CHAPTER FIVE

DECISION MAKING AND RELEVANT INFORMATION

Information and the Decision Process

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.
Consider a strategic decision facing management at Precision Sporting Goods, a manufacturer of golf
clubs: Should it reorganize its manufacturing operations to reduce manufacturing labor costs? Precision
Sporting Goods has only two alternatives: Do not reorganize or reorganize. The reorganization will
eliminate all manual handling of materials. Current manufacturing labor consists of 20 workers—15
workers operate machines, and 5 workers handle materials. Each worker works 2,000 hours annually.
The reorganization is predicted to cost $90,000 each year (mostly for new equipment leases). Production
output of 25,000 units as well as the selling price of $250, the direct material cost per unit of $50,
manufacturing overhead of $750,000, and marketing costs of $2,000,000 will be unaffected by the
reorganization.
The managers of Precision Sporting Goods are applied Five-Step Decision- Making Process to make the
decision
Step 1: Identify the Problem and Uncertainties Should Precision Sporting Goods reorganize its
manufacturing operations to reduce manufacturing labor costs? An important uncertainty is how the
reorganization will affect employee morale.
Step 2: Obtain Information the management should have to obtain Historical Costs and Other
Information Historical hourly wage rates are $14 per hour. However, a recently negotiated increase in
employee benefits of $2 per hour will increase wages to $16 per hour. The reorganization of
manufacturing operations is expected to reduce the number of workers from 20 to 15 by eliminating all 5
workers who handle materials. The reorganization is likely to have negative effects on employee morale.
Step 3: Make Predictions about the Future under the existing do-not reorganize alternative, costs are
predicted to be $640,000 (20 workers * 2,000 hours per worker per year * $16 per hour), and under the
reorganize alternative, costs are predicted to be $480,000 (15 workers * 2,000 hours per worker per year
* $16 per hour). Recall, the reorganization is predicted to cost $90,000 per year.
Step 4: Make Decisions by Choosing among Alternatives Managers compares the predicted benefits
calculated in Step 3
($640,000 - $480,000 = $160,000 against the cost of the reorganization ($90,000) along with other
considerations (such as likely negative effects on employee morale). The management chooses the
reorganize alternative because the financial benefits are significant and the effects on employee morale
are expected to be temporary and relatively small.
Step 5: Implement the Decision, Evaluate Performance, and Learn

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 The Concept of Relevance
Relevant Costs and Relevant Revenues
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—the probability of occurrence of that revenue or cost must be greater than the non-
probability of occurrence.
Differ among the alternative courses of action—costs and revenues that do not differ among
alternatives are considered as irrelevant 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.
 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.
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 nonfinancial; 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 nonfinancial factors.
Qualitative factors are outcomes that are difficult to measure accurately in numerical terms. Employee morale
is an example.
An Illustration of Relevance
One-Time-Only Special Orders
One type of decision that affects output levels is accepting or rejecting special orders when there is idle
production capacity and the special orders have no long-run implications. We use the term one-time-only
special order to describe these conditions.
Example 1: Surf Gear manufactures quality beach towels at its highly automated Burlington, North
Carolina, plant. The plant has a production capacity of 48,000 towels each month. Current monthly
production is 30,000 towels. The company assumes all costs can be classified as either fixed or variable
with respect to a single cost driver (units of output). As a result of a strike at its existing towel supplier,
Azelia, a luxury hotel chain, has offered to buy 5,000 towels from Surf Gear in August at $11 per towel.
No subsequent sales to Azelia are anticipated. Fixed manufacturing costs are based on the 48,000-towel

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production capacity. That is, fixed manufacturing costs relate to the production capacity available and not
the actual capacity used. If Surf Gear accepts the special order, it will use existing idle capacity to
produce the 5,000 towels, and fixed manufacturing costs will not change. No marketing costs will be
necessary for the 5,000-unit one-time-only special order. Accepting this special order is not expected to
affect the selling price or the quantity of towels sold to regular customers. Should Surf Gear accept
Azelia’s offer?

The relevant revenues and costs are the expected future revenues and costs that differ as a result of
accepting the special offer revenues of $55,000 ($11 per unit * 5,000 units) and variable manufacturing
costs of $37,500 ($7.50 per unit* 5,000 units). The fixed manufacturing costs and all marketing costs
(including variable marketing costs) are irrelevant in this case because these costs will not change in total
whether the special order is accepted or rejected. Surf Gear would gain an additional $17,500 (relevant
revenues, $55,000 – relevant costs, $37,500) in operating income by accepting the special order.
Potential Problems in Relevant-Cost Analysis
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.
In the Surf Gear example, the variable marketing cost of $5 per unit is irrelevant because Surf Gear will
incur no extra marketing costs by accepting the special order. But fixed manufacturing costs could be
relevant. The extra production of 5,000 towels per month does not affect fixed manufacturing costs
because we assumed that the relevant range is from 30,000 to 48,000 towels per month. In some cases,
however, producing the extra 5,000 towels might increase fixed manufacturing costs. Suppose Surf Gear
would need to run three shifts of 16,000 towels per shift to achieve full capacity of 48,000 towels per
month. Increasing the monthly production from 30,000 to 35,000 would require a partial third shift
because two shifts could produce only 32,000 towels. The extra shift would increase fixed manufacturing
costs, thereby making these additional fixed manufacturing costs relevant for this decision. Second, unit-
cost data can potentially mislead decision makers in two ways:
1. When irrelevant costs are included. Consider the $4.50 of fixed manufacturing cost per unit (direct
manufacturing labor, $1.50 per unit, plus manufacturing overhead,$3.00 per unit) included in the $12-

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per-unit manufacturing cost in the one-time-only special-order decision (see Exhibits 11-4 and 11-5).
This $4.50-per-unit cost is irrelevant, given the assumptions in our example, so it should be excluded.
2. When the same unit costs are used at different output levels. Generally, managers use total costs
rather than unit costs because total costs are easier to work with and reduce the chance for erroneous
conclusions. Then, if desired, the total costs can be unitized. In the Surf Gear example, total fixed
manufacturing costs remain at$135,000 even if Surf Gear accepts the special order and produces 35,000
towels. Including the fixed manufacturing cost per unit of $4.50 as a cost of the special order would lead
to the erroneous conclusion that total fixed manufacturing costs would increase to $157,500 ($4.50 per
towel 35,000 towels).
 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.
Insourcing-versus-Outsourcing and Make-versus-Buy Decisions
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 insourcing is producing the
product rather than acquiring it from external producer/supplier if acquisition cost is greater than
production cost. Honda relies on outside vendors to supply some component parts but 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. Surveys of companies indicate that managers consider quality,
dependability of suppliers, and costs as the most important factors in the make-or-buy decision.
Sometimes, however, qualitative factors dominate management’s make-or-buy decision.
Example 2: The Soho Company manufactures a two-in-one video system consisting of a DVD player
and a digital media receiver (that downloads movies and video from internet sites such as Netflix).
Columns 1 and 2 of the following table show the expected total and per-unit costs for manufacturing the
DVD-player of the video system. Soho plans to manufacture the 250,000 units in 2,000 batches of 125
units each. Variable batch-level costs of $625 per batch vary with the number of batches, not the total
number of units produced.

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 Expected Total Costs of
Producing 250,000 Units in
2,000 Batches Next Year Expected Cost per Unit
(1) (2) = (1) ÷ 250,000

Direct materials ($36 per unit * 250,000 units) $ 9,000,000 $36.00

DL ($10 per unit *250,000 units) 2,500,000 10.00
VMOH cost of power and utilities
($6 per unit * 250,000 units) 1,500,000 6.00
Mixed batch-level MOH cost of materials
Handling and setup [$750,000 +
($625 per batch * 2,000 batches)] 2,000,000 8.00
Fixed MOH costs of plant lease, insurance,
And administration 3,000,000 12.00
Total manufacturing costs $18,000,000 $72.00
Broad field, Inc., a manufacturer of DVD players, offers to sell Soho 250,000 DVD players next year for
$64 per unit on Soho’s preferred delivery schedule. Assume that financial factors will be the basis of this
make-or-buy decision. Should Soho make or buy the DVD player?
Based on the given information the company should buy DVD players because the expected $72-per-unit
cost of making the DVD player is more than the $64 per unit to buy it. But For the moment, suppose (a)
the capacity now used to make the DVD players will become an idle next year if the DVD players are
purchased and (b) the $3,000,000 of fixed manufacturing overhead will continue to be incurred next year
regardless of the decision made. Assume the $750,000 in fixed salaries to support materials handling and
setup will not be incurred if the manufacture of DVD players is completely shut down.
Total Relevant Cost Relevant Costs per Unit
Relevant Items Make Buy Make Buy
Outside purchase of parts $16,000,000 $64
Direct materials $ 9,000,000 $36
Direct manufacturing labor 2,500,000 10
Variable manufacturing overhead 1,500,000 5 6
Mixed (variable and fixed) materials handling
and setup overhead 2,000,000 8
Total relevant costs $15,000,000 $16,000,000 $60 $64
Difference in favor of making
DVD players $1,000,000 $4
A common term in decision making is an incremental cost. An incremental cost is the additional total
cost incurred for an activity. The incremental cost of making DVD players is the additional total cost of
$15,000,000 that Soho will incur if it decides to make DVD players. Similarly, the incremental cost of
buying DVD players from Broad field is the additional total cost of $16,000,000 that Soho will incur if it
decides to buy DVD players. A differential cost is a difference in total cost between incremental cost

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and incremental revenue. Based on this Soho should make the DVD player as production cost is lower
than acquisition cost.
Opportunity Costs and Outsourcing
In the simple make-or-buy decision, we assumed that the capacity currently used to make DVD players
will remain idle if Soho purchases the parts from Broad field. Often, however, the released capacity can
be used for other, profitable purposes. In this case, the choice Soho’s managers are faced with is not
whether to make or buy; the choice now centers on how best to use available product
ion capacity.
Example 3: Suppose that if Soho decides to buy DVD players for its video systems from Broadfield,
then Soho’s best use of the capacity that becomes available is to produce 100,000 Digitek, a portable,
stand-alone DVD player. From a manufacturing standpoint, Digitek are similar to DVD players made for
the video system. With help from operating managers, Soho’s management accountant estimates the
following future revenues and costs if Soho decides to manufacture and sell Digitek:
Incremental future revenues…………………………………………………………. $8,000,000
Incremental future costs
Direct materials………………………………………………. $3,400,000
Direct manufacturing labor……………………………………. 1,000,000
Variable overhead (such as power, utilities)…………………….. 600,000
Materials-handling and setup overheads …………………………500,000
Total incremental future costs ………………………………………………………..$5,500,000
Incremental future operating income…………………………………………………. $2,500,000
Because of capacity constraints, Soho can make either DVD players for its video-system unit or Digitek,
but not both. Which of the following two alternatives should Soho choose?
1. Make video-system DVD players and do not make Digitek
2. Buy video-system DVD players and make Digitek
The future incremental costs of buying video-system DVD players from an outside supplier
($16,000,000) exceed the future incremental costs of making video-system DVD players in-house
($15,000,000). Soho can use the capacity freed up by buying video-system DVD players to gain
$2,500,000 in operating income (incremental future revenues of $8,000,000 minus total incremental
future costs of $5,500,000) by making and selling Digitek. The net relevant costs of buying video-system
DVD players and making and selling Digitek are $16,000,000 – $2,500,000 = $13,500,000.
Alternatives for Soho
1. Make Video-System 2. Buy Video-System
DVD Players and Do DVD Players and
Relevant Items Not Make Digitek Make Digitek
PANEL A Total-Alternatives Approach to Make-or-Buy Decisions
Total incremental future costs of making/buying
Video -system DVD players $15,000,000 $16,000,000
Deduct excess of future revenues over future costs
from Digitek 0 (2,500,000)

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Total relevant costs under total-alternatives approach$15,000,000 $13,500,000
1) Make video system 2) Buy video system
DVD player DVD player
PANEL B Opportunity-Cost Approach to Make-or-Buy Decisions
Total incremental future costs of making/buying
Video-system DVD players $15,000,000 $16,000,000
Opportunity cost: Profit contribution forgone
Because capacity will not be used to make
Digitek, the next-best alternative 2,500,000 0
Total relevant costs under opportunity-cost approach $17,500,000 $16,000,000
Note that the differences in costs across the columns in Panels A and B are the same: The cost of
alternative 3 is $1,500,000 less than the cost of alternative 1, and $2,500,000 less than the cost of
alternative 2.
Product-Mix Decisions with 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. 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.
Example 4: Power Recreation assembles two engines, a snowmobile engine and a boat engine, at its
Lexington, Kentucky, plant.
Snowmobile Engine Boat Engine
Selling price ………………………………………………… $800………………………. $1,000
Variable cost per unit ………………………………………….560……………………………625
Contribution margin per unit………………………………... $240………………………….. $375
Contribution margin percentage ($240 ÷ $800; $375 ÷ $1,000) 30% ……………………….37.5%
Assume that only 600 machine-hours are available daily for assembling engines. Additional capacity
cannot be obtained in the short run. Power Recreation can sell as many engines as it produces. The
constraining resource, then, is machine-hours. It takes two machine-hours to produce one snowmobile
engine and five machine-hours to produce one boat engine. What product mix should Power Recreation’s
managers choose to maximize its operating income?
In terms of contribution margin per unit and contribution margin percentage, boat engines are more
profitable than snowmobile engines. The product that Power Recreation should produce and sell,
however, is not necessarily the product with the higher individual contribution margin per unit or
contribution margin percentage.

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Managers should choose the product with the highest contribution margin per unit of the constraining
resource (factor). That’s the resource that restricts or limits the production or sale of products.
Snowmobile Engine Boat Engine
Contribution margin per unit ………………………………..$240…………………………. $375
Machine-hours required producing one unit…………………2 m/hours ………..................5 m/hours
Contribution margin per machine-hour
$240 per unit ÷ 2 machine-hours/unit ………………………. $120/machine-hour
$375 per unit ÷ 5 machine-hours/unit…………………………………………………... $75/machine-hour
Total contribution margin for 600 machine-hours
$120/machine-hour * 600 machine-hours…………………… $72,000
$75/machine-hour * 600 machine-hours …………………………………………………. $45,000
Therefore, choosing to produce and sell snowmobile engines maximizes total contribution margin
($72,000 versus $45,000 from producing and selling boat engines) and operating income.
Customer Profitability (Dropping a Customer, Adding a Customer, Closing or Adding Branch
Offices or Segments)
Not only most companies make choices regarding which products and how much of each product to
produce, but they must also often make decisions about adding or dropping a product line or a business
segment. Similarly, if the cost object is a customer, companies must make decisions about adding or
dropping customers (analogous to a product line) or a branch office (analogous to a business segment).
We illustrate relevant-revenue and relevant-cost analysis for these kinds of decisions using customers
rather than products as the cost object.
Example 5: Allied West, the West Coast sales office of Allied Furniture, a wholesaler of specialized
furniture, supplies furniture to three local retailers: Vogel, Brenner, and Wisk. The expected revenues and
costs of Allied West by the customer for the upcoming year using its activity-based costing system.
Allied West assigns costs to customers based on the activities needed to support each customer.
Information on Allied West’s costs for different activities at various levels of the cost hierarchy follows:
 Furniture-handling labor costs vary with the number of units of furniture shipped to customers.
 Allied West reserves different areas of the warehouse to stock furniture for different customers.
For simplicity, assume that furniture-handling equipment in an area and depreciation costs on the
equipment that Allied West has already acquired are identified with individual customers
(customer level costs). Any unused equipment remains idle. The equipment has a one year useful
life and zero disposal value.
 Allied West allocates rent to each customer on the basis of the amount of warehouse space
reserved for that customer.
 Marketing costs vary with the number of sales visits made to customers.
 Sales-order costs are batch-level costs that vary with the number of sales orders received from
customers; delivery-processing costs are batch-level costs that vary with the number of shipments
made.
 Allied West allocates fixed general-administration costs (facility-level costs) to customers on the
basis of customer revenues.

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  Allied Furniture allocates its fixed corporate-office costs to sales offices on the basis of the
square feet area of each sales office. Allied West then allocates these costs to customers on the
basis of customer revenues.
In the following sections, we consider several decisions that Allied West’s managers face: Should Allied
West drop the Wisk account? Should it add a fourth customer, Loral? Should Allied Furniture close down
Allied West? Should it open another sales office, Allied South, whose revenues and costs are identical to
those of Allied West? Customer
Vogel Brenner Wisk Total
Revenues ……………………………………………. $500,000 $300,000 $400,000 $1,200,000
Cost of goods sold ……………………………………370,000 220,000 330,000 920,000
Furniture-handling labor ………………………………41,000 18,000 33,000 92,000
Furniture-handling equipment
Cost written off as depreciation ………………………12, 000 4,000 9,000 25,000
Rent ……………………………………………………14,000 8,000 14,000 36,000
Marketing support…………………………………….. 11,000 9,000 10,000 30,000
Sales-order and delivery processing………………….. 13,000 7,000 12,000 32,000
Fixed general administration…………………………. 20,000 12,000 16,000 48,000
Fixed corporate-office costs…………………………. 10,000 6,000 8,000 24,000
Total costs…………………………………………… 491,000 284,000 432,000 1,207,000
Operating income /Loss………………………………$ 9,000 $ 16,000 $ (32,000) $ (7,000)
Relevant-Revenue and Relevant-Cost Analysis of Dropping a Customer
Allied West’s managers believe the reason for the loss is that Wisk places low-margin orders with Allied,
and has relatively high sales-order, delivery-processing, furniture-handling, and marketing costs. Allied
West is considering several possible actions with respect to the Wisk account:
 Reducing its own costs of supporting Wisk by becoming more efficient
 Cutting back on some of the services that wisk offers
 Asking Wisk to place larger, less frequent orders
 Charging Wisk higher prices ,or
 Dropping the Wisk account.
The following analysis focuses on the operating-income effect of dropping the Wisk account for the year.
Allied West’s operating income will be $15,000 lower if it drops the Wisk account—the cost savings
from dropping the Wisk account, $385,000, will not be enough to offset the loss of $400,000 in
revenues—so Allied West’s managers decide to keep the account. Note that there is no opportunity cost
of using warehouse space for Wisk because without Wisk, the space and equipment will remain idle.
Depreciation on equipment that Allied West has already acquired is a past cost and therefore irrelevant;
rent, general-administration, and corporate-office costs are future costs that will not change if Allied
West drops the Wisk account, and hence irrelevant. Overhead costs allocated to the sales office and
individual customers are always irrelevant. The only question is, will expected total corporate-office
costs decrease as a result of dropping the Wisk account? In our example, they will not, so these costs are
irrelevant. If expected total corporate-office costs were to decrease by dropping the Wisk account, those

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savings would be relevant even if the amount allocated to Allied West did not change. To determine what
to do, Allied West’s managers must answer the question, what are the relevant revenues and relevant
costs? Information about the effect of dropping the Wisk account follows:
 Dropping the Wisk account will save cost of goods sold, furniture-handling labor, marketing
support, sales-order, and delivery-processing costs incurred on the account.
 Dropping the Wisk account will leave idle the warehouse space and furniture handling equipment
currently used to supply products to Wisk.
 Dropping the Wisk account will have no effect on fixed general-administration costs or fixed
corporate-office costs.
Allied West’s operating income will be $15,000 lower if it drops the Wisk account—the cost savings
from dropping the Wisk account, $385,000, will not be enough to offset the loss of $400,000 in
revenues—so Allied West’s managers decide to keep the account. Note that there is no opportunity cost
of using warehouse space for Wisk because without Wisk, the space and equipment will remain idle.
Depreciation on equipment that Allied West has already acquired is a past cost and therefore irrelevant;
rent, general-administration, and corporate-office costs are future costs that will not change if Allied
West drops the Wisk account, and hence irrelevant. Overhead costs allocated to the sales office and
individual customers are always irrelevant. The only question is, will expected total corporate-office
costs decrease as a result of dropping the Wisk account? In our example, they will not, so these costs are
irrelevant. If expected total corporate-office costs were to decrease by dropping the Wisk account, those
savings would be relevant even if the amount allocated to Allied West did not change.
(Incremental
Loss in Revenues)
and Incremental Incremental
Savings in Revenues and
Costs from (Incremental Costs)
Dropping Wisk from Adding
Account Loral Account
(1) (2)_____
Revenues $ (400,000) $400,000
Cost of goods sold 330,000 (330,000)
Furniture-handling labor 33,000 (33,000)
Furniture-handling equipment cost written off as depreciation 0 (9,000)
Rent 0 0
Marketing support 10,000 (10,000)
Sales-order and delivery processing 12,000 (12,000)
General administration 0 0
Corporate-office costs 0 0
Total costs 385,000 (394,000)
Effect on operating income (loss) $(15,000) $ 6,000

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Now suppose that if Allied West drops the Wisk account, it could lease the extra ware house space to
Sanchez Corporation for $20,000 per year. Then $20,000 would be Allied’s opportunity cost of
continuing to use the warehouse to service Wisk. Allied West would gain $5,000 by dropping the Wisk
account ($20,000 from lease revenue minus lost operating income of $15,000). Before reaching a
decision, Allied West’s managers must examine whether Wisk can be made more profitable so that
supplying products to Wisk earns more than the $20,000 from leasing to Sanchez. The managers must
also consider strategic factors such as the effect of the decision on Allied West’s reputation for
developing stable, long-run business relationships with its customers.
Relevant-Revenue and Relevant-Cost Analysis of Adding a Customer
Suppose that in addition to Vogel, Brenner, and Wisk, Allied West’s managers are evaluating the
profitability of adding a customer, Loral. There is no other alternative use of the Allied West facility.
Loral has a customer profile much like Wisk’s. Suppose Allied West’s managers predict revenues and
costs of doing business with Loral to be the same as the revenues and costs. In particular, Allied West
would have to acquire furniture-handling equipment for the Loral account costing $9,000, with a one-
year useful life and zero disposal value. If Loral is added as a customer, warehouse rent costs ($36,000),
general-administration costs ($48,000), and actual total corporate-office costs will not change. Should
Allied West add Loral as a customer? Incremental revenues exceed incremental costs by $6,000. The
opportunity cost of adding Loral is $0 because there is no alternative use of the Allied West facility. On
the basis of this analysis, Allied West’s managers would recommend adding Loral as a customer. Rent,
general-administration, and corporate-office costs are irrelevant because these costs will not change if
Loral is added as a customer. The cost of new equipment to support the Loral order (written off as
depreciation of $9,000, is relevant, that is because this cost can be avoided if Allied West decides not to
add Loral as a customer. Note the critical distinction here: Depreciation cost is irrelevant in deciding
whether to drop Wisk as a customer. Because depreciation on equipment that has already been purchased
is a past cost, but the cost of purchasing new equipment in the future, that will then be written off as
depreciation, is relevant in deciding whether to add Loral as a customer.
Relevant-Revenue and Relevant-Cost Analysis of Closing or Adding Branch Offices
or Segments
Companies periodically confront decisions about closing or adding branch offices or business segments.
For example, given Allied West’s expected loss of $7,000, should it be closed for the year? Assume that
closing Allied West will have no effect on total corporate-office costs and that there is no alternative use
for the Allied West space. The revenue loss of $1,200,000 will exceed the cost savings of $1,158,000,
leading to a decrease in operating income of $42,000 so Allied West should not be closed. The key
reasons are that closing Allied West will not save depreciation cost or actual total corporate-office costs.
Depreciation cost is past or sunk because it represents the cost of equipment that Allied West has already
purchased. Corporate-office costs allocated to various sales offices will change but the total amount of
these costs will not decline. The $24,000 no longer allocated to Allied West will be allocated to other
sales offices. Therefore, the $24,000 of allocated corporate-office costs is irrelevant, because it does not
represent expected cost savings from closing Allied West.

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Now suppose Allied Furniture has the opportunity to open another sales office, Allied South, whose
revenues and costs would be identical to Allied West’s costs, including a cost of $25,000 to acquire
furniture handling equipment with a one-year useful life and zero disposal value. Opening this office will
have no effect on total corporate-office costs.
(Incremental
Loss in Revenues)
and Incremental Incremental Revenues and
Savings in Costs (Incremental Costs)
from Closing from Opening
Allied West Allied South
(1) (2)
Revenues $(1,200,000) $1,200,000
Cost of goods sold 920,000 (920,000)
Furniture-handling labor 92,000 (92,000)
Furniture-handling equipment cost
Written off as depreciation 0 (25,000)
Rent 36,000 (36,000)
Marketing support 30,000 (30,000)
Sales-order and delivery processing 32,000 (32,000)
General administration 48,000 (48,000)
Corporate-office costs 0 0
Total costs 1,158,000 (1,183,000)
Effect on operating income (loss) $(42,000) $ 17,000
Should Allied Furniture open Allied South? It should open allied south, because opening Allied South
will increase operating income by $17,000. As before, the cost of new equipment to be purchased in the
future (and written off as depreciation) is relevant and allocated corporate-office costs should be ignored.
Total corporate office costs will not change if Allied South is opened, therefore these costs are irrelevant.
Irrelevance of Past Costs and Equipment- Replacement Decisions
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.
Example 6: East Company, a manufacturer of aircraft components, 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 aircraft parts ($1.1 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…………………………………. $1,000,000 $600,000
Useful life……………………………………... 5 years 2 years
Current age……………………………………. 3 years 0 years
Remaining useful life…………………………. 2 years 2 years
Accumulated depreciation…………………… $600,000 not acquired yet
Book value……………………………………. $400,000 Not acquired yet
Current disposal value (in cash) ……………… $40,000 Not acquired yet
Terminal disposal value (in cash 2 years from now) $0 $0
Annual operating costs (maintenance,
Energy, repairs, and so on) ………………………$800,000 $460,000
East Corporation uses straight-line depreciation. To focus on relevance, we ignore the time value of
money and income taxes. Should East replace its old machine?
1. Book value of old machine, $400,000is 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, $40,000. Relevant, because it is an expected future benefit that
will only occur if the machine is replaced.
3. Loss on disposal, $360,000. This is the difference between amounts in items 1 and 2.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, $600,000. Relevant, because it is an expected future cost that will only occur if
the machine is purchased.
The book value of the old machine does not differ between the alternatives and could be ignored for
decision-making purposes. No matter what the timing of the write-off— whether a lump-sum charge in
the current year or depreciation charges over the next two years—the total amount is still $400,000
because it is a past (historical) cost. In contrast, the $600,000 cost of the new machine and the current
disposal value of $40,000 for the old machine are relevant because they would not arise if Toledo’s
managers decided not to replace the machine. Note that the operating income from replacing is $120,000
higher for the two years together. Higher operating income as a result of lower costs of $120,000 by
replacing the machine—is obtained even though the book value is omitted from the calculations. The
only relevant items are the cash operating costs, the disposal value of the old machine, and the cost of the
new machine. Two Years Together
Keep Replace Difference
(1) (2) (3) = (1) – (2)
Cash operating costs ……………………… $1,600,000 $ 920,000 $680,000
Current disposal value of old machine……… — (40,000) 40,000
New machine, written off periodically
As depreciation………………………………. — 600,000 (600,000)
Total relevant costs ……………………… .$1,600,000 $1,480,000 $120,000
Based on this the organization should replace the old machinery to save the cost of $120,000.

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