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Relevant Costing for the Opportunity Cost

Explanation of Spreadsheet:

Primarily this question is one that resolves around incremental revenues and costs. According to my textbook, relevant information involves "costs or benefits that are different for each course of action". Horngren in another textbook on management accounting highlights that an "incremental cost is the additional cost incurred for an activity" (i.e, telemetry units). Incremental revenue is defined in an analogous manner - the additional revenue form an activity.

In this analysis, I have decided to leave out the standard room rate of $120 per day when calculating the revenue from the addition of the telemetry units. By only including the $80 or $120 incremental revenue from the telemetry units, I believe (but want your advice) that the revenue will be better matched to the costs as outlined in the question. As we can see in the question, the costs that are stipulated are only related to the telemetry units (incremental costs of this activity), not the actual standard room revenue.

I believe therefore that we will have a more accurate differential margin to base our Return On Equipment calculation (as seen in the attached solution) as the income figure I have derived (made up of only incremental revenues and incremental costs) is directly related to the initial investment amount ($44,570).

I was a little concerned about the effect on the 'bad debts and insurance estimate' of 10%. But in reality if we think back to the basics, we are only interested in the effect of the 10% on the differential revenue, not the entire room rate...

The Return On Capital percentages are much more realistic as well, ranging between 16.95% to over 252.81%.

The second part of the question to this problem asks us to "advice management as to the alternative to choose explaining why you think this is the right choice".

This is where the opportunity cost comes into play: Basing our answer only on the return on capital, we could deduce that charging $120 per day at a 60% usage rate is the best alternative (alternative D - the obvious choice) as it has the highest return on capital. But by including the opportunity cost, the whole story changes!

Because of the inherent opportunity costs of committing to this project (Forgone revenue from the cardiac rooms), we find that option C is actually the best alternative. In my answer of course, I would have to reveal that there are numerous qualitative issues to consider as well.

So what is your interpretation of this? Do you think I'm right here?

I know that in the end it makes no difference to the final alternative chosen but nevertheless the lecturer stipulated that if asked this sort of question in the exam to only include relevant information to the question at hand because in generating information in the workplace is a costly process, requiring time and effort and it is a requirement of the management accountant to simplify and shorten the data-gathering process so as to enhance decision-making within an organisation.


Solution Preview

please refer to the attachment.

* I think the "incremental revenues and costs" costs are used in comparing alternative projects, which only studies the differential between these options.
The average annual costs are actually the same for all the options. The opportunity cost from loss of regular medical-surgical patient is the same as well. So you can either include it as your opportunity cost OR deduct the standard room rate of $120 from the revenue.

However, the return on investment is another case, which requires ...

Solution Summary

The relevant costings for the opportunity costs are determined. Decision-making within an organization are determined.