal product mix is the mix that yields the highest total contribution: 75
snowmobile engines and 90 boat engines.
Graphic approach Consider all possible combinations that will produce an equal total
contribution margin of, say, €12 000. That is,
€240S + €375B = €12 000
This set of €12 000 contribution margins is a straight dashed line in Exhibit 10.14
through (S = 50; B = 0) and (S = 0; B = 32). Other equal total contribution margins can
be represented by lines parallel to this one. In Exhibit 10.14, we show three dashed
lines. The equal total contribution margins increase as the lines get farther from the
origin because lines drawn farther from the origin represent more sales of both snow-
mobile and boat engines.
The optimal line is the one farthest from the origin but still passing through a point
in the area of feasible solutions. This line represents the highest contribution margin.
The optimal solution is the point at the corner (S = 75; B = 90). This solution will
become apparent if you put a ruler on the graph and move it outward from the origin
and parallel with the €12 000 line. The idea is to move the ruler as far away from the
origin as possible (that is, to increase the total contribution margin) without leaving
the area of feasible solutions. In general, the optimal solution in a maximisation prob-
lem lies at the corner where the dashed line intersects an extreme point of the area of
feasible solutions. Moving the ruler out any further puts it outside the feasible region.
Sensitivity analysis
What are the implications of uncertainty about the accounting or technical
coefficients used in the LP model? Changes in coefficients affect the slope of the objec-
tive function (the equal contribution margin lines) or the area of feasible solutions.
Consider how a change in the contribution margin of snowmobile engines from €240
to €300 per unit might affect the optimal solution. Assume the contribution margin
for boat engines remains unchanged at €375 per unit. The revised objective function
will be
TCM = €300S + €375B
Using the trial-and-error approach, calculate the total contribution margin for each of
the five corner points described in the table above. The optimal solution is still (S = 75;
B = 90). What if the contribution margin falls to €160? Again, the optimal solution
remains the same (S = 75; B = 90). Big changes in the contribution margin per unit of
snowmobile engines have no effect on the optimal solution in this case.
333
Key terms
decision model (310) insourcing (316)
relevant costs (311) make-or-buy decisions (316)
relevant revenues (311) opportunity cost (319)
differential cost (312) book value (327)
quantitative factors (312) sunk costs (328)
qualitative factors (313) objective function (331)
incremental costs (315) constraint (331)
outsourcing (316)
Further reading
Bromwich, M. and Bhimani, A. (1994) Management Accounting: Pathways to Progress (London:
CIMA, chapter 4).
Kaplan, R.S. et al. (1990) ‘Contribution margin analysis: no longer relevant/strategic cost man-
agement: the new paradigm’, Journal of Management Accounting Research, pp. 1–32.
Shank, J. and Govindarajan, V. (1992) ‘Strategic cost management: the value chain perspective’,
Journal of Management Accounting Research, pp. 179–97.
Weblinks
American Printer
http://americanprinter.com/ar/printing_shocking_truth_scheduling
This article focuses on problems associated with capacity constraints and scheduling within
the print industry, and provides a different perspective from the chapter on the theory of
bottlenecking.
Harvard Business Review

http://www.harvardbusinessonline.org
At the forefront of thought leadership on management issues, the Harvard Business Review
website provides excellent access to articles and journals by the most respected authors in
the field, including articles on supply chain managements and capacity constraints.
Journal of Management Accounting Research

http://aaahq.org/MAS/JMAR/JMAR.cfm
The objective of this website is to contribute to improving the theory and practice of man-
agement accounting by promoting high-quality applied and theoretical research. There are
a number of articles and links on constraints and supply management.
Visit our website www.pearsoned.co.uk/bhimani for further questions, annotated

weblinks and an online glossary.
334
Chapter 10 Assessment material
Review questions
10.1 Outline the five-step sequence in a decision process.
10.2 Define relevant cost. Why are historical costs irrelevant?
10.3 ‘All future costs are relevant.’ Do you agree? Why?
10.4 Distinguish between quantitative and qualitative factors in decision making.
10.5 ‘Variable costs are always relevant, and fixed costs are always irrelevant.’ Do you agree?
Why?
10.6 ‘A component part should be purchased whenever the purchase price is less than its total
unit manufacturing cost.’ Do you agree? Why?
10.7 Define opportunity cost.
10.8 ‘Cost written off as depreciation is always irrelevant.’ Do you agree? Why?
10.9 ‘Managers will always choose the alternative that maximises operating profit or minimises
costs in the decision model.’ Do you agree? Why?
10.10 How might the optimal solution of a linear programming problem be determined?
Exercises
BASIC LEVEL
10.11 Relevant costs, contribution margin, product emphasis. (20–25 minutes)
Monteagudo-Playa SA is a take-away food store at a popular beach resort. Consuelo
Herreros, owner of Monteagudo-Playa, is deciding how much refrigerator space to devote
to four different drinks. Pertinent data on these four drinks are as follows:
Natural
Cola Lemonade Punch orange juice
Selling price per case €108.00 €115.20 €158.40 €230.40

Variable costs per case €81.00 €91.20 €120.60 €181.20
Cases sold per metre
of shelf-space per day 25 24 4 5
Consuelo has a maximum front shelf-space of 12 metres to devote to the four drinks. She
wants a minimum of 1 metre and a maximum of 6 metres of front shelf-space for each
drink.
335
Required
1 What is the contribution margin per case of each type of drink?
2 A co-worker of Consuelo’s recommends that she maximise the shelf-space devoted to
those drinks with the highest contribution margin per case. Evaluate this recommenda-
tion.
3 What shelf-space allocation for the four drinks would you recommend for Monteagudo-
Playa?
INTERMEDIATE LEVEL
10.12 Customer profitability, choosing customers. (20–25 minutes)
Jours-Daim SA operates a printing press with a monthly capacity of 2000 machine-
hours. Jours-Daim has two main customers, Harpes-à-Gonds, SNC and Fourbe-Riz SA.
Data on each customer for January follow:
Harpes-à-Gonds Fourbe-Riz Total
Revenues €120 000 €80 000 €200 000

––––––––––– ––––––––––– –––––––––––
Variable costs 42 000 48 000 90 000
Fixed costs (allocated on the
basis of revenues) 60 000 40 000 100 000
––––––––––– ––––––––––– –––––––––––
Total operating costs 102 000 88 000 190 000
––––––––––– ––––––––––– –––––––––––
Operating profit €18 000 €(8 000) €10 000
–––––––––––
––––––––––– –––––––––––
––––––––––– –––––––––––
–––––––––––
Machine-hours required 1500 hours 500 hours 2000 hours
Each of the following requirements refers only to the preceding data; there is no connection
between the requirements.
Required
1 Should Jours-Daim drop the Fourbe-Riz business? If Jours-Daim drops the Fourbe-Riz
business, its total fixed costs will decrease by 20%.
2 Fourbe-Riz indicates that it wants Jours-Daim to do an additional €80 000 worth of print-
ing jobs during February. These jobs are identical to the existing business Jours-Daim did
for Fourbe-Riz in January in terms of variable costs and machine-hours required. Jours-
Daim anticipates that the business from Harpes-à-Gonds in February would be the same
as that in January. Jours-Daim can choose to accept as much of the Harpes-à-Gonds and
Fourbe-Riz business for February as it wants. Assume that total fixed costs for February
will be the same as the fixed costs in January. What should Jours-Daim do? What will
Jours-Daim’s operating profit be in February?
10.13 Relevance of equipment costs. (30–40 minutes)

Jääskinen Oy has just today paid for and installed a special machine for polishing cars at
one of its several outlets. It is the first day of the company’s fiscal year. The machine cost
€20 000. Its annual operating costs total €15 000, exclusive of depreciation. The machine
will have a four-year useful life and a zero terminal disposal price.
After the machine has been used for a day, a machine salesperson offers a different
machine that promises to do the same job at a yearly operating cost of €9000, exclusive of
depreciation. The new machine will cost €24 000 cash, installed. The ‘old’ machine is
unique and can be sold outright for only €10 000, minus €2000 removal cost. The new
machine, like the old one, will have a four-year useful life and zero terminal disposal price.
Sales, all in cash, will be €150 000 annually, and other cash costs will be €110 000 annually,
regardless of this decision.
For simplicity, ignore income taxes, interest and present-value considerations.
336
Exercises
Required
1 a Prepare a statement of cash receipts and disbursements for each of the four years
under both alternatives. What is the cumulative difference in cash flow for the four
years taken together?
b Prepare income statements for each of the four years under both alternatives. Assume
straight-line depreciation. What is the cumulative difference in operating profit for
the four years taken together?
c What are the irrelevant items in your presentations in requirements (a) and (b)? Why
are they irrelevant?
2 Suppose the cost of the ‘old’ machine was €1 million rather than €20 000. Nevertheless,
the old machine can be sold outright for only €10 000, minus €2000 removal cost.
Would the net differences in requirements 1 and 2 change? Explain.
3 ‘To avoid a loss, we should keep the old machine.’ What is the role of book value in deci-
sions about replacement of machines?
*10.14 Contribution approach, relevant costs. (30 minutes)

Air Calabria owns a single jet aircraft and operates between Cantazaro and Venice. Flights leave
Cantazaro on Mondays and Thursdays and depart from Venice on Wednesdays and Saturdays.
Air Calabria cannot offer any more flights between Cantazaro and Venice. Only tourist-class
seats are available on its planes. An analyst has collected the following information:
Seating capacity per plane 360 passengers

Average number of passengers per flight 200 passengers
Flights per week 4 flights
Flights per year 208 flights
Average one-way fare €500
Variable fuel costs €14 000 per flight
Food and beverage service cost (no charge to passenger) €20 per passenger
Commission to travel agents paid by Air Calabria
(all tickets are booked by travel agents) 8% of fare
Fixed annual lease costs allocated to each flight €53 000 per flight
Fixed ground services (maintenance, check in,
baggage handling) cost allocated to each flight €7000 per flight
Fixed flight crew salaries allocated to each flight €4000 per flight
For simplicity, assume that fuel costs are unaffected by the actual number of passengers on
a flight.
Required
1 What is the operating profit that Air Calabria makes on each one-way flight between
Cantazaro and Venice?
2 The Market Research Department of Air Calabria indicates that lowering the average
one-way fare to €480 will increase the average number of passengers per flight to 212.
Should Air Calabria lower its fare?
3 Cima-Rosa, a tour operator, approaches Air Calabria on the possibility of chartering
(renting out) its jet aircraft twice each month, first to take Cima-Rosa’s tourists from
Cantazaro to Venice and then to bring the tourists back from Venice to Cantazaro. If Air
Calabria accepts Cima-Rosa’s offer, Air Calabria will be able to offer only 184 (208 – 24)
of its own flights each year. The terms of the charter are as follows: (a) For each one-way
flight, Cima-Rosa will pay Air Calabria €75 000 to charter the plane and to use its flight
crew and ground service staff; (b) Cima-Rosa will pay for fuel costs; and (c) Cima-Rosa
will pay for all food costs. On purely financial considerations, should Air Calabria accept
Cima-Rosa’s offer? What other factors should Air Calabria consider in deciding whether
or not to charter its plane to Cima-Rosa?
337
10.15 Optimal production plan, computer manufacturer. (Chapter appendix) (30 minutes)
Fiordi-Ligi Srl assembles and sells two products: printers and desktop computers. Customers
can purchase either (a) a computer, or (b) a computer plus a printer. The printers are not
sold without the computer. The result is that the quantity of printers sold is equal to or less
than the quantity of desktop computers sold. The contribution margins are €200 per
printer and €100 per computer.
Each printer requires 6 hours assembly time on production line 1 and 10 hours assembly
time on production line 2. Each computer requires 4 hours assembly time on production
line 1 only. (Many of the components of each computer are preassembled by external sup-
pliers.) Production line 1 has 24 hours of available time per day. Production line 2 has 20
hours of available time per day.
Let X represent units of printers and Y represent units of desktop computers. The produc-
tion manager must decide on the optimal mix of printers and computers to manufacture.
Required
1 Express the production manager’s problem in an LP format.
2 Which combination of printers and computers will maximise the operating profit of
Fiordi-Ligi? Use both the trial-and-error and the graphic approaches.
10.16 Optimal sales mix for a retailer, sensitivity analysis. (Chapter appendix) (30–40 minutes)
Vier-und-Zwanzig GmbH operates a chain of food stores open 24 hours a day. Each store
has a standard 4000 square metres of floor space available for merchandise. Merchandise is
grouped in two categories: grocery products and dairy products. Vier-und-Zwanzig requires
each store to devote a minimum of 1000 square metres to grocery products and a mini-
mum of 800 square metres to dairy products. Within these restrictions, each store manager
can choose the mix of products to carry.
The manager of the Salzburg store estimates the following weekly contribution margins per
square metre: grocery products, €100; dairy products, €30.
Required
1 Formulate the decision facing the store manager as an LP model. Use G to represent
square metres of floor space for grocery products and D to represent square metres of
floor space for dairy products.
2 Why might Vier-und-Zwanzig set minimum bounds on the floor space devoted to each
line of products?
3 Compute the optimal mix of grocery products and dairy products for the Salzburg store.
4 Will the optimal mix determined in requirement 3 change if the contribution margins
per square metre change to grocery products, €80, and dairy products, €50?
10.17 Relevant costing. (From ACCA Financial Information for Management, Part 1, June 2004)
(40 minutes)
Ennerdale Ltd has been asked to quote a price for a one-off contract. The company’s man-
agement accountant has asked for your advice on the relevant costs for the contract. The
following information is available:
Materials
The contract requires 3000 kg of material K, which is a material used regularly by the com-
pany in other production. The company has 2000 kg of material K currently in stock which
had been purchased last month for a total cost of £19 600. Since then the price per kilo-
gram for material K has increased by 5%. The contract also requires 200 kg of material L.
There are 250 kg of material L in stock which are not required for normal production. This
material originally cost a total of £3125. If not used on this contract, the stock of material L
would be sold for £11 per kg.
338
Exercises
Labour
The contract requires 800 hours of skilled labour. Skilled labour is paid £9.50 per hour.
There is a shortage of skilled labour and all the available skilled labour is fully employed in
the company in the manufacture of product P. The following information relates to
product P:
£ per unit
Selling price 100
Less
Skilled labour 38
Other variable costs 22
–––
(60)
–––
40
–––
Required
1 Prepare calculations showing the total relevant costs for making a decision about the
contract in respect of the following cost elements:
a materials K and L; and
b skilled labour.
2 Explain how you would decide which overhead costs would be relevant in the financial
appraisal of the contract.
ADVANCED LEVEL
*10.18 Special-order decision. (35–40 minutes)
Fri-Flask specialises in the manufacture of one-litre plastic bottles. The plastic moulding
machines are capable of producing 100 bottles per hour. The firm estimates that the vari-
able cost of producing a plastic bottle is 25 øre. The bottles are sold for 55 øre each.
Management has been approached by a local toy company that would like the firm to pro-
duce a moulded plastic toy for them. The toy company is willing to pay DKr 3.00 per unit for
the toy. The unit variable cost to manufacture the toy will be DKr 2.40. In addition, Fri-Flask
would have to incur a cost of DKr 20 000 to construct the mould required exclusively for this
order. Because the toy uses more plastic and is of a more intricate shape than a bottle, a
moulding machine can produce only 40 units per hour. The customer wants 100 000 units.
Assume that Fri-Flask has a total capacity of 10 000 machine-hours available during the
period in which the toy company wants delivery of the toys. The firm’s fixed costs, excluding
the costs to construct the toy mould, during the same period will be DKr 200 000.
Required
1 Suppose the demand for its bottles is 750 000 units, and the special toy order has to be
either taken in full or rejected totally. Should Fri-Flask accept the special toy? Explain
your answer.
either taken in full or rejected totally. Should Fri-Flask accept the special toy order?
Explain your answer.
3 Suppose the demand for its bottles is 850 000 units, and Fri-Flask can accept any quan-
tity of the special toy order. How many bottles and toys should it manufacture?
either taken in full or rejected totally. Should Fri-Flask accept the special toy order?
Explain your answer.
5 Suppose the demand for its bottles is 900 000 units, and Fri-Flask can accept any quan-
tity of the special toy order. How many bottles and toys should it manufacture?
339
6 Suppose the demand for its bottles is 950 000 units and Fri-Flask can accept any quantity
of the special toy order. How many bottles and toys should it manufacture?
7 The management has located a firm that has just entered the moulded plastic business.
This firm has considerable excess capacity and more efficient moulding machines, and is
willing to subcontract the toy job, or any portion of it, for DKr 2.80 per unit. It will con-
struct its own toy mould. Suppose the demand for its bottles is 900 000 units, and
Fri-Flask can accept any quantity of the special toy order. How many toys should it sub-
contract out?
340

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CHAPTER 10

Relevant information for

Information and the decision process

Exhibit 10.1 Accounting information and the decision process

Five-step sequence An illustration

Step 1: Historical labour costs were €14 per hour. A recently

The predicted benefits of the different alternatives in step 2 are

Evaluation of performance of the decision implemented in step 4

The concept of relevance

Relevant costs and relevant revenues

All data Relevant data

Revenues* €6 250 000 €6 250 000 – –

€70 000 difference €70 000 difference

* 25 000 × €250 = €6 250 000.

Qualitative factors can be relevant

An illustration of relevance: choosing output levels

One-off special orders

Exhibit 10.3 Budgeted income statement for August, absorption-costing

Total Per unit

Sales (30 000 towels × €20) €600 000 €20

Exhibit 10.3 presents data in an absorption-costing format: fixed manufacturing

Exhibit 10.4 Comparative income statements for August, contribution

Without one-off With one-off

Sales €20.00 €600 000 €655 000 €55 000‡

Potential problems in relevant-cost analysis

Outsourcing and make-or-buy decisions

Outsourcing and idle facilities

Exhibit 10.5 Financial data for HDS manufacturing at Brumaire SA

Direct materials €80 000 €8.00 €80 000 €8

Exhibit 10.6 Relevant (incremental) items for make-or-buy decision for

Total Per unit

Outside purchase of parts €160 000 €16

Opportunity costs, outsourcing and capacity constraints

Expected additional future revenues €80 000

Exhibit 10.7 Total-alternatives approach and opportunity-costs approach

Total incremental costs of

Panel B: Opportunity-costs approach to make-or-buy decisions

Total incremental costs of

Our analysis emphasises purely quantitative considerations. The final decision,

Carrying costs of stock

Annual estimated direct-materials requirements

The following table presents the two alternatives.

suppliers is for 10- to 15-year periods, with the conditions

Product-mix decisions under capacity constraints

Producing snowmobile engines contributes more margin per machine-hour, which

Customer profitability and relevant costs

Exhibit 10.8 Analysis of Imbro-Glio customer profits

Lucrezia Borgia Rigo-Letto Total

Sales €500 000 €300 000 €400 000 €1 200 000

Relevant-cost analysis of dropping a customer

Sales €1 200 000 €800 000 €(400 000)

Relevant-cost analysis of adding a customer

Irrelevance of past costs and equipment-replacement

Exhibit 10.10 Relevant-cost analysis for adding the Bocca-Negra account

Sales €1 200 000 €1 600 000 €400 000

Consider an example of equipment replacement. The irrelevant cost illustrated here

Exhibit 10.11 Cost comparison: replacement of machinery, including relevant and

Two years together

Keep Replace Difference