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CACC406 CH09.docx

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ACC 406
Vincent Cappelli

CACC406 CH09 RELEVANT INFORMATION AND MAKING PRODUCTION DECISIONS EX of Production Decisions - Make or buy - Sell at the split off point or process further - Keep or replace equipment DIFFERENTIAL AND OPPORTUNITY COSTS CONSIDER: - Maria Morales, a CA, employed by a large accounting firm at 60,000 per year - She is thinking about quitting her job to have her own practice and own business THE FOLLOWING IS A COMPARISON OF MARIA’S ALTERNATIVES CALLED A DIFFERENTIAL ANALYSIS: Remain as Open Independent Difference an Employee Practice Revenues $60,000 $200,000 $140,000 Outlay costs (operating expenses) --------- $120,000 $120,000 Income effects per year $60,000 $80,000 $20,000 Differential/Incremental Cost is the difference in total cost between the two alternatives Differential Income is the difference in total income between the two alternatives So: Differential Revenue = 140,000 Differential Cost = 120,000 Differential Income = 20,000  The annual difference of $20,000 favours Maria’s choosing independent practice, however independent practice has an opportunity cost of $60,000 – the foregone salary THE FOLLOWING IS A COMPARISON OF MARIA’S ALTERNATIVES WITH FOCUS ON OPPORTUNITY COST: Alternative Chosen: Independent practice Revenue $200,000 Expenses: Outlay costs (operating expenses) $120,000 Opportunity cost of employee salary $60,000 $180,000 Income Effects Per Year $20,000 Alternative Chosen: Remain as Employee Revenue $60,000 Expenses: Outlay costs (operating expenses) $0 Opportunity cost of indep. practice $80,000 $80,000 Income Effects Per Year $(20,000) Opportunity Cost  is the maximum foregone benefit (contribution to profit) by choosing to forego an alternative opportunity cost OR  Is the contribution of the best alternative that is excluded from consideration 1 CACC406 CH09 DECISION: MAKE OR BUY  Managers apply relevant cost analysis to a variety of make-or-buy decisions Consider: manufacturers who must often decide whether to make or buy a product  Qualitative reasons for making their own parts: o Control quality o Possess special know-how  Qualitative reasons for purchasing parts o Protect long-run relationships with suppliers o Avoid difficulties in obtaining needed parts during boom times, when there may be shortages of material and workers but no shortage of sales orders  Qualitative considerations often dominate quantitative cost assessments – so decisions are not made exclusively on numbers alone  Key factor that influences decision – Whether there are idle facilities o Many companies make parts only when their facilities cannot be used to better advantage EXAMPLE: Given the following costs at GE Company for Part No. 990: Total Cost for Cost/Unit 20,000 Units Direct Material $20,000 $1 Direct Labour $80,000 $4 Variable Factory Overhead $40,000 $2 Fixed Factory Overhead $80,000 $4 Total Costs $220,000 $11 Another manufacturer offers to sell GE the same part for $10. Should GE make or buy the part? → Must analyse the difference in expected future costs between the alternatives  $4 Fixed overhead cost will probably continue regardless of decision, therefore, the $4 cost becomes irrelevant. o Ex of such cost: amortization, property taxes, insurance, and allocated executive salaries  Variable costs are relevant  Fixed cost that maybe avoided in the future are relevant Scenario #1 – If parts are purchased, suppose: 1. Capacity now used to make parts will become idle (this is rarely the case, usually put into other use) 2. $20,000 workers’ salary is the only fixed cost that would be saved THEN: MAKE BUY TOTAL PER UNIT TOTAL PER UNIT Direct Material $20,000 $1 Direct Labour $80,000 $4 Variable factory overhead $40,000 $2 Fixed factory overhead that can be avoided by not making Workers’ Salary $20,000* $1* Total Relevant Costs $160,000 $8 $200,000 $10 Difference in favour of making $40,000 $2 *FIXED COSTS OF $60,000 ($80,000 ­ $20,000) are irrelevant. That is, the irrelevant cost/unit = $4 ­ $1= $3 2 CACC406 CH09 KEY TO MAKE-OR-BUY DECISIONS IS IDENTIFYING THE ADDITIONAL COSTS FOR MAKING (or the costs avoided by buying) A PART OR SUBCOMPONENT ACTIVITY ANALYSIS HELPS IDENTIFY COSTS:  PRODUCTION OF A PRODUCT REQUIRES A SET OF ACTIVITIES, AND A COMPANY THAT ACCURATELY MEASURES THE COSTS OF IT VARIOUS ACTIVITIES CAN BETTER ESTIMATE THE ADIDITON COSTS INCURRED TO PRODUCED AN ITEM GE’S ACTIVITIES FOR PRODUCTION PART NO. 900 WERE MEASURED BY TWO COST DRIVERS: 1. UNITS OF PRODUCTION OF $8 PER UNIT 2. WORKERS’ SALARY AT A $20,000 FIXED COST Scenario #2 If parts are purchased, suppose: 1. Idle facilities used for other manufacturing activity produces a contribution to profits of $55,000 2. Idle facilities rented out will produce a contribution to profits of $35,000 THEN: MAKE BUY AND LEAVE BUY AND RENT BUY AND USE FACILITIES FACILITIES IDLE FOR OTHER PRODUCTS Rent Revenue $ ---- $ ---- $ 35,000 $ ---- Contribution From oth
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