ACC5MCR

Management and Cost Reporting

Semester 1 2016
Solutions to specified Tutorial Questions for week 10

19.5 To be relevant to a decision, information must differ for the alternative courses of action being considered, relate to
the future, and provide a balance between timeliness and accuracy. This information may include both quantitative
and qualitative information. In addition, the information must have material impact on the decision being made.
Information is said to be relevant in decision-making if such information would change the future outcome of a
decision. For example, opportunity costs would be relevant in evaluating alternative courses of action, while sunk
costs would be deemed irrelevant.

Completely accurate information may require waiting for verifiable data, such as an actual cost incurred over a
year. Such information may be too late to be relevant. In management accounting relevance is more important than
absolute verifiability. Two examples of the trade-off between timeliness and accuracy include the following. First,
in a make-or-buy decision we may need to estimate the likely compensation demanded by employees if we cease
production of a product, even though it may not be possible to estimate this cost accurately. Second, in a special
order decision we need to estimate the impact on existing customers of taking on the order at a special price, even
though it may not be possible to estimate this impact accurately. In both cases, even though the information is not
accurate, it is needed at the time of making the decision.
Objective information need not be relevant. Indeed, in making decisions we need to consider future costs and
benefits, which can only be estimated rather than measured objectively. For example, in deciding whether to replace
a machine, the cost of future maintenance of the existing machine compared to buying a new machine is relevant.
Objective information is information obtained from verifiable sources and is therefore accurate. But this does not
mean that this accurate information is relevant.
For example, in deciding whether to replace the machine, some managers may include the cost of the original
machine, which can be measured objectively. However, this information is not relevant to the decision as it is a
sunk cost which does not differ between the maintain or replace courses of action.

19.7 When making calculations regarding the replacement of equipment, managers are often tempted to include the past
investment in equipment because they see it as an expense going through their statements as depreciation charges.
However the purchase was made in the past and represents a sunk cost. The written down value of the equipment
will pass through the income statement as annual depreciation over the rest of its life if it is kept, or will be offset
against what it is sold to calculate loss or gain on sale. Either way the full written down value will pass through
future income statements. It does not represent something that will change in the statements due to the decision.
Past investment in research is also irrelevant to decisions about whether to continue with research and development
on a proposed product. If a research project on a proposed product has already cost
$2 million after an initial forecast of $1 million, and a request is made for a further $500 000 to complete the
research, managers may say that going to $2.5 million is too much as it is 250 per cent of the expected commitment,
and the project must stop. However, $2 million has already been spent and the choice now is whether to pay $500
000 for an outcome that they were prepared to pay $1 million for, or drop the product proposal altogether.

19.9 An opportunity cost is the potential benefit given up when the choice of one action precludes a different action. For
example, one opportunity cost associated with getting a university education is the students foregone wages from
a job that might have been held during the educational period. Another example of an opportunity cost is profits
foregone from producing and selling product A, when a production facility is used instead to produce product B.
People often ignore or downplay the importance of opportunity costs in making a decision. Since an opportunity
cost is often not an out-of-pocket cost and is not measured within the business accounting system, people tend to
think it is less important than these costs that are recorded. This behavioural tendency can result in faulty decision
making. By definition, an opportunity cost is something that does not or will not happen. Hence it is often
overlooked.
To help students recognise opportunity costs that are not recorded in the accounting system in the immediate future
(but sometimes become large lost benefits in the long term), it might be helpful to discuss the impact on their
university results if a student spent the mid-semester break at the snowfields instead of catching up with academic
work. These might include the cost and effort of repeating parts of the degree, worse exam results that later affect
job hunting, later finishing of the degree and so on.

19.13 Avoidable costs are those costs that will not be incurred in the future if a particular decision is made. Costs that are
avoidable in the context of a particular decision are relevant to that decision as they will change as a result of that
decision, and should be included in the analysis of the financial outcome of the decision. Avoidable costs are
relevant in decisions such as whether to make or buy. Unavoidable costs will not change as a result of the decision
and should not be included in the analysis.

EXERCISE 19.24 (15 minutes) Special order: manufacturer

1 The relevant cost of the theolite to be used in producing the special order is the $14 500 sales value that the
company will forgo if it uses the chemical. This is an example of an opportunity cost.

(a) $14 500 sales value: Discussed in requirement 1.

(b) $16 000 carrying amount (8000 kg $2 per kg): irrelevant, since this is a sunk cost (no decision now can
change it).

$19 200 current purchase price (8000 kg $2.40 per kg): irrelevant, since the company will not be buying any
theolite.

EXERCISE 19.27 (15 minutes) Drop product line: retailer

The owners analysis incorrectly includes the following allocated costs that will be incurred regardless of whether the
gelato bar is continued.
Utilities

$4350

Depreciation of building

6000

Deli managers salary

4500

Total

$14 850

It is possible that closing the gelato bar might save a portion of the utility cost, but that is doubtful.

A better analysis follows:

Sales

67 500

Less: Cost of food

30 000

Gross profit

37 500

Less:

Operating expenses
Wages of counter staff

$18 000

Paper products

6 000

Depreciation of counter equipment and furnishings*

3 750

Total
Profit on ice cream counter

27 750
$9 750

* Depreciation on the counter equipment and furnishings is included because it is traceable to the gelato operation and is an
expense in the determination of profit. If a cash-flow analysis is desired, this non-cash expense should be excluded.

PROBLEM 19.38 (25 minutes) Introducing a new product: manufacturer

1

Per-unit contribution margins:

Standard
Selling price

Enhanced

$375.00

$495.00

Less: Variable costs:

Direct material

$42.00

$67.50

Direct labour

22.50

30.00

Variable manufacturing overhead

36.00

48.00

37.50

49.50

Sales commission
$375 10%; $495 10%
Total unit variable cost
Unit contribution margin

138.00

195.00

$237.00

$300.00

The following costs are not relevant to the decision:

development costssunk

fixed manufacturing overheadwill be incurred regardless of which product is selected

sales salariesidentical for both products

market studysunk.

EBP expects to sell 10 000 Standard units (40 000 units 25%) or 8000 Enhanced units (40 000 units 20%). On
the basis of this sales forecast, the company would be advised to select the Standard model.
Standard

Enhanced

$2 370 000

$2 400 000

195 000

300 000

$2 175 000

$2 100 000

Total contribution margin:

10 000 units $237; 8000 units $300
Less: Marketing and advertising
Profit

The quantitative difference between the profitability of Standard and Enhanced is relatively small, which may
prompt the firm to look at other factors before a final decision is made. These factors include:

competitive products in the marketplace

data validity

growth potential of the Standard and Enhanced models

production feasibility

effects, if any, on existing product sales

break-even points.