HCA16ge Ch11 SM - Summary Intermediate Accounting PDF

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CHAPTER 11DECISION MAKING AND RELEVANT INFORMATION11-1 Outline the five-step sequence in a decision process. The five steps in the decision process outlined in Exhibit 11-1 of the text are Identify the problem and uncertainties. Obtain information. Make predictions about the future. Make decisions b...

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CHAPTER 11 DECISION MAKING AND RELEVANT INFORMATION 11-1 Outline the five-step sequence in a decision process. The five steps in the decision process outlined in Exhibit 11-1 of the text are 1. Identify the problem and uncertainties. 2. Obtain information. 3. Make predictions about the future. 4. Make decisions by choosing among alternatives. 5. Implement the decision, evaluate performance, and learn. 11-2

Define relevant costs. Why are historical costs irrelevant?

Relevant costs are expected future costs that differ among the alternative courses of action being considered. Historical costs are irrelevant because they are past costs and, therefore, cannot differ among alternative future courses of action. 11-3

“All future costs are relevant.” Do you agree? Why?

No. Relevant costs are defined as those expected future costs that differ among alternative courses of action being considered. Thus, future costs that do not differ among the alternatives are irrelevant to deciding which alternative to choose. 11-4

Distinguish between quantitative and qualitative factors in decision making.

Quantitative factors are outcomes that are measured in numerical terms. Some quantitative factors are financial––that is, they can be easily expressed in monetary terms. Direct materials are an example of a quantitative financial factor. Other quantitative nonfinancial factors, such as on-time flight arrivals, cannot be easily expressed in monetary terms. Qualitative factors are outcomes that are difficult to measure accurately in numerical terms. An example is employee morale. 11-5 Describe two potential problems that should be avoided in relevant-cost analysis. Two potential problems that should be avoided in relevant cost analysis are (i) Do not assume all variable costs are relevant and all fixed costs are irrelevant. (ii) Do not use unit-cost data directly. It can mislead decision makers because a. it may include irrelevant costs, and b. comparisons of unit costs computed at different output levels lead to erroneous conclusions. 11-6 “Variable costs are always relevant, and fixed costs are always irrelevant.” Do you agree? Why? No. Some variable costs may not differ among the alternatives under consideration and, hence, will be irrelevant. Some fixed costs may differ among the alternatives and, hence, will be relevant. 11-7 “A component part should be purchased whenever the purchase price is less than its total manufacturing cost per unit.” Do you agree? Why?

11-1

No. Some of the total manufacturing cost per unit of a product may be fixed and, hence, will not differ between the make and buy alternatives. These fixed costs are irrelevant to the make-or-buy decision. The key comparison is between purchase costs and the costs that will be saved if the company purchases the component parts from outside plus the additional benefits of using the resources freed up in the next best alternative use (opportunity cost). Furthermore, managers should consider nonfinancial factors such as quality and timely delivery when making outsourcing decisions. 11-8

Define opportunity cost.

Opportunity cost is the contribution to income that is forgone (rejected) by not using a limited resource in its next-best alternative use. 11-9 “Managers should always buy inventory in quantities that result in the lowest purchase cost per unit.” Do you agree? Why? No. When deciding on the quantity of inventory to buy, managers must consider both the purchase cost per unit and the opportunity cost of funds invested in the inventory. For example, the purchase cost per unit may be low when the quantity of inventory purchased is large, but the benefit of the lower cost may be more than offset by the high opportunity cost of the funds invested in acquiring and holding inventory. 11-10 “Management should always maximize sales of the product with the highest contribution margin per unit.” Do you agree? Why? No. Managers should aim to get the highest contribution margin per unit of the constraining (that is, scarce, limiting, or critical) factor. The constraining factor is what restricts or limits the production or sale of a given product (for example, availability of machine-hours). 11-11 “A branch office or business segment that shows negative operating income should be shut down.” Do you agree? Explain briefly. No. For example, if the revenues that will be lost exceed the costs that will be saved, the branch or business segment should not be shut down. Shutting down will only increase the loss. Allocated costs and fixed costs that will not be saved are irrelevant to the shut-down decision. 11-12 “Cost written off as depreciation on equipment already purchased is always irrelevant.” Do you agree? Why? Cost written off as depreciation is irrelevant when it pertains to a past cost such as equipment already purchased. But the purchase cost of new equipment to be acquired in the future that will then be written off as depreciation is often relevant. 11-13 “Managers will always choose the alternative that maximizes operating income or minimizes costs in the decision model.” Do you agree? Why? No. Managers often favor the alternative that makes their performance look best so they focus on the measures used in the performance-evaluation model. If the performance-evaluation model

11-2

does not emphasize maximizing operating income or minimizing costs, managers will most likely not choose the alternative that maximizes operating income or minimizes costs. 11-14 Describe the three steps in solving a linear programming problem. The three steps in solving a linear programming problem are (i) Determine the objective function. (ii) Specify the constraints. (iii) Compute the optimal solution. 11-15 How might the optimal solution of a linear programming problem be determined? The text outlines two methods of determining the optimal solution to an LP problem: (i) Trial-and-error approach (ii) Graphic approach Most LP applications in practice use standard software packages that rely on the simplex method to compute the optimal solution.

11-16 Qualitative and quantitative factors. Which of the following is not a qualitative factor that Atlas Manufacturing should consider when deciding whether to buy or make a part used in manufacturing their product? a. Quality of the outside producer’s product. b. Potential loss of trade secrets. c. Manufacturing deadlines and special orders. d. Variable cost per unit of the product. SOLUTION Choice "d" is correct. Calculating the costs of production of the part versus buying the part from an outside source is a quantitative factor used by a company to determine the lowest cost alternative. Choice "a" is incorrect. Whether the outsourced part can be manufactured to the required level of quality is a qualitative factor that Atlas would consider in their decision. Choice "b" is incorrect. Loss of confidentiality and trade secrets is a qualitative factor to consider when buying outside of the organization. Choice "c" is incorrect. An outside supplier may not be able to meet specific deadlines or have the same priorities as the purchaser and is a qualitative factor that needs to be considered. 11-17 Special order, opportunity cost. Chade Corp. is considering a special order brought to it by a new client. If Chade determines the variable cost to be $9 per unit, and the contribution margin of the next best alternative of the facility to be $5 per unit, then if Chade has: a. Full capacity, the company will be profitable at $4 per unit. b. Excess capacity, the company will be profitable at $6 per unit. 11-3

c. Full capacity, the selling price must be greater than $5 per unit. d. Excess capacity, the selling price must be greater than $9 per unit. SOLUTION Choice "d" is correct. At excess capacity, Chade will accept the special order as long as the sales price is greater than the variable cost per unit. At $9 per unit for variable cost, Chade will accept the special order at a sales price greater than $9 per unit. Choice "a" is incorrect. At full capacity, Chade will accept the special order as long as the sales price is greater than both the variable cost per unit and the opportunity cost (contribution margin) of the next best alternative per unit. The company will not be profitable in this scenario unless the sales price is greater than $14 per unit ($9 variable cost + $5 contribution margin). Choice "b" is incorrect. At excess capacity, the company must receive a selling price greater than $9 per unit in order to be profitable. Choice "c" is incorrect. At full capacity, the selling price must be greater than $14 per unit in order for the special order to be profitable. 11-18 Special order, opportunity cost. In order to determine whether a special order should be accepted at full capacity, the sales price of the special order must be compared to the per unit: a. Contribution margin of the special order. b. Variable cost and contribution margin of the special order. c. Variable cost and contribution margin of the next best alternative. d. Variable cost of current production and the contribution margin of the next best alternative. SOLUTION Choice "d" is correct. If the selling price is greater than the variable cost per unit of the special order (at full capacity) plus the contribution margin per unit of the next best alternative (the opportunity cost), then the company will accept the special order. Choice "a" is incorrect. Variable costs have to be taken into account, in addition to the contribution margin of the next best alternative. Choice "b" is incorrect. The contribution margin of the next best alternative (rather than the special order) must be taken into account in order to determine whether to accept the special order. Choice "c" is incorrect. The variable costs of the special order (not the next best alternative) must be accounted for in this determination. 11-19 Keep or drop a business segment. Lees Corp. is deciding whether to keep or drop a small segment of its business. Key information regarding the segment includes: Contribution margin: 35,000 Avoidable fixed costs: 30,000 Unavoidable fixed costs: 25,000 Given the information above, Lees should: a. Drop the segment because the contribution margin is less than total fixed costs. b. Drop the segment because avoidable fixed costs exceed unavoidable fixed costs. c. Keep the segment because the contribution margin exceeds avoidable fixed costs. d. Keep the segment because the contribution margin exceeds unavoidable fixed costs. SOLUTION Choice "c" is correct. Whether to keep or drop a segment will depend on whether the contribution margin of the segment in question exceeds avoidable fixed costs (relevant costs that wouldn’t exist if the 11-4

segment did not exist). Unavoidable fixed costs will be incurred regardless of whether or not the segment is kept, so they are not factored into the decision. Choice "a" is incorrect. Fixed costs need to be broken out between avoidable and unavoidable in order to make the determination as to whether to keep or drop a segment. Lees Corp. would only drop the segment if the contribution margin of the segment is less than the avoidable fixed (relevant) cost. Choice "b" is incorrect. The contribution margin needs to be compared to avoidable fixed costs in order to determine whether to keep or drop a segment. Choice "d" is incorrect. Unavoidable fixed costs will be incurred regardless, so contribution margin of the segment needs to be compared to the avoidable fixed costs as the key elements to determine whether to keep or drop a segment. 11-20 Relevant costs. Ace Cleaning Service is considering expanding into one or more new market areas. Which costs are relevant to Ace’s decision on whether to expand?

SOLUTION Choice "a" is correct. Sunk costs are not relevant since they were incurred in the past and cannot be recovered as a result of the company’s current decision. Variable costs are relevant as also any avoidable fixed costs associated with the decision. Opportunity cost is the cost of foregoing the next best alternative when making a decision. These costs are relevant since the company has alternative courses of action. Choice "b" is incorrect. Sunk costs are not relevant since they were incurred in the past and cannot be recovered as a result of the company’s current decision. Choice "c" is incorrect. Opportunity cost is the cost of foregoing the next best alternative when making a decision. These costs are relevant since the company has alternative courses of action. Choice "d" is incorrect. Sunk costs are not relevant since they were incurred in the past and cannot be recovered as a result of the company’s current decision. Variable costs are relevant as also any avoidable fixed costs associated with the decision. 11-21 Disposal of assets. Answer the following questions. 1. A company has an inventory of 1,250 assorted parts for a line of missiles that has been discontinued. The inventory cost is $76,000. The parts can be either (a) remachined at total additional costs of $26,500 and then sold for $33,500 or (b) sold as scrap for $2,500. Which action is more profitable? Show your calculations. 2. A truck, costing $100,500 and uninsured, is wrecked its first day in use. It can be either (a) disposed of for $18,000 cash and replaced with a similar truck costing $103,000 or (b) rebuilt for $88,500 and thus be brand-new as far as operating characteristics and looks are concerned. Which action is less costly? Show your calculations. SOLUTION (20 min.)

Disposal of assets.

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1. This is an unfortunate situation, yet the $76,000 costs are irrelevant regarding the decision to remachine or scrap. The only relevant factors are the future revenues and future costs. By ignoring the accumulated costs and deciding on the basis of expected future costs, operating income will be maximized (or losses minimized). The difference in favor of remachining is $4,500: (a) (b) Remachine Scrap Future revenues Deduct future costs Operating income

$33,500 26,500 $ 7,000

Difference in favor of remachining

$2,500 – $2,500 $4,500

2. This, too, is an unfortunate situation. But the $100,500 original cost is irrelevant to this decision. The difference in relevant costs in favor of replacing is $3,500 as follows:

(a) Replace New truck Deduct current disposal price of existing truck Rebuild existing truck

Difference in favor of replacing

(b) Rebuild

$103,000

–

18,000 – $ 85,000

– $88,500 $88,500 $3,500

Note, here, that the current disposal price of $18,000 is relevant, but the original cost (or book value, if the truck were not brand new) is irrelevant. 11-22 Relevant and irrelevant costs. Answer the following questions. 1. DeCesare Computers makes 5,200 units of a circuit board, CB76, at a cost of $280 each. Variable cost per unit is $190 and fixed cost per unit is $90. Peach Electronics offers to supply 5,200 units of CB76 for $260. If DeCesare buys from Peach it will be able to save $10 per unit in fixed costs but continue to incur the remaining $80 per unit. Should DeCesare accept Peach’s offer? Explain. 2. LN Manufacturing is deciding whether to keep or replace an old machine. It obtains the following information: Old Machine $10,700 10 years 7 years

Original cost Useful life Current age

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New Machine $9,000 3 years 0 years

Remaining useful life Accumulated depreciation Book value Current disposal value (in cash) Terminal disposal value (3 years from now) Annual cash operating costs

3 years $7,490 $3,210 $2,200 $0 $17,500

3 years Not acquired yet Not acquired yet Not acquired yet $0 $15,500

LN Manufacturing uses straight-line depreciation. Ignore the time value of money and income taxes. Should LN Manufacturing replace the old machine? Explain. SOLUTION (20 min.) Relevant and irrelevant costs. 1. Relevant costs Variable costs Avoidable fixed costs Purchase price Unit relevant cost

Make

Buy

$190 10 ____ $200

$260 $260

DeCesare Computers should reject Peach’s offer. The $80 of fixed costs is irrelevant because it will be incurred regardless of this decision. When comparing relevant costs between the choices, Peach’s offer price is higher than the cost to continue to produce. 2. Cash operating costs (3 years) Current disposal value of old machine Cost of new machine Total relevant costs

Keep $52,500 _ _____ $52,500

Replace $46,500 (2,200) 9,000 $53,300

Difference $6,000 2,200 (9,000) $ (800)

LN Manufacturing should keep the old machine. The cost savings are less than the cost to purchase the new machine. 11-23 Multiple choice. (CPA) Choose the best answer. 1. The Dalton Company manufactures slippers and sells them at $12 a pair. Variable manufacturing cost is $5.00 a pair, and allocated fixed manufacturing cost is $1.25 a pair. It has enough idle capacity available to accept a one-time-only special order of 5,000 pairs of slippers at $6.25 a pair. Dalton will not incur any marketing costs as a result of the special order. What would the effect on operating income be if the special order could be accepted without affecting normal sales: (a) $0, (b) $6,250 increase, (c) $28,750 increase, or (d) $31,250 increase? Show your calculations. 2. The Sacramento Company manufactures Part No. 498 for use in its production line. The manufacturing cost per unit for 30,000 units of Part No. 498 is as follows: Direct materials

$5 11-7

Direct manufacturing labor Variable manufacturing overhead Fixed manufacturing overhead allocated Total manufacturing cost per unit

22 8 15 50

The Counter Company has offered to sell 30,000 units of Part No. 498 to Sacramento for $47 per unit. Sacramento will make the decision to buy the part from Counter if there is an overall savings of at least $30,000 for Sacramento. If Sacramento accepts Counter’s offer, $8 per unit of the fixed overhead allocated would be eliminated. Furthermore, Sacramento has determined that the released facilities could be used to save relevant costs in the manufacture of Part No. 575. For Sacramento to achieve an overall savings of $30,000, the amount of relevant costs that would have to be saved by using the released facilities in the manufacture of Part No. 575 would be which of the following: (a) $90,000, (b) $150,000, (c) $180,000, or (d) $210,000? Show your calculations. What other factors might Sacramento consider before outsourcing to Counter? SOLUTION (15 min.) 1. (b)

Multiple choice. Special order price per unit Variable manufacturing cost per unit Contribution margin per unit

Effect on operating income

$6.25 5.00 $1.25

= $1.25  5,000 units = $6,250 increase

2. (b) Costs of purchases, 30,000 units  $47 Total relevant costs of making: Variable manufacturing costs, $5 + $22 + $8 Fixed costs eliminated Costs saved by not making Multiply by 30,000 units, so total costs saved are $43  30,000 Extra costs of purchasing outside Minimum overall savings for Sacramento Necessary relevant costs that would have to be saved in manufacturing Part No. 575

$1,410,000 $35 8 $43 1,290,000 120,000 30,000 $

150,000

Before outsourcing to Counter, Sacramento must consider the consequence of increasing its dependence on Counter. Sacramento would want to be sure about the quality of Counter’s product and the reliability of its delivery schedules over a long-run period. Sacramento would also want Counter to continuously reduce costs. To achieve all these goals, Sacramento may want to build close partnerships and alliances with Counter. 11-24 Special order, activity-based costing. (CMA, adapted) The Gold Plus Company manufactures medals for winners of athletic events and other contests. Its manufacturing plant has the capacity to produce 11,000 medals each month. Current product...