Question

1. Mastery Problem: Decision Making using Differential Analysis

   Decision making involves quantifying relevant revenues and costs with the goal of maximizing net cash flows. In many situations it is difficult to quantify all the important elements of a decision. Fixed costs are generally in the short-term because they are often unavoidable. Costs that have been incurred in the past and cannot be recouped are not relevant. These costs are called . Revenue given up by not choosing an alternative is relevant. This is an example of . Factors that cannot be expressed in numerical terms may or may not be relevant to the decision.

   Indicate whether the costs that are described are relevant or irrelevant for decision-making purposes.

   The cost to hire and train temporary labor to cover normal business processes so permanent employees can work on the project that is being considered
   The future depreciation on a new machine with the decision to replace an older fully depreciated machine (assume no tax benefit for depreciation)
   The revenue given up by not choosing an alternative
   The risk of substandard quality from an outside supplier with the decision to outsource
   Variable costs that are the same for all alternatives under consideration

   Managers often have to choose between mutually exclusive alternatives. The first step is to identify the alternatives and the relevant revenues and costs of each option. The next step is to compare the alternatives. This is called analysis, or incremental analysis. The concept is to determine the differential income or loss from choosing one option over the other. If irrelevant costs are included in one option, the cost also be included in the other options for comparison purposes.

   Make or buy decisions, sell or process further decisions, lease or buy decisions, whether to accept an order at a discounted price, and when to replace equipment, are all examples of common decisions where differential analysis is used.

   Many formats may be used. Click here for a template that includes all revenues and costs. Click here for a template with relevant costs only.

   Make or Buy Decision:

   Zee-Drive Ltd. is a computer manufacturer. One of the items they make is monitors. Zee-Drive has the opportunity to purchase 18,000 monitors from an outside supplier for $205 per unit. One of the company's cost-accounting interns prepared the following schedule of Zee-Drive's cost to produce 18,000 monitors:

   	Total cost of producing 18,000 monitors		Unit cost
   Direct materials	$	2,070,000	$	115
   Direct labor		1,350,000		75
   Variable factory overhead		504,000		28
   Fixed manufacturing overhead		522,000		29
   Fixed non-manufacturing overhead		774,000		43
   	$	5,220,000	$	290

   You are asked to look over the intern's estimate before the information is shared with members of management who will decide to continue to make the monitors or buy them. The company's controller believes that the estimate may be incorrect because it includes costs that are not relevant. If Zee-Drive buys the monitors, the direct labor force currently employed in producing the monitors will be terminated and there would be no termination costs incurred. There are no materials on hand and no commitments to suppliers to purchase materials, so all materials would need to be purchased to make the monitors. Variable overheads are avoidable if monitors are bought. Fixed manufacturing overhead costs would be reduced by $52,800, but non-manufacturing costs would remain the same if monitors are bought.

   Fill in the differential analysis.

   Make or Buy Decisions Differential Analysis Report
   Purchase price of 18,000 monitors		$
   Differential cost to make:
   Direct materials	$
   Direct labor
   Overhead
   Differential income (loss) from making monitors		$

   Keep or Replace Machine:

   Skiles Coporation is a manufacturer of classic rocking chairs. The company has been using a particular sanding and finishing machine for over 10 years and believes that it may be time to replace the machine. The company is trying to decide whether replacing the old machine is a wise economic decision. The company's controller pulled together the following information on the old machine and the new possible replacement machine.

   Old Machine:
   Original cost	$451,800
   Current accumulated depreciation	332,000
   Estimated annual variable manufacturing costs for machine	73,750
   Estimated selling price of machine	190,800
   Estimated remaining useful life (in years)	6
   New Machine:
   Purchase cost	$794,800
   Estimated annual variable manufacturing costs for machine	48,200
   Estimated residual value	0
   Estimated useful life (in years)	6

   Select the relevant or irrelevant information below:

   Annual variable costs of old machine
   Selling price of old machine
   Matching lives
   Purchase price of new machine
   Accumulated depreciation of old machine

   Fill in the differential analysis.

   Replace or Keep Decision Differential Analysis Report
   Cost of replacing old machine:
   Annual differential decrease in cost	$
   x number of years
   Total differential decrease in cost
   Proceeds from sale of present machine		$
   Cost of new machine
   Net differential (increase)/decrease in cost, six year total		$

Check My Work

Answer 1

Make or Buy Decisions
Differential Analysis Report
Purchase price of 18,000 monitors (18000*205)		$3,690,000
Differential cost to make:
Direct materials	$2,070,000
Direct labor	$1,350,000
Overhead (504000+522000-52800)	$   973,200	$4,393,200
Differential income (loss) from making monitors		$ (703,200)
Annual variable costs of old machine	Relevant
Selling price of old machine	Relevant
Matching lives	Relevant
Purchase price of new machine	Relevant
Accumulated depreciation of old machine	Irrelevant
Replace or Keep Decision
Differential Analysis Report
Cost of replacing old machine:
Annual differential decrease in cost (73750-48200)	$     25,550
x number of years	6
Total differential decrease in cost	$   153,300
Proceeds from sale of present machine	$   190,800	$   344,100
Cost of new machine		$ (794,800)
Net differential (increase)/decrease in cost, six year total		$ (450,700)