Chapter 11

Chapter 11- Relevant cost Decision making

A. Every decision involves a choice from among at 2. Relevant costs should be isolated in cost anal-
least two alternatives. A relevant cost or benefit is a ysis for three reasons:
cost or benefit that differs between alternatives. If a
cost or benefit does not differ between alternatives, it a. In any given situation, the irrelevant costs
is not relevant in the decision and can be ignored. greatly outnumber the relevant costs. Focusing just on
Avoidable cost, differential cost, and incremental cost the relevant costs simply takes less time and effort.
are synonyms for relevant cost. b. The use of irrelevant costs intermingled
1. Two broad classifications of costs are irrele- with relevant costs may draw the decision-maker’s at-
vant in decisions: (a) sunk costs; and (b) future costs tention away from the really critical data.
that do not differ between alternatives. Sunk costs are c. People often make mistakes when they in-
not relevant since they have already been incurred and clude irrelevant costs in an analysis. They often incor-
therefore cannot differ between alternatives. rectly calculate the amount of the irrelevant cost under
2. To make a decision, you should: the alternatives and it may appear that the amount of
the irrelevant cost differs between the alternatives

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a. Eliminate the costs and benefits that do when in fact it does not. It is particularly easy to make

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not differ between alternatives. These irrelevant costs this mistake when dealing with fixed costs that are

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consist of sunk costs and future costs that do not differ stated on a per unit basis. This makes the fixed costs

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between alternatives. appear as if they are variable costs that change if the
number of units produced and sold changes.

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b. Make a decision based on the remaining

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cost and benefit data. These data consist of the costs
and benefits that differ between alternatives.
D. Adding or dropping a segment such as a product
line is one of the decision-making situations covered
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in the chapter. In making this decision, compare the
3. Costs that are relevant in one situation may not contribution margin of the segment to the fixed costs
be relevant in another situation. that could be avoided by dropping the segment.
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B. As stated above, sunk costs are never relevant 1. If the contribution margin lost by dropping a
since they are not avoidable; that is, they can never
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segment is greater than the fixed costs that can be

differ between alternatives.
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avoided, then the segment should be retained.

1. The book value of old equipment is a sunk 2. If the contribution margin lost by dropping a
cost. Hence, it is not relevant in decision making. Peri- segment is less than the fixed costs that can be avoid-
odic depreciation based on the book value of old ed, then the segment should be dropped.
equipment is also irrelevant.
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3. Exhibit 11-3 illustrates an alternative approach

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2. However, depreciation is a sunk cost only if it to deciding whether to retain or drop a product line or
relates to old equipment (e.g., equipment that has al- other segment of a company. In this approach two in-
ready been purchased). Thus, depreciation on new come statements are prepared —one for each alterna-
equipment would be a relevant cost. tive.
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3. Even though the book value of old equipment 4. The decision to keep or drop a product line or
is not relevant in a decision, the resale value of old other segment of a company is often clouded by the al-
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equipment may be relevant. For example, if you are location of common fixed costs, which are costs that
considering whether to replace an old machine, its re- would not be avoided, in whole or in part, when a seg-
sale value is relevant. If the machine were not re- ment is eliminated.
placed, the resale value would not be realized.
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a. Allocations of common costs can make a

C. As stated above, future costs that do not differ be- product line or other segment appear to be unprof-
tween alternatives are not relevant costs. itable, when in fact the segment may be contributing
1. For example, maintenance costs are irrelevant substantially to the overall profits of the company.
to the decision of which machine to purchase if main- b. Common fixed costs should never be allo-
tenance costs will be the same regardless of which ma- cated to segments of a company; segments should be
chine is purchased. charged only with those costs that are directly trace-
able to them, as shown in Exhibit 11-4.

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 Chapter 11

E. A decision to produce a part internally rather than and time on the machine would be a scarce resource
to buy it from a supplier is called a make or buy deci- that is a constraint.
sion. The relevant costs in such a decision, as always,
are the costs that differ between the alternatives. 1. When there is a production constraint, demand
exceeds capacity. In that case, managers must decide
1. Exhibit 11-5 contains an example of a make or what the company will not do since it cannot do every-
buy decision. Notice from the exhibit that the costs thing.
that are relevant in a make or buy decision are the
costs that differ between the make or buy alternatives. 2. If the problem is how to best utilize a scarce
resource, fixed costs are likely to be constant and
2. Opportunity cost may be a key factor in a therefore irrelevant. Maximizing the company’s total
make or buy decision as well as in other decisions. contribution margin is equivalent to maximizing the
company’s profit. Given capacity and the company’s
a. If there are no alternative uses of the ca- fixed costs, the problem is how to best use that capaci-
pacity that is currently being used to make a part or a ty to maximize total contribution margin and profit.
product, then the opportunity cost is zero and it does
not need to be considered. 3. The key to the efficient utilization of a scarce
resource is the contribution margin per unit of the
b. On the other hand, if buying from outside constrained resource. The products with the greatest
the company would release capacity that could be used

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contribution margin per unit of the constrained re-

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to produce something else, then there is an opportunity source are the most profitable; they generate the great-
cost involved in using that capacity to make parts in- est profit from a given amount of the constrained re-

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ternally. This opportunity cost is the segment margin source. These products should be emphasized over

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that could be obtained from the alternative use of the products with a lower contribution margin per unit of
capacity. The opportunity cost should be included in the constrained resource.

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the analysis.
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F. Another decision concerns special orders. A com-
4. Since the constraint limits the output of the en-
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tire organization, there can be a tremendous payoff to
pany may have an opportunity to sell products under increasing the amount of the available scarce resource.
special circumstances that don’t affect regular sales. This is called “elevating the constraint” and can be ac-
For example, a company may receive an order on a complished in a variety of ways including working
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one-time basis from an overseas customer in a market overtime on the bottleneck, buying another machine,
the company does not ordinarily sell in. Such a special subcontracting work, and so on.
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order should be accepted if the incremental revenue

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from the special order exceeds the incremental (i.e., 5. The contribution margin per unit of the con-
avoidable) costs of the order. Any opportunity costs strained resource is also a measure of opportunity cost.
should be taken into account. For example, when considering whether to accept an
order for a product that uses the constrained resource,
G. A constraint is a scarce resource that limits out- the opportunity cost of using the constrained resource
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put. When the constraint is a machine or a worksta- should be considered. That opportunity cost is the lost
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tion, it is called a bottleneck. For example, a company contribution margin for the job that would be dis-
may be able to sell 1,000 units of a product per week, placed if the order were accepted.
but have a machine that is capable of only producing
800 units a week. The machine would be a bottleneck
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 Chapter 11

REVIEW AND SELF TEST

Questions and Exercises
.

T 1. All costs are relevant in a decision except costs that do not differ between alternatives.
F 2. In a decision, variable costs are relevant costs and fixed costs are irrelevant. Variable can be irrelevant
F 3. Sunk costs may be relevant in a decision.
T 4. Depreciation is a relevant cost if it relates to equipment that has not yet been purchased.
F 5. Future costs are always relevant in decision-making.
Future costs are relevant only if they differ between alternatives; future costs that do not differ between alter-
natives are irrelevant.
T 6. Costs that are relevant in one decision are not necessarily relevant in another decision.
T 7. If a company is able to avoid more in fixed costs than it loses in contribution margin by dropping a
product, then it will be better off financially if the product is eliminated.
F 8. Allocation of common fixed costs to product lines and to other segments of a company helps the man -
ager to see if the product line or segment is profitable.
F 9. If a product has a negative segment margin, the product should be discontinued.

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T 10. Opportunity cost may be a key factor in a make or buy decision.

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F 11. If there is a constrained resource, a company should emphasize the product that has the highest contri-

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bution margin per unit.

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Multiple Choice

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1.All of the following costs are relevant in a make or buy decision except:

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a) The opportunity cost of space
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b) Costs that are avoidable by buying rather than making
c) Variable costs of producing the item
d) Costs that are differential between the make and buy alternatives
e) All of the above costs are relevant.
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___ 2. One of Simplex Company’s products has a contribution margin of $50,000 and fixed costs totaling
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$60,000. If the product is dropped, $40,000 of the fixed costs will continue unchanged. As a result of dropping the
product, the company’s net operating income should:
a) Decrease by $50,000; Contribution margin (50,000)
b) Increase by $30,000; Less variable (60000-40000) = 20000
c) Decrease by $30,000;
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d) Increase by $10,000. = Decrease by (30,000)

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___ 3. Halley Company produces 2,000 parts each year that are used in one of its products. The unit product
cost of this part is:
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Variable manuf. cost ........... $ 7.50

Fixed manuf. cost ................ 6.00
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Unit product cost ................. $13.50

The part can be purchased from an outside supplier for $10 per unit. If the part is purchased from the outside sup-
plier, two-thirds of the fixed manufacturing costs can be eliminated. The effect on net operating income from
purchasing the part would be a:
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a) $3,000 increase
b) $1,000 decrease
c) $7,000 increase
d) $5,000 decrease.

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 Chapter 11

___ 4. Product A has a contribution margin of $8 per unit, a contribution margin ratio of 50%, and requires 4
machine-hours to produce.
Product B has a contribution margin of $12 per unit, a contribution margin ratio of 40%, and requires 5 ma -
chine-hours to produce. If the constraint is machine-hours, then the company should emphasize:
a) Product A Product A : Product B :
b) Product B. CM: $8 CM: $12
MH: 4 hours MH: 5 hours

8/4 = 2 12/5 = 2.4

___ 5. Sunderson Products, Inc. has received a special order for 1,000 units of a sport-fighting kite. The cus-
tomer has offered a price of $9.95 for each kite. The unit costs of the kite, at its normal sales level of 30,000 units
per year, are detailed below:

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Variable production costs ......................... $5.25

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Fixed production costs ............................. 2.35

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Variable selling costs ............................... 0.75

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Fixed selling and admin. costs .................. 3.45

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There is ample idle capacity to produce the special order without any increase in total fixed costs. The variable

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selling costs on the special order would be $0.15 per unit instead of $0.75 per unit. The special order would have
no impact on the company’s other sales. What effect would accepting this special order have on the company’s
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net operating income?
Incremental revenue: 9.95 x 1000 = 9950
a) $1,850 increase Incremental costs:
b) $1,850 decrease Variable production: 5.25 x 1000 = 5250
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c) $4,550 Increase Variable selling: 0.15 x 1000 = 150

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d) $4,550 decrease. 9950 - 5250 – 150 = 4550

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Chapter 12 :Capital Budgeting Decisions

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A. The term capital budgeting is used to describe 3. The time value of money should be consid-
planning major outlays on projects that commit the ered. A dollar in the future is worth less than a dollar
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company for some time into the future such as pur- today for the simple reason that a dollar today can be
chasing new equipment, building a new facility, or in- invested to yield more than a dollar in the future.
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troducing a new product.

a. Discounted cash flow methods give full
1. Capital budgeting usually involves investment; recognition to the time value of money.
i.e., committing funds now so as to obtain cash inflows
in the future. b. There are two methods that use discount-
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ed cash flows—the net present value method and the

2. Capital budgeting decisions fall into two broad internal rate of return method.
categories:
B. The net present value method is illustrated in Ex-
a. Screening decisions: Potential projects are ample A (Exhibit 12-1) and in Example B (Exhibit 12-
categorized as acceptable or unacceptable. 2). The basic steps in this method are:
b. Preference decisions: Projects must be 1. Determine the required investment.
ranked because funds are insufficient to support all of
the acceptable projects.

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 Chapter 11

2. Determine the future cash inflows and out- D. The internal rate of return method is another dis-
flows that result from the investment. counted cash flow method used in capital budgeting
decisions. The internal rate of return is the rate of re-
3. Use the present value tables to find the appro- turn promised by an investment project over its useful
priate present value factors. life; it is the discount rate for which the net present
a. The values (or factors) in the present val- value of a project is zero. The details of the internal
ue tables depend on the discount rate and the number rate of return method are covered in more advanced
of periods (usually years). texts.

b. The discount rate in present value analy- E. The total-cost approach or the incremental-cost
sis is the company’s required rate of return, which is approach can be used to compare projects.
often the company’s cost of capital. The cost of capi- 1. The total-cost approach is the most flexible
tal is the average rate of return the company must pay and the most widely used method. Exhibit 12-3 shows
its long-term creditors and shareholders for the use of this approach. Note in Exhibit 12-3 that all cash in-
their funds. The details of the cost of capital are cov- flows and all cash outflows are included in the solu-
ered in finance courses. tion under each alternative.
4. Multiply each cash flow by the appropriate 2. The incremental-cost approach is a simpler
present value factor and then sum the results. The end

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and more direct route to a decision since it ignores all

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result (which is net of the initial investment) is called cash flows that are the same under both alternatives.
the net present value of the project. The incremental-cost approach focuses on differential

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costs. Exhibit 12-4 shows this approach.

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5. In a screening decision, if the net present value
is positive, the investment is acceptable. If the net 3. The total-cost and incremental-cost approach-

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present value is negative, the investment should be re- es should lead to the same decision.
jected.
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F. Sometimes no revenue or cash inflow is directly
C. Discounted cash flow analysis is based entirely on involved in a decision. In this situation, the alternative
cash flows—not on accounting net income. Account- with the least cost should be selected. The least cost
ing net income is ignored in cash flow analysis. alternative can be determined using either the to-
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1. Typical cash flows associated with an invest- tal-cost approach or the incremental approach. Ex-
hibits 12-5 and 12-6 illustrate least-cost decisions.
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ment are:
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a. Outflows: initial investment (including in- H. Preference decisions involve ranking investment
stallation costs); increased working capital needs; re- projects. Such a ranking is necessary whenever there
pairs and maintenance; and incremental operating are limited funds available for investment.
costs. 1. Preference decisions are sometimes called
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b. Inflows: include incremental revenues; re- ranking decisions or rationing decisions because they
ration limited investment funds among competing in-
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ductions in costs; salvage value; and release of work-

ing capital at the end of the project. vestment opportunities.

2. Depreciation is not a cash flow and therefore 2. When using the internal rate of return to rank
is not part of the analysis. (However, depreciation can competing investment projects, the preference rule is:
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affect taxes, which is a cash flow. This aspect of de- The higher the internal rate of return, the more desir-
preciation is covered in more advanced texts.) able the project.
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3. Quite often, a project requires an infusion of 3. If the net present value method is used to rank
cash (i.e., working capital) to finance inventories, re- competing investment projects, the net present value
ceivables, and other working capital items. Typically, of one project should not be compared directly to the
net present value of another project, unless the invest-
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at the end of the project these working capital items

can be liquidated (i.e., the inventory can be sold) and ments in the projects are of equal size.
the cash that had been invested in these items can be a. To make a valid comparison between
recovered. Thus, working capital is counted as a cash projects that require different investment amounts, a
outflow at the beginning of a project and as a cash in- profitability index is computed. The formula for the
flow at the end of the project. profitability index is:
4. We usually assume that all cash flows, other Present value of cash inflows
than the initial investment, occur at the end of a peri- Profitability index 
od. Investment required

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 Chapter 11

This is basically an application of the idea from Chap- Incremental  Incremental

ter 11 of utilization of a scarce resource. In this case, Simple rate revenue expenses
the scarce resource is the investment funds. The prof- 
of retun Initial investment
itability index is similar to the contribution margin per
unit of the scarce resource. If new equipment is replacing old equipment, then the
“initial investment” in the new equipment is the cost
b. The preference rule when using the prof- of the new equipment reduced by any salvage value
itability index is: The higher the profitability index, obtained from the old equipment.
the more desirable the project.
2. Like the payback method, the simple rate of
H. Two other capital budgeting methods are consid- return method does not consider the time value of
ered in the chapter. These methods do not involve dis- money. Therefore, the rate of return computed by this
counting cash flows One of these is the payback method will not be an accurate guide to the profitabili-
method. ty of an investment project.
1. The payback method focuses on how long it Appendix 12A: The Concept of Present Value
takes for a project to recover its initial cost out of the
cash receipts it generates. The payback period is ex- A. Since most business investments extend over long
pressed in years. periods, it is important to recognize the time value of

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money in capital budgeting analysis. Essentially, a

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a. When the cash inflows from the project dollar received today is more valuable than a dollar re-
are the same every year, the following formula can be ceived in the future for the simple reason that a dollar

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used to compute the payback period: received today can be invested—yielding more than a

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Investment required dollar in the future.

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Payback period 
Net annual cash inflows B. Present value analysis recognizes the time value
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b. If new equipment is replacing old equip-
ment, the “investment required” should be reduced by 1. Present value analysis involves expressing a
any salvage value obtained from the disposal of old future cash flow in terms of present dollars. When a
equipment. And in this case, in computing the “net an- future cash flow is expressed in terms of its present
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nual cash inflows,” only the incremental cash inflow value, the process is called discounting.
provided by the new equipment over the old equip-
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ment should be used. 2. Use Table 12B-3 in Appendix 12B to deter-

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mine the present value of a single sum to be received

2. The payback period is not a measure of prof- in the future. This table contains factors for various
itability. Rather it is a measure of how long it takes for rates of interest for various periods, which when multi-
a project to recover its investment cost. plied by a future sum, will give the sum’s present val-
ue.
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3. Major defects in the payback method are that

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it ignores the time value of money, and that it ignores 3. Use Table 12B-4 in Appendix 12B to deter-
all cash flows that occur once the initial cost has been mine the present value of an annuity, or stream, of
recovered. Therefore, this method is very crude and cash flows. This table contains factors that, when mul-
should be used only with a great deal of caution. Nev- tiplied by the stream of cash flows, will give the
ertheless, the payback method can be useful in indus- stream’s present value. Be careful to note that this an-
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tries where project lives are very short and uncertain. nuity table is for a very specific type of annuity in
which the first payment occurs at the end of the first
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I. The simple rate of return method is another capi- year.

tal budgeting method that does not involve discounted
cash flows.
1. The simple rate of return method focuses on
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accounting net income, rather than on cash flows. The

formula for its computation is:

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 Chapter 11

REVIEW AND SELF TEST CH 12

Questions and Exercises

T 1.Under the net present value method, the present value of all cash inflows associated with an investment
project is compared to the present value of all cash outflows, with the difference, or net present value, determining
whether or not the project is acceptable.
F 2. Cash outlays for noncurrent assets such as machines would be considered in a capital budgeting analy-
sis, but not cash outlays for current assets such as inventory.
T 3. The internal rate of return is the discount rate for which a project’s net present value is zero.
F 4. In present value analysis, the higher the discount rate, the higher is the present value of a given future
cash inflow.
T 5. When comparing two investment alternatives, the total-cost approach provides the same ultimate an-
swer as the incremental-cost approach.
F 6. In ranking investment projects, a project with a high net present value should be ranked above a project

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with a lower net present value.

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T 7. The simple rate of return method explicitly takes depreciation into account.

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T 8. The payback method does not consider the time value of money.

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T
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9. The present value of a cash inflow to be received in 5 years is greater than the present value of the
same sum to be received in 10 years.
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 Chapter 11

Multiple Choice
Peters Company is considering the purchase of a machine to further automate its production line. The machine
would cost $30,000, and have a ten-year life with no salvage value. It would save $8,000 per year in labor costs,
but would increase power costs by $1,000 annually. The company’s discount rate is 12%.
___ 1. The present value of the net annual cost savings would be:
a) $39,550
b) $45,200
c) $5,650
d) $70,000.

___ 2. The net present value of the proposed machine would be: a) $(15,200); b) $5,650; c) $9,550; d)
$30,000.
___ 3. White Company’s required rate of return and discount rate is 12%. The company is considering an in -
vestment opportunity that would yield a return of $10,000 in five years. What is the most that the company should
be willing to invest in this project? a) $36,050; b) $5,670; c) $17,637; d) $2,774.

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___ 4. Dover Company is considering an investment project in which a working capital investment of

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$30,000 would be required. The investment would provide cash inflows of $10,000 per year for six years. If the

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company’s discount rate is 18%, and if the working capital is released at the end of the project, then the project’s
net present value is: a) $4,980; b) $(4,980); c) $16,080; d) $(12,360).

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___ 5. Frumer Company has purchased a machine that cost $30,000, that will save $6,000 per year in cash op-
erating costs, and that has an expected life of 15 years with zero salvage value. The payback period on the ma -
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chine will be: a) 2 years; b) 7.5 years; c) 5 years; d) 0.2 years.
___ 6. Refer to the data in question (5) above. The simple rate of return on the machine is approximately: a)
20%; b) 13.3%; c) 18%; d) 10%.
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 Chapter14

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