Chapter

6
Relevant Costs for
Decision Making
 Cost Concepts for Decision Making

A relevant cost is a cost that differs

between alternatives.

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 Identifying Relevant Costs

Costs that can be eliminated (in whole or in

part) by choosing one alternative over
another are avoidable costs. Avoidable
costs are relevant costs.
Unavoidable costs are never relevant and
include:
Sunk costs.
Future costs that do not differ between the
alternatives.
Irwin/McGraw-Hill 3 © The McGraw-Hill Companies, Inc., 2002
 Identifying Relevant Costs

Sunk cost -- a cost that has already

been incurred and that cannot be
avoided regardless of what a manager
decides to do.

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 Identifying Relevant Costs

Well, I’ve assembled

all the costs associated
with the alternatives
we are considering.

Irwin/McGraw-Hill 5 © The McGraw-Hill Companies, Inc., 2002

 Identifying Relevant Costs

Great! The first

thing we need to
do is eliminate all
the sunk costs.

Irwin/McGraw-Hill 6 © The McGraw-Hill Companies, Inc., 2002

 Quick Check 
In a decision of whether to buy a new car and
trade-in your old car or just keep your old car,
which of the following are sunk costs?
a. The cost of licensing the new car.
b. The cost of licensing your old car next year if
you keep it.
c. The amount you paid for your old car.
d. The amount you paid to repair your old car
last month in case you wanted to sell it.

Irwin/McGraw-Hill 7 © The McGraw-Hill Companies, Inc., 2002

 Identifying Relevant Costs

Now that we have eliminated the

sunk costs, we need to eliminate
the future costs that don’t differ
between alternatives.

Irwin/McGraw-Hill 9 © The McGraw-Hill Companies, Inc., 2002

 Quick Check 
In a decision of whether to buy a new car and
trade-in your old car or just keep your old car,
which of the following are future costs that don’t
differ between the alternatives?
a. Monthly parking fees.
b. Auto insurance.
c. Theater tickets.
d. Driver’s license renewal fee.

Irwin/McGraw-Hill 10 © The McGraw-Hill Companies, Inc., 2002

 Identifying Relevant Costs

The decision will be

easier now. All we
have left are the
avoidable costs.

Irwin/McGraw-Hill 12 © The McGraw-Hill Companies, Inc., 2002

 Note

 Do not underestimate the importance and

power of the relevant cost idea.

 Most costs (and benefits) do not differ between

alternatives. This allows you to focus on the
few things that matter.
 This principle also helps avoid mistakes.

Irwin/McGraw-Hill 13 © The McGraw-Hill Companies, Inc., 2002

 Sunk Costs are not Relevant Costs
Let’s look at
the White
Company
example.

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 Sunk Costs are not Relevant Costs
A manager at White Co. wants to replace an old
machine with a new, more efficient machine.
New machine:
List price $ 90,000
Annual variable expenses 80,000
Expected life in years 5
Old machine:
Original cost $ 72,000
Remaining book value 60,000
Disposal value now 15,000
Annual variable expenses 100,000
Remaining life in years 5
Irwin/McGraw-Hill 15 © The McGraw-Hill Companies, Inc., 2002
 Sunk Costs are not Relevant Costs
 White’s sales are $200,000 per year.
 Fixed expenses, other than depreciation, are
$70,000 per year.

Should the manager purchase the new

machine?

Irwin/McGraw-Hill 16 © The McGraw-Hill Companies, Inc., 2002

 Incorrect Analysis
The manager recommends that the
company not purchase the new
machine since disposal of the old
machine would result in a loss:

Remaining book value $ 60,000

Disposal value (15,000)
Loss from disposal $ 45,000

Irwin/McGraw-Hill 17 © The McGraw-Hill Companies, Inc., 2002

 Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales $ 1,000,000
Variable expenses (500,000)
Other fixed expenses
Depreciation - new
Depreciation - old
Disposal of old machine
Total net income

$200,000 per year × 5 years

$100,000 per year × 5 years
Irwin/McGraw-Hill 18 © The McGraw-Hill Companies, Inc., 2002
 Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales $ 1,000,000
Variable expenses (500,000)
Other fixed expenses (350,000)
Depreciation - new
Depreciation - old
Disposal of old machine
Total net income

$70,000 per year × 5 years

Irwin/McGraw-Hill 19 © The McGraw-Hill Companies, Inc., 2002

 Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales $ 1,000,000
Variable expenses (500,000)
Other fixed expenses (350,000)
Depreciation - new
Depreciation - old (60,000)
Disposal of old machine
Total net income $ 90,000

The remaining book

value of the old machine.
Irwin/McGraw-Hill 20 © The McGraw-Hill Companies, Inc., 2002
 Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales $ 1,000,000 $ 1,000,000 $ -
Variable expenses (500,000) (400,000) 100,000
Other fixed expenses (350,000)
Depreciation - new
Depreciation - old (60,000)
Disposal of old machine
Total net income $ 90,000

$80,000 per year × 5 years

Irwin/McGraw-Hill 21 © The McGraw-Hill Companies, Inc., 2002

 Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales $ 1,000,000 $ 1,000,000 $ -
Variable expenses (500,000) (400,000) 100,000
Other fixed expenses (350,000) (350,000) -
Depreciation - new (90,000) (90,000)
Depreciation - old (60,000)
Disposal of old machine
Total net income $ 90,000

The total cost will be depreciated

over the five year period.

Irwin/McGraw-Hill 22 © The McGraw-Hill Companies, Inc., 2002

 Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales $ 1,000,000 $ 1,000,000 $ -
Variable expenses (500,000) (400,000) 100,000
Other fixed expenses (350,000) (350,000) -
Depreciation - new (90,000) (90,000)
Depreciation - old (60,000) (60,000) -
Disposal of old machine 15,000 15,000
Total net income $ 90,000 $ 115,000 $ 25,000
The remaining book value of the old
machine is a sunk cost and is not
relevant to the decision.
Irwin/McGraw-Hill 23 © The McGraw-Hill Companies, Inc., 2002
 Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales $ 1,000,000 $ 1,000,000 $ -
Variable expenses (500,000) (400,000) 100,000
Other fixed expenses (350,000) (350,000) -
Depreciation - new (90,000) (90,000)
Depreciation - old (60,000) (60,000) -
Disposal of old machine 15,000 15,000
Total net income $ 90,000 $ 115,000 $ 25,000

Would you recommend purchasing the new

machine?

Irwin/McGraw-Hill 24 © The McGraw-Hill Companies, Inc., 2002

 Relevant Cost Analysis

Let’s look at a
more efficient
way to analyze
this decision.

Irwin/McGraw-Hill 25 © The McGraw-Hill Companies, Inc., 2002

 Relevant Cost Analysis

Just focus on
the costs that
differ between
alternatives.

Irwin/McGraw-Hill 26 © The McGraw-Hill Companies, Inc., 2002

 Relevant Cost Analysis

Relevant Cost Analysis

Savings in variable expenses
provided by the new machine
($20,000 × 5 yrs.) $ 100,000

Net effect

$100,000 - $80,000 = $20,000 variable cost savings

Irwin/McGraw-Hill 27 © The McGraw-Hill Companies, Inc., 2002

 Relevant Cost Analysis

Relevant Cost Analysis

Savings in variable expenses
provided by the new machine
($20,000 × 5 yrs.) $ 100,000
Cost of the new machine (90,000)
Disposal value of old machine 15,000
Net effect $ 25,000

Irwin/McGraw-Hill 28 © The McGraw-Hill Companies, Inc., 2002

 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.

Let’s see how relevant costs should

be used in this decision.

Irwin/McGraw-Hill 29 © The McGraw-Hill Companies, Inc., 2002

 Adding/Dropping Segments

Due to the declining popularity of digital

watches, Lovell Company’s digital watch
line has not reported a profit for several
years. An income statement for last year
is shown on the next screen.

Irwin/McGraw-Hill 30 © The McGraw-Hill Companies, Inc., 2002

 Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable mfg. costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net loss $ (100,000)

Irwin/McGraw-Hill 31 © The McGraw-Hill Companies, Inc., 2002

 Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Investigation has revealed that total fixed
Less: variable expenses
general
Variable mfg.factory
costs overhead$ and general
120,000
administrative
Variable expenses would
shipping costs 5,000not be
Commissions
affected 75,000
if the digital watch line is dropped. 200,000
Contribution margin $ 300,000
Thefixed
Less: fixed general factory overhead and
expenses
general administrative
General factory overhead expenses
$ assigned
60,000
to this
Salary of product would be reallocated
line manager 90,000 to
Depreciation of equipment 50,000
other product lines.
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net loss $ (100,000)

Irwin/McGraw-Hill 32 © The McGraw-Hill Companies, Inc., 2002

 Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
The equipment
Variable mfg. costsused to manufacture
$ 120,000
Variable shipping costs 5,000
digital watches has no resale
Commissions 75,000 200,000
valuemargin
Contribution or alternative use. $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000retain or drop
Should Lovell
Advertising - direct 100,000
Rent - factory space
the digital70,000
watch segment?
General admin. expenses 30,000 400,000
Net loss $ (100,000)

Irwin/McGraw-Hill 33 © The McGraw-Hill Companies, Inc., 2002

 A Contribution Margin Approach

DECISION RULE
Lovell should drop the digital watch
segment only if its profit would increase.
This would only happen if the fixed cost
savings exceed the lost contribution
margin.

Let’s look at this solution.

Irwin/McGraw-Hill 34 © The McGraw-Hill Companies, Inc., 2002

 A Contribution Margin Approach
Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped $ (300,000)
Less fixed costs that can be avoided
Salary of the line manager $ 90,000
Advertising - direct 100,000
Rent - factory space 70,000 260,000
Net disadvantage $ (40,000)

Irwin/McGraw-Hill 35 © The McGraw-Hill Companies, Inc., 2002

 Comparative Income Approach

The Lovell solution can also be obtained by

preparing comparative income
statements showing results with and
without the digital watch segment.

Let’s look at this second approach.

Irwin/McGraw-Hill 36 © The McGraw-Hill Companies, Inc., 2002

 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Mfg. expenses 120,000 - 120,000
Freight out 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000
Salary of line manager 90,000
Depreciation 50,000 If the digital watch
Advertising - direct 100,000
Rent - factory space 70,000
line is dropped, the
General admin. expenses 30,000 company gives up
Total fixed expenses 400,000 its contribution
Net loss $ (100,000)
margin.
Irwin/McGraw-Hill 37 © The McGraw-Hill Companies, Inc., 2002
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Mfg. expenses 120,000 - 120,000
Freight out 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000
Depreciation 50,000
Advertising - direct On 100,000
the other hand, the general
Rent - factory space factory overhead would be the
70,000
General admin. expenses
same. So this cost really isn’t
30,000
Total fixed expenses 400,000
Net loss $ (100,000) relevant.

Irwin/McGraw-Hill 38 © The McGraw-Hill Companies, Inc., 2002

 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses:
But we wouldn’t need -
a
Mfg. expenses manager for the product-line
120,000 120,000
Freight out 5,000
anymore. - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net loss $ (100,000)

Irwin/McGraw-Hill 39 © The McGraw-Hill Companies, Inc., 2002

 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
If variable
Less the digital watch line is dropped, the net- book value
expenses:
Mfg.
of expenses
the equipment would be written 120,000 off. The depreciation
- 120,000
Freight out 5,000 - 5,000
that
Commissions would have been taken will
75,000 flow through
- the 75,000
income statement as
Total variable expenses a loss instead.
200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net loss $ (100,000)

Irwin/McGraw-Hill 40 © The McGraw-Hill Companies, Inc., 2002

 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Mfg. expenses 120,000 - 120,000
Freight out 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000 - 100,000
Rent - factory space 70,000 - 70,000
General admin. expenses 30,000 30,000 -
Total fixed expenses 400,000 140,000 260,000
Net loss $(100,000) $(140,000) $ (40,000)

Irwin/McGraw-Hill 41 © The McGraw-Hill Companies, Inc., 2002

 Beware of Allocated Fixed Costs
Why should we keep
the digital watch
segment when it’s
showing a loss?

Irwin/McGraw-Hill 42 © The McGraw-Hill Companies, Inc., 2002

 Beware of Allocated Fixed Costs
The answer lies in the
way we allocate
common fixed costs
to our products.

Irwin/McGraw-Hill 43 © The McGraw-Hill Companies, Inc., 2002

 Beware of Allocated Fixed Costs
Our allocations can
make a segment
look less profitable
than it really is.

Irwin/McGraw-Hill 44 © The McGraw-Hill Companies, Inc., 2002

 The Make or Buy Decision

A decision concerning whether an item

should be produced internally or
purchased from an outside supplier is
called a “make or buy” decision.

Let’s look at the Essex Company example.

Irwin/McGraw-Hill 45 © The McGraw-Hill Companies, Inc., 2002

 The Make or Buy Decision
 Essex manufactures part 4A that is currently
used in one of its products.
 The cost per unit of this part is:

Direct materials $ 9
Direct labor 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary 2
General factory overhead 10
Total cost per unit $ 30

Irwin/McGraw-Hill 46 © The McGraw-Hill Companies, Inc., 2002

 The Make or Buy Decision
 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 total cost per unit 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 supplier’s offer?

Irwin/McGraw-Hill 47 © The McGraw-Hill Companies, Inc., 2002

 The Make or Buy Decision
Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

20,000 × $9 per unit = $180,000

Irwin/McGraw-Hill 48 © The McGraw-Hill Companies, Inc., 2002

 The Make or Buy Decision
Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The special equipment has no resale

value and is a sunk cost.

Irwin/McGraw-Hill 49 © The McGraw-Hill Companies, Inc., 2002

 The Make or Buy Decision
Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

Not avoidable and is irrelevant. If the product is

dropped, it will be reallocated to other products.

Irwin/McGraw-Hill 50 © The McGraw-Hill Companies, Inc., 2002

 The Make or Buy Decision
Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

Should we make or buy part 4A?

Irwin/McGraw-Hill 51 © The McGraw-Hill Companies, Inc., 2002
 The Make or Buy Decision

DECISION RULE
In deciding whether to accept the outside
supplier’s offer, Essex isolated the relevant
costs of making the part by eliminating:
The sunk costs.
The future costs that will not differ between
making or buying the parts.

Irwin/McGraw-Hill 52 © The McGraw-Hill Companies, Inc., 2002

 The Matter of Opportunity Cost

The benefits that are foregone as a result of

pursuing some course of action.
Opportunity costs are not actual dollar outlays
and are not recorded in the accounts of an
organization.

Irwin/McGraw-Hill 53 © The McGraw-Hill Companies, Inc., 2002

 Quick Check 
Which of the following are opportunity costs of
attending the university?
a. Tuition.
b. Books.
c. Lost wages.
d. Not enough time for other interests.

Irwin/McGraw-Hill 54 © The McGraw-Hill Companies, Inc., 2002

 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
company’s 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?

Irwin/McGraw-Hill 56 © The McGraw-Hill Companies, Inc., 2002
 Special Orders
Jet, Inc.
Contribution Income Statement
Revenue (5,000 × $20) $ 100,000
Variable costs:
Direct materials $ 20,000
Direct labor 5,000
Manufacturing overhead 10,000 $8 variable cost
Marketing costs 5,000
Total variable costs 40,000
Contribution margin 60,000
Fixed costs:
Manufacturing overhead $ 28,000
Marketing costs 20,000
Total fixed costs 48,000
Net income $ 12,000

Irwin/McGraw-Hill 57 © The McGraw-Hill Companies, Inc., 2002

 Special Orders

If Jet accepts the offer, net income will

increase by $6,000.

Increase in revenue (3,000 × $10) $ 30,000

Increase in costs (3,000 × $8 variable cost) 24,000
Increase in net income $ 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.

Irwin/McGraw-Hill 58 © The McGraw-Hill Companies, Inc., 2002

 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 customer’s 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)

Irwin/McGraw-Hill 59 © The McGraw-Hill Companies, Inc., 2002

 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.
a. $50
b. $10
c. $15
d. $29

Irwin/McGraw-Hill 60 © The McGraw-Hill Companies, Inc., 2002

 Utilization of a Constrained Resource

 Firms often face the problem of deciding how

to best utilize a constrained resource.
 Usually fixed costs are not affected by this
particular decision, so management can focus
on maximizing total contribution margin.

Let’s look at the Ensign Company example.

Irwin/McGraw-Hill 62 © The McGraw-Hill Companies, Inc., 2002

 Utilization of a Constrained Resource
Ensign Company produces two products and
selected data is shown below:
Product
1 2
Selling price per unit $ 60 $ 50
Less variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.

Irwin/McGraw-Hill 63 © The McGraw-Hill Companies, Inc., 2002

 Utilization of a Constrained Resource

 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 2?

Irwin/McGraw-Hill 64 © The McGraw-Hill Companies, Inc., 2002

 Quick Check 
How many units of each product can be
processed through Machine A1 in one minute?

Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2 units
c. 2 units 1 unit
d. 2 units 0.5 unit

Irwin/McGraw-Hill 65 © The McGraw-Hill Companies, Inc., 2002

 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

Irwin/McGraw-Hill 67 © The McGraw-Hill Companies, Inc., 2002

 Utilization of a Constrained Resource
The key is the contribution margin per unit of the
constrained resource.
Product
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.
Contribution margin per minute $ 24 min. $ 30 min.

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.

Irwin/McGraw-Hill 69 © The McGraw-Hill Companies, Inc., 2002

 Utilization of a Constrained Resource

Product
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.
Contribution margin per minute $ 24 min. $ 30 min.

If there are no other considerations, the best

plan would be to produce to meet current
demand for Product 2 and then use
remaining capacity to make Product 1.

Irwin/McGraw-Hill 70 © The McGraw-Hill Companies, Inc., 2002

 Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting Our Constrained Recource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Irwin/McGraw-Hill 71 © The McGraw-Hill Companies, Inc., 2002

 Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting Our Constrained Recource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.

Irwin/McGraw-Hill 72 © The McGraw-Hill Companies, Inc., 2002

 Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting Our Constrained Recource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.
Time required per unit ÷ 1.00 min.
Production of Product 1 1,300 units

Irwin/McGraw-Hill 73 © The McGraw-Hill Companies, Inc., 2002

 Utilization of a Constrained Resource

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.

Product 1 Product 2
Production and sales (units) 1,300 2,200
Contribution margin per unit $ 24 $ 15
Total contribution margin $ 31,200 $ 33,000

The total contribution margin for Ensign is $64,200.

Irwin/McGraw-Hill 74 © The McGraw-Hill Companies, Inc., 2002

 Quick Check 
Colonial Heritage makes reproduction colonial
furniture from select hardwoods.
Chairs Tables
Sellilng price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s 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
Irwin/McGraw-Hill 75 © The McGraw-Hill Companies, Inc., 2002
 Quick Check 
Chairs Tables
Sellilng price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s 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

Irwin/McGraw-Hill 77 © The McGraw-Hill Companies, Inc., 2002

 Quick Check 
As before, Colonial Heritage’s 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

Irwin/McGraw-Hill 79 © The McGraw-Hill Companies, Inc., 2002

 Quick Check 
As before, Colonial Heritage’s supplier of
hardwood will only be able to supply 2,000
board feet this month. Assume there is unlimited
demand for chairs. 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

Irwin/McGraw-Hill 81 © The McGraw-Hill Companies, Inc., 2002

 Managing Constraints
Produce only
what can be sold.
Finding ways to At the bottleneck itself:
process more units
through a resource •Improve the process
bottleneck • Add overtime or another shift
• Hire new workers or acquired
more machines
• Subcontract production
Eliminate waste.
Streamline production process.

Irwin/McGraw-Hill 83 © The McGraw-Hill Companies, Inc., 2002

 End of Chapter 6

Irwin/McGraw-Hill 84 © The McGraw-Hill Companies, Inc., 2002