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		- Select your answer
The future depreciation on a new machine with the decision to replace an older fully depreciated machine (assume no tax benefit for depreciation)		- Select your answer -
The revenue given up by not choosing an alternative		- Select your answer -
The risk of substandard quality from an outside supplier with the decision to outsource		- Select your answer -
Variable costs that are the same for all alternatives under consideration		- Select your answer -

Hide FeedbackShow All Feedback

Check My Work Feedback

Post Submission Feedback

Solution

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 16,400 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 16,400 monitors:

	Total cost of producing 16,400 monitors		Unit cost
Direct materials	$	1,918,800	$	117
Direct labor		1,066,000		65
Variable factory overhead		590,400		36
Fixed manufacturing overhead		492,000		30
Fixed non-manufacturing overhead		672,400		41
	$	4,739,600	$	289

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 $56,700, but non-manufacturing costs would remain the same if monitors are bought.

Fill in the differential analysis. If an amount box does not require an entry, leave it blank or enter "0".

	Cost of producing 16,400 monitors	Cost to purchase 16,400 monitors	Difference costs/(savings) of buying 16,400 monitors
Direct materials	$	$	$
Direct labor
Variable factory overhead
-???????????
--??????????
Total costs	$	$	$

Hide FeedbackShow All Feedback

Check My Work Feedback

Post Submission Feedback

Solution

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	$431,300
Current accumulated depreciation	329,400
Estimated annual variable manufacturing costs for machine	72,250
Estimated selling price of machine	190,300
Estimated remaining useful life (in years)	6
New Machine:
Purchase cost	$802,300
Estimated annual variable manufacturing costs for machine	43,350
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. If an amount box does not require an entry, leave it blank or enter "0".

	Replace old machine	Continue with old machine	Difference (Cost)/Savings with replacing machine
Revenue:
Proceeds from sale of old machine	$	$	$
Costs:
Cost of new machine
Variable costs (6 years worth)
Total costs	$	$	$
Income (loss)	$	$	$