MAACT Test 2 Relevant Costs and Benefits for Decision Making

Sunk Cost

A cost that has already been committed and cannot be recovered A cost that has already been incurred and that cannot be changed by any decision made now or in the future. A cost that has been paid or must be paid, regardless of any future action being considered

What is opportunity cost?

Any benefit foregone as a result of rejecting one opportunity in favor of another opportunity is described as an opportunity cost of the accepted alternative. Example: if you earn a salary of $40,000 per year and you have the opportunity to continue to work or to go back to school - the cost of getting the dgree includes not only all the outlay costs for tuition, books, and so forth, it also includes the salary foregone (or opportunity cost) of $40,000 per year. So, if your tution and other outlay costs are going to be $25,000 per year for two years, the cost of earning the degree will be $50,000 of outlay costs and $80,000 of opportunity costs, for a total cost of earning the degree of $130,000. **Opportunity costs are always relevant in maiing decisions among competing alternatives.

Outlay Costs

Any concrete costs that can be identified in the past, present or future. Explicit payment: past, present, or future cash outflow include direct variable costs of the product and any additional costs incurred because of the transfer opportunity cost (giving up opportunity to do job

Short Term Planning

Estimate working capital needs using AR policy, AP policy, inventory levels & cash levels

Relevant Costs

Future costs that will change as a result of a decision Costs that differ depending on your course of action

For a specific decision, the key to relevant cost analysis is first to identify the relevant costs (and revenues) and then to organize them in a manner that clearly indicates how they differ under each alternative. Consider the following: Assume: One of its components used in wireless heasets is forecasted to sell 10,000 units during the coming year at a price of $20 per unit. Further assume that each of Beats' components is manufactured with seperate machines in a shared plant. The machine used in the manufacture of headset components is two years onld and has a remaining useful life of four years. Its purchase price was $90,000 (new), estimated salvage value of zero dollars at the end of its useful life, book value (original cost less accumulated depreciation) is $60,000, but it could be sold today for only $35,000. A new machine costs $80,000, useful life of four years, $0 dollars at end of useful life, operating costs are lower, production is faster, maintenance is lower, although the new machine has the same production capacity as the old machine. In this example, are revenues relevant?

In this example revenues are not relevant because they are identical under each alternative. The key phrase is, "capacity is the same" therefore output is the same, and supply is the same. They would be relevant if the new machine had greater capacity or if management intended to change the selling price should it acquire the new machine. (The $35,000 disposal value of the old machine is an inflow. However, revenues refer to resources from the sale of goods and services to customers in the normal course of business. We include the sale of the old machine under disposal and salvage values.) i.e. the sale of the machine would be relevant, but not a relevant (receivable) revenue, it would be relevant under disposal and salvage values.

What are disposal and salvage values?

Relevance of Disposal and Salvage Values: The gains on a sale of a piece of equipment is relevant, but is not a relevant revenue: The sale of fixed assets is a source of resources. Because the sale of fixed assets is a nonoperating item, cash inflows obtained from these sales are discussed seperately. So, The disposal value of the old machine is a relevant cash inflow. It is obtained only if the replacement alternative is selected. Any salvage value available at the end of the useful life of either machine is also relevant. **A loss on disposal can have a favorable tax impact if the loss can be offset against taxable gains or taxable income. (tax implications discussed in chapter 12)

What are future revenues and outlay costs?

Relevance of future revenues: Revenues, which are inflows of resources from the sale of goods and services, are relevant to a decision only if they differ between alternatives. Relevance of Outlay Costs: Outlay costs are costs that require future expenditures of cash or other resources. Outlay costs that differ under the decision alternatives are relevant; outlay costs that do not differ are irrelevant. Assume Beat's relevant and irrelevant outlay costs for the equipment replacement decision follow. Where Relevant reveue represents inflows, Relevant Outlay Costs are all costs that represent outflow (and of course differ between alternatives)

What is the difference between relevant and irrelevant costs?

Relevant costs: future costs that differ among competing decision alternatives Irrelavant costs: do not differ among cometing decision alternatives i.e. sameness

What are sunk costs?

Sunk costs result from past decisions that cannot be changed. Suppose we pruchased a car for $15,000 four years. Today we must decide whether to purchase another car or have major maintenance performed on our current car. In making this decision, the purchase price of our current car is a sunk cost i.e. the decision has already been made, money paid, and we can't change it. *Although the relevance of outlay costs is determined by the decision scenario, sunk costs are never relevant.

Irrelevant costs

costs that do not affect a decision costs which do not differ between alternatives-or-Sunk Costs:costs to be incurred int he past which cannot be changed Cost that is not relevant because it will not change depending on a manager's decision.

Cost Reduction Proposal

managerial decision based on the assumption that the organization is committed to an activity and that management desires to minimize the cost of activities.

Salvage Value (aka disposal value)

the estimated value of a fixed asset at the end of its useful life In computing depreciation for tax purposes, the reasonably anticipated fair market value of the property at the end of its useful life and must be considered with all but the declining balance methods of depreciation. The expected market value of an asset at the end of its useful life

Disposal Value (aka salvage value)

the estimated value of a plant asset at its replacement time; also called salvage value the net amount realized after subtracting the costs of getting rid of an asset from its selling price **Amount of cash an old asset can be sold for at the time the new asset is purchased

Opportunity costs

the most desirable alternative given up as the result of a decision cost of the next best alternative use of money, time, or resources when one choice is made rather than another ***Opportunity costs can and should be estimated in any decision where they are a factor. For instance, in a make-or-buy decision, if the facilities to make an item could be used in the production of an alternative item, the contribution to income from the alternative item (the item that is foregone to use the facilities to make the first item) is an opportunity cost, if the first item is made.