Mastery Problem: Decision Making using Differential Analysis

Question Content Area

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

relevantnot relevant

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

fixed costsopportunity costssunk costsvariable costs

. Revenue given up by not choosing an alternative is relevant. This is an example of

a fixed costan opportunity costa sunk costa variable cost

. 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

Question Content Area

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 17,000 monitors from an outside supplier for $204 per unit. One of the company's cost-accounting interns prepared the following schedule of Zee-Drive's cost to produce 17,000 monitors:

	Total cost of producing 17,000 monitors	Unit cost
Direct materials	$	2,006,000	$	118
Direct labor		1,258,000		74
Variable factory overhead		493,000		29
Fixed manufacturing overhead		425,000		25
Fixed non-manufacturing overhead		748,000		44
	$	4,930,000	$	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 $48,300, 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 17,000 monitors		$fill in the blank c5b54b07607ef84_3
Differential cost to make:
Direct materials	$fill in the blank c5b54b07607ef84_4
Direct labor	fill in the blank c5b54b07607ef84_5
Overhead	fill in the blank c5b54b07607ef84_6	fill in the blank c5b54b07607ef84_7
Differential income (loss) from making monitors		$fill in the blank c5b54b07607ef84_8

Question Content Area

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	$459,300
Current accumulated depreciation	308,600
Estimated annual variable manufacturing costs for machine	70,150
Estimated selling price of machine	182,600
Estimated remaining useful life (in years)	6
New Machine:
Purchase cost	$792,900
Estimated annual variable manufacturing costs for machine	40,650
Estimated residual value	0
Estimated useful life (in years)	6

Select the relevant or irrelevant information below:

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

Fill in the differential analysis.

Replace or Keep Decision Differential Analysis Report
Cost of replacing old machine:
Annual differential decrease in cost	$fill in the blank d66fd3fc6fcd05a_6
x number of years	fill in the blank d66fd3fc6fcd05a_7
Total differential decrease in cost	fill in the blank d66fd3fc6fcd05a_8
Proceeds from sale of present machine	fill in the blank d66fd3fc6fcd05a_9	$fill in the blank d66fd3fc6fcd05a_10
Cost of new machine		fill in the blank d66fd3fc6fcd05a_11
Net differential (increase)/decrease in cost, six year total		$fill in the blank d66fd3fc6fcd05a_12

I need help in finding the answers to "Make or Buy Decisions Differential Analysis Report" table as well as "Replace of Keep Differntial Analysis Report".

Thank you.