Week 9 Notes

Relevant Costs for Decision Making (continued)

Introduction:
This lesson continues the exploration and use of relevant costs for managerial decision
making with a focus on common production concerns.

Learning Objective:
 Prepare an analysis showing whether joint products should be sold at the split-off
point or processed further.
 Determine the most profitable use of a constrained resource and the value of
obtaining more of the constrained resource.

Textbook Study:
Pages 547 to 553

Chapter 12: Relevant Costs for Decision Making- Continued

G. In some industries, such as petroleum refining, a number of end products are produced
from a single raw material input. Such end products are known as joint products. The
split-off point is that point in the manufacturing process at which the joint products can be
recognized as separate products.

1. Decisions as to whether a joint product should be sold at the split-off point or

processed further and then sold are known as sell or process further decisions.

2. Costs incurred up to the split-off point are called joint costs. These costs are
irrelevant in decisions concerning whether a product should be processed
further after the split-off point because they will be incurred regardless of
what is done after the split-off point.

3. It is profitable to continue processing joint products after the split-off point so

long as the incremental revenue from such processing exceeds the incremental
processing costs.

H. A constraint is anything that limits the organization’s ability to further its goals. For
example, when a profit-making company is unable to satisfy the demand for its products
with its existing capacity, it has a production constraint. When the constraint is a machine
or a workstation, it is called a bottleneck. The theory of constraints (TOC) maintains that
effectively managing a constraint is important to the financial success of an organization.
For example, a company may be able to sell 1,000 units of a product per week, but the
product may require a machine that is capable of only producing 800 units a week. The
machine would be a bottleneck.
 1. When demand exceeds capacity, the company has a production constraint. In
that case, managers must decide what the company will and will not do
because the company cannot do everything. The problem is how to best utilize
a constrained resource.

2. Fixed costs are likely to be unaffected by the decision of how best to utilize
the constrained resource. If the fixed costs are unaffected by the decision, and
hence irrelevant, maximizing the company’s total contribution margin is
equivalent to maximizing the company’s profit. Given capacity and the
company’s fixed costs, the problem is how to best use that capacity to
maximize total contribution margin and profit.

3. The key to the efficient utilization of a scarce resource is the contribution

margin per unit of the constrained resource. The products with the greatest
contribution margin per unit of the constrained resource are the most
profitable; they generate the greatest profit from a given amount of the
constrained resource. These products should be emphasized over products
with a lower contribution margin per unit of the constrained resource.

4. Because the constraint limits the output of the entire organization, increasing
the amount of the constrained resource can yield a huge payoff. This is called
“elevating the constraint” and can be accomplished in a variety of ways
including working overtime on the bottleneck, buying another machine,
subcontracting work, and so on.

5. The contribution margin per unit of the constrained resource is also a measure
of opportunity cost. For example, when considering whether to accept an
order for a product that uses the constrained resource, the opportunity cost of
using the constrained resource should be considered. That opportunity cost is
the lost contribution margin for the job that would be displaced if the order
were accepted.

What To Watch Out For (Hints, Tips and Traps)

 While studying the utilization of constrained resources, consider that a production

process can be thought of as a chain, with each link in the chain representing a
step in the process. A chain is only as strong as its weakest link. Likewise, the
capacity of a production process is determined by its weakest link, which is the
constraint. The only way to increase the strength of a chain is to strengthen the
weakest link. The only way to increase the output of the entire process is to
increase the output of the constraint. Strengthening the stronger links has no effect
on the strength of the entire chain. The moral is to identify the constraint and
concentrate management attention on effectively increasing its capacity.

Summary:
This lesson continued the exploration and use of relevant costs for managerial decision
making with a focus on common production concerns. The student needs to have a full
understanding of:
 Make or buy decisions.
 Joint products and options for selling at split off or further processing.
 Constrained resources.