DECISION MAKING AND RELEVANT INFORMATION 11-1 Outline the five-step sequence in a decision process. The five steps in the decision process outlined in Exhibit 11-1 of the text are 1. Identify the problem and uncertainties. 2. Obtain information. 3. Make predictions about the future. 4. Make decisions by choosing among alternatives. 5. Implement the decision, evaluate performance, and learn. 11-2 Define relevant costs. Why are historical costs irrelevant? Relevant costs are expected future costs that differ among the alternative courses of action being considered. Historical costs are irrelevant because they are past costs and, therefore, cannot differ among alternative future courses of action. 11-3 “All future costs are relevant.” Do you agree? Why? No. Relevant costs are defined as those expected future costs that differ among alternative courses of action being considered. Thus, future costs that do not differ among the alternatives are irrelevant to deciding which alternative to choose. 11-4 Distinguish between quantitative and qualitative factors in decision making. Quantitative factors are outcomes that are measured in numerical terms. Some quantitative factors are financial––that is, they can be easily expressed in monetary terms. Direct materials are an example of a quantitative financial factor. Other quantitative nonfinancial factors, such as on-time flight arrivals, cannot be easily expressed in monetary terms. Qualitative factors are outcomes that are difficult to measure accurately in numerical terms. An example is employee morale. 11-5 Describe two potential problems that should be avoided in relevant-cost analysis. Two potential problems that should be avoided in relevant cost analysis are (i) Do not assume all variable costs are relevant and all fixed costs are irrelevant. (ii) Do not use unit-cost data directly. It can mislead decision makers because a. it may include irrelevant costs, and b. comparisons of unit costs computed at different output levels lead to erroneous conclusions. 11-6 “Variable costs are always relevant, and fixed costs are always irrelevant.” Do you agree? Why? No. Some variable costs may not differ among the alternatives under consideration and, hence, will be irrelevant. Some fixed costs may differ among the alternatives and, hence, will be relevant. 11-7 “A component part should be purchased whenever the purchase price is less than its total manufacturing cost per unit.” Do you agree? Why? No. Some of the total manufacturing cost per unit of a product may be fixed and, hence, will not differ between the make and buy alternatives. These fixed costs are irrelevant to the make-or-buy decision. The key comparison is between purchase costs and the costs that will be saved if the company purchases the component parts from outside plus the additional benefits of using the resources freed up in the next best alternative use (opportunity cost). Furthermore, managers should consider nonfinancial factors such as quality and timely delivery when making outsourcing decisions. 11-8 Define opportunity cost. Opportunity cost is the contribution to income that is forgone (rejected) by not using a limited resource in its next-best alternative use. 11-9 “Managers should always buy inventory in quantities that result in the lowest purchase cost per unit.” Do you agree? Why? No. When deciding on the quantity of inventory to buy, managers must consider both the purchase cost per unit and the opportunity cost of funds invested in the inventory. For example, the purchase cost per unit may be low when the quantity of inventory purchased is large, but the benefit of the lower cost may be more than offset by the high opportunity cost of the funds invested in acquiring and holding inventory. 11-10 “Management should always maximize sales of the product with the highest contribution margin per unit.” Do you agree? Why? No. Managers should aim to get the highest contribution margin per unit of the constraining (that is, scarce, limiting, or critical) factor. The constraining factor is what restricts or limits the production or sale of a given product (for example, availability of machine-hours). 11-11 “A branch office or business segment that shows negative operating income should be shut down.” Do you agree? Explain briefly. No. For example, if the revenues that will be lost exceed the costs that will be saved, the branch or business segment should not be shut down. Shutting down will only increase the loss. Allocated costs and fixed costs that will not be saved are irrelevant to the shut-down decision. 11-12 “Cost written off as depreciation on equipment already purchased is always irrelevant.” Do you agree? Why? Cost written off as depreciation is irrelevant when it pertains to a past cost such as equipment already purchased. But the purchase cost of new equipment to be acquired in the future that will then be written off as depreciation is often relevant. 11-13 “Managers will always choose the alternative that maximizes operating income or minimizes costs in the decision model.” Do you agree? Why? No. Managers often favor the alternative that makes their performance look best so they focus on the measures used in the performance-evaluation model. If the performance-evaluation model does not emphasize maximizing operating income or minimizing costs, managers will most likely not choose the alternative that maximizes operating income or minimizes costs. 11-14 Describe the three steps in solving a linear programming problem. The three steps in solving a linear programming problem are (i) Determine the objective function. (ii) Specify the constraints. (iii) Compute the optimal solution. 11-15 How might the optimal solution of a linear programming problem be determined? The text outlines two methods of determining the optimal solution to an LP problem: (i) Trial-and-error approach (ii) Graphic approach Most LP applications in practice use standard software packages that rely on the simplex method to compute the optimal solution. 11-16 Qualitative and quantitative factors. Which of the following is not a qualitative factor that Atlas Manufacturing should consider when deciding whether to buy or make a part used in manufacturing their product? a. Quality of the outside producer’s product. b. Potential loss of trade secrets. c. Manufacturing deadlines and special orders. d. Variable cost per unit of the product. SOLUTION Choice "d" is correct. Calculating the costs of production of the part versus buying the part from an outside source is a quantitative factor used by a company to determine the lowest cost alternative. Choice "a" is incorrect. Whether the outsourced part can be manufactured to the required level of quality is a qualitative factor that Atlas would consider in their decision. Choice "b" is incorrect. Loss of confidentiality and trade secrets is a qualitative factor to consider when buying outside of the organization. Choice "c" is incorrect. An outside supplier may not be able to meet specific deadlines or have the same priorities as the purchaser and is a qualitative factor that needs to be considered. 11-17 Special order, opportunity cost. Chade Corp. is considering a special order brought to it by a new client. If Chade determines the variable cost to be $9 per unit, and the contribution margin of the next best alternative of the facility to be $5 per unit, then if Chade has: a. Full capacity, the company will be profitable at $4 per unit. b. Excess capacity, the company will be profitable at $6 per unit. c. Full capacity, the selling price must be greater than $5 per unit. d. Excess capacity, the selling price must be greater than $9 per unit. SOLUTION Choice "d" is correct. At excess capacity, Chade will accept the special order as long as the sales price is greater than the variable cost per unit. At $9 per unit for variable cost, Chade will accept the special order at a sales price greater than $9 per unit. Choice "a" is incorrect. At full capacity, Chade will accept the special order as long as the sales price is greater than both the variable cost per unit and the opportunity cost (contribution margin) of the next best alternative per unit. The company will not be profitable in this scenario unless the sales price is greater than $14 per unit ($9 variable cost + $5 contribution margin). Choice "b" is incorrect. At excess capacity, the company must receive a selling price greater than $9 per unit in order to be profitable. Choice "c" is incorrect. At full capacity, the selling price must be greater than $14 per unit in order for the special order to be profitable. 11-18 Special order, opportunity cost. In order to determine whether a special order should be accepted at full capacity, the sales price of the special order must be compared to the per unit: a. Contribution margin of the special order. b. Variable cost and contribution margin of the special order. c. Variable cost and contribution margin of the next best alternative. d. Variable cost of current production and the contribution margin of the next best alternative. SOLUTION Choice "d" is correct. If the selling price is greater than the variable cost per unit of the special order (at full capacity) plus the contribution margin per unit of the next best alternative (the opportunity cost), then the company will accept the special order. Choice "a" is incorrect. Variable costs have to be taken into account, in addition to the contribution margin of the next best alternative. Choice "b" is incorrect. The contribution margin of the next best alternative (rather than the special order) must be taken into account in order to determine whether to accept the special order. Choice "c" is incorrect. The variable costs of the special order (not the next best alternative) must be accounted for in this determination. 11-19 Keep or drop a business segment. Lees Corp. is deciding whether to keep or drop a small segment of its business. Key information regarding the segment includes: Contribution margin: 35,000 Avoidable fixed costs: 30,000 Unavoidable fixed costs: 25,000 Given the information above, Lees should: a. Drop the segment because the contribution margin is less than total fixed costs. b. Drop the segment because avoidable fixed costs exceed unavoidable fixed costs. c. Keep the segment because the contribution margin exceeds avoidable fixed costs. d. Keep the segment because the contribution margin exceeds unavoidable fixed costs. SOLUTION Choice "c" is correct. Whether to keep or drop a segment will depend on whether the contribution margin of the segment in question exceeds avoidable fixed costs (relevant costs that wouldn’t exist if the segment did not exist). Unavoidable fixed costs will be incurred regardless of whether or not the segment is kept, so they are not factored into the decision. Choice "a" is incorrect. Fixed costs need to be broken out between avoidable and unavoidable in order to make the determination as to whether to keep or drop a segment. Lees Corp. would only drop the segment if the contribution margin of the segment is less than the avoidable fixed (relevant) cost. Choice "b" is incorrect. The contribution margin needs to be compared to avoidable fixed costs in order to determine whether to keep or drop a segment. Choice "d" is incorrect. Unavoidable fixed costs will be incurred regardless, so contribution margin of the segment needs to be compared to the avoidable fixed costs as the key elements to determine whether to keep or drop a segment. 11-20 Relevant costs. Ace Cleaning Service is considering expanding into one or more new market areas. Which costs are relevant to Ace’s decision on whether to expand? SOLUTION Choice "a" is correct. Sunk costs are not relevant since they were incurred in the past and cannot be recovered as a result of the company’s current decision. Variable costs are relevant as also any avoidable fixed costs associated with the decision. Opportunity cost is the cost of foregoing the next best alternative when making a decision. These costs are relevant since the company has alternative courses of action. Choice "b" is incorrect. Sunk costs are not relevant since they were incurred in the past and cannot be recovered as a result of the company’s current decision. Choice "c" is incorrect. Opportunity cost is the cost of foregoing the next best alternative when making a decision. These costs are relevant since the company has alternative courses of action. Choice "d" is incorrect. Sunk costs are not relevant since they were incurred in the past and cannot be recovered as a result of the company’s current decision. Variable costs are relevant as also any avoidable fixed costs associated with the decision. 11-21 Disposal of assets. Answer the following questions. 1. A company has an inventory of 1,250 assorted parts for a line of missiles that has been discontinued. The inventory cost is $76,000. The parts can be either (a) remachined at total additional costs of $26,500 and then sold for $33,500 or (b) sold as scrap for $2,500. Which action is more profitable? Show your calculations. 2. A truck, costing $100,500 and uninsured, is wrecked its first day in use. It can be either (a) disposed of for $18,000 cash and replaced with a similar truck costing $103,000 or (b) rebuilt for $88,500 and thus be brand-new as far as operating characteristics and looks are concerned. Which action is less costly? Show your calculations. SOLUTION (20 min.) Disposal of assets. 1. This is an unfortunate situation, yet the $76,000 costs are irrelevant regarding the decision to remachine or scrap. The only relevant factors are the future revenues and future costs. By ignoring the accumulated costs and deciding on the basis of expected future costs, operating income will be maximized (or losses minimized). The difference in favor of remachining is $4,500: (a) (b) Remachine Scrap Future revenues Deduct future costs Operating income $33,500 26,500 $ 7,000 Difference in favor of remachining $2,500 – $2,500 $4,500 2. This, too, is an unfortunate situation. But the $100,500 original cost is irrelevant to this decision. The difference in relevant costs in favor of replacing is $3,500 as follows: (a) (b) Replace New truck Deduct current disposal price of existing truck Rebuild existing truck Difference in favor of replacing Rebuild $103,000 – 18,000 – $ 85,000 – $88,500 $88,500 $3,500 Note, here, that the current disposal price of $18,000 is relevant, but the original cost (or book value, if the truck were not brand new) is irrelevant. 11-22 Relevant and irrelevant costs. Answer the following questions. 1. DeCesare Computers makes 5,200 units of a circuit board, CB76, at a cost of $280 each. Variable cost per unit is $190 and fixed cost per unit is $90. Peach Electronics offers to supply 5,200 units of CB76 for $260. If DeCesare buys from Peach it will be able to save $10 per unit in fixed costs but continue to incur the remaining $80 per unit. Should DeCesare accept Peach’s offer? Explain. 2. LN Manufacturing is deciding whether to keep or replace an old machine. It obtains the following information: Original cost Useful life Current age Old Machine $10,700 10 years 7 years New Machine $9,000 3 years 0 years Remaining useful life Accumulated depreciation Book value Current disposal value (in cash) Terminal disposal value (3 years from now) Annual cash operating costs 3 years $7,490 $3,210 $2,200 $0 $17,500 3 years Not acquired yet Not acquired yet Not acquired yet $0 $15,500 LN Manufacturing uses straight-line depreciation. Ignore the time value of money and income taxes. Should LN Manufacturing replace the old machine? Explain. SOLUTION (20 min.) Relevant and irrelevant costs. 1. Relevant costs Variable costs Avoidable fixed costs Purchase price Unit relevant cost Make Buy $190 10 ____ $200 $260 $260 DeCesare Computers should reject Peach’s offer. The $80 of fixed costs is irrelevant because it will be incurred regardless of this decision. When comparing relevant costs between the choices, Peach’s offer price is higher than the cost to continue to produce. 2. Cash operating costs (3 years) Current disposal value of old machine Cost of new machine Total relevant costs Keep $52,500 _ _____ $52,500 Replace $46,500 (2,200) 9,000 $53,300 Difference $6,000 2,200 (9,000) $ (800) LN Manufacturing should keep the old machine. The cost savings are less than the cost to purchase the new machine. 11-23 Multiple choice. (CPA) Choose the best answer. 1. The Dalton Company manufactures slippers and sells them at $12 a pair. Variable manufacturing cost is $5.00 a pair, and allocated fixed manufacturing cost is $1.25 a pair. It has enough idle capacity available to accept a one-time-only special order of 5,000 pairs of slippers at $6.25 a pair. Dalton will not incur any marketing costs as a result of the special order. What would the effect on operating income be if the special order could be accepted without affecting normal sales: (a) $0, (b) $6,250 increase, (c) $28,750 increase, or (d) $31,250 increase? Show your calculations. 2. The Sacramento Company manufactures Part No. 498 for use in its production line. The manufacturing cost per unit for 30,000 units of Part No. 498 is as follows: Direct materials $5 Direct manufacturing labor Variable manufacturing overhead Fixed manufacturing overhead allocated Total manufacturing cost per unit 22 8 15 50 The Counter Company has offered to sell 30,000 units of Part No. 498 to Sacramento for $47 per unit. Sacramento will make the decision to buy the part from Counter if there is an overall savings of at least $30,000 for Sacramento. If Sacramento accepts Counter’s offer, $8 per unit of the fixed overhead allocated would be eliminated. Furthermore, Sacramento has determined that the released facilities could be used to save relevant costs in the manufacture of Part No. 575. For Sacramento to achieve an overall savings of $30,000, the amount of relevant costs that would have to be saved by using the released facilities in the manufacture of Part No. 575 would be which of the following: (a) $90,000, (b) $150,000, (c) $180,000, or (d) $210,000? Show your calculations. What other factors might Sacramento consider before outsourcing to Counter? SOLUTION (15 min.) 1. (b) Multiple choice. Special order price per unit Variable manufacturing cost per unit Contribution margin per unit Effect on operating income $6.25 5.00 $1.25 = $1.25  5,000 units = $6,250 increase 2. (b) Costs of purchases, 30,000 units  $47 Total relevant costs of making: Variable manufacturing costs, $5 + $22 + $8 Fixed costs eliminated Costs saved by not making Multiply by 30,000 units, so total costs saved are $43  30,000 Extra costs of purchasing outside Minimum overall savings for Sacramento Necessary relevant costs that would have to be saved in manufacturing Part No. 575 $1,410,000 $35 8 $43 1,290,000 120,000 30,000 $ 150,000 Before outsourcing to Counter, Sacramento must consider the consequence of increasing its dependence on Counter. Sacramento would want to be sure about the quality of Counter’s product and the reliability of its delivery schedules over a long-run period. Sacramento would also want Counter to continuously reduce costs. To achieve all these goals, Sacramento may want to build close partnerships and alliances with Counter. 11-24 Special order, activity-based costing. (CMA, adapted) The Gold Plus Company manufactures medals for winners of athletic events and other contests. Its manufacturing plant has the capacity to produce 11,000 medals each month. Current production and sales are 10,000 medals per month. The company normally charges $150 per medal. Cost information for the current activity level is as follows: Variable costs that vary with number of units produced $ 350,000 Direct materials 375,000 Direct manufacturing labor 100,000 Variable costs (for setups, materials handling, quality control, and so on) that vary with number of batches, 200 batches * $500 per batch Fixed manufacturing costs 300,000 Fixed marketing costs 275,000 Total costs $1,400,000 Gold Plus has just received a special one-time-only order for 1,000 medals at $100 per medal. Accepting the special order would not affect the company’s regular business. Gold Plus makes medals for its existing customers in batch sizes of 50 medals (200 batches × 50 medals per batch = 10,000 medals). The special order requires Gold Plus to make the medals in 25 batches of 40 medals. Required: 1. Should Gold Plus accept this special order? Show your calculations. 2. Suppose plant capacity were only 10,500 medals instead of 11,000 medals each month. The special order must either be taken in full or be rejected completely. Should Gold Plus accept the special order? Show your calculations. 3. As in requirement 1, assume that monthly capacity is 11,000 medals. Gold Plus is concerned that if it accepts the special order, its existing customers will immediately demand a price discount of $10 in the month in which the special order is being filled. They would argue that Gold Plus’s capacity costs are now being spread over more units and that existing customers should get the benefit of these lower costs. Should Gold Plus accept the special order under these conditions? Show your calculations. SOLUTION (30 min.) Special order, activity-based costing. 1. Direct materials cost per unit ($350,000  10,000 units) = $35 per unit Direct manufacturing labor cost per unit ($375,000  10,000 units) = $37.50 per unit Variable cost per batch = $500 per batch Gold Plus’ operating income under the alternatives of accepting/rejecting the special order are: Revenues Variable costs: Direct materials With OneWithout OneTime Only Time Only Special Order Special Order 11,000 Units 10,000 Units $1,500,000 $1,600,000 350,000 385,0001 Difference 1,000 Units $100,000 35,000 Direct manufacturing labor Batch manufacturing costs Fixed costs: Fixed manufacturing costs Fixed marketing costs Total costs Operating income 1 2 3 375,000 100,000 412,5002 112,5003 37,500 12,500 300,000 275,000 1,400,000 $ 100,000 300,000 275,000 1,485,000 $ 115,000 –– –– 85,000 $ 15,000 $350,000 + ($35  1,000 units) $375,000 + ($37.50  1,000 units) $100,000 + ($500  25 batches) Alternatively, we could calculate the incremental revenue and the incremental costs of the additional 1,000 units as follows: Incremental revenue $100  1,000 $100,000 Incremental direct manufacturing costs $35  1,000 units 35,000 Incremental direct manufacturing costs $37.50  1,000 units 37,500 Incremental batch manufacturing costs $500  25 batches 12,500 Total incremental costs 85,000 Total incremental operating income from accepting the special order $ 15,000 Gold Plus should accept the one-time-only special order if it has no long-term implications because accepting the order increases Gold Plus’ operating income by $15,000. If, however, accepting the special order would cause the regular customers to be dissatisfied or to demand lower prices, then Gold Plus will have to trade off the $15,000 gain from accepting the special order against the operating income it might lose from regular customers. 2. Gold Plus has a capacity of 10,500 medals. Therefore, if it accepts the special one-time order of 1,000 medals, it can sell only 9,500 medals instead of the 10,000 medals that it currently sells to existing customers. That is, by accepting the special order, Gold Plus must forgo sales of 500 medals to its regular customers. Alternatively, Gold Plus can reject the special order and continue to sell 9,500 medals to its regular customers. Gold Plus’ operating income from selling 9,500 medals to regular customers and 1,000 medals under one-time special order follow: Revenues (9,500  $150) + (1,000  $100) $1,525,000 Direct materials (9,500  $35) + (1,000  $35) 367,500 Direct manufacturing labor (9,500  $37.50) + (1,000  $37.50) 393,750 Batch manufacturing costs (1901  $500) + (25  $500) 107,500 Fixed manufacturing costs 300,000 Fixed marketing costs 275,000 Total costs 1,443,750 Operating income $ 81,250 1 Gold Plus makes regular medals in batch sizes of 50. To produce 9,500 medals requires 190 (9,500 ÷ 50) batches. Accepting the special order will result in a decrease in operating income of $18,750 ($100,000 – $81,250). The special order should, therefore, be rejected. A more direct approach would be to focus on the incremental effects––the benefits of accepting the special order of 1,000 units versus the costs of selling 500 fewer units to regular customers. Increase in operating income from the 1,000-unit special order equals $15,000 (requirement 1). The loss in operating income from selling 500 fewer units to regular customers equals: Lost revenue, $150  500 Savings in direct materials costs, $35  500 Savings in direct manufacturing labor costs, $37.50  500 Savings in batch manufacturing costs, $500  10 Operating income lost $(75,000) 17,500 18,750 5,000 $(33,750) Accepting the special order will result in a decrease in operating income of $18,750 ($15,000 – $33,750). The special order should, therefore, be rejected. NOTE: Even if operating income had increased by accepting the special order, Gold Plus should consider the effect on its regular customers of accepting the special order. For example, would selling 1,000 fewer medals to its regular customers cause these customers to find new suppliers that might adversely impact Gold Plus’s business in the long run. 3. Gold Plus should not accept the special order. Increase in operating income by selling 1,000 units under the special order (requirement 1) Operating income lost from existing customers ($10  10,000) Net effect on operating income of accepting special order $ 15,000 (100,000) $ (85,000) The special order should, therefore, be rejected. 11-25 Make versus buy, activity-based costing. The Svenson Corporation manufactures cellular modems. It manufactures its own cellular modem circuit boards (CMCB), an important part of the cellular modem. It reports the following cost information about the costs of making CMCBs in 2017 and the expected costs in 2018: Svenson manufactured 8,000 CMCBs in 2017 in 40 batches of 200 each. In 2018, Svenson anticipates needing 10,000 CMCBs. The CMCBs would be produced in 80 batches of 125 each. The Minton Corporation has approached Svenson about supplying CMCBs to Svenson in 2018 at $300 per CMCB on whatever delivery schedule Svenson wants. Required: 1. Calculate the total expected manufacturing cost per unit of making CMCBs in 2018. 2. Suppose the capacity currently used to make CMCBs will become idle if Svenson purchases CMCBs from Minton. On the basis of financial considerations alone, should Svenson make CMCBs or buy them from Minton? Show your calculations. 3. Now suppose that if Svenson purchases CMCBs from Minton, its best alternative use of the capacity currently used for CMCBs is to make and sell special circuit boards (CB3s) to the Essex Corporation. Svenson estimates the following incremental revenues and costs from CB3s: On the basis of financial considerations alone, should Svenson make CMCBs or buy them from Minton? Show your calculations. SOLUTION (30 min.) 1. Make versus buy, activity-based costing. The expected manufacturing cost per unit of CMCBs in 2018 is as follows: Direct materials, $170  10,000 Direct manufacturing labor, $45  10,000 Variable batch manufacturing costs, $1,500  80 Fixed manufacturing costs Avoidable fixed manufacturing costs Unavoidable fixed manufacturing costs Total manufacturing costs Total Manufacturing Costs of CMCB (1) $1,700,000 450,000 120,000 Manufacturing Cost per Unit (2) = (1) ÷ 10,000 $170 45 12 320,000 800,000 $3,390,000 32 80 $339 2. The following table identifies the incremental costs in 2015 if Svenson (a) made CMCBs and (b) purchased CMCBs from Minton. Incremental Items Total Incremental Costs Make Buy Per-Unit Incremental Costs Make Buy Cost of purchasing CMCBs from Minton Direct materials Direct manufacturing labor Variable batch manufacturing costs Avoidable fixed manufacturing costs Total incremental costs Difference in favor of making $3,000,000 $1,700,000 450,000 120,000 320,000 $2,590,000 $3,000,000 $300 $170 45 12 32 $259 $300 $41 $410,000 Note that the opportunity cost of using capacity to make CMCBs is zero because Svenson would keep this capacity idle if it purchases CMCBs from Minton. Svenson should continue to manufacture the CMCBs internally because the incremental costs to manufacture are $259 per unit compared to the $300 per unit that Minton has quoted. Note that the unavoidable fixed manufacturing costs of $800,000 ($80 per unit) will continue to be incurred whether Svenson makes or buys CMCBs. These are not incremental costs under either the make or the buy alternative and, hence, are irrelevant. 3. Svenson should continue to make CMCBs. The simplest way to analyze this problem is to recognize that Svenson would prefer to keep any excess capacity idle rather than use it to make CB3s. Why? Because expected incremental future revenues from CB3s, $2,000,000, are less than expected incremental future costs, $2,150,000. If Svenson keeps its capacity idle, we know from requirement 2 that it should make CMCBs rather than buy them. An important point to note is that, because Svenson forgoes no contribution by not being able to make and sell CB3s, the opportunity cost of using its facilities to make CMCBs is zero. It is, therefore, not forgoing any profits by using the capacity to manufacture CMCBs. If it does not manufacture CMCBs, rather than lose money on CB3s, Svenson will keep capacity idle. A longer and more detailed approach is to use the total alternatives or opportunity cost analyses shown in Exhibit 11-7 of the chapter. Choices for Svenson Make CMCBs Buy CMCBs and Do Not and Make Relevant Items Make CB3s CB3s, if Profitable TOTAL-ALTERNATIVES APPROACH TO MAKE-OR-BUY DECISIONS Total incremental costs of making/buying CMCBs (from requirement 2) Because incremental future costs exceed incremental future revenues from CB3s, Svenson will make zero CB3s even if it buys CMCBs from Minton Total relevant costs $2,590,000 $3,000,000 0 0 $2,590,000 $3,000,000 Svenson will minimize manufacturing costs and maximize operating income by making CMCBs. OPPORTUNITY-COST APPROACH TO MAKE-OR-BUY DECISIONS Total incremental costs of making/buying CMCBs (from requirement 2) Opportunity cost: profit contribution forgone because capacity will not be used to make CB3s Total relevant costs * $2,590,000 $3,000,000 0* $2,590,000 0 $3,000,000 Opportunity cost is zero because Svenson does not give up anything by not making CB3s. Svenson is best off leaving the capacity idle (rather than manufacturing and selling CB3s).