Cost Accounting (14th Edition)

402 CHAPTER 11 DECISION MAKING AND RELEVANT INFORMATION
Exhibit 11-7
Total-Alternatives Approach and Opportunity-Cost Approach to Make-or-
Buy Decisions for Soho Company
Relevant Items
PANEL A Total-Alternatives Approach to Make-or-Buy Decisions
1. Make Video-System
DVD Players and Do
Not Make Digitek
Alternatives for Soho
2. Buy Video-System
DVD Players and
Make Digitek
Total incremental future costs of making/buying
video-system DVD players (from Exhibit 11-6) $15,000,000 $16,000,000
Deduct excess of future revenues over future costs
from Digitek 0 (2,500,000)
Total relevant costs under total-alternatives approach $15,000,000 $13,500,000
PANEL B Opportunity-Cost Approach to Make-or-Buy Decisions
1. Make Video-System
DVD Players
2. Buy Video-System
DVD Players
Total incremental future costs of making/buying
video-system DVD players (from Exhibit 11-6) $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.
The Opportunity-Cost Approach
Deciding to use a resource in a particular way causes a manager to forgo the opportunity
to use the resource in alternative ways. This lost opportunity is a cost that the manager
must consider when making a decision. Opportunity cost is the contribution to operating
income that is forgone by not using a limited resource in its next-best alternative use. For
example, the (relevant) cost of going to school for an MBA degree is not only the cost of
tuition, books, lodging, and food, but also the income sacrificed (opportunity cost) by
not working. Presumably, the estimated future benefits of obtaining an MBA (for example,
a higher-paying career) will exceed these costs.
Exhibit 11-7, Panel B, displays the opportunity-cost approach for analyzing the
alternatives faced by Soho. Note that the alternatives are defined differently in the total
alternatives approach (1. Make Video-System DVD Players and Do Not Make Digiteks
and 2. Buy Video-System DVD Players and Make Digiteks) and the opportunity cost
approach (1. Make Video-System DVD Players and 2. Buy Video-System DVD Players),
which does not reference Digiteks. Under the opportunity-cost approach, the cost of
each alternative includes (1) the incremental costs and (2) the opportunity cost, the profit
forgone from not making Digiteks. This opportunity cost arises because Digitek is
excluded from formal consideration in the alternatives.
Consider alternative 1, making video-system DVD players. What are all the costs of
making video-system DVD players? Certainly Soho will incur $15,000,000 of incremental
costs to make video-system DVD players, but is this the entire cost? No, because by
deciding to use limited manufacturing resources to make video-system DVD players, Soho
will give up the opportunity to earn $2,500,000 by not using these resources to make
Digiteks. Therefore, the relevant costs of making video-system DVD players are the incremental
costs of $15,000,000 plus the opportunity cost of $2,500,000.
Next, consider alternative 2, buy video-system DVD players. The incremental cost of
buying video-system DVD players will be $16,000,000. The opportunity cost is zero.