Short-Run Decision Making:

Relevant Costing

Practical applications to Relevant Costing:

To take the jeep or take the taxi when going to school.
To buy the required textbook or rent/borrow it from the
senior students.
To buy lunch from Kolks Nook or Jollibee.
To study or cheat for the exam.
To go to Ayala or stay at home during the weekend.
To buy a gown or rent the gown for the JS Prom next year.

What is your choice?

What is relevant cost analysis?

Relevant cost analysis is also known as differential
analysis or incremental analysis.
Relevant costing is the use of cost and revenue data
in making short-run decisions. It consists of
choosing among alternatives with an immediate or
limited end in view.
Although relevant costing decisions are short run in
nature, they often have long-run consequences,
and although they are often small scale actions,
they often serve a larger purposes.

What are relevant costs?

Relevant costs
They are future costs and they differ across
alternatives. They are frequently (but not always)
variable costs called flexible resources.
The two bolded and underlined conditions MUST
BE MET in order for a cost to qualify as a relevant
cost.

Decision making model/process:

A decision making model is a formal method of making a choice,
often involving both quantitative and qualitative analysis. It details
specific set of procedures that can be used to structure the
decision makers thinking and organize information to make good
decisions.
Steps in the decision making process:
Recognize, define, and clarify the problem.
Identify a decision criteria.
Identify alternatives as possible solutions to the problem and eliminate
alternatives that clearly are not feasible.
Identify the costs and benefits associated with each feasible alternative.
Classify costs and benefits as relevant or irrelevant, and eliminate
irrelevant ones from consideration.
Estimate the relevant costs and benefits for each alternative.
Assess qualitative factors.
Make the decision by selecting the alternative with the greatest overall
net benefit.

Quantitative versus Qualitative

Analysis
Quantitative
Factors in a decision problem that is expressed in
numerical terms.

Qualitative
Factors in a decision problem that cannot be
expressed effectively in numerical terms.

Usefulness of information is
determined by its:
Relevance
Information is pertinent to a decision problem.
Relevant information is different under competing courses
of action, it relates to the future, provides a balance
between accuracy and timeliness, and may consist of both
quantitative and qualitative information.

Accuracy
Information is reasonably precise.

Timeliness
Information is available in time for a decision to be made.

Interrelationship between budgeting

and relevant costing
Recall: Budgeting involves the acquisition and
allocation of scarce resources over a specified time
period.
In relevant costing, two or more alternatives are
presented and are evaluated quantitatively and
qualitatively. The alternative that presents the
highest return or least cost is chosen. Relevant
costing strives to allocate resources in the best way
possible to increase profitability of the company,
and ultimately, to increase shareholder value.

Relevant Costs versus Irrelevant Costs

Relevant costs are future costs that differ among
alternatives while irrelevant costs are costs that do
not differ among alternatives and/or costs that
already occurred in the past.
Importance of identifying relevant information:
By focusing on only the relevant information, the
managerial accountant can simplify and shorten the
data-gathering process.
By routinely providing only relevant information, the
managerial accountant can reduce the possibility of
information overload.

Relevant Costs versus Irrelevant Costs

What costs are relevant?

Differential costs
Incremental costs
Opportunity costs
Avoidable costs
Out of pocket costs

What costs are irrelevant?

Sunk costs
Committed costs
Non-cash costs
Unavoidable costs
Future costs that do not differ between alternatives.

Identifying if costs are relevant or not:

Darlene is trying to decide whether it would be less expensive to drive or take the bus
to Santander. By car, it is 230 kilometers to her friends apartment. Her car costs
P2,400,000 and is expected to have a 5 year remaining life with a P1,000,000 salvage
value. The straight line method of depreciation is used. Price of gas per gallon is P160
and her car can run 32 kilometers per gallon of gas. Annual cost of auto insurance and
license is P138,000. Maintenance and repairs costs P6.50 per kilometer. The parking
fee at school is fixed at P4,500 a month. Darlene attends school only 8 months out of
the year.
The reduction in resale value of car when the car is used is P2.60 per kilometer.
Round-trip bus ticket fare is P10,400. The parking fee in Santander is estimated to be
P2,500 per day, and she plans to stay in Santander for two days. The cost of putting
Darlenes dog in the kennel during her absence is P4,000. Furthermore, Darlene
believes that if she takes the bus rather than drive her car, she would have the benefit
of relaxing. If she drives her car, it would give her more convenience, although there is
also the hassle of parking her car in Santander. (base this on 10k miles driven/ year).

Requirement 1: Identify the relevant costs of the two alternatives.

Requirement 2: Determine which decision should Darlene take?

Approaches in Relevant Cost Analysis

Total Cost Approach
All costs and benefits are included in the
computation to identify which alternative is the
best.

Incremental Cost Approach

Only the costs and benefits that differ between
alternatives are included in the computation to
identify which alternative is the best.

Exercise on the Approaches in Relevant

Cost Analysis
Digital Musical Instruments
Income Statement for 2012
Sales
Less: variable expenses
Variable mfg. costs
Variable shipping costs
Commissions
Contribution margin
Less: fixed expenses
General factory overhead
Salary of line manager
Depreciation of equipment
Advertising - direct
Rent - factory space
General admin. expenses
Net loss

1,000,000
240,000
10,000
150,000

120,000
180,000
100,000
200,000
140,000
60,000

400,000
600,000

800,000
(200,000)

General Factory Overhead and General Administrative Expenses are unavoidable costs.
Assume that the equipment used in manufacturing digital instruments has no resale value or
alternative use.

Exercise on the Approaches in Relevant

Cost Analysis
Required:
Illustrate relevant cost analysis using the Total Cost
Approach
Illustrate relevant cost analysis using the Incremental
Cost Approach

Relevant Cost Decisions:

Make or buy? (Outsourcing)
Adding a product line or segment? (Adoption of new
products)
Keeping or dropping a product line or segment?
(Discontinuance of products)
Lease or operate?
Sell as is or process further?
Shutdown or continue operations?
Accept or reject a special order?
Equipment replacement decisions.
Utilization of scarce resources (Optimizing product mix)
Financing versus investing decisions.

MAKE OR BUY

Make or Buy (Outsourcing)

What is it?
It is a choice between producing a product internally/using inhouse service versus sourcing the product or service from an
outside supplier.

When does this decision issue arise?

If the firm has the capability to produce its own
products/services (vertical integration) and it wants to decide
whether it is more cost effective to producing a product or
service or to outsource it from an outside supplier.

What is the decision rule/guideline?

Compare internal production costs and opportunity costs to
external purchase costs. Choose the alternative with the lowest
relevant (incremental) cost.

Make or Buy (Outsourcing)

Common relevant information in a make or buy decision:

Variable manufacturing costs that will be saved

Fixed manufacturing costs that can be eliminated
Purchase price
Opportunity costs

Other important factors to consider:

Is the quality of the manufactured component superior to the
quality of the purchased component?
Will there be timeliness in the part of the supplier if one decides
to buy or outsource the needed materials/parts?
Will purchasing the component result in more timely availability
of the component?
Would a relationship with the potential supplier benefit the
company in any way?
Are there any worker productivity issues that affect this decision?

Make or Buy Sample Problem 1

Granger Inc. purchased boards from an outside supplier at the cost of P100
each. The company uses 50,000 units of boards a year. Management requests
that an analysis be made to determine the profitability of producing the
boards internally.
The raw materials required to manufacture each board cost P15 per board. To
process the raw materials includes a direct labor cost of P20 per board. The
company would also have to lease a board press costing P2,000,000 for a fouryear lease. Presently, there is adequate space in to manufacture 20,000
boards per year.
If the company were to produce all of its boards internally, it would be
necessary to cease its manufacture of its other products and to purchase these
outside, resulting in an additional P2,500,000 cost. Also, a machine used to
create its other products costing P800,000 with a P400,000 book value would
have to be scrapped without a salvage value.
Required: Should Granger buy all 50k boards inside, 20k boards inside and
30k boards outside, or buy all 50k boards outside?

Make or Buy Sample Problem 2

Tremolo Inc. is considering whether to continue to make a component or to buy it
from an outside supplier. The company uses 17,000 of the components each year. The
unit product cost of the component according to the company's cost accounting
system is given as follows:
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
Unit product cost

P 8.20
8.30
1.20
4.30
P22.00

Assume that direct labor is a variable cost. Of the fixed manufacturing overhead, 70%
is avoidable if the component were bought from the outside supplier. In addition,
making the component uses 2 minutes on the machine that is the company's current
constraint. If the component were bought, this machine time would be freed up for
use on another product that requires 4 minutes on the constraining machine and that
has a contribution margin of P7.00 per unit.
When deciding whether to make or buy the component, what are the relevant costs to
make the component

Make or Buy Sample Problem 3

Best Corp is working at full capacity producing 10,000 units of
Product XYZ. Manufacturing costs per unit for XYZ follow:
Direct material
P 2
Direct manufacturing labor
3
Manufacturing overhead
5
P 10
The unit manufacturing overhead cost is based on a variable cost per
unit of P2 and fixed costs of P30,000 (at full capacity of 10,000 units).
The non-manufacturing costs, all variable, are P4 per unit, and the
selling price is P20 per unit. A customer, Hue Inc. has asked Best to
produce 2,000 units of a modification of XYZ to be called ABC. ABC
would require the same manufacturing processes as XYZ and Hue has
offered to share equally the non-manufacturing costs with Best. ABC
will sell at P15 per unit.

Make or Buy Sample Problem 3

Required:
a. Assume that no overtime is worked, what is the
opportunity cost to Best of producing the 2,000 units
of ABC?
b. A supplier, Jonny Co. has offered to produce 2,000
units of XYZ for Best, so Best can accept Hues offer.
Jonny would charge Best P14 per unit for the XYZ.
Should Best accept the offer of Jonny?
c. Suppose Best had been working at less than full
capacity producing 8,000 units of XYZ at the time the
ABC offer was made. What is the minimum price Best
should accept for ABC under these conditions
(ignoring the P15 price mentioned previously)?

ADDING A
PRODUCT
LINE OR
SEGMENT

Adding a Product Line or Segment

What is it?
It is a choice of whether the company should include
another product line or segment in its business
operations.

When does this decision issue arise?

When the company feels that it is ready to expand its
operations.

What is the decision rule/guideline?

Choose the alternative that gives you the highest
profitability.

Adding a Product Line or Segment

Common relevant information in adding a product line or
segment:
Externalities
Additional fixed costs incurred
Impact of additional contribution margin

Other important factors to be considered:

Will the new product line or segment cannibalize the sales of existing
product lines or segments of the company?
If existing workers are transferred from their present position to the
new position that serves customers of the new product line or segment,
will there be any productivity issues? Do they have the requisite skills?
Will the firm have enough equipment/materials needed to produce the
new product?
If there are resource constraints and the number of existing products
decline due to the constraints, how will the customers of existing
products react?

Adding a Product Line or Segment Sample

Problem
Shure Inc.s contribution margin statement is shown below:
Sales (20,000 units x P500)
Variable cost
Contribution margin
Fixed cost
Operating income

P
P
P

10,000,000
(3,000,000)
7,000,000
(2,000,000)
5,000,000

The company is contemplating on adding another segment which will

result to a contribution margin of P500,000. Moreover, the company
foresees that adding another segment will not result to any
additional incurrence of fixed cost. However, the new segment is
expected to detrimentally affect the number of units sold of existing
products by 5%. If you were Shure, would you add the new
segment? Why or why not?

KEEPING OR DROPPING A
PRODUCT LINE OR
SEGMENT

Keeping or Dropping a Product Line or

Segment

What is it?

It is a choice of whether it is more profitable to keep a

product line or segment (that usually results in an operating
loss) or to drop that product line or segment.

When does this decision issue arise?

When a product line or segment is deemed unprofitable to
the company as a whole, the company may want to consider
dropping that product line or segment.

What is the decision rule/guideline?

Keep, if Lost CM > Fixed cost savings or avoidable fixed costs.
Drop, if Lost CM < Fixed costs savings or avoidable fixed
costs.

Keeping or Dropping a Product Line or

Segment
Common relevant information in keeping or dropping a
product line or segment:
Variable costs that drive the contribution, if any, produced by the
segment.
Contribution margin produced by the segment
Disposition of the segments fixed expenses.

Other important factors to be considered:

What will be the effect on the customers of a particular segment if
it is eliminated? What is the effect on the companys reputation?
What will be the effect on the employees of a segment if it is
eliminated? Can any of them be reassigned to other divisions?
What will be the effect on the community where a particular
segment is located if the decision is made to drop that segment
What will be the effect on the morale of the employees of the
remaining divisions?

Keeping or Dropping a Product Line or

Segment Sample Problem 1
ABC Company produces three versions of baseball bats: wood, aluminum, and hard
rubber. A condensed segmented income statement for a recent period follows:
Wood
Sales
P500,000
Variable expenses 325,000
Contrib. margin
P175,000
Fixed expenses
75,000
Net income (loss) P100,000

Aluminum
P200,000
140,000
P 60,000
35,000
P 25,000

Hard Rubber
P 65,000
58,000
P 7,000
22,000
P (15,000)

Total
P765,000
523,000
P242,000
132,000
P110,000

Requirement 1: Assume that none of the fixed expenses for the hard rubber are
avoidable. What will be the total net income if the line is dropped? What should be
ABCs decision?
Requirement 2: Assume that all of the fixed expenses for the hard rubber line are
avoidable. What will be the total net income if that line is dropped? What should be
ABCs decision?
Requirement 3: If the total net income after dropping the hard rubber line is P105,000,
what is the amount of avoidable fixed expenses for hard rubber line?

Keeping or Dropping a Product Line or

Segment Sample Problem 2
Parity Company has three product lines in its retail stores: books, videos, and
music. The allocated fixed costs are based on units sold and are unavoidable.
Demand of individual products is not affected by changes in other product
lines. Results of the fourth quarter are presented below:
Books
Music
Videos
Total
Units sold
1,000
2,000
2,000
5,000
Revenue
P24,000 P48,000
P32,000
P104,000
Variable departmental costs
15,000
22,000
23,000
60,000
Direct fixed costs
P 3,000 P 6,000
P 4,000
P 13,000
Allocated fixed costs
4,400
8,800
8,800
22,000
Net income (loss)
P 1,600 P11,200
P(3,800)
P 9,000
Requirement 1: Should Parity drop the Video product line? Why or why not?
Requirement 2: If 40% of fixed costs are avoidable, should Parity drop the
Video product line? Why or why not?

LEASE OR OPERATE

Lease or Operate
What is it?
Decisions may either be in the point of view of the lessee or the lessor.
Point of view of lessee: Decisions that need to be made when a firm is
deciding on whether to lease equipment or to operate its own
equipment in pursuance of organizational goals.
Point of view of lessor: Decisions that need to be made when a firm is
deciding what to do with its equipment whether it will sell the
equipment or let the equipment be leased.

When does this decision issue arise?

When a company is into manufacturing and the cost of the equipment
is considerable.

What is the decision rule/guideline?

Identify the costs for leasing and operating and choose the alternative
that will give you the highest returns or the lowest costs.

Lease or Operate
Common relevant information in the decision to lease
or operate:
Lease payments.
Foreseeable repairs and maintenance expenses.
Opportunity costs.

Other important factors to be considered:

Are there any terms that the lessor and lessee have agreed
upon as to who will shoulder the repairs and maintenance
cost of the machine?
Do the current employees know how to operate the leased
equipment?
Are there any worker productivity issues that will affect this
decision?

Lease or Operate [Lessor] Sample Problem

1
Vina Inc. has bought a new machine and is deciding
what to do with the old one. The cost of the old
machine was originally P60,000 and has been
depreciated P45,000. The company has received
two offers that it must consider. One offer was
made to purchase the machine outright for P18,500
less a 5% sales commission. The other offer was to
lease the machine for P7,000 for the next five years
but the company will be required to provide
maintenance and insurance totaling P3,000 per
year. What offer should Vina accept?

Lease or Operate [Lessor] Sample Problem

2
Homia Inc. owns a building but uses only half of the
building and is considering two options. First option is
that Yasui would purchase the half of the building that is
not being used for P550,000. A 7% commission would
have to be paid at the time of purchase. The second
option is that Chongbeng would lease the half of the
building for the next 5 years at P100,000 each year.
Homia would have to continue paying P9,000 of property
taxes each year and P1,000 of yearly insurance on the
property, according to the proposed lease agreement.
Requirement 1: Determine the differential income or loss
from each of the options.
Requirement 2: Which option must Homia take?

Lease or Operate [Lessee] Sample Problem

Mike Osmea Inc. is expanding, and is looking for suitable
office space for its operations. It is evaluating between two
proposals.
It can buy the property directly for P25 million, and must
pay a 7% commission to its broker. The company estimates
that the building accounts for 70% of the property value.
It can lease the property for ten years, paying P3 million in
rent. Although the title remains with the landlord, the
lease contract stipulates that Mike is responsible for
maintenance and association dues amounting to P150,000
per year.
What should the company do? Its policy is to depreciate
buildings using the straight line method over 10 years, and
has a 30% income tax rate.

SELL AS IS

OR
PROCESS
FURTHER

Sell as is or process further

What is it?
Decisions regarding joint products that need to be made
when a firm is deciding on whether to sell products at a
given point in the production cycle or continuing to
process with the expectation of selling them at a later
point at a higher price.

When does this decision issue arise?

When a company has joint products and it is able to sell
these either in their rawer form or in their processed form.

What is the decision rule/guideline?

Process further, if Incremental Revenue after split-off point
> Incremental Cost after split-off point
Sell as is, if Incremental Revenue after split-off point <
Incremental Cost after split-off point

Sell as is or process further

Joint
Input

Joint
Costs

Oil

Common
Production
Process

Gasoline

Chemicals

Split-Off
Point

Separate
Processing

Final
Sale

Final
Sale

Separate
Processing

Separate
Product
Costs

Final
Sale

Sell as is or process further

Common relevant information in the decision to sell as
is or process further:
Incremental processing costs.

Other important factors to be considered:

Is there a good demand for joint products that are processed
further? If not, is it still profitable for the firm to sell the
joint products as is?
Do the employees have the knowhow to continue processing
the joint products?
Does the firm have the necessary equipment to process the
joint products?
Can the firm procure enough materials needed to process
the joint product further?

Sell as is or process further sample

problem 1
Hudson Inc. sells unfinished wood planks at a price of
P15.00 per wood plank. The current profit margin is
P5.00 per wood plank. The company is considering
taking individual orders and customizing them for
sale. To finish the wood planks, the company would
have to pay (per plank) additional labor of P3.00,
additional materials costing an average of P4.00, and
fixed costs would increase by P1,500. The company
estimates that it can sell 600 finished planks for P25
each month. Should Hudson sell the planks as is or
should it process the planks further? Why?

Sell as is or process further sample

problem 2
RD Company manufactures three chemicals (AB, CD, and EF) from a
joint process. The three chemicals are in industrial grade form at the
split-off point. They can either be sold at that point or processed
further into premium grade. Costs related to each batch of this
chemical process is as follows:

Sales value at split-off point

Allocated joint costs
Sales value after further proc.
Cost of further processing

AB
P16,000
P6,000
P20,000
P5,000

CD
P12,000
P6,000
P18,000
P3,000

EF
P5,000
P6,000
P9,000
P2,000

For which product(s) above would it be more profitable for RD to sell

at the split-off point rather than process further?

SHUT DOWN OR
CONTINUE OPERATIONS

Shutdown or continue operations

What is it?
Choice a company makes if it is essential for a firm to
shut down temporarily or to continue operations.

When does this decision issue arise?

When a firm is highly seasonal/cyclical and is expected
to experience cyclical lows during foreseeable periods.

What is the decision rule/guideline?

Continue operations, if sales > shut down point.
Shut down temporarily, if sales < shut down point.
*shut down point = (fixed costs shut down costs) / unit
contribution margin.

Shutdown or continue operations

Relevant information in the decision to shutdown or
continue operations:
Avoidable fixed costs.
Shutdown costs.

Other important factors to be considered:

Will the decision to shut down operations temporarily affect
employee morale?
Will the valuable employees seek employment elsewhere
while the firm is shut down temporarily?
Will shutting down operations temporarily send a negative
signal to the firms customers, and will it adversely affect the
sales of the firm even during supposedly profitable
periods?

Shutdown or continue operations sample

problem
XYZ Corporation had been experiencing a slowdown in business activities in March, April, and
May, and is considering temporarily shutting down its operations during those months. The
accounting department has provided the following normal operating data for considerations:
Unit Sales Price
Unit Variable Production Costs
Unit Variable Marketing Costs

P200
P80
P20

Monthly fixed OH
Monthly fixed Expenses
Regular Sales in Units

P800,000
P500,000
20,000/month

Estimated Sales in units during off peak months 5,000/month

If the company shuts down its operations, the following costs are expected to be incurred:
Security and Safety P400,000/month
Regular Fixed OH
40% of total is avoidable
Re-start up costs
P250,000/set-up
Regular Fixed Expenses will be reduced by 60%
Requirement 1: How much is the total shutdown cost?
Requirement 2: What is the shutdown point in three months?
Requirement 3: Should the company shut down or continue operations?

ACCEPT OR REJECT A
SPECIAL ORDER

Accept or reject a special order

What is it?
A choice a company makes whether it should
accommodate a one-time special order that is usually
discounted or at lower price.

When does this decision issue arise?

When a company receives an order (usually at a
special price) that is not considered part of the
companys normal ongoing business.

What is the decision rule/guideline?

Accept, if incremental revenue > incremental cost.
Reject, if incremental revenue < incremental cost.

Accept or reject a special order

Relevant information in the decision to accept or reject a special
order:
Expected additional revenues from the special order.
Expected additional costs from the special order.

Other important factors to be considered:

Will the customer expect the same selling price per unit on future orders?
Will other regular customers be upset if they discover the lower selling price to
one of their competitors?
Will employee productivity change with the increase in production?
Given the increase in production, will the incremental costs remain as
predicted for this special order?
Are materials available from its supplier to meet the increase in production?
What is the effect on the companys reputation of leaving orders from regular
customers unfilled, just to fill the special order?
Will any of the projected costs change if the company operates at 100%
capacity?
Are there any methods to increase capacity? What effects do these methods
have on employees and on the community?

Accept or reject a special order sample

problem 1
Beulah Inc. incurs costs of P28 per unit (P18 variable
and P10 fixed) to make a product that normally sells
for P42. A customer approaches Beulah and offers to
buy 5,000 units at P25 each. Beulah will incur
additional shipping costs of P1 per unit. Assuming
that Beulah has excess operating capacity, should
Beulah accept the special order?

Accept or reject a special order sample

problem 2
Simba Company, when operating at full capacity, can produce one million units a year.
The per unit and total costs for a unit when the company operates at full capacity are
as follows:
Per Unit(in pesos)
Total (in pesos)
Direct materials
2.00
2,000,000
Direct labor
0.75
750,000
Variable manufacturing overhead
1.00
1,000,000
Fixed manufacturing overhead
1.50
1,500,000
Variable selling expenses
0.25
250,000
Total
5.50
5,500,000
Nala Company expressed interest in purchasing 250,000 units. It offers to pay the unit
cost for direct materials, direct labor, and variable manufacturing overhead costs. In
addition, Nala has agreed to pay an additional P1 per unit to cover all other costs and
provide a profit . Presently, Simba is operating at 70% capacity and does not have any
other potential buyers of its products. If Simba accepts Nalas offer, it will not incur
any variable selling expenses related to this order.
Should Simba accept Nalas offer? Why or why not?

EQUIPMENT
REPLACEMENT DECISIONS

Equipment replacement decision

What is it?
A choice a company makes when deciding if it is more
beneficial for the company as a whole to keep using its
existing equipment or would it be more beneficial to replace
its equipment.

When does this decision issue arise?

When a companys equipment is either not working at
optimal level or is becoming obsolete.

What is the decision rule/guideline?

Choose the alternative (to replace the old equipment or to
keep the old equipment) that will give you the highest
returns or the lowest costs.

Equipment replacement decision

Relevant information in the decision to keep or replace the
old equipment:
Effects on variable costs.
Cost of the new equipment.
Any disposal value of the existing equipment.

Other important factors to be considered:

If the company decides to use its existing equipment, is there a
risk that the equipment will fail? Are contingency plans put in
place in case the existing equipment fails?
If the company decides to replace the equipment, do the current
employees know how to operate the new equipment?
Are there any worker productivity issues that will affect this
decision?

Equipment replacement decision

sample problem 1
Sonny Inc. is considering disposing of a machine
with a book value of P22,500 and an estimated
remaining life of three years. The old machine can
be sold for P6,250. A new machine with a purchase
price of P68,750 is being considered as a
replacement. It will have a useful life of three years
and no residual value. It is estimated that variable
manufacturing costs will be reduced from P43,750
to P20,000 if the new machine is purchased. What
is the net differential increase or decrease in cost
for the entire three years for the new equipment?

Equipment replacement decision

sample problem 2
Taylor Inc. wants to replace an old machine with a new, more efficient
machine.
New machine:
List price
Annual variable expenses
Expected life in years
Old machine:
Original cost
Remaining book value
Disposal value now
Annual variable expenses
Remaining life in years

90,000
80,000
5 years

72,000
60,000
15,000
100,000
5 years

Taylors sales are P200,000 per year. Fixed expenses (other than amortization)
are P70,000 per year. Should Taylor purchase the new machine?

UTILIZATION OF SCARCE
RESOURCES

Utilization of scarce resources

(Optimizing product mix)
What is it?
A decision in which a manufacturing firm needs to
determine which product must be prioritized. It
answers the question Which product(s) should be
emphasized when capacity is limited?

When does this decision issue arise?

When resources are scarce, when capacity is limited,
and when the company manufactures two or more
products.

What is the decision rule/guideline?

Prioritize the product which has the highest
contribution margin per unit of constrained resource.

Utilization of scarce resources

(Optimizing product mix)
Relevant information in the decision to determine how
to utilize scarce resources and optimize product mix:
Constrained resource or bottleneck.
Contribution margin.

Other important factors to be considered:

Are there any fluctuations in demand that may force the
firm to change the unit selling price and change
contribution margin per unit of constrained resource?
Will customers of products that are not prioritized be
upset if the company does not produce enough of that
product to satisfy demand due to constrained resources?

Utilization of scarce resources (Optimizing

product mix) sample problem
Browning Company makes four products in a single facility. These products have the following
unit product costs (in pesos)
Product A
Product B
Product C
Product D
Direct materials
10.60
7.90
6.10
3.80
Direct labor
11.40
16.80
8.70
11.40
Variable MOH
3.70
4.10
5.40
6.10
Fixed MOH
24.60
34.40
21.50
19.30
Unit product cost
50.30
63.20
41.70
40.60
Additional data concerning these products are listed below.

Grinding minutes/unit
Selling price/unit
Variable selling cost/unit
Monthly demand in units

Prod. A
2.60
P69.50
P 1.60
4,000

Prod. B
1.80
P74.80
P 1.50
2,000

Prod. C
2.50
P59.50
P 2.60
3,000

Prod. D
1.40
P59.60
P 3.40
4,000

The grinding machines are potentially the constraint in the production facility. A total of 24,500
minutes are available per month on these machines. Direct labor is a variable cost in this
company.

Utilization of scarce resources (Optimizing

product mix) sample problem
Requirement 1: How many minutes of grinding time
would be required to satisfy demand for all four
products?
Requirement 2: Which product makes the least profitable
use of the grinding machines?
Requirement 3: Which product makes the most profitable
use of the grinding machines?
Requirement 4: Up to how much should the company be
willing to pay for one additional minute of grinding
machine time if the company has made the best use of
the existing grinding machine capacity?

FINANCING VS.
INVESTING DECISIONS

Financing vs. investing decision (A review)

What is it?
Investing: The determination of how to best allocate capital
to maximize their value.
Financing: The determination of how to pay for investments
and expenses. Eg: How much funding is needed (AFN), and a
choice a company makes on how it should raise money.

When does this decision issue arise?

When a company is wants to maximize its value.

What is the decision rule/guideline?

Choose the alternative which will maximize shareholder
wealth or minimize cost of capital (WACC)

Financing vs. investing decision (A review)

Investing
Deals with how to spend money on assets that will gain the most
value. Companies would want to spend money on assets that
potentially gives the highest return for the company. There must
be a balance between short-term and long-term goals.
3 main criteria:
It must maximize the value of the firm after considering the amount of risk.
It must be financed appropriately.
If there is no appropriate investment opportunity, cash must be returned to
shareholders to maximize shareholder value.

Financing
Deals with how to acquire money, and the most common ways to
do this is to use the companys own money (retained earnings) or
by raising money externally (debt, issuing stocks)

Financing vs. investing decision (A review)

Relevant information in financing decisions:
Amount of financing needed.
WACC (and all the needed information to derive it)

Other important factors to be considered:

Will the decision made send any signal (positive or
negative) to the existing/potential shareholders?
Will the decision result to dilution of shares?
Are there any debt covenants that would preclude
the company from incurring additional debt?

Investing decision sample problem

(Computation of expected returns A review)
You have gathered information about two stocks, one
of which you are intending to invest in.
State of economy
Recession
Slowdown
Average
Upturn
Boom

Probability
15%
25%
20%
25%
15%

Y Returns
20%
10%
8%
14%
20%

Which stock should you invest in?

Z Returns
24%
15%
6%
1%
5%

Financing decision sample problem

(Financing Mix A review)
Suppose, the risk-free rate for Vista Inc. is 6%, as is the market
risk premium. The unlevered beta of the firm is 1.0. If the firm
borrows P0, P250,000; P500,000; P750,000; P1,000,000, their
corresponding cost of debt would be 0%, 8%, 9%, 11.5%, and
14.0%, respectively; and assume that the firm needs to finance
P2,000,000.
Further assume that EBIT is P400,000, par value is P25 per
share, and that there should have been 80,000 shares
outstanding if the firm uses 100% new equity financing. All
earnings are given out as dividends, and the firm experiences
zero growth. Tax rate is 40%.

How should the Vista finance its needed funds of P2,000,000?

Nothing Follows