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I'm Larry Walther.
This is principlesofaccounting.com, Chapter 24,
in which we consider analytics for managerial decision making.
We need to begin this chapter by considering cost characteristics and
their impact on decisions.
Specifically, giving consideration to costs that are sunk
versus those that are relevant.
Sunk costs are costs that have already been expended and
they should not influence future decision-making.
Relevant costs are items where future costs and
revenues are expected to differ between alternatives.
Our decision-making process is going to be to identify relevant items and
identify which has the best incremental outcome.
This is easier said than done, however.
And so let's look at a fairly comprehensive example for
Dillaway Company.
They had a truck that was involved in an accident.
The truck cost $60,000 and was 40% depreciated.
An insurance company is going to provide $30,000 toward the damages on the truck.
Thinking additionally,
they'd gone to a local car dealer who said that they could repair the truck for
$24,000 or they're willing to buy the truck as is, where is for $10,000.
And that Dillaway has found an undamaged, but
otherwise identical truck on sale for $32,000.
And so you look at all of that information,
well, what of that is sunk and what of that is relevant?
The truck's original cost is sunk.
It's irrelevant.
So is the degree to which it's depreciated.
So is the degree to which there might be a gain or loss on the disposal of the truck.
The $30,000 to be received from the insurance company is irrelevant.
There's no difference between the two alternatives.
We're only looking for costs and
revenue items where there's a difference between alternative actions.
So all that matters, really, is that the truck can be repaired for $24,000.
Or it can be sold for 10,000 and an alternative truck purchased for 32,000.
On the one hand, we'd be spending $24,000 to be up and running.
On the other hand, we would be spending 22,000 to be up and running.
That is, 32,000 minus 10,000.
In that very simple way, the only difference is the relevant items reflect
the $2,000 advantage for the sale of the truck.
That's the better option, so we're going to sell the truck and
buy the new one for 32,000.
Can it really be that simple?
What about all of the other information?
Well, I've done quite a bit of factual analysis to determine the impact on income
and cash flows to prove we get to exactly the same conclusion
by a much more cumbersome process.
I'm not so concerned that you follow the details of this,
except that you see that we do get to the same, simple $2,000 difference.
So to think through this thoroughly,
the sale of the truck at $60,000 with 24,000 of accumulated depreciation.
So the truck has a 36,000 net book value and
we're going to get 30,000 back on insurance.
Which will leave a remaining basis in the truck, if you will, of 6,000.
We can trade it in for $10,00 trade-in allowance, which would give rise to
a 4,000 accounting gain at that point on the truck.
And then we'll buy a new truck for 32,000,
which triggers depreciation in the future of 32,000.
Alternatively, for the repair of the truck, it's really the same analysis.
We have a $6,000 reduced basis.
We add $24,000 for repair.
And we're at a $30,000 basis, which gives rise to 30,000 of future depreciation.
So let's look at our financial accounting statement outcomes.
The sale of the truck would trigger a $4,000 gain and
32,000 of future depreciation.
The repair would trigger a 30,000 future depreciation.
And so looking, the impact net if we sell the truck is
a $28,000 reduction in income after all is said and done.
It's a $30,000 reduction in income if we repair the truck.
A $2,000 difference in accounting incomes.
That's the same $2,000 we saw with the simple relevant items analysis.
The cash flow analysis shows the same thing.
On the sale of the truck, we've got 30,000 cash inflow from insurance.
We've got 10,000 inflow from selling the used truck.
We've got 32,000 cash outflow from buying the alternative truck.
A net $8,000 of cash inflow.
Whereas, on the repair of the truck,
we've got 30,000 of insurance proceeds less 24,000 to repair it.
Leaves us with $6,000 less cash, a less favorable outcome on cash flow analysis.
We keep circling back to the same conclusion.
However, sometimes decisions are not given just two clear cut options.
Suppose the dealer says hey, we've got a very brand new wonderful truck out there
that's 80,000 and we'll give you a $27,000 trade-in allowance for your truck on that.
The incremental cost of this option can be seen as $53,000.
Now, far more than the other choices but you'd have a brand new truck.
Maybe that delivers certain qualitative advantages that you'd
also want to take into account.
So managers must be mindful of the impacts of decisions on production capacity,
customers, employees, and other qualitative factors.
Analytics support decision making but they certainly don't supplant judgment.
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