Management Accounting

PGP Section D
Instructor: Akanksha Jalan
Session 7: February 2, 2017
Session Objectives:
Understand:

The meaning and identification of relevant costs and benefits

Opportunity versus Sunk costs

The management accountants role in planning for certain special

decisions such as launching new product lines, closing down
segments, make or buy etc.
What are Relevant costs and benefits?
These refer to items of costs and revenues that possess BOTH these features:
They relate to the future (i.e. they should not be sunk!) AND
They differ between alternatives being considered

If something has been done in the past and cannot be changed by any future action, it is
considered SUNK and hence, irrelevant for decision making

Similarly, if an item will remain the same under all the alternatives being considered, its
incremental impact on a decision is zero. It is therefore, considered irrelevant

Opportunity costs are always relevant!

Understanding Relevant costs
and benefits: The case of
Worldwide Airways
Source: Managerial Accounting, Hilton and Platt, 9th edition
Worldwide Airways: A background

For understanding the nuances of relevant costs and benefits in different

situations, let us consider the example of Worldwide Airways, based in
London.

The airline currently flies routes between Europe and the United States,
between several European cities and several Asian and African cities.
Case 1: Replacement decision
At Heathrow airport in London, Worldwide Airways

has a three-year old loader truck used to load in-flight

meals onto airplanes. The box on the truck can be

lifted hydraulically to the level of the airplanes side

doors. The book-value of the loader, defined as the

assets acquisition value, less accumulated

depreciation thereon, is provided to you:

Case 1: Replacement decision
At Heathrow airport in London, Worldwide Airways has a three-year old loader
truck used to load in-flight meals onto airplanes. The box on the truck can be lifted
hydraulically to the level of the airplanes side doors. The book-value of the loader,
defined as the assets acquisition value, less accumulated depreciation thereon, is
provided to you:
Acquisition cost of old loader.$ 1,00,000
Less: Accumulated depreciation till date (25,000 X 3)..(75,000)
Book value......$ 25,000
The loader has one year of useful life remaining, after which its salvage value will
be reduced to zero. However, it can be sold today at $ 5,000. In addition to the
annual depreciation of $ 25,000, WA annually incurs $ 80,000 in variable costs to
operate the loader. This includes the cost of operator labor, gasoline and
maintenance.
So whats the problem?
John Orville, WAs ramp manager at Heathrow Airport, faces a decision
concerning replacement of the loader. A new loader that uses a conveyor belt
to move meals onto the plane is being considered. The new loader is much
cheaper than the old hydraulic one and costs less to operate on an yearly basis.
However, the new loader would be operable for only one year before it will need
to be replaced.
The information about the new loader is as follows:
Acquisition cost of new loader$ 15,000
Useful life....1 year
Salvage value after one year$ 0
Annual operating costs$ 45,000
The whats the confusion about?
Orville prefers to use the old loader for another year. He believes that We paid $
1,00,000 for it, and weve only used it three years. If we get rid of that loader now,
well lose $ 20,000 on the disposal.
We know that the remaining useful life of the old loader is only one more year.
This means that replacement is inevitable.
The problem therefore boils down to the timing issue:
Replace today? OR
Replace after a year?
Lets compare
Cost of two alternatives

(a) Continue with old (b) Replace old

loader loader today
Depreciation of old loader 25,000 -

Write-off old loaders value to P/L A/c 25,000

Proceeds from disposal of old loader 0 (5,000)

Depreciation of new loader - 15,000

Operating costs p.a. 80,000 45,000

Total cost $ 1,05,000 $ 80,000

An Incremental analysis
Cost of two alternatives

(a) Continue (b) Replace old (c ) Differential

with old loader loader today cost (a b)
Depreciation of old loader 25,000 -

Write-off old loaders value to P/L A/c 25,000 0

Proceeds from disposal of old loader 0 (5,000) 5,000

Depreciation of new loader - 15,000 (15,000)

Operating costs p.a. 80,000 45,000 35,000

Total incremental cost of continuing $ 1,05,000 $ 80,000 $ 25,000

with the old loader
Final decision
Cost of two alternatives

(a) Continue (b) Replace old (c ) Differential

with old loader loader today cost (a b)
Depreciation of old loader 25,000 -

Write-off old loaders value to P/L A/c 25,000 0

Proceeds from disposal of old loader 0 (5,000) 5,000

Depreciation of new loader - 15,000 (15,000)

Operating costs p.a. 80,000 45,000 35,000

Total incremental cost of continuing $ 1,05,000 $ 80,000 $ 25,000

with the old loader
Case 2: Inventory at hand
The inventory of spare parts held by WA at Heathrow Airport
includes some obsolete parts originally costing $ 20,000. The
company no longer uses the planes for which the parts were
purchased.

The spare parts could be sold for $ 17,000 to another airline.

However, with some modifications, the parts could be used in
companys current fleet of aircrafts. Using the modified parts will
save WA the cost of purchasing new parts for its airplanes, which
can be purchased at $ 26,000.

John Orville decides not to dispose the parts since doing so will
entail a loss of $ 3,000, which is the difference between book value
and sale value for these.

What do you think?

An Incremental Analysis
Cost of two alternatives

(a) Modify and (b) Sell parts (c ) Differential

use parts cost (a b)
Book value of inventory of parts 20,000 $ 20,000 0

Sale value of obsolete parts 0 (17,000) 17,000

Cost of modification 12,000 0 12,000

Cost incurred to buy new parts for the - 26,000 (26,000)

fleet
Total Cost $ 32,000 $ 29,000

Incremental Saving in cost if parts are $ 3,000

sold
An Incremental Analysis
Cost of two alternatives

(a) Modify and (b) Sell parts (c ) Differential

use parts cost (a b)
Book value of inventory of parts 20,000 $ 20,000 0

Sale value of obsolete parts 0 (17,000) 17,000

Cost of modification 12,000 0 12,000

Cost incurred to buy new parts for the - 26,000 (26,000)

fleet
Total Cost $ 32,000 $ 29,000

Incremental Saving in cost if parts are $ 3,000

sold
Final decision
Cost of two alternatives

(a) Modify and (b) Sell parts (c ) Differential

use parts cost (a b)
Book value of inventory of parts 20,000 $ 20,000 0

Sale value of obsolete parts 0 (17,000) 17,000

Cost of modification 12,000 0 12,000

Cost incurred to buy new parts for the - 26,000 (26,000)

fleet
Total Cost $ 32,000 $ 29,000

Incremental Saving in cost if parts are $ 3,000

sold
Case 3: Adding a route
Emma Rees, manager of flight scheduling at WA in

London, is contemplating adding a stop in New Delhi to

the currently nonstop London to Hong Kong route.

She feels that adding the stop would attract additional

passengers, but also involve additional variable costs. The

cost schedule for the decision is presented in the next slide.

Should the stop in New Delhi be added?`

Revenues and costs under two alternatives
(A) Non-stop route (b) Stop in New Delhi

Passenger revenue $ 2,40,000 $ 2,58,000

Cargo revenue 80,000 80,000

Landing fee in Delhi 0 (5,000)

Use of airport gate facilities 0 (3,000)

Flight crew cost (2,000) (2,500)

Fuel (21,000) (24,000)

Meals and services (4,000) (4,600)

Aircraft maintenance (1,000) (1,000)

Total revenues less costs $ 2,92,000 $ 2,97,900

An Incremental Analysis
(A) Non-stop (B) Stop in New Differential
route Delhi revenue (B-A)
Passenger revenue $ 2,40,000 $ 2,58,000 18,000
Cargo revenue 80,000 80,000 0
Landing fee in Delhi 0 (5,000) (5,000)
Use of airport gate facilities 0 (3,000) (3,000)
Flight crew cost (2,000) (2,500) (500)
Fuel (21,000) (24,000) (3,000)
Meals and services (4,000) (4,600) (600)
Aircraft maintenance (1,000) (1,000) 0
Total revenues less costs $ 2,92,000 $ 2,97,900
Incremental revenue from adding stop $ 5,900
in Delhi
Final decision
(A) Non-stop (B) Stop in New Differential
route Delhi revenue (B-A)
Passenger revenue $ 2,40,000 $ 2,58,000 18,000

Cargo revenue 80,000 80,000 0

Landing fee in Delhi 0 (5,000) (5,000)

Use of airport gate facilities 0 (3,000) (3,000)

Flight crew cost (2,000) (2,500) (500)

Fuel (21,000) (24,000) (3,000)

Meals and services (4,000) (4,600) (600)

Aircraft maintenance (1,000) (1,000) 0

Total revenues less costs $ 2,92,000 $ 2,97,900 $ 5,900

 Case 4: Adding flights
Emma Rees is contemplating whether to add two daily round-
trip flights between London and Toronto. Her initial relevant
cost and benefit analysis suggests that additional revenue from
the new flights will exceed their costs by $ 30,000 per month.
Hence, she has almost decided to go ahead with adding the
flights.

However, Rex Ifans, WAs hangar manager in London, points

out that Rees has overlooked an important consideration in the
matter. WA currently has excess space in its hangar. A commuter
airline has offered to rent the hangar space for $ 40,000 per
month. However, if the London to Toronto flights are added,
the additional aircraft needed in London will require the
additional hangar space.

What do you think?

An Incremental Analysis
Cost of two alternatives

(a) Add flights (b) Do not add Differential

flights amount (a b)
Additional revenue from new flights $ 30,000 0 $ 30,000

Revenue from rental of excess hangar 0 $ 40,000 (40,000)

space
Total Revenue $ 30,000 $ 40,000

Loss from adding flights $ (10,000)

Final decision
Cost of two alternatives

(a) Add flights (b) Do not add (c )

flights Differential
amount (a b)
Additional revenue from new flights $ 30,000 0 $ 30,000

Revenue from rental of excess hangar 0 $ 40,000 (40,000)

space
Total Revenue $ 30,000 $ 40,000

Loss from adding flights $ (10,000)

Case 5A: Special offer, idle capacity
Jim Wright, WAs vice-president for operations, has been approached by a
Chinese tourist agency for flying chartered tourist flights from Hong Kong to
London. The agency has offered $ 1,50,000 per roundtrip on a jumbo jet. Given
the airlines usual occupancy rate and air fares, a round-trip jumbo-jet flight
between Hong Kong and London typically brings in revenue of $ 2,50,000. Thus,
the Chinese agencys specially-priced offer requires special analysis by Wright.

Wright knows that WAs two jumbo jets that are not currently in use. WA is not
currently planning to launch any new routes, hence the two jets are lying idle.
Also, $ 5,000 will be saved in variable operating costs of running these special
flights, related to ticketing etc.

Given the cost data for a typical round-trip flight between Hong Kong and
London in the next slide, do you suggest accepting the Chinese companys offer?
Cost data HK to London, round-trip
Revenue:

Passenger $ 2,50,000

Cargo 30,000 $ 2,80,000

Expenses:

Variable expenses of flight 90,000

Fixed expenses allocated to each flight 1,00,000 1,90,000

Profit per round-trip flight $ 90,000

An Incremental Analysis
Incremental costs and revenues of the special chartered flights per round-trip

Special price for charter $ 1,50,000

Variable costs:

Variable expenses of a routine flight $ 90,000

Less: Saving in ticketing cost (5,000) 85,000

Contribution per round-trip of chartered flights $ 65,000

Case 5B: Special offer, no excess capacity

Now consider another situation. If there is no idle aircraft available with WA

for meeting the special chartered flight requirement and in order to fly the
charter between Hong Kong and London, the airline would have to cancel its
least-profitable route, which is between Tokyo and Hong Kong. This route
contributes $ 80,000 towards covering the airlines fixed costs and profit.

Can you re-analyze the charter decision for Wright?

An Incremental Analysis
Incremental costs and revenues of the special chartered flights per round-trip

Special price for charter $ 1,50,000

Variable costs:

Variable expenses of a routine flight $ 90,000

Less: Saving in ticketing cost (5,000)

85,000

Add: Contribution foregone on HK-Tokyo route 80,000 1,65,000

Loss from charter $ (15,000)

 Case 6: Make or buy?
Ellie Rickenbacker is WAs manager for in-flight services.
She supervises the firms food and beverage operations. She
is currently faced with a decision regarding the preparation
of in-flight dinners at the airlines Atlanta hub. In the Atlanta
flight kitchen, full-course dinners are prepared and packaged
for long-flights that pass through Atlanta. In the past, all of
the desserts were baked and packaged in the flights kitchen.
However, Rickenbacker has received an offer from an
Atlanta bakery to bake WAs desserts at 21 cents each.

You are further informed that 1 cent of the total supervisors

salary can be avoided per unit if the desserts are outsourced.

What do you prefer make or buy?

Cost per dessert baked in-house
Cost per dessert

Variable costs:

Direct material (food and packaging) $ 0.06

Direct labor 0.04

Variable overhead 0.04

Fixed costs (allocated to products):

Supervisory salaries 0.04

Depreciation of flight-kitchen equipment 0.07

Total cost per dessert $ 0.25

An Incremental analysis
Make ($) Buy ($) Differential
(A) (B) Cost (A B)
Relevant Manufacturing costs:
Direct material (food and packaging) $ 0.06
Direct labor 0.04
Variable overhead 0.04
Total variable costs of manufacture (M) $ 0.14
Purchase price per dessert $ 0.21
Less: Saving in supervisory salaries (0.01)
Total purchase price, less savings (B) $ 0.20
Loss per dessert if outsourced (M B) $ 0.06
Final decision
Make ($) Buy ($) Differential
(A) (B) Cost (A B)
Relevant Manufacturing costs:
Direct material (food and packaging) $ 0.06
Direct labor 0.04
Variable overhead 0.04
Total variable costs of manufacture (M) $ 0.14
Purchase price per dessert $ 0.21
Less: Saving in supervisory salaries (0.01)
Total purchase price, less savings (B) $ 0.20
Loss per dessert if outsourced (M B) $ (0.06)
 Case 7A: Dropping a segment
WA offers its passengers the opportunity to join its World Express
Club. Club membership entitles a traveler to use the club facilities
at the airport in London. Jayne Wing, the president of WA is
worried that the WA Club may not be profitable. Her concern
arises out of the statement of monthly operating income in the
next slide. While she is almost convinced about discontinuing the
club, the vice-president for sales tells her that the club helps them
attract passengers, who it might otherwise lose to a competitor.

Based on the Clubs operating income statement in the next slide,

what do you suggest? You are further informed that in the event of
closing the club, supervisory salaries and airport fees can be
avoided.
Clubs Monthly Operating Income Statement
Sales revenue $ 2,00,000
Less: Variable expenses:
Food and beverages $ 70,000
Personnel 40,000
Variable overhead 25,000 1,35,000
Contribution margin $ 65,000
Less: Fixed expenses
Depreciation $ 30,000
Supervisory salaries 20,000
Insurance 10,000
Airport fees 5,000
General overhead (allocated) 10,000 75,000
Total loss from club $ (10,000)
An Incremental Analysis
Keep Club (A) Drop Club (B) Differential
amount (A B)
Sales revenue $ 2,00,000 0 $ 2,00,000
Less: Variable expenses:
Food and beverages $ (70,000) 0 (70,000)
Personnel (40,000) 0 (40,000)
Variable overhead (25,000) 0 (25,000)
Contribution margin lost if club is dropped (C) $ 65,000
Less: Fixed expenses
Depreciation $ (30,000) $ (30,000) 0
Supervisory salaries (20,000) 0 (20,000)
Insurance (10,000) (10,000) 0
Airport fees (5,000) 0 (5,000)
General overhead (allocated) (10,000) (10,000) 0
Costs saved if club is dropped (25,000)
Total loss on dropping club $ 40,000
Case 7B: What if ?

Now suppose that you are informed that discontinuation of the WA club

will result in a loss of contribution margin from general airline

operations to the extent of $ 60,000 each month.

Will you still suggest continuing the club?

Lets compare
Keep Club (A) Drop Club (B) Differential
amount (A B)

Sales revenue $ 2,00,000 0 $ 2,00,000

Less: Variable expenses:
Food and beverages $ (70,000) 0 (70,000)
Personnel (40,000) 0 (40,000)
Variable overhead (25,000) 0 (25,000)
Contribution margin lost if club is dropped (C) $ 65,000
Contribution lost on general airlines business (D) 60,000
Total Contribution lost if club is dropped (E) $ 1,25,000
Less: Fixed expenses $ 75,000 $ 50,000
Fixed costs saved if club is dropped (F) (25,000)
Total loss on dropping club (E F) $ 1,00,000
Decisions involving limited
resources
Decision making and scarcity
Organizations typically have limited resources, which could be machine hours, labor hours, production
capacity, raw material etc.

Scarcity necessitates that these resources be used in the best possible manner, to maximize profitability

Scarcity can be dealt with relatively easily in case of a firm selling a single product, but they can be
difficult to deal with in a multi-product firm, given the need to calculate the production priority or the
optimum mix

The reason is that different products use different quantities of the scarce resource, have different
contribution margins etc.

Simple thumb-rule: Always calculate for each product, its contribution per unit of the scarce
resource and then calculate ranks in terms of production preference
Example: International
Chocolate Company
Source: Managerial Accounting, Hilton and Platt, 9th edition
The International Chocolate Company
(ICC)
The ICCs Bruges plant makes two specialty products bars and truffles
The contribution-margin data for both these products is provided to you:
Bars Truffles
Machine hours required per case 0.02 0.05
Sales price $ 10 $ 14
Less: Variable costs
Direct material $3 $ 3.75
Direct labor 2 2.50
Variable overhead 3 3.75
Variable selling and administrative costs 1 2
Total variable costs $ 9.00 $ 12.00
Contribution margin per case $ 1.00 $ 2.00
A. Dealing with scarcity

You are further informed that the Bruges plant capacity is limited by
its available machine time. Only 700 machine hours are available in
the plant each month

ICC can sell any quantity of both products as it desires to produce

What, in your opinion, should be the optimum production mix in terms

of bars and truffles ?
Calculating Contribution per machine hour
Bars Truffles

Sales price $ 10 $ 14

Less: Variable costs $ 9.00 $ 12.00

Contribution margin per case (A) $ 1.00 $ 2.00

Machine hours required per case (B) 0.02 0.05

Contribution per machine hour (A/ B) $ 50 $ 40

Rank 1 2

Machine hours available 700 per month

Decision: Produce ONLY Bars

Quantity 700/ 0.02 = 35,000 units

B. What if?

1. Now suppose that the maximum quantity of bar cases that can be
sold in the market are 25,000. How much of each product would you
produce now?

2. Independent of (1) above, how would your answer change if the

minimum production of truffles must be 5,000 units to meet a
existing contract?
Thank you!