Managerial accounting

Are variable costs always relevant? Explain.

A variable cost may or may not be relevant. The fact that a cost is variable has no bearing on its relevance. For instance, the cost of direct labor is usually considered a variable cost in the decision as to how many products to produce. But labor costs in another decision context may be irrelevant. For instance, in a decision as to which of two products to produce when labor cost is the same for both, the cost of labor becomes irrelevant (it is now unavoidable). Also, variable costs that are historical in nature would not be relevant.

What is an opportunity cost? How does it differ from a sunk cost?

An opportunity cost is the sacrifice of some benefit (revenues, cost savings) that is given up by not choosing an alternative. Opportunity costs are relevant in decisions where the acceptance of one alternative precludes the possibility of accepting other alternatives. Since opportunity costs are future oriented, they are avoidable and relevant for decision making even though the costs are not recorded in accounting records. Sunk costs are costs that have been previously recorded in financial accounting records. They are historical in nature and therefore unavoidable and not relevant for decision making.

Identify some of the constraints that limit a business's ability to satisfy the demand for its products or services.

Constraints are caused by resources that are limited. Examples of these business resources include: labor hours, material quantities, shelf space, warehouse space, machine capacity, and machine hours.

Identify the four hierarchical levels used to classify costs. When can each of these levels of costs be avoided?

Costs can be classified into the following levels: (1) Unit-level costs - Costs that are incurred each time a company makes a product or performs a service. These costs can be avoided by eliminating the production of a single unit of product or service. (2) Batch-level costs - Costs related to the production of more than one product or performance of more than one service that are organized into batches and completed at the same time. Batch-level costs are eliminated when the batch of work is eliminated. When a batch is eliminated, unit-level costs associated with the units in a batch are also eliminated. (3) Product-level costs - Costs that are incurred to support specific kinds of products or services. Product-level costs are eliminated when the product line is discontinued. (4) Facility-level costs - Costs that are incurred on behalf of the entire business. These costs are usually totally eliminated when the business is dissolved, or they can be partially eliminated when a segment of the business that is in a separate facility is eliminated.

Chris Sutter, the production manager of Satellite Computers, insists that the drives used in the company's upper-end computers be outsourced since they can be purchased from a supplier at a lower cost per unit than the company is presently incurring to produce the drives. Jane Meyers, assistant, insists that if sales growth continues at the current levels, the corbpany will be able to produce the drives in the near future at a lower cost because of the company's predominately fixed cost structure. Does Ms. Meyers have a legitimate argument? Explain.

If the fixed costs that Ms. Meyers is referring to are avoidable fixed costs, increases in production volume would result in decreases in the avoidable cost per unit to produce the drives. If volume increases enough to reduce the production cost per unit below the cost to outsource, Ms. Meyers' point is valid.

Describe the relationship between relevance and accuracy.

Information does not have to be entirely accurate to be relevant for decision making. Knowing that a future cost can be avoided makes the cost relevant even if the exact amount is unknown. Relevance is the predominant characteristic. Precision only enhances relevance. Irrelevant data, no matter how precise, is useless to decision making.

Identify the primary qualities of revenues and costs that are relevant for decision making.

Information that is relevant for decision making differs between the alternatives and is future oriented.

Why would a company consider outsourcing products or services?

It may be possible for a company to purchase a product or service at a price below what it would cost to make the product or provide the service. This could result from differences in wage rates, economies of scale, technological competence and specialization between companies.

Identify two qualitative considerations that could be associated with special order decisions.

Numerous qualitative characteristics could apply to special order decisions. Two specific considerations are: (1) the effects on regular customers who may learn that they are paying higher prices than those charged on the special order and (2) the capacity effects on profitability. When idle capacity no longer exists, special order customers must be rejected or profitability will suffer. Capacity should not be used to produce special orders that are usually sold at lower prices unless there is idle capacity. The fact that rejection may lead to hard feelings that affect the business' reputation is also a consideration.

Identify some qualitative factors that should be considered in addition to quantitative costs in deciding whether to outsource.

Qualitative factors that should be considered include: (1) the availability of reliable suppliers that can comply with quality standards and delivery schedules, (2) the possibility of low-ball pricing where the supplier accepts a low price for the outsourced product until the manufacturer becomes dependent and then the supplier raises the price, (3) the internal effects such as employee displacement and the possibility of morale problems with remaining employees which can affect productivity, and (4) the difficulty of reestablishing production capacity if the supplier relationship does not work out.

Why would a supervisor choose to continue using a more costly old machine instead of replacing it with a less costly new machine?

Replacing the old machine could result in lower operating income in the first year of the replacement if the old machine is sold at a loss. The loss would affect profitability and may occur when the manager is under significant pressure to maximize profits. The financial benefits of the new machine will not appear in operating reports until the second year of its use, too late for the supervisor that needs immediate results. Under these conditions, the supervisor may sacrifice long-run profitability for short-run rewards.

Are all fixed costs unavoidable?

Some fixed costs are avoidable. For example advertising costs may be fixed regardless of the volume of activity. However, they may be curtailed or eliminated at management's discretion. Whether a cost is avoidable or not is context sensitive to the decision under consideration

Which of the following would not be relevant to a make-or-buy decision? (a) Allocated portion of depreciation expense on existing facilities. (b) Variable cost of labor used to produce products currently purchased from suppliers. (c) Warehousing costs for inventory of completed products (inventory levels will be constant regardless of whether products are purchased or produced). (d) Cost of materials used to produce the items currently purchased from suppliers. (e) Property taxes on the factory building.

The allocated depreciation, warehousing costs, and property taxes will be the same regardless of whether products are produced or purchased. Accordingly, these items would not be relevant to a make-or-buy decision.

A local bank advertises that it offers a free noninterest-bearing checking account if the depositor maintains a $500 minimum balance in the account. Is the checking account truly free?

The checking account is not truly free. There is an opportunity cost associated with the account. For example, by leaving a $500 minimum balance in a checking account, the depositor is giving up the opportunity to earn the interest that would accrue if the funds were placed in a savings account.

"It all comes down to the bottom line. The numbers never lie." Do you agree with this conclusion? Explain your position.

The conclusion is invalid because it fails to consider the importance of qualitative data. Factors such as company reputation, employee morale, and customer satisfaction are not quantifiable, but are crucial to the survival of most businesses.

A manager is faced with deciding whether to replace Machine A or Machine B. The original cost of machine A was $20,000 and that of Machine B was $30,000. Because the two cost figures differ, they are relevant to the manager's decision. Do you agree? Explain your position.

The original costs of the two machines represent sunk costs and should not be considered in the decision regarding which machine to replace. Differential costs are relevant when they apply to future considerations.

Carmon Company invested $300,000 in the equity securitiès of Mann Corporation. The current market value of Carmon's investment in Mann is $250,000. Carmon currently needs funds for operating purposes. Although interest rates are high, Carmon's president has decided to borrow the needed funds instead of selling the investment in Mann. He explains that his company cannot afford to take a $50,000 loss on the Mann stock. Evaluate the president's decision based on this information.

The president appears to be overlooking the concept of a sunk cost. His company has already incurred a $50,000 loss. The fact that it has not recognized the loss does not mean that the loss has not been incurred. The loss in market value cannot be avoided by borrowing the money for operating activities. The loss (sunk cost) is not relevant and should not be considered. What is important to the decision is whether Carmon today would invest $250,000 by purchasing Mann Stock or would the funds be better invested in operating activities? If the answer is to invest in operating activities, then Carmon should sell the Mann stock instead of borrowing the funds.

What level(s) of costs is (are) relevant in special order decisions?

The relevant costs are the additional costs that will be incurred as a result of accepting the special order. These are the unit-level costs such as materials, labor, and overhead associated with the special order and the batch-level costs that are necessary to fill the special order batch.

What two factors should be considered in deciding how to allocate shelf space in a retail establishment?

The two factors that should be considered in allocating shelf space are per unit contribution margin and turnover.

The managers of Wilcox Inc. are suggesting that the company president eliminate one of the company's segments that is operating at a loss. Why may this be a hasty decision?

While it may appear from the segment's reports that it is operating at a loss, this is not necessarily the case. When a segment is eliminated, some of the costs assigned to that segment may still continue. Some of the facility-level costs that have been arbitrarily allocated to the segment may still be incurred after the segment is eliminated. Therefore, these costs should not be considered in an elimination decision. Only the costs that can be avoided by the elimination of the segment are relevant to the decision. If the revenue generated by the segment exceeds avoidable costs, the segment is contributing to the overall profitability of the company and should not be eliminated.