Relevant Costs for Decision Making

Chapter 13

Making correct decisions is one of the most important tasks of a successful

manager. Every decision involves a choice between at least two alternatives. The
decision process may be complicated by volumes of data, irrelevant data,
incomplete information, an unlimited array of alternatives, etc. The role of the
managerial accountant in this process is often that of a gatherer and summarizer
of relevant information rather than the ultimate decision maker.

The costs and benefits of the alternatives need to be compared and contrasted
before making a decision.
The decision should be based only on RELEVANT information. Relevant
information includes the predicted future costs and revenues that differ among
the alternatives. Any cost or benefit that does not differ between alternatives is
irrelevant and can be ignored in a decision. All future revenues and/or costs that
do not differ between the alternatives are irrelevant. Sunk costs (costs already
irrevocably incurred) are always irrelevant since they will be the same for any
alternative.
To identify which costs are relevant in a particular situation, take this three step
approach:
1. Eliminate sunk costs
2. Eliminate costs and benefits that do not differ between alternatives
3. Compare the remaining costs and benefits that do differ between alternatives
to make the
proper decision

Five separate types of decisions are discussed in Chapter 13 as follows:

Adding and Dropping Product Lines and Other Segments
Make or Buy Decisions
Special Orders
Utilization of a Scarce Resources
Sell or Process further Decisions

Adding and Dropping Product Lines and Other Segments

In Exhibit 13-2, Page 609, it appears that Discount Drug Company will improve its
overall profits if it drops the House-wares Product Line. However, in order to make
the correct decision regarding dropping a product line, we need to compare lost
contribution margin with avoidable fixed costs. If the avoidable fixed costs are
greater than lost contribution margin then Discount Drug Company is better off
dropping the House-wares Product Line. In analyzing the House-wares fixed costs,
we find that $13,000 of the total fixed costs of $28,000 are not avoidable, that
is, they will continue even if the House-wares line is dropped. Only $15,000 of the
fixed costs are avoidable. When we compare the avoidable fixed costs of $15,000
with the loss contribution margin of $20,000, we see that total net profits will
decrease by $5,000 if the House-wares Product Line is dropped.

A segment should be added only if the increase in total contribution margin is

greater than the increase in fixed costs. A segment should be dropped only if the
decrease in total contribution margin is less than the decrease in fixed costs. The
authors warn the reader to beware of allocated common costs. Common fixed costs
are fixed costs that support the operation of more than one segment, but are not
traceable in whole or in part to any one segment. Thus they continue even when the
product line is dropped. Allocated common fixed costs can make a segment look
unprofitable even though dropping the segment might result in a decrease in
overall company net operating income
Make or Buy Decisions
A make or buy decision relates to whether an item should be made internally or
purchased from an external supplier. Beginning on Page 613 the authors describe
how Mountain Goat Cycles Company is producing 8,000 gear shifters annually at an
internal “cost” of $21 per unit. An outside supplier has offered to sell 8,000
shifters per year to Mountain Goat Cycles at a unit price of $19. Should Mountain
Goat Cycles continue to make the shifter or should they purchase it? Analyzing the
“costs” of the internally produced shifter reveals that the depreciation and
allocated general overhead costs (totalling $7 per unit) will continue even if the
shifter is purchased externally. Thus the relevant costs are $14 to make versus
$19 to buy or a difference in favor of the cycle firm continuing to make the
shifter of ($5 * 8,000) or $40,000.

Special Orders
Special orders are one-time orders that do not affect a company’s normal sales.
The profit from a special order equals the incremental revenue less the
incremental costs. As long as the incremental revenue exceeds the incremental
costs and present sales are unaffected, the special order should be accepted.
Beginning on Page 616 the authors describe an example of a special order in which
the Seattle Police Department offers to buy bicycles from Mountain Goat Cycles
on a special order price of $179 per unit. The bikes have a unit product “cost” of
$182. Should the special order be accepted? Since this order would have no effect
on other sales and since the company has idle capacity, then only incremental costs
and benefits are relevant. See the analysis on Page 617 showing why the special
order should be accepted.

Utilization of a Constrained Resources

Whenever demand exceeds productive capacity, a production constraint
(bottleneck) exists. This means that the company is unable to fill all orders and
some choices have to be made concerning which orders are filled and which are not
filled. Total contribution margin will be maximized by promoting those products or
accepting those orders that provide the highest unit contribution margin in
relation to the constrained resource. See the example on Pages 618-9. Since the
capacity of an entire factory or an entire service organization may be determined
by a single constraint, it is extremely important to effectively manage the
constraint. Methods to increase the capacity of the constraint or bottleneck are
described on Page 605.

Sell or Process Further Decisions

In some manufacturing processes, several intermediate products are produced
from a single input. Such products are known as joint products. The costs
associated with making these products up to the point where they can be
recognized as separate products (the split-off point) are called joint product
costs.

A decision often must be made about selling a joint product as is or processing it

further. It is profitable to continue processing a joint product after the split-off
point so long as the incremental revenue from such processing exceeds the
incremental processing costs. In such decisions, the joint product costs incurred
before the split-off point are irrelevant and should be ignored. See example on
Page 623-4.