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Fundamental Managerial Accounting ConceptsThomas P. Edmonds

Bor-Yi Tsay

Philip R. Olds

Copyright © Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/IrwinMcGraw-Hill/Irwin

Fifth Edition

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CHAPTER 5

Relevant Information for Special Decisions

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Learning Objective

LO1LO1

Identify the characteristics of

relevant information.

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Relevant Information

Two primary characteristics distinguish Two primary characteristics distinguish relevant from useless information:relevant from useless information:

1.1. Relevant information Relevant information differs differs among the among the alternatives under consideration.alternatives under consideration.

2.2. Relevant information is Relevant information is future future oriented.oriented.

Two primary characteristics distinguish Two primary characteristics distinguish relevant from useless information:relevant from useless information:

1.1. Relevant information Relevant information differs differs among the among the alternatives under consideration.alternatives under consideration.

2.2. Relevant information is Relevant information is future future oriented.oriented.

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Sunk CostA sunk cost has been incurred in a past transaction and cannot be changed. It is

not relevant for making current decisions.

I wish I hadn’t bought that I wish I hadn’t bought that stock. Cost me $25,000, stock. Cost me $25,000, and now it’s worth only and now it’s worth only $15,000. I really need a $15,000. I really need a car but don’t have the car but don’t have the

cash!cash!

I wish I hadn’t bought that I wish I hadn’t bought that stock. Cost me $25,000, stock. Cost me $25,000, and now it’s worth only and now it’s worth only $15,000. I really need a $15,000. I really need a car but don’t have the car but don’t have the

cash!cash!

Just sell the stock Just sell the stock and buy the car!and buy the car!Just sell the stock Just sell the stock and buy the car!and buy the car!

You’ve already taken You’ve already taken the loss. The $25,000 the loss. The $25,000 is a sunk cost. Like I is a sunk cost. Like I

said, sell the stock and said, sell the stock and buy the car you need.buy the car you need.

You’ve already taken You’ve already taken the loss. The $25,000 the loss. The $25,000 is a sunk cost. Like I is a sunk cost. Like I

said, sell the stock and said, sell the stock and buy the car you need.buy the car you need.

I don’t want to take I don’t want to take the loss!the loss!

I don’t want to take I don’t want to take the loss!the loss!

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Opportunity CostsAn opportunity cost is the sacrifice that is incurred in order to obtain an alternative

opportunity.

I think I am I think I am beginning to see beginning to see what you mean.what you mean.

I think I am I think I am beginning to see beginning to see what you mean.what you mean.

The opportunity cost The opportunity cost of owning the stock is of owning the stock is $15,000. That is the $15,000. That is the amount you could amount you could

receive if you decide receive if you decide to sell.to sell.

The opportunity cost The opportunity cost of owning the stock is of owning the stock is $15,000. That is the $15,000. That is the amount you could amount you could

receive if you decide receive if you decide to sell.to sell.

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Relevance is an Independent Concept

Management at Better Bakery Products is debating whether to add a new product, either cakes or pies, to the company’s product line.

Projected costs are shown:Materials (per unit) 1.50$ Materials (per unit) 2.00$ Direct labor (per unit) 1.00 Direct labor (per unit) 1.00 Supervisor's salary 25,000.00 Supervisor's salary 25,000.00 Franchise fee 50,000.00 Advertising 40,000.00

Cost of Cakes Cost of Pies

Under either alternative, a new production supervisor must be hired at a cost of $25,000 per

year. Cakes are distributed under a nationally advertised label. Pies are marketed under the

company’s own name and will require new advertising.

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Relevance is an Independent Concept

Which costs are relevant?

Materials (per unit) 1.50$ Materials (per unit) 2.00$ Direct labor (per unit) 1.00 Direct labor (per unit) 1.00 Supervisor's salary 25,000.00 Supervisor's salary 25,000.00 Franchise fee 50,000.00 Advertising 40,000.00

Cost of Cakes Cost of Pies

Material costs are relevant because they differ. Fifty cents can be avoided by choosing cakes

instead of pies. Labor costs and the supervisor’s salary are not relevant because they do not

differ. The advertising costs can be avoided if the company elects to make cakes. The franchise fee can be avoided if the company elects to

make pies. Whether a cost is fixed or variable has no bearing on its relevance.

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Relevance is Context-Sensitive

A particular cost that is relevant in one context may be irrelevant in another.

A department store sells men’s, A department store sells men’s, women’s, and children’s clothing. women’s, and children’s clothing. The store manager’s salary could The store manager’s salary could

not be eliminated if the store not be eliminated if the store eliminated the line of children’s eliminated the line of children’s clothing. Is the store manager’s clothing. Is the store manager’s salary relevant to the decision to salary relevant to the decision to stop selling children’s clothing?stop selling children’s clothing?

A department store sells men’s, A department store sells men’s, women’s, and children’s clothing. women’s, and children’s clothing. The store manager’s salary could The store manager’s salary could

not be eliminated if the store not be eliminated if the store eliminated the line of children’s eliminated the line of children’s clothing. Is the store manager’s clothing. Is the store manager’s salary relevant to the decision to salary relevant to the decision to stop selling children’s clothing?stop selling children’s clothing?

No, the store manager’s salary will be the same if children’s clothing is no

longer sold.

No, the store manager’s salary will be the same if children’s clothing is no

longer sold.

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Relevance is Context-Sensitive

A particular cost that is relevant in one context may be irrelevant in another.

Would the store manager’s salary Would the store manager’s salary be a relevant cost, if the company be a relevant cost, if the company

was thinking about closing the was thinking about closing the store completely?store completely?

Would the store manager’s salary Would the store manager’s salary be a relevant cost, if the company be a relevant cost, if the company

was thinking about closing the was thinking about closing the store completely?store completely?

Yes, it is a relevant cost. If the store remains open, the company will incur the manager’s salary. If the store is closed,

the cost will be eliminated.

Yes, it is a relevant cost. If the store remains open, the company will incur the manager’s salary. If the store is closed,

the cost will be eliminated.

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Relationship BetweenRelevance and AccuracyInformation need not be exact to be

relevant.

You may be considering the purchase of a laptop computer. You may decide to delay your decision because you think the price will decrease. You are not sure of the amount of the price drop, but you do believe part of the cost can be avoided by waiting.

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A quantitative focus considers the cost,

increase in profits, or other numerical aspects

of the decision.

Quantitative Versus Qualitative CharacteristicsRelevant information can have both

quantitative and qualitative characteristics.

A qualitative focus considers non-

quantitative aspects such as the impact on people and attractiveness of the

products.

For example, suppose you are deciding which of two laptops to purchase. Computer A costs $300 more than Computer B. Both computers satisfy your technical requirements; however,

Computer A has a more attractive appearance.

Computer A Computer B

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Differential Revenue and Avoidable Cost

Relevant revenues must (1) be future oriented and (2) differ for the

alternatives under consideration. Since relevant revenues differ between the

alternatives, they are sometimes called differential revenues.

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Differential Revenue and Avoidable Cost

Avoidable costs are the costs managers can eliminate by making specific

choices.

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Learning Objective

LO2LO2

Distinguish between unit-level, batch-level, product

level, and facility-level costs and understand how these costs affect decision

making.

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Relevant (Avoidable) Costs

Unit-levelUnit-levelCostsCosts

Batch-levelBatch-levelCostsCosts

Product-levelProduct-levelCostsCosts

Facility-levelFacility-levelCostsCosts

Avoided by eliminating oneAvoided by eliminating oneunit of product.unit of product.

Avoided when a batch ofAvoided when a batch ofwork is eliminated.work is eliminated.

Avoided if a product lineAvoided if a product lineis eliminated.is eliminated.

Some costs may be avoidedSome costs may be avoidedif a business segment is if a business segment is

eliminated.eliminated.

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Check Yourself

Aqua, Inc., makes statues for use in fountains. On Aqua, Inc., makes statues for use in fountains. On January 1, 2009, the company paid $13,500 for a January 1, 2009, the company paid $13,500 for a

mold to make a particular type of statue. The mold mold to make a particular type of statue. The mold had an expected life of four years and a salvage had an expected life of four years and a salvage

value of $1,500. On January 1, 2011, the mold had value of $1,500. On January 1, 2011, the mold had a market value of $3,000, and a salvage value of a market value of $3,000, and a salvage value of $1,200. The expected useful life did not change. $1,200. The expected useful life did not change.

What is the relevant cost of using the mold during What is the relevant cost of using the mold during 2011?2011?

Aqua, Inc., makes statues for use in fountains. On Aqua, Inc., makes statues for use in fountains. On January 1, 2009, the company paid $13,500 for a January 1, 2009, the company paid $13,500 for a

mold to make a particular type of statue. The mold mold to make a particular type of statue. The mold had an expected life of four years and a salvage had an expected life of four years and a salvage

value of $1,500. On January 1, 2011, the mold had value of $1,500. On January 1, 2011, the mold had a market value of $3,000, and a salvage value of a market value of $3,000, and a salvage value of $1,200. The expected useful life did not change. $1,200. The expected useful life did not change.

What is the relevant cost of using the mold during What is the relevant cost of using the mold during 2011?2011?

($3,000 ($3,000 – $1,200) ÷ 2 years = – $1,200) ÷ 2 years = $900$900

($3,000 ($3,000 – $1,200) ÷ 2 years = – $1,200) ÷ 2 years = $900$900

Of course, Aqua could avoid the cost by selling the mold for its market value of

$3,000.

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Learning Objective

LO3LO3

Make appropriatespecial order

decisions.

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Relevant Information andSpecial Decisions

Occasionally, a company receives an offer to sell its Occasionally, a company receives an offer to sell its product at a price significantly below its normal selling product at a price significantly below its normal selling

price. The company must make a price. The company must make a special order decisionspecial order decision to to accept or reject the offer.accept or reject the offer.

Occasionally, a company receives an offer to sell its Occasionally, a company receives an offer to sell its product at a price significantly below its normal selling product at a price significantly below its normal selling

price. The company must make a price. The company must make a special order decisionspecial order decision to to accept or reject the offer.accept or reject the offer.

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Unit-level costs Materials costs (2,000 × $90) 180,000$ Labor costs (2,000 × $82.50) 165,000 Overhead (2,000 × $7.50) 15,000 Total unit-level costs 360,000$ Batch-level costs Assembly setup (10 × $1,700) 17,000 Materials handling (10 × $500) 5,000 Total batch-level costs 22,000 Product-level costs Engineering design 14,000 Production manager's salary 63,300 Total product-level costs 77,300 Facility-level costs Segement-level costs 85,000 Division manager's salary 12,700 Company president's salary 43,200 Depreciation 27,300 General expenses 31,000 Total facility-level costs 199,200 Total expected costs 658,500$

Budgeted Cost for Expected Production of 2,000 Printers

Cost per unit - $658,500 ÷ 2000 = $329.25$329.25

Here is budgeted cost information

for Premier, a company that

produces printers. The company has enough capacity

to produce additional

printers, but is planning to

produce to meet current demand.

Here is budgeted cost information

for Premier, a company that

produces printers. The company has enough capacity

to produce additional

printers, but is planning to

produce to meet current demand.

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Special Order Decision

A foreign customer offers to purchase 200 printers at $250 per printer. This price is well below the unit cost of

$329.25. Should the company accept this one time order?

Differential revenue ($250 ×200) 50,000$ Avoidable unit-level costs ($180 × 200) (36,000) Avoidable batch-level costs: Assembly setup (1,700) Materials handling (500) Contribution to income 11,800$

Relevant Information for Special Order

If the order is accepted, profitability will increase by If the order is accepted, profitability will increase by $11,800.$11,800.

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Special Order DecisionOpportunity Costs

Premier has excess productive capacity. Suppose Premier has the opportunity to lease its excess capacity (unused

building and equipment) for $15,000. Should Premier accept the special offer given this new information?

Differential revenue ($250 ×200) 50,000$ Avoidable unit-level costs ($180 × 200) (36,000) Avoidable batch-level costs: Assembly setup (1,700) Materials handling (500) Opportunity cost (15,000) Contribution to income (3,200)$

Relevant Information for Special Order

If the order is accepted, profitability will If the order is accepted, profitability will decrease by $3,200.decrease by $3,200.

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Special Order Decision

If Premier can increase income by selling its printers for $250, can the company reduce its normal selling

price to $250?

Revenue ($250 × 2,200) 550,000$ Unit-level costs ($180 × 2,200) 396,000$ Batch-level costs (11 × $2,200) 24,200 Production-level costs 77,300 Facility-level costs 199,200 Total cost 696,700 Projected loss (146,700)$

Selling 2,200 Printers for $250 Per Unit

Relevance and the Decision Context

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Special Order Decision

Should a company ever reject a special order if the relevant revenues exceed the relevant

costs?

Qualitative Characteristics

What will happen if Premier’s regular customers learn that the company sold

printers to another buyer for $250 per unit?

What will happen if Premier’s regular customers learn that the company sold

printers to another buyer for $250 per unit?

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Learning Objective

LO4LO4

Make appropriateoutsourcing decisions.

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Outsourcing DecisionsCompanies can sometimes purchase products

needed in the manufacturing process for less than it would cost to make them. Buying goods and services

from other companies rather than producing them internally is commonly called outsourcingoutsourcing.

That test was so That test was so easy. How did you easy. How did you

score so low?score so low?

That test was so That test was so easy. How did you easy. How did you

score so low?score so low?

I outsourced my I outsourced my homework!!homework!!

I outsourced my I outsourced my homework!!homework!!

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Outsourcing Decisions

Let’s return to our Premier example. Recall that the unit cost per printer was $329.25. A supplier offers to sell an unlimited number of printers to Premier for $240 each.

Should Premier accept this outsourcing offer?

Step 1Step 1Determine the production costs Premier can avoid if itDetermine the production costs Premier can avoid if itelects to outsource printer production.elects to outsource printer production.

Step 1Step 1Determine the production costs Premier can avoid if itDetermine the production costs Premier can avoid if itelects to outsource printer production.elects to outsource printer production.

Unit-level costs ($180 × 2,000) 360,000$ Batch-level costs ($2,200 x 10) 22,000 Product-level costs 77,300 Total relevant cost 459,300$

Relevent Costs for 2,000 Printers

Cost per unit = $459,300 Cost per unit = $459,300 ÷ 2,000 = $229.65÷ 2,000 = $229.65Cost per unit = $459,300 Cost per unit = $459,300 ÷ 2,000 = $229.65÷ 2,000 = $229.65

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Outsourcing Decisions

Step 2Step 2Compare the avoidable production costs with the cost ofCompare the avoidable production costs with the cost ofbuying the product and select the lower-cost option.buying the product and select the lower-cost option.

Step 2Step 2Compare the avoidable production costs with the cost ofCompare the avoidable production costs with the cost ofbuying the product and select the lower-cost option.buying the product and select the lower-cost option.

Purchase price per unit 240.00$ Relevant cost per unit 229.65 In favor of manufacturing 10.35 Number of printers 2,000 Profit decline by outsourcing 20,700$

Comparison

Premier should reject the outsourcing offer.

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Outsourcing DecisionsOpportunity Costs

If Premier purchases the printers, it could use its manufacturing space for storing finished goods inventory. Premier is currently

renting warehouse space at the cost of $40,000. Should Premier continue to manufacture the printers?

Unit-level costs ($180 × 2,000) 360,000$ Batch-level costs ($2,200 x 10) 22,000 Product-level costs 77,300 Opportunity cost of warehouse 40,000 Total relevant cost 499,300$

Relevent Costs for 2,000 Printers

Cost per unit = $499,300 Cost per unit = $499,300 ÷ 2,000 = $249.65÷ 2,000 = $249.65Cost per unit = $499,300 Cost per unit = $499,300 ÷ 2,000 = $249.65÷ 2,000 = $249.65

Management should purchase the printersManagement should purchase the printersbecause the price of $240 is below the cost ofbecause the price of $240 is below the cost of

$249.65 when the opportunity cost is factored in.$249.65 when the opportunity cost is factored in.

Management should purchase the printersManagement should purchase the printersbecause the price of $240 is below the cost ofbecause the price of $240 is below the cost of

$249.65 when the opportunity cost is factored in.$249.65 when the opportunity cost is factored in.

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Growth and the Level of Production

The decision to outsource would change if expected production increases from 2,000 to 3,000 units. Some avoidable costs are fixed relative to production, so cost

per unit decreases as volume increases. If Premier outsources the 3,000 printers it will save $40,000

currently being spent on warehouse space.

Unit-level costs ($180 × 3,000) 540,000$ Batch-level costs ($2,200 × 15) 33,000 Product-level costs 77,300 Opportunity cost 40,000 Total relevant cost 690,300$

Relevant Costs for 3,000 Printers

Cost per unit = $690,300 Cost per unit = $690,300 ÷ 3,000 = $230.10÷ 3,000 = $230.10Cost per unit = $690,300 Cost per unit = $690,300 ÷ 3,000 = $230.10÷ 3,000 = $230.10

Management should reject the offer, but if growthManagement should reject the offer, but if growthis expected in the future it must be factored intois expected in the future it must be factored into

management’s decision.management’s decision.

Management should reject the offer, but if growthManagement should reject the offer, but if growthis expected in the future it must be factored intois expected in the future it must be factored into

management’s decision.management’s decision.

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Qualitative Features

A company that uses vertical integration controls the full range of activities from acquiring raw materials to

distributing goods and services. An oil company, like ExxonMobil, is a good example of vertical integration.

Outsourcing reduces the level of vertical integration,Outsourcing reduces the level of vertical integration,passing some of a company’s control over itspassing some of a company’s control over its

production to outside suppliers.production to outside suppliers.

Outsourcing reduces the level of vertical integration,Outsourcing reduces the level of vertical integration,passing some of a company’s control over itspassing some of a company’s control over its

production to outside suppliers.production to outside suppliers.

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Learning Objective

LO5LO5

Make appropriatesegment elimination

decisions.

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Segment Elimination Decisions

Businesses are frequently organized into operating units known as segments. Segment reports can be prepared for products, services, departments, branches, centers,

offices, or divisions. These reports normally show segment revenues and costs. Let’s look at a segment report for Premier Office Products that has divided its

operations into three segments: (1) copiers, (2) computers, and (3) printers.

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Copiers Computers Printers TotalProjected revenue 550,000$ 850,000$ 780,000$ 2,180,000$ Projected costs Unit-level costs Materials costs (120,000) (178,000) (180,000) (478,000) Labor costs (160,000) (202,000) (165,000) (527,000) Overhead (30,800) (20,000) (15,000) (65,800) Batch-level costs Assembly setup (15,000) (26,000) (17,000) (58,000) Materials handling (6,000) (8,000) (5,000) (19,000) Product-level costs Engineering costs (10,000) (12,000) (14,000) (36,000) Production manager salary (52,000) (55,800) (63,300) (171,100) Facility-level costs Segment level Division manager salary (82,000) (92,000) (85,000) (259,000) Administrative costs (12,200) (13,200) (12,700) (38,100) Allocated-corporate level Company president salary (34,000) (46,000) (43,200) (123,200) Building rental (19,250) (29,750) (27,300) (76,300) General expenses (31,000) (31,000) (31,000) (93,000) Projected profit (loss) (22,250)$ 136,250$ 121,500$ 235,500$

Should management eliminate the copier segment?

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Segment Elimination Decisions

A three part decision:A three part decision:

1.1. Determine the amount of relevant revenue Determine the amount of relevant revenue that pertains to eliminating the segment.that pertains to eliminating the segment.

2.2. Determine the amount of cost that can be Determine the amount of cost that can be avoided if the segment is eliminated.avoided if the segment is eliminated.

3.3. If the relevant revenue is less than the If the relevant revenue is less than the avoidable cost, eliminate the segment. If not, avoidable cost, eliminate the segment. If not, continue to operate it.continue to operate it.

A three part decision:A three part decision:

1.1. Determine the amount of relevant revenue Determine the amount of relevant revenue that pertains to eliminating the segment.that pertains to eliminating the segment.

2.2. Determine the amount of cost that can be Determine the amount of cost that can be avoided if the segment is eliminated.avoided if the segment is eliminated.

3.3. If the relevant revenue is less than the If the relevant revenue is less than the avoidable cost, eliminate the segment. If not, avoidable cost, eliminate the segment. If not, continue to operate it.continue to operate it.

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Segment Elimination Decisions

Step 1:Step 1:If Premier eliminates the copier segment, it If Premier eliminates the copier segment, it will lose the $550,000 of revenue currently will lose the $550,000 of revenue currently earned. If the segment continues, the revenue earned. If the segment continues, the revenue will be earned. Since the revenue differs will be earned. Since the revenue differs between the alternatives, between the alternatives, it is relevantit is relevant..

Step 1:Step 1:If Premier eliminates the copier segment, it If Premier eliminates the copier segment, it will lose the $550,000 of revenue currently will lose the $550,000 of revenue currently earned. If the segment continues, the revenue earned. If the segment continues, the revenue will be earned. Since the revenue differs will be earned. Since the revenue differs between the alternatives, between the alternatives, it is relevantit is relevant..

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Segment Elimination Decisions

Unit-level costs Materials costs (120,000)$ Labor costs (160,000) Overhead (30,800) Batch-level costs Assembly setup (15,000) Materials handling (6,000) Product-level costs Engineering costs (10,000) Production manager salary (52,000) Facility-level costs Segment level Division manager salary (82,000) Administrative costs (12,200) Total relevant costs (488,000)$

Step 2:Step 2:If Premier eliminates copiers, it will avoid the following If Premier eliminates copiers, it will avoid the following costs:costs:

Step 2:Step 2:If Premier eliminates copiers, it will avoid the following If Premier eliminates copiers, it will avoid the following costs:costs:

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Segment Elimination Decisions

Step 3:Step 3:If Premier eliminates copiers, its profits will If Premier eliminates copiers, its profits will decrease:decrease:

Step 3:Step 3:If Premier eliminates copiers, its profits will If Premier eliminates copiers, its profits will decrease:decrease:

Revenue lost 550,000$ Costs avoided (488,000) Decrease in profit 62,000$

The corporate-level facility-sustaining costs will The corporate-level facility-sustaining costs will not be eliminated, but will be allocated to the not be eliminated, but will be allocated to the

remaining segments.remaining segments.

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Qualitative Considerations

1.1. Employee lives will be disrupted.Employee lives will be disrupted.

2.2. Sales of different product lines are frequently Sales of different product lines are frequently interdependent.interdependent.

3.3. What will happen to the space freed by the What will happen to the space freed by the eliminated segment?eliminated segment?

4.4. Volume changes can affect elimination Volume changes can affect elimination decisions.decisions.

1.1. Employee lives will be disrupted.Employee lives will be disrupted.

2.2. Sales of different product lines are frequently Sales of different product lines are frequently interdependent.interdependent.

3.3. What will happen to the space freed by the What will happen to the space freed by the eliminated segment?eliminated segment?

4.4. Volume changes can affect elimination Volume changes can affect elimination decisions.decisions.

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Relationships Between Avoidable Costs and Business Activity

1.1. Special order decisions affect unit-level and Special order decisions affect unit-level and possibly batch-level costs.possibly batch-level costs.

2.2. Outsourcing can avoid many product-level as Outsourcing can avoid many product-level as well as unit- and batch-level costs.well as unit- and batch-level costs.

3.3. Segment elimination can avoid some of the Segment elimination can avoid some of the facility-level costs.facility-level costs.

1.1. Special order decisions affect unit-level and Special order decisions affect unit-level and possibly batch-level costs.possibly batch-level costs.

2.2. Outsourcing can avoid many product-level as Outsourcing can avoid many product-level as well as unit- and batch-level costs.well as unit- and batch-level costs.

3.3. Segment elimination can avoid some of the Segment elimination can avoid some of the facility-level costs.facility-level costs.

The more complex the decision level, the more The more complex the decision level, the more opportunities there are to avoid costs.opportunities there are to avoid costs.

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Learning Objective

LO6LO6

Make appropriateasset replacement

decisions.

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Equipment Replacement Decisions

The equipment replacement decision should be based on profitability rather than physical

deterioration. Consider the following:

Original cost 90,000$ Accumulated depreciation (33,000) Book value 57,000$

Market value (now) 14,000$ Salvage value (in 5 years) 2,000 Annual depreciation expenses 11,000 Operating expenses ($9,000 × 5 years) 45,000

Cost 29,000$ Salvage value (in 5 years) 4,000 Operating expenses ($4,500 × 5 years) 22,500

Old Machine

New Machine

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Equipment Replacement Decisions

1.1. The original cost, current book value, accumulated The original cost, current book value, accumulated depreciation, and annual depreciation expense are depreciation, and annual depreciation expense are measures of cost of the old machine relating to prior measures of cost of the old machine relating to prior periods. They are irrelevant because they are sunk costs.periods. They are irrelevant because they are sunk costs.

2.2. The $14,000 market value of the old machine is an The $14,000 market value of the old machine is an opportunity cost and is relevant to the replacement opportunity cost and is relevant to the replacement decision.decision.

3.3. The salvage value of the old machine reduces the The salvage value of the old machine reduces the opportunity cost. The opportunity cost of using the old opportunity cost. The opportunity cost of using the old machine for five more years is $12,000 ($14,000 machine for five more years is $12,000 ($14,000 – – $2,000).$2,000).

4.4. The $45,000 operating expenses of using the old machine The $45,000 operating expenses of using the old machine can be avoided if it is replaced. It is a relevant cost.can be avoided if it is replaced. It is a relevant cost.

1.1. The original cost, current book value, accumulated The original cost, current book value, accumulated depreciation, and annual depreciation expense are depreciation, and annual depreciation expense are measures of cost of the old machine relating to prior measures of cost of the old machine relating to prior periods. They are irrelevant because they are sunk costs.periods. They are irrelevant because they are sunk costs.

2.2. The $14,000 market value of the old machine is an The $14,000 market value of the old machine is an opportunity cost and is relevant to the replacement opportunity cost and is relevant to the replacement decision.decision.

3.3. The salvage value of the old machine reduces the The salvage value of the old machine reduces the opportunity cost. The opportunity cost of using the old opportunity cost. The opportunity cost of using the old machine for five more years is $12,000 ($14,000 machine for five more years is $12,000 ($14,000 – – $2,000).$2,000).

4.4. The $45,000 operating expenses of using the old machine The $45,000 operating expenses of using the old machine can be avoided if it is replaced. It is a relevant cost.can be avoided if it is replaced. It is a relevant cost.

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Equipment Replacement Decisions

1.1. The cost of the new machine can be avoided by The cost of the new machine can be avoided by keeping the old machine. It is a relevant cost.keeping the old machine. It is a relevant cost.

2.2. The relevant cost of purchasing the new machine The relevant cost of purchasing the new machine is $25,000 ($29,000 is $25,000 ($29,000 – $4,000)– $4,000)..

3.3. The $22,500 of operating expenses can be The $22,500 of operating expenses can be avoided by keeping the old machine. The avoided by keeping the old machine. The operating expenses are relevant costs.operating expenses are relevant costs.

Let’s summarize the relevant costs for the two machines.Let’s summarize the relevant costs for the two machines.

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Equipment Replacement Decisions

Opportunity cost 14,000$ Salvage value (2,000) Operating expenses 45,000 Total 57,000$

Cost 29,000$ Salvage value (4,000) Operating expenses 22,500 Total 47,500$

Old Machine

New Machine

Our analysis shows Our analysis shows that Premier should that Premier should

acquire the new acquire the new machine. Over a machine. Over a

five-year period the five-year period the company will save a company will save a

total of $9,500total of $9,500($57,000 ($57,000 – $47,500).– $47,500).

5-46

End of Chapter 5