CHAPTER TWO

Relevant Information and Decision Making

Decision making is the process of selecting among alternative courses of action. Managers
usually follow a decision model for choosing among different courses of action. A decision
model is a formal method of making a choice that often involves both quantitative and
qualitative analyses. Management accountants analyze and present relevant data to guide
managers’ decisions. The formal decision model involves five major steps. These are: identifying
the Problem and uncertainties; Obtain information regarding to different alternatives; Make
predictions about the future; Make decisions by choosing among alternatives and implement the
decision, evaluate performance, and learn.

Regardless of whether decisions are significant or routine, most people follow a simple, logical
process when making them. This process involves gathering information, making predictions,
making a choice, acting on the choice, and evaluating results. It also includes deciding what costs
and benefits each choice affords. Some costs are irrelevant. This chapter will explain which costs
and benefits are relevant and which are not—and how you should think of them when choosing
among alternatives.

2.1. The concept of relevance

While managers chose among alternative courses of action for a specific problem, they are using
relevant information. Only those projected costs and benefits that differ in total between
alternatives are relevant in a decision. If the total amount of a cost will be the same regardless of
the alternative selected, then the decision has no effect on the cost, so the cost can be ignored.
Much of this chapter focuses on the concepts of relevant costs and relevant revenues when
choosing among alternatives.

Relevant costs are expected future costs, and relevant revenues are expected future revenues
that differ among the alternative courses of action being considered. Revenues and costs that are
not relevant are said to be irrelevant. It is important to recognize that to be relevant costs and
relevant revenues they must:
- Occur in the future—every decision deals with selecting a course of action based on its
expected future results. Past costs are also called sunk costs because they are
unavoidable and cannot be changed no matter what action is taken. Hence, past costs are
called irrelevant for decision making. In other word, since sunk costs are already spent
(sunk), they are never used in future decision making.
- Differ among the alternative courses of action—costs and revenues that do not differ
will not matter and, hence, will have no bearing on the decision being made.
Key features of relevant information:
 Past (historical) costs may be helpful as a basis for making predictions. However, past
costs themselves are always irrelevant when making decisions.

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  Different alternatives can be compared by examining differences in expected total future
revenues and expected total future costs.
 Not all expected future revenues and expected future costs are relevant. Expected future
revenues and expected future costs that do not differ among alternatives are irrelevant
and, hence, can be eliminated from the analysis. The key question is always, “What
difference will an action make?”
 Appropriate weight must be given to qualitative factors and quantitative nonfinancial
factors.
 Managers should avoid two potential problems in relevant-cost analysis. First, they must
watch for incorrect general assumptions, such as all variable costs are relevant and all
fixed costs are irrelevant. Second, unit-cost data can potentially mislead decision makers
in two ways: When irrelevant costs are included and when the same unit costs are used at
different output levels. The best way for managers to avoid these two potential problems
is to keep focusing on (1) total revenues and total costs (rather than unit revenue and unit
cost) and (2) the relevance concept. Managers should always require all items included in
an analysis to be expected total future revenues and expected total future costs that differ
among the alternatives.
2.2. Qualitative and quantitative relevant information
Managers divide the outcomes of decisions into two broad categories: quantitative and
qualitative.
Quantitative factors: are outcomes that are measured in numerical terms. Some quantitative
factors are financial; they can be expressed in monetary terms. Examples include the cost of
direct materials, direct manufacturing labor, and marketing. Other quantitative factors are non-
financial; they can be measured numerically, but they are not expressed in monetary terms.
Reduction in new product-development time and the percentage of on-time flight arrivals are
examples of quantitative non-financial factors.
Qualitative factors: are outcomes that are difficult to measure accurately in numerical terms.
Relevant qualitative information has the same characteristics as relevant financial information.
The qualitative effect occurs in the future and it differs between alternatives. Employee morale is
an example.

Relevant-cost analysis generally emphasizes quantitative factors that can be expressed in

financial terms. But just because qualitative factors and quantitative non-financial factors cannot
be measured easily in financial terms does not make them unimportant. In fact, managers must
wisely weigh these factors. Managers who ignore qualitative factors can make serious mistakes.

Illustration:
Consider a strategic decision facing management at Precision Sporting Goods, a manufacturer of
different sport materials: Should it reorganize its manufacturing operations to reduce
manufacturing labor costs? Precision Sporting Goods has only two alternatives: Do not
reorganize or reorganize. Reorganization will eliminate all manual handling of materials.

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Current manufacturing labor consists of 20 workers—15 workers operate machines, and 5
workers handle materials. The 5 materials-handling workers have been hired on contracts that
permit layoffs without additional payments. Each worker works 2,000 hours annually. ”The
financial data underlying the choice between the do-not reorganize and reorganize alternatives
for Precision Sporting Goods are as follows:
All Revenues and Costs Relevant Revenues and Costs

Alternative 1 (do not Alternative 2 Alternative 1 (do Alternative 2

reorganize) (reorganize) not reorganize) (reorganize)

Revenues Birr 6,250,000 (birr 250 * Birr 6,250,000 (birr 250 - -

2,500 units) * 2,500 units)

Costs:
- Direct materials 1,250,000 1,250,000 - -
- Manufacturing labor 640,000 480,000 640,000 480,000
- MOH 750,000 750,000 - -
- Marketing 2,000,000 2,000,000 - -
- Reorganization costs - 90,000 - 90,000
- Total costs 4,640,000 4,570,000 640,000 570,000

Operating income Birr 1,610,000 Birr 1,680,000 Birr (640,000) Birr (570,000)

Difference Birr 70,000 Birr 70,000

There are two ways to analyze the data. The first considers “All revenues and costs,” while the
second considers only “Relevant revenues and costs. The analysis in the above table indicates
that reorganizing the manufacturing operations will increase predicted operating income by birr
70,000 each year. Note that the managers at Precision Sporting Goods reach the same conclusion
whether they use all data or include only relevant data in the analysis.

2.3. Relevant information and Making Short-Term Special Decisions

Our approach to making short-term special decisions is called the relevant information
approach, or the incremental analysis approach. Instead of looking at the company’s entire
income statement under each decision alternative, we will just look at how operating income
would differ under each alternative. Using this approach, we will leave out irrelevant information
—the costs and revenues that will not differ between alternatives. We will consider five kinds of
short-term special decisions in this chapter such as decisions to make or buy a component, to
keep or drop a segment or product line, to accept a special order at less than the usual price, and
to process a joint product further or sell it at the split-off point, and other several decisions.

Note: The two keys to making short term decisions are:

- To focus on relevant revenues, costs, and profits, and

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 - To use a contribution margin approach to separate variable and fixed costs. Because fixed
costs and variable costs behave differently, they must be analyzed separately. Traditional
(absorption costing) income statements, which blend fixed and variable costs together,
can mislead managers. Contribution margin income statements, which isolate costs by
behavior (variable or fixed), help managers gather the cost-behavior information they
need. Keep in mind that unit manufacturing costs are mixed costs, too, so they can also
mislead managers. If you use unit manufacturing costs in your analysis, be sure to first
separate the unit cost into its fixed and variable portions.
2.3.1. Accept or reject a one-time special order decision

A special order occurs when a customer requests a one-time order at a reduced sale price. Before
agreeing to the special deal, first, managers must consider available manufacturing capacity. If
the company is already using all its existing manufacturing capacity and selling all units made at
its regular sales price, it would not be profitable to fill a special order at a reduced sales price.
Therefore, available excess capacity is a necessity for accepting a special order. This is true for
service firms as well as manufacturers.

Second, managers need to consider whether the special reduced sales price is high enough to
cover the incremental costs of filling the special order. The special price must be greater than the
variable costs of filling the order or the company will lose money on the deal. In other words, the
special order must provide a positive contribution margin.

Next, the company must consider fixed costs. If the company has excess capacity, fixed costs
probably will not be affected by producing more units (or delivering more service). However, in
some cases, management may have to incur some other fixed cost to fill the special order, such
as additional insurance premiums. If so, they will need to consider whether the special sales price
is high enough to generate a positive contribution margin and cover the additional fixed costs.

Finally, managers need to consider whether the special order will affect regular sales in the long
run. Will regular customers find out about the special order and demand a lower price? Will the
special order customer come back again and again, asking for the same reduced price? Will the
special order price start a price war with competitors? Managers should determine the answers to
these questions and consider how customers will respond. Managers may decide that any profit
from the special sales order is not worth these risks.

Illustration: MC Alexander Company makes tennis balls. It can produce up to 2,500,000 cans of
balls per year. Current production is 2,000,000 cans. The total annual manufacturing, selling, and
administrative fixed costs are $700,000. The variable cost of making and selling each can of
balls is $1.00. Stockholders expect a 12% annual return on the company’s $3,000,000 of assets.
Assume MC Alexander is a price-taker, and the current market price is $1.45 per can of balls.

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Nike has just asked MC Alexander to supply the company with 400,000 cans of balls at a special
order price of $1.20 per can. Nike wants MC Alexander to package the balls under the Nike
label (MC Alexander will imprint the Nike logo on each ball and can). MC Alexander will have
to spend $10,000 to change the packaging machinery. Assuming the original volume and costs,
should MC Alexander accept this special order? (Unlike the chapter problem, assume MC
Alexander will incur variable selling costs as well as variable manufacturing costs related to this
order.)

Solution:
Step1: compare the practical capacity level (i.e. 2,500,000 cans of tennis balls per year) with the
actual production (i.e. 2,000,000 cans of tennis per year). The company has excess production
capacity of producing 500,000 cans of tennis balls per year. Hence, the company can fill the
special order from Nike (i.e. 400,000 cans of tennis balls) with in its practical capacity of without
affecting its long term strategic decisions. Nike’s special order price ($1.20) is less than the
current full cost of each can of balls $1.35 (VC per unit (1.00) + FC per unit (0.35)). However,
this should not influence management’s decision. MC Alexander could fill Nike’s special order
using existing excess capacity.
Step 2: compare the extra revenue from the special order with the incremental cost to fill the
special order. MC Alexander takes an incremental analysis approach to its decision, comparing
the extra revenue with the incremental costs of accepting the order. Variable costs will increase if
MC Alexander accepts the order, so the variable costs are relevant. Only the additional fixed
costs of changing the packaging machine ($10,000) are relevant since all other fixed costs will
remain unchanged.

Revenue from special order (400,000 * $1.20 per unit) .......... $ 480,000
Less: Variable cost of special order (400,000 * $1.00).............. 400,000
Contribution margin from special order..................................... $ 80,000
Less: Additional fixed costs of special order............................... 10,000
Operating income provided by special order ............................ $ 70,000

Decision: MC Alexander should accept the special order because it will increase operating
income by $70,000. However, MC Alexander also needs to consider whether its regular
customers will find out about the special price and demand lower prices too.

2.3.2. Insourcing (make) Versus Outsourcing (buy) decision

Outsourcing is purchasing goods and services from outside vendors rather than producing the
same goods or providing the same services within the organization, which is in sourcing. For
example, Kodak prefers to manufacture its own film (in sourcing) but has IBM do its data
processing (outsourcing). Honda relies on outside vendors to supply some component parts but

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chooses to manufacture other parts internally. Decisions about whether a producer of goods or
services will in-source or outsource are also called make-or-buy decisions.

Managers are often faced with the decision of whether to make or buy components used in
manufacturing. Indeed, management periodically should evaluate past decisions concerning
production. Conditions upon which prior decisions were based may have changed, and as a
result, a different approach may be required. Periodic evaluations, of course, are not the only
source of these make-or-buy decisions.

In order to outsource the company’s variable costs should be greater than the outsourcing cost.
The manager should look in to fixed costs that can be avoidable if the company outsource and
see what the company could do with the freed manufacturing capacity. If the incremental costs of
making exceed the incremental costs of outsourcing, make Outsourcing decision.

Illustration:
Shelly’s Shades produces standard sunglasses having different types of shades/lenses: the selling
price per pair is $20 and the variable cost per pair is $16. The company has 15,000 machine
hours available. In one machine hour, Shelly’s can produce 70 pairs of the standard model.
Shelly’s incurs the following costs for 20,000 of its hiking Shades/lenses:
Direct materials....................................................... $ 20,000
Direct labor................................................................ 80,000
Variable manufacturing overhead............................. 40,000
Fixed manufacturing overhead (direct) ..................... 80,000
Total manufacturing cost......................................... $220,000
Cost per pair ($220,000/20,000)................................. $ 11

Another manufacturer has offered to sell similar shades to Shelly’s for $10, a total purchase cost
of $200,000. If Shelly’s outsources and leaves its plant idle, it can save $50,000 of fixed
overhead cost. Or, it can use the freed manufacturing facilities to make other products that will
contribute $70,000 to profits. In this case, the company will not be able to avoid any fixed costs.
Identify and analyze the alternatives. What is the best course of action?
In-source shades Outsource (Buy) Shades

Make Shades Facilities Idle Make Other Products

Relevant costs:
- Direct materials $ 20,000 - -
- Direct labor 80,000 - -
- Variable overhead 40,000 - -
- Fixed overhead 80,000 $ 30,000 (80,000 – 50,000) $ 80,000
- Purchase cost (20,000 * $10) - 200,000 200,000
Total cost of obtaining shades 220,000 230,000 280,000

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 Profit from other products - - (70,000)
Net cost of obtaining shades $220,000 $230,000 $210,000
Decision: Shelly’s should buy the hiking shades from the outside supplier and use the freed
manufacturing facilities to make other products.

2.3.3. Keep or drop service, product or department decision

Often, a manager needs to determine whether or not a segment, such as a product line, should be
kept or dropped. Segmented reports prepared on a variable-costing basis provide valuable
information for these keep-or-drop decisions. Both the segment’s contribution margin and its
segment margin are useful in evaluating the performance of segments. However, while
segmented reports provide useful information for keep-or-drop decisions, relevant costing
describes how the information should be used to arrive at a decision.

Before deciding to keep or drop a product managers should analyze first, whether the product
provide positive contribution margin. If the product has a negative contribution margin, then
the product is not even covering its variable costs. Therefore, the company should drop the
product. However, if the product has a positive contribution margin, then it is helping to cover
some of the company’s fixed costs. Secondly, in addition to its contribution margin the manager
should see some fixed cost that would continue and direct fixed costs that can be avoided if the
company drops the product. Then, what would the company do with the freed capacity. Finally,
the manager should see the impact of dropping a product on sales of the company’s other
products. The relevant financial data are still the changes in revenues and expenses. But now we
are considering a decrease in volume rather than an increase, as we did in the special sales order
decision.

Illustration:
Assume ANBESA Shoe Factory currently produces and sells two types of shoe: Standard shoe
and First class shoe. The company’s contribution margin income statement by product, assuming
fixed costs are shared by both products is shown below. Because the First class shoe line has an
operating loss of birr 520, management is considering dropping the product.
ANBESA Shoe Factory
Income Statement
For the Month Ended March 31, 2013

Products

Standard shoe(10,000 First class shoe

Total
shoes) (1000 shoes)

Sales revenue Birr 6,700,000 Birr 6,000,000 Birr 700,000

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 Variable expenses:
- Manufacturing 4,860,000 4,400,000 460,000
- Marketing and administrative 2,020 2,000 20
- Total variable expenses 4,862,020 4,402,000 460,020
Contribution margin Birr 1,837,980 Birr 1,598,000 Birr 239,980
Fixed expenses:
- Manufacturing (839,500) 600,000 239,500
- Marketing and administrative (31,000) 30,000 1000
- Total fixed expenses 870,500 630,000 240,500

Operating income (loss) Birr 967,480 Birr 968,000 (Birr520)

Step 1: Consideration of contribution margin: In ANBESA’s case, the First class shoe provide a
positive contribution margin of birr 239,980. Positive contribution margin then is helping to
cover some of the company’s fixed costs. Therefore, ANBESA’s managers now need to consider
fixed costs under the following two assumptions.
Step 2:
Assumption 1: the fixed costs continue to exist even if the product is dropped.
Fixed costs that will continue to exist even after a product is dropped are often called
unavoidable fixed costs. Unavoidable fixed costs are irrelevant to the decision because they will
not change if the company drops the product. Let’s assume that all of ANBESA’s fixed costs of
birr 870,500 will continue to exist even if the company drops the First class shoe. Assume that
ANBESA makes the First class shoe in the same plant using the same machinery as the Standard
shoe. Thus, only the contribution margin the First class shoe s provide is relevant. If ANBESA
drops the First class shoe, it will lose the birr 239,980 contribution margin.

Expected decrease in revenues (1000 females’ shoe * birr 700.00) ………….. Birr (700,000)
Expected decrease in variable costs (birr 460,000 + birr 20) ………………………. 460,020
Expected decrease in operating income …………………………………………... birr (239,980)

Decision: This analysis suggests that management should not drop First class shoe. It is actually
more beneficial for ANBESA to lose birr 520 than to drop the First class shoe and lose birr
239,980 in operating income.

Assumption 2: Direct fixed costs of the First class shoe that can be avoided if the product is
dropped. Assume that birr 240,500 of the fixed costs will be avoidable if ANBESA drops the
First class shoe product. Then, birr 240,500 is avoidable fixed cost and is relevant to the decision
because it would change (go away) if the product is dropped.

Expected decrease in revenues (1000 females’ shoe * birr 700.00) ………….. Birr (700,000)
Expected decrease in variable costs (birr 460,000 + birr 20)………. 460,020
Expected decrease in fixed costs………………..………………….. 240,500
Expected decrease in total expenses………………………..……………………… 700,520

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Expected increase in operating income …………………………………………… birr 520

Decision: This analysis suggests that management should drop First class shoe to have the rise in
operating income by birr 520.

Note: The key to deciding whether to drop products, departments, or territories is to compare the
lost revenue against the costs that can be saved and to consider what would be done with the
freed capacity.

2.3.4. Product mix decision under capacity constraints

We now examine how the concept of relevance applies to product-mix decisions—the decisions
made by a company about which products to sell and in what quantities. These decisions usually
have only a short-run focus, because they typically arise in the context of capacity constraints
that can be relaxed in the long run. Companies do not have unlimited resources. Constraints that
restrict production or sale of a product vary from company to company.

To determine product mix, a company maximizes operating income, subject to constraints such
as capacity and demand. Throughout this section, we assume that as short run changes in
product mix occur, the only costs that change are costs that are variable with respect to the
number of units produced (and sold). Under this assumption, the analysis of individual product
contribution margins provides insight into the product mix that maximizes operating income.
Before determining its product mix a manager should answer the following questions: What
constraint(s) stop(s) the company from making (or displaying) all the units the company can
sell? Which products offer the highest contribution margin per unit of the constraint? Would
emphasizing one product over another affect fixed costs?

Illustration:
Assume ANBESA Shoe Factory in the previous example can sell all the Standard shoes and all
the First class shoes it produces, but it only has 2,000 machine hours of manufacturing capacity.
The company uses the same machines to make both types of shoes. In this case, a machine hour
is the constraint. Note that this is a short-term decision because in the long run, ANBESA could
expand its production facilities to meet sales demand if it made financial sense to do so. Assume
that ANBESA can produce either 16Standard shoes or 10 First class shoes per machine hour.
The company will incur the same fixed costs either way so fixed costs are irrelevant. Which
product should it emphasize?

Standard shoe First class shoe

Sale price per shoe Birr 600 Birr 700

Variable cost per shoe 440.20 460.02

Contribution margin per unit 159.80 239.98

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 Contribution margin ratio:
- Males’ shoe birr 159.8/birr 600 27%
- Females’ shoe birr 239.98/birr390 34%

Solution:
Because machine hour is the constraint, ANBESA needs to figure out which product has the
highest contribution margin per machine hour.
Standard shoe First class shoe

(1) shoes that can be produced each machine hour 16 10

(2) Contribution margin per shoe Birr 159.80 Birr 239.98

Contribution margin per machine hour (1) * (2) Birr 2,556.8 Birr 2,399.80

Available capacity—number of machine hours 2,000 2,000

Total contribution margin at full capacity Birr 5,113,600 Birr 4,799,600

To maximize profit, ANBESA should make 32,000 Standard shoe (2,000 machine hours * 16
males’ shoe per hour) and zero First class shoe. Why should ANBESA make zero First class
shoe? Because for every machine hour spent making First class shoe, ANBESA would give up
birr 157 of contribution margin (birr 2,556.8 per hour for Standard shoe versus birr 2,399.80 per
hour for First class shoe). We made two assumptions here: (1) ANBESA sales of other products
will not be hurt by this decision and (2) ANBESA can sell as many Standard shoes as it can
produce. Let’s challenge these assumptions. First, how could making only Standard shoe hurt
sales of other products? By producing the First class shoe, the factory also sells many of its
standard offerings like the Standard shoe that coordinate with the First class shoe. Other shoe
sales might fall if the factory no longer offers First class shoe.

Let’s challenge our second assumption. Suppose that a new competitor has decreased the
demand for ANBESA’s Standard shoe. Now the company can only sell 24,000 Standard shoes.
ANBESA should only make as many Standard shoes as it can sell and use the remaining
machine hours to produce First class shoe. How will this constraint in sales demand change
profitability?

Recall from the above table, ANBESA will make birr 5,113,600 of contribution margin by using
all 2,000 machine hours to produce Standard shoe. However, if ANBESA only makes 24,000
Standard shoes, it will only use 1,500 machine hours (24,000 standard shoes ÷ 16standard shoes
per machine hour). That leaves 500 machine hours available for making First class shoe.

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 Standard shoe First class shoe Total

(1) shoes that can be produced each machine hour 16 10

(2) Contribution margin per shoe from the table Birr 159.80 Birr 239.98
above

Contribution margin per machine hour (1) * (2) Birr 2,556.8 Birr 2,399.80

Machine hours devoted to product 1,500 500

Total contribution margin at full capacity Birr 3,835,200 Birr 1,199,900 Birr 5,035,100

Because of the change in product mix, ANBESA’s total contribution margin will fall from Birr
5,113,600 to Birr 5,035,100, a birr 78,500 decrease. ANBESA had to give up birr 157 of
contribution margin per machine hour (birr 2,556.8 – birr 2,399.80) on the 500 hours it spent
producing First class shoe rather than Standard shoe. However, ANBESA had no choice—the
company would have incurred an actual loss from producing Standard shoe that it could not sell.
If ANBESA had produced 32,000 Standard shoe but only sold 24,000, the company would have
spent birr 3,521,600 to make the unsold shoes (8,000 Standard shoes * birr 440.20 variable cost
per Standard shoe), yet received no sales revenue from them.

2.3.5. Sell or process further decision

Joint products have common processes and costs of production up to a split-off point. At that
point, they become distinguishable. For example, certain minerals such as copper and gold may
both be found in a given ore. The ore must be mined, crushed, and treated before the copper and
gold are separated. The point of separation is called the split-off point. The costs of mining,
crushing, and treatment are common to both products. Often, joint products are sold at the split-
off point. Sometimes, it is more profitable to process a joint product further, beyond the split-off
point, prior to selling it.

Determining whether to sell or process further is an important decision that a manager must
make. When a company is considering selling a product as is or processing it further, if the extra
revenue (revenue –separable costs) from processing the product further exceeds the revenue from
the sale of the product without further processing, then the company should process the product
further.

Illustration:

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Suppose Addis Mojo oil Factory spent birr 1,000,000 to process vegetable into 50,000 gallons
of standard oil. After processing vegetable into standard oil, should Addis Mojo sell the standard
oil as is or should it spend more to process the standard oil in to fine grade oil? In making the
decision, Addis Mojo’s managers consider the following relevant information: The company
could sell fine grade oil for birr 100 per gallon, for a total of birr 5,000,000 (50,000 * birr 100).
Addis Mojo could sell regular standard oil for birr 95 per gallon, for a total of birr 4,750,000
(50,000 * birr 95). Addis Mojo would have to spend birr 3.75 per gallon, or birr 187,500 (50,000
gallons * birr 3.75), to further process standard oil into fine grade oil.

Solution:
Notice that Addis Mojo’s managers do not consider the birr 1,000,000 spent on processing
vegetable into standard oil. Why? It is a sunk cost. Addis Mojo has incurred birr 1,00,000—
regardless of whether it sells the standard oil as is or processes it further into fine grade oil.
Therefore, the cost is not relevant to the decision.
Sell as is Process Difference
further

Expected revenue from selling 50,000 gallons of standard oil at Birr 4,750,000
birr 95 per gallon

Expected revenue from selling 50,000 fine grade oil at birr 100 Birr 5,000,000 Birr 250,000
per gallon

Additional costs of birr 3.75 per gallon to convert 50,000 gallons (187,500) (187,500)
of regular gasoline into fine grade oil

Total net revenue Birr 4,750,000 Birr 4,812,500 Birr 62,500

Decision: Managers see that they can increase profit by birr 62,500 if they convert the standard
oil into fine grade oil. The birr 250,000 extra revenue (birr 5,000,000 – birr 4,750,000)
outweighs the incremental birr 187,500 cost of the extra processing.
2.4. Irrelevance of past cost and equipment replacement cost
At several points in this chapter, when discussing the concept of relevance, we reasoned that past
(historical or sunk) costs are irrelevant to decision making. That’s because a decision cannot
change something that has already happened. We now apply this concept to decisions about
replacing equipment. We stress the idea that book value= original cost minus accumulated
depreciation—of existing equipment is a past cost that is irrelevant.

Illustration:
Kaliti Metal works Factory, a manufacturer of different types of metals, is considering replacing
a metal-cutting machine with a newer model. The new machine is more efficient than the old
machine, but it has a shorter life. Revenues from sale of different types of metals (birr 2 million
per year) will be unaffected by the replacement decision. Here are the data the management
accountant prepares for the existing (old) machine and the replacement (new) machine:
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 Old Machine New Machine

Original cost Birr 1,000,000 Birr 600,000

Useful life 5 years 2 years

Current age 3 years 0 years

Remaining useful life 2 years 2 years

Accumulated depreciation Birr 600,000 Not acquired yet

Book value Birr 400,000 Not acquired yet

Current disposal value (in cash) Birr 40,000 Not acquired yet

Terminal disposal value (in cash 2 years from now) Birr 0 Birr 0

Annual operating costs (maintenance, energy, repairs, coolants, and so on) Birr 800,000 Birr 460,000

Kaliti Metal works Factory uses straight-line depreciation. To focus on relevance, we ignore the
time value of money and income taxes.
Required: Should Kaliti replace its old machine?

Solution:
1. Book value of old machine, birr 400,000 is irrelevant, because it is a past or sunk cost. All
past costs are “down the drain.” Nothing can change what has already been spent or what has
already happened.
2. Current disposal value of old machine, birr 40,000. Relevant, because it is an expected
future benefit that will only occur if the machine is replaced.
3. Loss on disposal, birr 360,000. This is the difference between book value and current
disposal value (400,000 – 40,000). It is a meaningless combination blurring the distinction
between the irrelevant book value and the relevant disposal value. Each should be considered
separately, as was done in items 1 and 2.
4. Cost of new machine, birr 600,000. Relevant, because it is an expected future cost that will
only occur if the machine is purchased.
Two Years Together

Keep (1) Replace (2) Difference (3) = (1) – (2)

Revenues Birr 4,000,000 Birr 4,000,000 -

Operating costs:

- Cash operating costs (birr 800,000/yr * 1,600,000

2 yrs), (birr 460,000/yr * 2 yrs)

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 920,000 680,000

- Book value of old machine

- Periodic write-off as depreciation or 400,000 -
- Lump-sum write-off - 400,000 -

Current disposal value of old - (40,000) 40,000

machine

- New machine cost, written off - 600,000

periodically as depreciation (600,000)

- Total operating cost 2,000,000 1,880,000 120,000

- Operating income 2,000,000 2,120,000 (120,000)

Decision: to get higher operating income as a result of lower costs of birr 120,000 by replacing
the machine—is obtained even though the book value is omitted from the calculations. Hence,
the company should replace its machine.

14 | P a g e