Relevant Cost For Decision Making

Relevant Costs for Decision
Making
Chapter Thirteen
McGrawHill/Irwin
Copyright2008,TheMcGrawHillCompanies,Inc.
13-2
Learning Objective 1
Identify relevant and

irrelevant costs and
benefits in a decision.
McGrawHill/Irwin
13-3
Cost Concepts for Decision Making
A relevant cost is a cost that differs

between alternatives.
1
McGrawHill/Irwin
13-4
Identifying Relevant Costs
An avoidable cost can be eliminated, in whole or

in part, by choosing one alternative over
another. Avoidable costs are relevant costs.
Unavoidable costs are irrelevant costs.
Two broad categories of costs are never
relevant in any decision. They include:
Sunk costs.
Future costs that do not differ between the
alternatives.
McGrawHill/Irwin
13-5
Relevant Cost Analysis: A Two-Step

Process
Step 1 Eliminate costs and benefits that do not differ
between alternatives.
Step 2 Use the remaining costs and benefits that
differ between alternatives in making the
decision. The costs that remain are the
differential, or avoidable, costs.
McGrawHill/Irwin
13-6
Different Costs for Different Purposes
Costs that are

relevant in one
decision situation
may not be relevant
in another context.
McGrawHill/Irwin
13-7

Cynthia, a Boston student, is considering visiting her friend in New York.
She can drive or take the train. By car, it is 230 miles to her friends
apartment. She is trying to decide which alternative is less expensive
and has gathered the following information:
Automobile Costs (based on 10,000 miles driven per year)
1
2
3
4
5
6
Annual straight-line depreciation on car

Cost of gasoline
Annual cost of auto insurance and license
Maintenance and repairs
Parking fees at school
Total average cost
$45 per month

month 8 months
months
Annual Cost
of Fixed Items
$
2,800
1,380
360
Cost per
Mile
$
0.280
0.050
0.138
0.065
0.036
$
0.569
$1.60 per gallon 32 MPG

$18,000 cost $4,000
$4,000 salvage
salvage value
value 5 years
McGrawHill/Irwin
13-8

Automobile Costs (based on 10,000 miles driven per year)
1
2
3
4
5
6
Annual straight-line depreciation on car

Cost of gasoline
Annual cost of auto insurance and license
Maintenance and repairs
Parking fees at school
Total average cost
7
8
9
10
11
12
13
McGrawHill/Irwin
Annual Cost
of Fixed Items
$
2,800
1,380
360
Cost per
Mile
$
0.280
0.050
0.138
0.065
0.036
$
0.569
Some Additional Information

Reduction in resale value of car per mile of wear
Round-tip train fare
Benefits of relaxing on train trip
Cost of putting dog in kennel while gone
Benefit of having car in New York
Hassle of parking car in New York
Per day cost of parking car in New York
$ 0.026
$
104
????
$
40
????
????
$
25
13-9

Which costs and benefits are relevant in Cynthias
decision?
The cost of the
car is a sunk cost
and is not
relevant to the
current decision.
The annual cost of

insurance is not
relevant. It will remain
the same if she drives
or takes the train.
However, the cost of gasoline is clearly relevant

if she decides to drive. If she takes the train,
the cost would now be incurred, so it varies
depending on the decision.
McGrawHill/Irwin
13-10

decision?
The cost of
maintenance and
repairs is relevant. In
the long-run these
costs depend upon
miles driven.
The monthly
school parking
fee is not
relevant because
it must be paid if
Cynthia drives or
takes the train.
At this point, we can see that some of the average

cost of $0.569 per mile are relevant and others are
not.
McGrawHill/Irwin
13-11

decision?
The decline in resale
value due to additional
miles is a relevant
cost.
The round-trip train

fare is clearly relevant.
If she drives the cost
can be avoided.
Relaxing on the train is

relevant even though it
is difficult to assign a
dollar value to the
benefit.
The kennel cost is not

relevant because
Cynthia will incur the
cost if she drives or
takes the train.
McGrawHill/Irwin
13-12

decision?
The cost of parking is
relevant because it can
be avoided if she takes
the train.
The benefits of having a car in New York and
the problems of finding a parking space are
both relevant but are difficult to assign a
dollar amount.
McGrawHill/Irwin
13-13

From a financial standpoint, Cynthia would be better
off taking the train to visit her friend. Some of the
non-financial factor may influence her final decision.
Relevant Financial Cost of Driving
Gasoline (460 @ $0.050 per mile)
Maintenance (460 @ $0.065 per mile)
Reduction in resale (460 @ $0.026 per mile)
Parking in New York (2 days @ $25 per day)
Total
$ 23.00
29.90
11.96
50.00
$ 114.86
Relevant Financial Cost of Taking the Train

Round-trip ticket
$ 104.00
McGrawHill/Irwin
13-14
Total and Differential Cost Approaches

The management of a company is considering a new labor saving
machine that rents for $3,000 per year. Data about the companys
annual sales and costs with and without the new machine are:
Sales (5,000 units @ $40 per unit)

Less variable expenses:
Direct materials (5,000 units @ $14 per unit)
Direct labor (5,000 units @ $8 and $5 per unit)
Variable overhead (5,000 units @ $2 per unit)
Total variable expenses
Contribution margin
Less fixed expense:
Other
Rent on new machine
Total fixed expenses
Net operating income
McGrawHill/Irwin
Current
Situation
$
200,000
Situation
With New
Machine
$
200,000
Differential
Costs and
Benefits
-
70,000
40,000
10,000
120,000
80,000
70,000
25,000
10,000
105,000
95,000
15,000
15,000
62,000
62,000
18,000
62,000
3,000
65,000
30,000
(3,000)
(3,000)
12,000
13-15

As you can see, the only costs that differ between the alternatives are
the direct labor costs savings and the increase in fixed rental costs.
Current
Situation
$
200,000
Situation
With New
Machine
$
200,000
Differential
Costs and
Benefits
-
70,000
40,000
10,000
120,000
80,000
70,000
25,000
10,000
105,000
95,000
15,000
15,000
We can efficiently analyze the decision by 62,000

62,000
looking at the different costs and revenues
$
18,000
and arrive at the same solution.
62,000
3,000
65,000
30,000
(3,000)
(3,000)
12,000
Sales (5,000 units @ $40 per unit)

Direct materials (5,000 units @ $14 per unit)
Direct labor (5,000 units @ $8 and $5 per unit)
Variable overhead (5,000 units @ $2 per unit)
Contribution margin
Less fixed expense:
Other
Rent on new machine
Net operating income
Net Advantage to Renting the New Machine

Decrease in direct labor costs (5,000 units @ $3 per unit)
Increase in fixed rental expenses
Net annual cost saving from renting the new machine
McGrawHill/Irwin
$
$
15,000
(3,000)
12,000
13-16

Using the differential approach is desirable for
two reasons:
1. Only rarely will enough information be
available to prepare detailed income
statements for both alternatives.
2. Mingling irrelevant costs with relevant costs
may cause confusion and distract attention
away from the information that is really
critical.
McGrawHill/Irwin
13-17
Prepare an analysis
showing whether a product
line or other business
segment should be
dropped or retained.
McGrawHill/Irwin
13-18
Adding/Dropping Segments
One of the most important decisions
managers make is whether to add or
drop a business segment, such as a
product or a store.
Lets see how relevant costs should

be used in this type of decision.
McGrawHill/Irwin
13-19
Due to the declining popularity of digital

watches, Lovell Companys digital
watch line has not reported a profit for
several years. Lovell is considering
dropping this product line.
McGrawHill/Irwin
13-20
A Contribution Margin Approach

DECISION
DECISION RULE
RULE
Lovell
Lovell should
should drop
drop the
the digital
digital watch
watch segment
segment only
only
ifif its
its profit
profit would
would increase.
increase. This
This would
would only
only
happen
happen ifif the
the fixed
fixed cost
cost savings
savings exceed
exceed the
the lost
lost
contribution
contribution margin.
margin.
Lets look at this solution.
McGrawHill/Irwin
13-21
Segment Income Statement
Digital Watches
Sales
Less: variable expenses
Variable manufacturing costs
Variable shipping costs
Commissions
Contribution margin
Less: fixed expenses
General factory overhead
Salary of line manager
Depreciation of equipment
Advertising - direct
Rent - factory space
General admin. expenses
Net operating loss
McGrawHill/Irwin
$ 500,000
$ 120,000
5,000
75,000
$ 60,000
90,000
50,000
100,000
70,000
30,000
200,000
$ 300,000
400,000
$ (100,000)
13-22
Digital Watches
Sales
$ 500,000
Less:
variable expenses
Investigation
has
Investigation
has revealed
revealed that
that total
total fixed
fixed general
general
Variable manufacuring costs $ 120,000
factory
overhead
factory costs
overhead and
and general
general
Variable shipping
5,000
administrative
expenses
not
ifif
Commissions
200,000
administrative
expenses would
would75,000
not be
be affected
affected
Contribution
margin
$
300,000
the
watch
the digital
digital
watch line
line is
is dropped.
dropped. The
The fixed
fixed
general
factory
overhead
and
general
general
factory
overhead
and
$ 60,000general
administrative
expenses
to
administrative
expenses assigned
assigned
to this
this product
product
90,000
Depreciation
equipment to
50,000
would
reallocated
product
would be
be of
reallocated
to other
other
product lines.
lines.
100,000
70,000
30,000
400,000
Net operating loss
$ (100,000)
McGrawHill/Irwin
13-23
Digital Watches
Sales
$ 500,000
Less: variable expenses
Variable
manufacturing
$ 120,000
The
used
to
The equipment
equipment
usedcosts
to manufacture
manufacture
Variable shipping costs
5,000
digital
watches
has
no
resale
digital watches has no resale
Commissions
75,000
200,000
value
or
value
or alternative
alternative use.
use.
Contribution
margin
$ 300,000
$ 60,000
90,000
Depreciation of equipment
50,000
Should
Lovell
retain
Should
Lovell
retain or
or drop
drop
100,000
the digital
digital watch
watch
segment?
Rent - factory space the
70,000 segment?
30,000
400,000
Net operating loss
$ (100,000)
McGrawHill/Irwin
13-24
A Contribution Margin Approach

Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped
Less fixed costs that can be avoided
Salary of the line manager
$
90,000
100,000
70,000
Net disadvantage
$ (300,000)
260,000
$ (40,000)
RRe
ettaai
inn
McGrawHill/Irwin
13-25
Comparative Income Approach
The Lovell solution can also be obtained by

preparing comparative income statements
showing results with and without the digital
watch segment.
Lets look at this second approach.
McGrawHill/Irwin
13-26

Solution
Keep
Drop
Digital
Digital
Watches
Watches
Difference
Sales
$ 500,000
$
$ (500,000)
Manufacturing expenses
120,000
120,000
Shipping
5,000
5,000
Commissions
75,000
75,000
200,000
200,000
Contribution margin
300,000
(300,000)
Less fixed expenses:
60,000
90,000
Depreciation
50,000
IfIf the
the digital
digital watch
watch
100,000
line
line is
is dropped,
dropped, the
the
70,000
company
30,000
company gives
gives up
up
400,000
its
contribution
its
contribution
Net operating loss
$ (100,000)
margin.
margin.
McGrawHill/Irwin
13-27

Solution
Keep
Drop
Digital
Digital
Watches
Watches
Difference
Sales
$ 500,000
$
$ (500,000)
120,000
120,000
Shipping
5,000
5,000
Commissions
75,000
75,000
200,000
200,000
Contribution margin
300,000
(300,000)
60,000
60,000
90,000
Depreciation
50,000
On
the
On 100,000
the other
other hand,
hand, the
the general
general
70,000
factory
overhead
factory
overhead would
would be
be the
the
30,000
same.
So
same.
So this
this cost
cost really
really isnt
isnt
400,000
Net operating loss
$ (100,000) relevant.
relevant.
McGrawHill/Irwin
13-28

Solution
Keep
Drop
Digital
Digital
Watches
Watches
Sales
$ 500,000
$
But
we
wouldnt
need
But we 120,000
wouldnt need -aa
manager
the
Shipping
manager for
for5,000
the product
product-line
line
Commissions
75,000
anymore.
anymore.
200,000
Contribution margin
300,000
60,000
60,000
90,000
Depreciation
50,000
100,000
70,000
30,000
400,000
Net operating loss
$ (100,000)
McGrawHill/Irwin
Difference
$ (500,000)
120,000
5,000
75,000
200,000
(300,000)
90,000
13-29

Solution
Keep
Drop
Digital
Digital
Watches
Watches
Difference
Sales
$ 500,000
$
$ (500,000)
Less
expenses:
IfIfvariable
the
watch
the digital
digital
watch line
line is
is dropped,
dropped, the
the net
net-book
book value
value
Manufacturing
expenses
120,000
- The
120,000
of
the
equipment
would
be
written
off.
of
the
equipment
would
be
written
off.
The
Shipping
5,000
5,000
depreciation
been
depreciation that
that would
would have
have
been taken
taken- will
will flow
flow75,000
Commissions
75,000
Total variable
expenses
200,000as
through
the
through
the income
income statement
statement
as aa loss
loss-instead.
instead.200,000
Contribution margin
300,000
(300,000)
60,000
60,000
90,000
90,000
Depreciation
50,000
50,000
100,000
70,000
30,000
400,000
Net operating loss
$ (100,000)
McGrawHill/Irwin
13-30

Solution
Keep
Drop
Digital
Digital
Watches
Watches
Sales
$ 500,000
$
120,000
Shipping
5,000
Commissions
75,000
200,000
Contribution margin
300,000
60,000
60,000
90,000
Depreciation
50,000
50,000
100,000
70,000
30,000
30,000
400,000
140,000
Net operating loss
$ (100,000)
$ (140,000)
McGrawHill/Irwin
Difference
$ (500,000)
120,000
5,000
75,000
200,000
(300,000)
90,000
100,000
70,000
260,000
$ (40,000)
13-31
Beware of Allocated Fixed Costs
Why should we keep the

digital watch segment
when its showing a
$100,000 loss?
McGrawHill/Irwin
13-32
The answer lies in the

way we allocate
common fixed costs to
our products.
McGrawHill/Irwin
13-33
Our allocations can

make a segment look
less profitable than it
really is.
McGrawHill/Irwin
13-34
Prepare a make or buy

analysis.
McGrawHill/Irwin
13-35
The Make or Buy Decision

When a company is involved in more than one activity
in the entire value chain, it is vertically integrated.
A decision to carry out one of the activities in the
value chain internally, rather than to buy externally
from a supplier is called a make or buy decision.
McGrawHill/Irwin
13-36
Vertical Integration- Advantages
Smoother flow of
parts and materials
Better quality
control
Realize profits
McGrawHill/Irwin
13-37
Vertical Integration- Disadvantage
Companies may fail

to take advantage of
suppliers who can
create economies of
scale advantage by
pooling demand from
numerous
companies.
McGrawHill/Irwin
13-38
The Make or Buy Decision: An Example

Essex Company manufactures part 4A that is
used in one of its products.
The unit product cost of this part is:
Direct materials
Direct labor
Variable overhead
Depreciation of special equip.
Supervisor's salary
Unit product cost
McGrawHill/Irwin
9
5
1
3
2
10
$ 30
13-39

The special equipment used to manufacture part 4A
has no resale value.
The total amount of general factory overhead, which
is allocated on the basis of direct labor hours, would
be unaffected by this decision.
The $30 unit product cost is based on 20,000 parts
produced each year.
An outside supplier has offered to provide the
20,000 parts at a cost of $25 per part.
Should we accept the suppliers offer?

McGrawHill/Irwin
13-40

Cost
Per Unit
Outside purchase price
$ 25
Direct materials
Direct labor
Variable overhead
Depreciation of equip.
Supervisor's salary
Total cost
9
5
1
3
2
10
$ 30
Cost of 20,000 Units

Buy
Make
$ 500,000
180,000
100,000
20,000
40,000
$ 340,000
$ 500,000
20,000 $9 per unit = $180,000

McGrawHill/Irwin
13-41

Cost
Per Unit
$ 25
Direct materials
Direct labor
Variable overhead
Supervisor's salary
Total cost
9
5
1
3
2
10
$ 30

Buy
Make
$ 500,000
180,000
100,000
20,000
40,000
$ 340,000
$ 500,000
The
The special
special equipment
equipment has
has no
no resale
resale
value
value and
and is
is aa sunk
sunk cost.
cost.
McGrawHill/Irwin
13-42

Cost
Per Unit
$ 25
Direct materials
Direct labor
Variable overhead
Supervisor's salary
Total cost
9
5
1
3
2
10
$ 30

Buy
Make
$ 500,000
180,000
100,000
20,000
40,000
$ 340,000
$ 500,000
Not
Not avoidable;
avoidable; irrelevant.
irrelevant. IfIf the
the product
product is
is
dropped,
dropped, itit will
will be
be reallocated
reallocated to
to other
other products.
products.
McGrawHill/Irwin
13-43

Cost
Per Unit
$ 25
Direct materials
Direct labor
Variable overhead
Supervisor's salary
Total cost
9
5
1
3
2
10
$ 30

Buy
Make
$ 500,000
180,000
100,000
20,000
40,000
$ 340,000
$ 500,000
Should we make or buy part 4A?

McGrawHill/Irwin
13-44
Opportunity Cost
An opportunity cost is the benefit that is foregone as

a result of pursuing some course of action.
Opportunity costs are not actual dollar outlays and
are not recorded in the formal accounts of an
organization.
How would this concept potentially relate to the
Essex Company?
McGrawHill/Irwin
13-45
Prepare an analysis
showing whether a special
order should be accepted.
McGrawHill/Irwin
13-46
Key Terms and Concepts
A special order is a one-time

order that is not considered
part of the companys normal
ongoing business.
When analyzing a special

order, only the incremental
costs and benefits are
relevant.
McGrawHill/Irwin
13-47
Special Orders
Jet, Inc. makes a single product whose normal selling
price is $20 per unit.
A foreign distributor offers to purchase 3,000 units for $10
per unit.
This is a one-time order that would not affect the
companys regular business.
Annual capacity is 10,000 units, but Jet, Inc. is currently
producing and selling only 5,000 units.
Should Jet accept the offer?
McGrawHill/Irwin
13-48
Special Orders
$8 variable cost
McGrawHill/Irwin
13-49
Special Orders
If Jet accepts the offer, net operating income will
increase by $6,000.
Increase
Increase
Increase
in revenue (3,000 $10)

in costs (3,000 $8 variable cost)
in net income
$ 30,000
24,000
$ 6,000
Note: This answer assumes that fixed costs are

unaffected by the order and that variable marketing
costs must be incurred on the special order.
McGrawHill/Irwin
13-50
Quick Check
Northern Optical ordinarily sells the X-lens for $50.
The variable production cost is $10, the fixed
production cost is $18 per unit, and the variable
selling cost is $1. A customer has requested a
special order for 10,000 units of the X-lens to be
imprinted with the customers logo. This special
order would not involve any selling costs, but
Northern Optical would have to purchase an
imprinting machine for $50,000.
(see the next page)
McGrawHill/Irwin
13-51
Quick Check
What is the rock bottom minimum price below which
Northern Optical should not go in its negotiations
with the customer? In other words, below what
price would Northern Optical actually be losing
money on the sale? There is ample idle capacity to
fulfill the order and the imprinting machine has no
further use after this order.
a. $50
b. $10
c. $15
d. $29
McGrawHill/Irwin
13-52
Quick Check
What is the rock bottom minimum price below which
Northern Optical should not go in its negotiations
with the customer? In other words, below what
price would Northern Optical actually be losing
money on the sale? There is ample idle capacity to
fulfill the order and the imprinting machine has no
further use after this order.
Variable production cost
$100,000
a. $50
Additional fixed cost
+ 50,000
b. $10
Total relevant cost
$150,000
c. $15 Number of units
10,000
d. $29 Average cost per unit =
$15
McGrawHill/Irwin
13-53
Determine the most

profitable use of a
constrained resource and
the value of obtaining
more of the constrained
resource.
McGrawHill/Irwin
13-54
Key Terms and Concepts

When a limited resource
of some type restricts
the companys ability to
satisfy demand, the
company is said to have
a constraint.
The machine or process

that is limiting overall
output is called the
bottleneck it is the
constraint.
McGrawHill/Irwin
13-55
Utilization of a Constrained Resource
When a constraint exists, a company should

select a product mix that maximizes the total
contribution margin earned since fixed costs
usually remain unchanged.
A company should not necessarily promote those
products that have the highest unit contribution
margin.
Rather, it should promote those products that
earn the highest contribution margin in relation to
the constraining resource.
McGrawHill/Irwin
13-56
Utilization of a Constrained Resource: An

Example
Ensign Company produces two products and
selected data are shown below:
McGrawHill/Irwin
13-57

Machine A1 is the constrained resource and
is being used at 100% of its capacity.
There is excess capacity on all other
machines.
Machine A1 has a capacity of 2,400 minutes
per week.
Should Ensign focus its efforts on

Product 1 or Product 2?
McGrawHill/Irwin
13-58
Quick Check
How many units of each product can be
processed through Machine A1 in one minute?
a.
b.
c.
d.
McGrawHill/Irwin
Product 1
1 unit
1 unit
2 units
2 units
Product 2
0.5 unit
2.0 units
1.0 unit
0.5 unit
13-59
Quick Check
How many units of each product can be
processed through Machine A1 in one minute?
a.
b.
c.
d.
Product 1
1 unit
1 unit
2 units
2 units
Product 2
0.5 unit
2.0 units
1.0 unit
0.5 unit
I was just checking to make sure

you are with us.
McGrawHill/Irwin
13-60
Quick Check
What generates more profit for the company,
using one minute of machine A1 to process
Product 1 or using one minute of machine A1
to process Product 2?
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.
McGrawHill/Irwin
13-61
Quick Check
With one minute of machine A1, we could
makegenerates
1 unit of Product
1, with
a contribution
What
more profit
for the
company,
margin
$24, or
units of A1
Product
2, each
using
oneof
minute
of2machine
to process
with
a contribution
margin
$15. A1
Product
1 or
using one minute
ofof
machine
to process Product
2?= $30 > $24
2 $15
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.
McGrawHill/Irwin
13-62

The key is the contribution margin per unit of the
constrained resource.
Product 2 should be emphasized. Provides more

valuable use of the constrained resource machine A1,
yielding a contribution margin of $30 per minute as
opposed to $24 for Product 1.
McGrawHill/Irwin
13-63

The key is the contribution margin per unit of the
constrained resource.
IfIf there
there are
are no
no other
other considerations,
considerations, the
the best
best
plan
plan would
would be
be to
to produce
produce to
to meet
meet current
current
demand
demand for
for Product
Product 22 and
and then
then use
use remaining
remaining
capacity
capacity to
to make
make Product
Product 1.
1.
McGrawHill/Irwin
13-64

Lets see how this plan would work.
Alloting
Alloting Our
Our Constrained
Constrained Resource
Resource (Machine
(Machine A1)
A1)
Weekly
Weeklydemand
demand for
for Product
Product22
Time
Time required
required per
perunit
unit
Total
Total time
time required
required to
to make
make
Product
Product22
McGrawHill/Irwin
2,200
2,200
0.50
0.50
units
units
min.
min.
1,100
1,100 min.
min.
13-65

Alloting
Alloting Our
Our Constrained
Resource (Machine
(Machine A1)
A1)
Weekly
Weeklydemand
demand for
for Product
Product22
Time
Time required
required per
perunit
unit
Total
Total time
time required
required to
to make
make
Product
Product22
Total
Total time
time available
available
Time
Time used
used to
to make
make Product
Product22
Time
Time available
available for
for Product
Product11
McGrawHill/Irwin
2,200
2,200
0.50
0.50
units
units
min.
min.
1,100
1,100 min.
min.
2,400
2,400
1,100
1,100
1,300
1,300
min.
min.
min.
min.
min.
min.
13-66

Alloting
Alloting Our
Our Constrained
Resource (Machine
(Machine A1)
A1)
Weekly
Weeklydemand
demand for
for Product
Product22
Time
Time required
required per
perunit
unit
Total
Total time
time required
required to
to make
make
Product
Product22
Total
Total time
time available
available
Time
Time used
used to
to make
make Product
Product22
Time
Time available
available for
for Product
Product11
Time
Time required
required per
perunit
unit
Production
Production of
ofProduct
Product11
McGrawHill/Irwin
2,200
2,200
0.50
0.50
units
units
min.
min.
1,100
1,100 min.
min.
2,400
2,400
1,100
1,100
1,300
1,300
1.00
1.00
1,300
1,300
min.
min.
min.
min.
min.
min.
min.
min.
units
units
13-67

According to the plan, we will produce 2,200 units
of Product 2 and 1,300 of Product 1. Our
contribution margin looks like this.
Production and sales (units)

Contribution margin per unit
Total contribution margin
Product 1
1,300
$
24
$ 31,200
Product 2
2,200
$
15
$ 33,000
The total contribution margin for Ensign is $64,200.

McGrawHill/Irwin
13-68
Quick Check
Colonial Heritage makes reproduction colonial
furniture from select hardwoods.
Chairs
Selling price per unit
$80
Variable cost per unit
$30
Board feet per unit
2
Monthly demand
600
Tables
$400
$200
10
100
The companys supplier of hardwood will only be

able to supply 2,000 board feet this month. Is this
enough hardwood to satisfy demand?
a. Yes
b. No
McGrawHill/Irwin
13-69
Quick Check
Colonial Heritage makes reproduction colonial
furniture from select hardwoods.
Chairs
$80
$30
Board feet per unit
2
Monthly demand
600
Tables
$400
$200
10
100
The companys supplier of hardwood will only be

able to supply 2,000 board feet this month. Is this
enough hardwood to satisfy demand?
a. Yes
b. No (2 600) + (10 100 ) = 2,200 > 2,000
McGrawHill/Irwin
13-70
Quick Check
Chairs
$80
$30
Board feet per unit
2
Monthly demand
600
Tables
$400
$200
10
100
The companys supplier of hardwood will only

be able to supply 2,000 board feet this month.
What plan would maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
McGrawHill/Irwin
13-71
Quick Check
Chairs Tables
Selling price
$ 80 $ 400
Chairs Tables
Variable
200
Selling price per
unit cost$80
$400 30
Variable cost Contribution
per unit
$30
margin $200
$ 50 $ 200
Board feet perBoard
unit feet
2
10 2
10
Monthly demand
600
100
CM per board foot
$ 25 $ 20
The companys supplier of hardwood will only

of chairs
be able to supply Production
2,000 board
feet this 600
month.
feet required
What plan would Board
maximize
profits? 1,200
Board feet remaining
800
a. 500 chairs andBoard
100 feet
tables
per table
10
b. 600 chairs andProduction
80 tablesof tables
80
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
McGrawHill/Irwin
13-72
Quick Check
As before, Colonial Heritages supplier of hardwood will
only be able to supply 2,000 board feet this month.
Assume the company follows the plan we have
proposed. Up to how much should Colonial Heritage be
willing to pay above the usual price to obtain more
hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero
McGrawHill/Irwin
13-73
Quick Check
As before, Colonial Heritages supplier of hardwood will
The
additional
wood
would
used
to make
only be
able to supply
2,000
boardbe
feet
this month.
tables.
In this use,
each
board
Assume
the company
follows
the plan
we foot
have of
proposed. Up
to how
should
Heritage
be
additional
wood
willmuch
allow
the Colonial
company
to earn
willing
to pay above
price to obtain
moreand
an
additional
$20the
of usual
contribution
margin
hardwood?
profit.
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero
McGrawHill/Irwin
13-74
Managing Constraints
Finding ways to
process more units
through a resource
bottleneck
McGrawHill/Irwin
At the bottleneck itself:

Improve the process
Add overtime or another shift
Hire new workers or acquire
more machines
Subcontract production
Reduce amount of defective
units produced
Add workers transferred from
non-bottleneck departments
13-75
Prepare an analysis
showing whether joint
products should be sold at
the split-off point or
processed further.
McGrawHill/Irwin
13-76
Joint Costs
In some industries, a number of end
products are produced from a single raw
material input.
Two or more products produced from a
common input are called joint products.
products
The point in the manufacturing process
where each joint product can be
recognized as a separate product is
called the split-off point.
point
McGrawHill/Irwin
13-77
Joint Products
Oil
Joint
Input
Common
Production
Process
Gasoline
Chemicals
Split-Off
Point
McGrawHill/Irwin
13-78
Joint Products
Joint
Costs
Joint
Input
Common
Production
Process
Oil
Gasoline
Chemicals
Split-Off
Point
McGrawHill/Irwin
Separate
Processing
Final
Sale
Final
Sale
Separate
Processing
Final
Sale
Separate
Product
Costs
13-79
The Pitfalls of Allocation

Joint costs are often
allocated to end products on
the basis of the relative
sales value of each product
or on some other basis.
Although allocation is needed for
some purposes such as balance
sheet inventory valuation,
allocations of this kind are very
dangerous for decision making.
McGrawHill/Irwin
13-80
Sell or Process Further

Joint costs are irrelevant in decisions regarding
what to do with a product from the split-off
point forward.
It will always be profitable to continue
processing a joint product after the split-off
point so long as the incremental revenue
exceeds the incremental processing costs
incurred after the split-off point.
McGrawHill/Irwin
13-81
Sell or Process Further: An Example

Sawmill, Inc. cuts logs from which unfinished
lumber and sawdust are the immediate joint
products.
Unfinished lumber is sold as is or processed
further into finished lumber.
Sawdust can also be sold as is to gardening
wholesalers or processed further into prestologs.
McGrawHill/Irwin
13-82
Data about Sawmills joint products includes:
Sales value at the split-off point

Sales value after further processing
Allocated joint product costs
Cost of further processing
McGrawHill/Irwin
Per Log
Lumber
Sawdust
$
140
$
40
270
176
50
50
24
20
13-83

Analysis of Sell or Process Further
Per Log
Lumber

Incremental revenue
McGrawHill/Irwin
270
140
130
Sawdust
50
40
10
13-84

Per Log
Lumber

Incremental revenue
Profit (loss) from further processing
McGrawHill/Irwin
270
140
130
50
80
Sawdust
50
40
10
20
(10)
13-85

Per Log
Lumber

Incremental revenue
Profit (loss) from further processing
270
140
130
50
80
Sawdust
50
40
10
20
(10)
Should we process the lumber further

and sell the sawdust as is?
McGrawHill/Irwin
13-86
Activity-Based Costing and Relevant

Costs
ABC can be used to help identify potentially
relevant costs for decision-making purposes.
However, before making a
decision, managers must
decide which of the
potentially relevant costs are
actually avoidable.
McGrawHill/Irwin
13-87
McGrawHill/Irwin
End of Chapter 13

Relevant Cost For Decision Making

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Relevant Costs for Decision

Identify relevant and

Cost Concepts for Decision Making

A relevant cost is a cost that differs

Identifying Relevant Costs

An avoidable cost can be eliminated, in whole or

Relevant Cost Analysis: A Two-Step

Different Costs for Different Purposes

Costs that are

Identifying Relevant Costs

Annual straight-line depreciation on car

$45 per month

$1.60 per gallon 32 MPG

Identifying Relevant Costs

Annual straight-line depreciation on car

Some Additional Information

Identifying Relevant Costs

The annual cost of

However, the cost of gasoline is clearly relevant

Identifying Relevant Costs

At this point, we can see that some of the average

Identifying Relevant Costs

The round-trip train

Relaxing on the train is

The kennel cost is not

Identifying Relevant Costs

Identifying Relevant Costs

Relevant Financial Cost of Taking the Train

Total and Differential Cost Approaches

Sales (5,000 units @ $40 per unit)

Total and Differential Cost Approaches

We can efficiently analyze the decision by 62,000

Sales (5,000 units @ $40 per unit)

Net Advantage to Renting the New Machine

Total and Differential Cost Approaches

Lets see how relevant costs should

Due to the declining popularity of digital

A Contribution Margin Approach

Lets look at this solution.

A Contribution Margin Approach

Comparative Income Approach

The Lovell solution can also be obtained by

Lets look at this second approach.

Comparative Income Approach

Comparative Income Approach

Comparative Income Approach

Comparative Income Approach

Comparative Income Approach

Beware of Allocated Fixed Costs

Why should we keep the

Beware of Allocated Fixed Costs

The answer lies in the

Beware of Allocated Fixed Costs

Our allocations can

Prepare a make or buy

The Make or Buy Decision

Vertical Integration- Advantages

Vertical Integration- Disadvantage

Companies may fail

The Make or Buy Decision: An Example

The Make or Buy Decision

Should we accept the suppliers offer?