© 2007 Pearson Education Canada Slide 9-1

Relevant Informationand Decision Making:Production Decisions

9

© 2007 Pearson Education Canada Slide 9-2

Opportunity Costs

Opportunity Cost• The maximum available contribution to profit

foregone by using limited resources for a particular purpose

• Not a cost in the normal sense of the word

• Consider the choice between staying with your current job or returning to school; if you quit your job to return to school the wages which you would have earned had you stayed in the job are an opportunity cost of returning to school

© 2007 Pearson Education Canada Slide 9-3

Differential Costs

Differential Analysis• Differences in revenues and costs between two

alternatives

• Also called incremental analysis

Remain Open AnAs An Independent

Employee Practice Difference

Revenues $60,000 $200,000 $140,000Outlay costs 0 120,000 120,000

Income effect per year $60,000 $80,000 $ 20,000

© 2007 Pearson Education Canada Slide 9-4

Make or Buy Decision

• decision to manufacture the product or subcontract to an independent supplier (outsource)

Make Buy

Relevant costs:

Direct material $20,000

Direct labour 80,000

Variable overhead 40,000

Fixed overhead 20,000

Cost to buy $200,000

Total cost $160,000 $200,000

© 2007 Pearson Education Canada Slide 9-5

Joint and Separable Costs in Joint Production Processes

Split-Off Point• Point in manufacturing process where products separate

Joint Product Cost• A cost incurred in a production process prior to the split-off point

which cannot be identified with specific intermediate or final products except in an arbitrary manner

Separable Cost• A cost which related to a specific product (cost objective)

ChemicalX

$90,000

SeparableProcessing Cost

$40,000

ChemicalY

$30,000

ChemicalYA

$80,000

JointCost

$100,000

Split-OffPoint

© 2007 Pearson Education Canada Slide 9-6

Sell or Process Further Decision

• decision, in a joint production process, to sell product at the split-off point or process further

Sell @ Split Process Further

Relevant revenue: $30,000 $80,000

Relevant costs:

Cost to processbeyond split-off point 40,000

Total cost $30,000 $40,000

© 2007 Pearson Education Canada Slide 9-7

Irrelevance of Past Costs

• Need to irrelevant costs

• Past cost are typically irrelevant e.g. obsolete inventory, book value of old equipment

• Also known as “sunk” costs

© 2007 Pearson Education Canada Slide 9-8

Conflicts Between Decision Making and Performance Evaluation

• To motivate employees to make optimal decisions, methods of performance evaluation should be consistent with decision making

• Sometimes there is a conflict between decision making analysis and the method used to evaluate performance

• Organizations need to protect against this to avoid dysfunctional decision making

© 2007 Pearson Education Canada Slide 9-9

Irrelevance of Future Costs?

• Some future costs may be irrelevant because they are the same under all feasible alternatives

• They may be safely ignored for the purposes of making a particular decision

• Example: salaries of top management