5.9. Make-or-buy decisions (2)

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Core Concepts of Accounting – Numbers and People

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Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

7 notes

Cours 3 sur 5 dans Specialization Understanding Modern Finance

Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them. Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation. This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects. The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

À partir de la leçon

Activity-Based Costing (ABC). Relevant Costs

In Week 5 we will study the more advanced approaches to costing – activity-based costing (ABC) and relevant costs – that provide for the more accurate costing of products, projects, and divisions, and allow to reveal actual relationship between numbers and people. We start with the analysis of ABC on an example of a small retail firm. Then we move on to the more detailed example of the use of ABC in manufacturing. Both examples will help us gain insight in the role of ABC in identifying ways to improve performance. Finally, we analyze the idea of relevant costs and its application to managerial actions –make-or-buy decisions, product mix under capacity constraints, customer profit analysis. Of special attention will be the role of relevant and opportunity costs in valuation.

5.1. Activity-based costing (ABC) – an overview8:38

5.2. ABC for a retail firm (1)9:01

5.3. ABC for a retail firm (2)13:21

5.4. ABC in manufacturing (1)13:37

5.5. ABC in manufacturing (2)13:21

5.6. Insights provided by ABC8:30

5.7. Relevant costs – an idea10:53

5.8. Make-or-buy decisions (1)6:04

5.9. Make-or-buy decisions (2)10:30

5.10. Product mix under capacity constraints8:33

5.11. Customer profit, ABC, and relevant costs7:32

5.12. Irrelevance of past costs10:43

Rencontrer les enseignants

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Now, let's proceed and

analyze the case when we buy these relays from company Alpha, Beta, Gamma.

But we will use the fried facilities to

produce switches for another company that is willing to buy them from us.

So, this is make or buy two.

So, we make switches

and so 6,000 at $15 a piece.

Let's see what we have now and we analyze our incremental.

So expected incremental revenue.

Well, this is clear this is $90,000 multiplied $15 by 6000.

Now, what are expected incremental costs?

Well, here we have some components and let's say direct materials will be $36,000,

now direct labor stands at $6,000,

a variable overhead $18,000

and mixed overhead $6,000.

We already know that fixed overhead is irrelevant.

So, now we can see that total incremental costs are $66,000

and therefore we have expected

incremental operating income of $24,000.

So, that is kind of cool because

remember we said that if we bought 5,000 relays from company Alpha,

Beta, Gamma we would save just $17 a piece instead of $20 and therefore we

may have sort of quoted loss of

about 5,000 because 5,000 pieces and a dollar a piece.

Here we make an additional $24,000.

So, it seems that the combined decisions or the choice of

selling switches to a third company and buying relays from Alpha,

Beta, Gamma for us seems to be the best choice.

Let's go ahead and analyze the all these choices.

So, we have three options.

Option one is, make relays and then do nothing else.

Then option two, buy relays from Alpha,

Beta, Gamma and then do nothing else.

Then option three, we buy relays plus make switches and sell them.

So, what do these alternative give us?

Let's say this is

the alternative and these are irrelevant costs.

Now, this is alternative one,

this is alternative two and this is an alternative three.

Let's see what do we have here.

Well, first of all we start at total cost

for relays and if we may total irrelevant costs,

these are only relevant costs and for alternative one if we make them in cost,

so this is $85,000.

Remember the total is 100 but 15 are irrelevant.

If we buy them versus $90,000,

if we buy and make switches this is also $90,000,

so this is the first part.

Then there are also future expected incremental revenues.

So, if we take option one,

we make relays and do nothing,

so here there is nothing.

For option two, we buy relays and here there is also nothing but in the third case,

it's $24,000 and I put that in brackets because this is we count costs.

So, the bottom line is the following.

So, these are total relevant costs and see what happens.

So, in option one, this is $85,000,

in option two this is

$90,000 and in option three this is just $66,000.

So, clearly option three is preferred.

We can see that the delta here is plus 19,000 if we compared against this.

So, we see the hierarchy all these options.

So, this is the worst this is second worst and this is the best option.

So, why did this happen?

This happens because if we buy relays we free up our facilities and that

gives us an option to make something else and compensate

part over costs by these additional or incremental revenues.

Now, so we can see here how close the idea of the opportunity cost is.

So, let's do the following,

so the opportunity cost idea.

I will redo the previous table keeping that in mind.

So, here we have relevant items,

and here are two options,

so this is make relays,

and this is by relays.

So, I analyze only these two but then see what happens.

So, we start with and here

a total incremental costs and here

this is remember that was $85,000 from

the previous page only colors have been changed but that's all right and this is $90,000.

But the next line goes differently and we'll put that the opportunity cost.

So this is foregone revenue

or better to say revenue less cost,

so this is forgone profit.

See how that goes.

Here this is nothing.

When we buy relays because this opportunity stays well,

but if we make them by having decided to make these relays in house,

we have to use our facilities.

So, we forego the opportunity cost of $24,000 and therefore

our total relevant costs here

are $109,000 and here are just $90,000.

So, we see the same difference of $19,000.

So we sort of,

this is the analysis or the opportunity cost,

the previous one was the just incremental costs and revenues but the idea stays the same.

We can see that if we decide to buy these relays,

then we have the option of adding $24,000 of

incremental revenue and if we decide not to buy but do them make them in-house,

that sort of freezes our opportunity to make these switches.

That does show the inextricable link

between the idea of relevance and the idea of the opportunity cost.

Now, in what follows,

we will apply the idea of relevant costs to

some other important areas that are key in valuing projects and companies.

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