RELEVANT COSTING

AND SHORT TERM

DECISION MAKING
Joey Raine Jamero, CPA
OBJECTIVES
Concept Review
Decision Making
Goal of Relevant Costing
Pitfalls in Decision Making
Relevant and Non-Relevant Costs
Relevant Revenues
Differential Analysis
Decision Types
 Relevant Costing and Short Term Decision Making 3

CONCEPT REVIEW
Managers must make decisions about the use of organizational resources that
will yield utmost benefit to the owners.

Challenges of
Changing Markets

Changing
Price cuts by New products
preferences of
competitors by competitor
customers
 Relevant Costing and Short Term Decision Making 4

DECISION MAKING
With a fixed set of resources, managers must make short-run decisions to react to
the changing marketplace.

Steps in Decision Making

1. Identify and define the problem, and assign responsibility
2. Specify the criterion
3. Determine and evaluate possible courses of actions (alternatives)
4. Identify and estimate the costs and benefits associated with each feasible
alternative
5. Assess qualitative factors
6. Make a decision
7. Review results of the decision
 Relevant Costing and Short Term Decision Making 5

GOAL OF RELEVANT COSTING

Goal of Relevant Costing:
Profit Maximization or
Maximization of Return of
Investments

Alternative 1: Alternative 2:
Choosing the alternative with Choosing the alternative with
the LOWEST COST. the HIGHEST REVENUE.

Caveats:
• The financial figures are only part of the information needed for a fully
informed decision.
• Relevant non-financial factors when making a decision are also considered.

KEY CONCERN: Managers must be able to distinguish between RELEVANT

and NON-RELEVANT ITEMS.
 Relevant Costing and Short Term Decision Making 6

PITFALLS IN DECISION MAKING

Hidden Cost
Sunk Cost Fallacy
Fallacy

• Not able to
• Not able to
identify
identify sunk
relevant costs
cost
• Opportunity
• Sunk cost still
cost not
considered in
considered in
decisions
decisions
 Relevant Costing and Short Term Decision Making 7

PITFALLS IN DECISION MAKING

Qualifications for a Cost or Revenue to Relevant:
• Future Cost or Revenue
• Cost or Revenue will differ between or among alternatives

Types of Relevant Costs:

• Differential/incremental costs - the difference in total cost between alternatives
• Avoidable costs - the specific costs of an activity or sector of a business which would
be avoided if that activity or sector did not exist
• Opportunity costs - the value of the benefit sacrificed when one course of action is
taken

Types of Non-Relevant Costs:

• Sunk or past costs
• Absorbed Fixed Overhead that will not change as a result of a decision
• Cost to be incurred in the future but will not differ between or among alternatives.
• Historical cost depreciation
 Relevant Costing and Short Term Decision Making 8

PITFALLS IN DECISION MAKING

Relevant or Irrelevant Costs
Relevant Costs Examples
Variable costs Cost of labor involved in the production.
Cost of material used in manufacturing.
Variable production overheads such as the cost of electricity used
in production.
Direct fixed costs Rent of production facility.
Salary of factory supervisor.
Opportunity cost Rental income from machinery that is given up for
manufacturing in-house.
Irrelevant Costs Examples
Indirect fixed costs General and administrative expense.
Non-cash expenses Depreciation.
Sunk costs Cost of machinery already paid.
Committed costs The rental expense of a factory building whose lease agreement
does not allow termination until the end of the lease term.
 Relevant Costing and Short Term Decision Making 9

RELEVANT REVENUES
A revenue is considered relevant if there is a difference in revenues between the
alternatives.

KEY CONCERN:
• Consider only RELEVANT ITEMS
• Disregard NON-RELEVANT ITEMS
 Relevant Costing and Short Term Decision Making 10

DIFFERENTIAL ANALYSIS
Differential Analysis is to:
1. Eliminate costs and benefits that do not differ between or among alternatives.
2. Use the remaining costs and benefits that differ between or among alternatives in
making the decision.

Decision Types based on Information Needed:

• Decisions Involving Cost Information
• Outsourcing Decision – MAKE or BUY PRODUCT/COMPONENT
•  Replacement Decision – RETAIN or REPLACE EQUIPMENT
• Decisions Involving Cost and Revenue Information
• Disinvestment Decision– KEEP or DROP SEGMENT/PRODUCT
• Further Processing Decision – SELL AS IS or PROCESS FURTHER
• Product Mix Decision – UTILIZATION OF CONSTRAINED
RESOURCE (BEST PRODUCT COMBINATION)
 These decision types are
normally classified to be part •  Lease or Sell Decision – LEASE or SELL ASSETS
of capital budgeting decisions, • Additional Business Decision – ACCEPT or REJECT SPECIAL ORDER
not short-term decision • Pricing Decision
 Relevant Costing and Short Term Decision Making 11

DECISION TYPES
Outsourcing Decision: MAKE or BUY PRODUCT/COMPONENT
Company has existing facilities to make product or component (vertical integration), and
an option to purchase it elsewhere.

• Efficient use of available resources; those that are produced least efficiently should be
outsourced (or capacity should be expanded)
• Support services may be outsourced domestically or internationally (computer
processing, legal work, accounting, training)
• Must factor in opportunity cost for freed up facilities
• Quality control (Make) vs. Economies of scale (Buy)

• Relevant Cost of Making vs. Relevant Cost of Buying

 Relevant Costing and Short Term Decision Making 12

OUTSOURCING DECISION
Winwin Company produces a mechanical part used in one of its engines. (Winwin produces engines for
snowblowers.) An outside supplier has offered to sell a part (Part 34B) for $4.75. The company normally
produces 100,000 units of the part each year. The following costs will be incurred if Winwin decides to make
100,000 units of Part 34B or buy it from the outside supplier:

Activity Make Buy

• Using materials $ 50,000 $ 0
• Using direct labor 200,000 0
• Providing supervision 300,000 240,000
• Moving materials 394,000 345,000
• Providing power 90,000 0
• Inspecting products 301,000 263,000
• Setting up equipment 600,000 540,000

Decide. Should Winwin continue to make the product or buy the product from the supplier?
 Relevant Costing and Short Term Decision Making 13

OUTSOURCING DECISION
Activity Make Buy Savings (Expense)
• Using materials $ 50,000 $ 0 $ 50,000
• Using direct labor 200,000 0 200,000
• Providing supervision 300,000 240,000 60,000
• Moving materials 394,000 345,000 49,000
• Providing power 90,000 0 90,000
• Inspecting products 301,000 263,000 38,000
• Setting up equipment 600,000 540,000 60,000

• Acquiring Part 34B 0 475,000 (475,000)

Total Savings (Expense) 72,000

DECISION: Buy the Part 34B from the outside supplier.

 Relevant Costing and Short Term Decision Making 14

DECISION TYPES
Disinvesting Decision: KEEP or DROP PRODUCT/SEGMENT
Existence of an unprofitable segment or product line.

• Opposite of Capital Budgeting Decision

• Relevant: Revenue and costs that will be lost by dropping the segment or product
• Irrelevant: Unavoidable Cost or costs that will remain to be incurred even if the segment
or product will be dropped
• Excess capacity may exist, unless another project uses this capacity immediately
• Temporary vs. Permanent/Final

• Contribution Margin or Loss of Keeping vs. Contribution Margin or Loss of

Dropping
Relevant Costing and Short Term Decision Making 15

DISINVESTING DECISION
Hendery Wong Company is in the business of manufacturing seat covers and floor mats. Hendery provided the
following information:
Seat Covers Floor Mats Total
• Sales $950,000 $1,680,000 $2,630,000 Hendery is thinking of
• Less: unit-level variable expenses -665,000 -765,000 -1,430,000 discontinuing the
• Contribution margin $285,000 $ 915,000 $1,200,000 production of seat covers.
• Less traceable expenses -405,000 -325,000 -730,000
Decide. Should Hendery
• Product margin $ -120,000 $ 590,000 $ 470,000
keep or drop the Seat
• Less: common expenses -430,000 Covers?
• Income before taxes $ 40,000

By dropping the production of seat covers, the company will not be incurring the following expenses:
Advertising, $ 50,000 Supervision, $ 30,000 Inspecting products, $140,000
Material handling, $80,000

The company has allocated $45,000 of the cost of customer service to the Seat Covers; $15,000 will still be charged to the
company even if it discontinues the production of seat covers.
 Relevant Costing and Short Term Decision Making 16

DISINVESTING DECISION
Keep Drop
• Contribution margin $ 285,000 $ 0
• Advertising -50,000 0
• Supervision -30,000 0
• Inspecting products -140,000 0
• Material handling -80,000 0
• Customer service -45,000 -15,000
• Total $ -60,000 $ -15,000

By keeping the production of seat covers, the company generates a loss of $60,000. However, by dropping the seat
covers, the company will only generate a loss of $15,000.

By dropping the seat covers, the company saves $45,000.

 Relevant Costing and Short Term Decision Making 17

DECISION TYPES
Further Processing Decision: SELL AS IS or PROCESS FURTHER
The company makes products that go through a joint process, producing joint products.

• Company has the option to sell at split-off, or to sell after further processing
• Relevant: Revenue at split-off; Revenue after incremental processing cost
• Irrelevant: Joint cost

• Net profit of selling after processing further vs. Net profit of selling at split off

• For the illustration, please refer to Illustration #3 in our discussion of Joint and
Byproduct Costing.
 Relevant Costing and Short Term Decision Making 18

DECISION TYPES
Additional Business Decision: ACCEPT or REJECT SPECIAL ORDER
The company has opportunity for additional business; one-time order that is not part of the
company’s normal ongoing business; additional sale at a substantially lower price

• Basic assumption: Regular sales will not be affected by the special order; Company is not
operating at full capacity (there is excess capacity to accommodate the special order)
• Negotiations and arrangements regarding the special order must be discreet, so as not to
unsettle the existing customer base
• Company must ascertain that this one-time customer is not currently operating in a
market where the customer is a player
• If company is operating at full capacity, lost CM will be spread over the units
accommodated for the special order

• Incremental revenue must be greater than incremental cost.

Relevant Costing and Short Term Decision Making 19

ADDITIONAL BUSINESS DECISION

Liu Yangyang Ice Cream, Inc. is operating at 80 percent of its 20 million half-gallon capacity. A distributor from
another geographically area offered to buy 2 million units of premium ice cream at $1.75 per unit. They have
agreed to provide their own label and pay transportation costs. On top of the unit variable costs, nonunit-level
variable costs of $304,000 will also be incurred to produce the additional 2 million units.
The following variable costs were provided:
• Dairy ingredients $0.70
• Sugar 0.10
• Flavoring 0.15
• Direct labor 0.25
• Packaging 0.20
• Commissions 0.02
• Distribution 0.03
• Other 0.05 Decide: Should Yangyang accept or
• Total unit-level costs $1.50 reject the offer?
Relevant Costing and Short Term Decision Making 20

ADDITIONAL BUSINESS DECISION

Variable Costs: Accept
• Dairy ingredients $0.70 $0.70
• Sugar 0.10 0.10
• Flavoring 0.15 0.15
• Direct labor 0.25 0.25
• Packaging 0.20 0.20
• Commissions 0.02 -
• Distribution 0.03 -
• Other 0.05 0.05
• Total unit-level costs $1.50 $1.45

Addition to contribution margin: ($1.75-$1.45) x 2,000,000 = $600,000 - $304,000 = $296,000

DECISION: Accept the order.

 Relevant Costing and Short Term Decision Making 21

DECISION TYPES
Product Mix Decision: UTILIZATION OF CONSTRAINED RESOURCE (BEST
PRODUCT COMBINATION)
Company has a limited or constrained resource, and several product lines are utilizing
this resource.

• Company cannot fully accommodate demand due to constraint imposed by the scarce
resource.
• Products according to the CM per unit of constrained resource (or CM per limiting
factor)
• Additional concerns: • Shifting workers from non-
• Managing constraints: bottleneck processes to the
• Working overtime bottleneck
• Subcontracting some work • Business process improvements on
bottleneck
• Investing in additional machines
• Reducing defective units processed
• Complicating factor: Multiple constraints through bottleneck
• Prioritize making the product with the highestCM per unit of constrained
resource, or satisfy product demand according to ranking
 Relevant Costing and Short Term Decision Making 22

DECISION TYPES
Pricing Decisions
The pricing policy of the company will have an impact on profit; the pricing policy of the
company will depend on whether the company is a price-setter or a price taker.

• Price-setters: Firms that have discretion over setting the selling prices of their products
and services
• Price-takers: Firms that have little control over the prices of their products and services
• Firms may be price-setters for some of their products, and price-takers for other products

• Common Approaches: • Other Approaches:

• Cost-Based Price • Competition-Based Pricing
• Full Cost • New Product Pricing
• Variable Cost • Pricing by Intermediaries
• Price Adjustments
• Market-Based Price
• Product Mix Pricing
• Profit-Maximizing Price
• Time-and-Material Pricing
Relevant Costing and Short Term Decision Making 23

DIFFERENTIAL ANALYSIS SUMMARY

THANK YOU
Any questions?