Relevant Revenues and Costs of Delays

Learning Objective 6 Determine the costs of delays

To determine the relevant revenues and costs of producing motor panels under Step 4, the management accountant prepares the following additional information:

ProductAnnual Average Number of OrdersAverage Selling Price per Order If the Average Manufacturing Cycle Time per Order IsDirect Materials Cost per OrderInventory Carrying Cost per Order per Hour
Less Than 300 HoursMore Than 300 Hours
Heating Blocks30$22,000$21,500$16,000$1.00
Motor Panels10  10,000    9,600    8,000  0.50

Manufacturing cycle times affect both revenues and costs. Revenues are affected because customers are willing to pay a higher price for faster delivery. On the cost side, direct materials costs and inventory carrying costs are the only relevant costs of introducing motor panels (all other costs are unaffected and therefore irrelevant). Inventory carrying costs equal the opportunity costs of the investment tied up in inventory (see Chapter 12) and the relevant costs of storage, such as space rental, spoilage, deterioration, and materials handling. Usually, companies calculate inventory carrying costs on a per-unit, per-year basis. To simplify the calculations, the management accountant calculates inventory carrying costs on a per-order, per-hour basis. Also, Formrob acquires direct materials at the time the order is received by manufacturing and, therefore, calculates inventory carrying costs for the duration of the manufacturing cycle time.

Exhibit 20-8 presents expected relevant revenues and relevant costs for the “introduce motor panels” and “do not introduce motor panels” alternatives. Based on the analysis, Formrob’s managers decide not to introduce motor panels, even though they have a positive contribution margin of $1,600 ($9,600−$8,000) per order and Formrob has the capacity to make them. If it produces motor panels, Formrob will, on average, use only 3,500 (Heating blocks:100 hours per order×30 orders+Motor panels: 50 hours per order×10 orders) of the available 4,000 machine-hours. So why is Formrob better off not introducing motor panels? Because of the negative effects that producing them will have on the existing product, heating blocks. The following table presents the costs of time, the expected loss in revenues and expected increase in carrying costs as a result of the delays caused by manufacturing motor panels.

Exhibit 20-8

Determining Expected Relevant Revenues and Relevant Costs for Formrob’s Decision to Introduce Motor Panels

Spreadsheet screenshot shows determining expected relevant revenues and relevant costs for Photon’s Decision to introduce Gears.

Relevant Items as described below:

Expected revenues

1. Alternative 1 Introduce Motor Panels: ($21,500 x 30) + ($9,600 x 10) = $741,000; average manufacturing cycle time will be more than 300 hours.

2. Alternative 2 Do Not Introduce Motor Panels: ($22,000 x 30) = $660,000; average manufacturing cycle time will be less than 300 hours.

3. Difference Relevant Items (difference between above 1 and 2): $81,000

Expected variable costs

1. Alternative 1 Introduce Motor Panels: ($16,000 x 30) + ($8,000 x 10) = $560,000.

2. Alternative 2 Do Not Introduce Motor Panels: $16,000 x 30 = $480,000. 

3. Difference Relevant Items (difference between above 1 and 2): (80,000)

Expected inventory carrying costs

1. Alternative 1 Introduce Motor Panels: (Average manufacturing cycle time for heating blocks x Carrying cost per order per hour for heating blocks x Expected number of orders for heating blocks) + (Average manufacturing cycle time for motor panels x Carrying cost per order per hour for motor panels x Expected number of orders for motor panels) = (425 x $1.00 x 30) + (375 x $0.50 x 10) = $12,750 + $1,875 = $14,625.

2. Alternative 2 Do Not Introduce Motor Panels: Average manufacturing cycle time for heating blocks x Carrying cost per order per hour for heating blocks x Expected number of orders for heating blocks = 250 x $1.00 x 30 = $7,500.

3. Difference Relevant Items (difference between above 1 and 2): (7,125) in parenthesis

Expected total costs

1. Alternative 1 Introduce Motor Panels: 574,625

2. Alternative 2 Do Not Introduce Motor Panels: 487,500

3. Difference Relevant Items (difference between above 1 and 2): (87,125) in parenthesis

Expected revenues minus expected costs

1. Alternative 1 Introduce Motor Panels: $166,375

2. Alternative 2 Do Not Introduce Motor Panels: $172,500

3. Difference Relevant Items (difference between above 1 and 2): (6,125) in parenthesis

A table shows costs of time, the expected loss in revenues and expected increase in carrying costs as a result of the delays caused by manufacturing motor panels

The table depicts heating blocks and motor panels in terms of the effect of increasing average manufacturing cycle time, including expected loss in revenues for heating blocks and expected increase in carrying costs for all products, as well as the expected loss in revenues plus expected increase in carrying costs of introducing motor panels. Totals are included as well. The details of the table are as follows:

1. Heating blocks

2. Motor panels

3. Total

Introducing motor panels will cause the average manufacturing cycle time of heating blocks to increase from 250 hours to 425 hours. Longer manufacturing cycle times will increase the inventory carrying costs of heating blocks and decrease heating block revenues (the average manufacturing cycle time for heating blocks will exceed 300 hours, so the average selling price per order will decrease from $22,000 to $21,500). Together with the inventory carrying cost of the motor panels, the expected cost of introducing the motor panels, $22,125, will exceed the expected contribution margin of $16,000 ($1,600 per order×10 expected orders) from selling motor panels by $6,125 (the difference calculated in Exhibit 20-8).

This example illustrates that when demand uncertainty is high, some unused capacity is desirable.* Increasing the capacity of a bottleneck resource reduces manufacturing cycle times and delays. One way to increase capacity is to reduce the time it takes for setups and processing. Another way to increase capacity is to invest in new equipment, such as flexible manufacturing systems that can be programmed to switch quickly from producing one product to producing another. Delays can also be reduced by carefully scheduling production, such as by batching similar jobs together for processing.

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