Relevant Cost Decisions

DECISION MAKING IN THE SHORT

TERM
Decisions
 A decision model is a formal method
of making a choice, often involving
both quantitative and qualitative
analyses
 A relevant cost is a cost that
differs between alternatives.

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Five-Step
Decision-Making Process

Step 2:
Make Step 3: Step 4:
Step 1: Step 5:
Predictions Choose Implement
Obtain Evaluate
About An The
Information Performance
Future Alternative Decision
Costs

Feedback

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Relevance
 Relevant Information has two
characteristics:
 It occurs in the future
 It differs among the alternative courses
of action
 Relevant Costs – expected future
costs
 Relevant Revenues – expected future
revenues
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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.

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Identifying Relevant Costs

 gather all costs associated with the

alternatives
 eliminate all sunk costs
 Eliminate all future costs that don’t
differ between alternatives
 left are the avoidable costs

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Irrelevance
 Historical costs are past costs that
are irrelevant to decision making
 Also called Sunk Costs- cost that has
already been incurred and that cannot be
avoided regardless of what a manager
decides to do

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Types of Information
 Quantitative factors are outcomes
that can be measured in numerical
terms
 Qualitative factors are outcomes that
are difficult to measure accurately in
numerical terms, such as satisfaction
 Are just as important as quantitative
factors even though they are difficult to
measure

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Terminology
 Incremental Cost – the additional
total cost incurred for an activity
 Differential Cost – the difference in
total cost between two alternatives
 Incremental Revenue – the additional
total revenue from an activity
 Differential Revenue – the difference
in total revenue between two
alternatives

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Types of Decisions
 One-Time-Only Special Orders
 Insourcing vs. Outsourcing
 Make or Buy
 Product-Mix
 Customer Profitability
 Branch / Segment: Adding or
Discontinuing
 Equipment Replacement
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One-Time-Only Special Orders
 Accepting or rejecting special orders
when there is idle production capacity
and the special orders have no long-
run implications
 Decision Rule: does the special order
generate additional operating
income?
 Yes – accept
 No – reject
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One-Time-Only Special Orders
 Compares relevant revenues and
relevant costs to determine
profitability

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Special Orders
 Acki Company receives a one-time order that
is not considered part of its normal ongoing
business.
 Acki Company only produces one type of
silver key chain with a unit variable cost of
TL 16. Normal selling price is TL 40 per unit.
 A company in KKTC offers to purchase 3,000
units for TL 20 per unit.
 Annual capacity is 10,000 units, and annual
fixed costs total TL78,000, but Acki company
is currently producing and selling only 5,000
units.
Should Acki accept the offer?
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Special Orders
Acki Company
Contribution Income Statement
Revenue (5,000 × TL40) TL200.000
Variable costs:
Direct materials TL40.000
Direct labor 10.000
Manufacturing overhead 20.000
Marketing costs 10.000
Total variable costs 80.000
Contribution margin 120.000
Fixed costs:
Manufacturing overhead TL78.000
Marketing costs 25.000
Total fixed costs 103.000
Net income TL17.000
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 Special Orders
If Acki accepts the offer, net income will
increase by TL 12.000.

Increase in revenue (3,000 × TL20) TL60.000

Increase in costs (3,000 × TL16 variable cost) 48.000
Increase in net income TL12.000

Using the incremental approach:

Special order contribution margin = TL20 – TL 16 = TL 4
Change in income = TL 4 × 3,000 units = TL 12.000.

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Potential Problems with
Relevant-Cost Analysis
 Avoid incorrect general assumptions
about information, especially:
 “All variable costs are relevant and all
fixed costs are irrelevant”
 There are notable exceptions for both
costs

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Potential Problems with
Relevant-Cost Analysis
 Problems with using unit-cost data:
 Including irrelevant costs in error
 Using the same unit-cost with different
output levels
 Fixed costs per unit change with different
levels of output

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Avoiding Potential Problems with
Relevant-Cost Analysis
 Focus on Total Revenues and Total
Costs, not their per-unit equivalents
 Continually evaluate data to ensure
that they meet the requirements of
relevant information

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Insourcing vs. Outsourcing
 Insourcing – producing goods or
services within an organization
 Outsourcing – purchasing goods or
services from outside vendors
 Also called the “Make or Buy” decision
 Decision Rule: Select the option that
will provide the firm with the lowest
cost, and therefore the highest profit.

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Qualitative Factors
 Nonquantitative factors may be
extremely important in an evaluation
process, yet do not show up directly
in calculations:
 Quality Requirements
 Reputation of Outsourcer
 Employee Morale
 Logistical Considerations – distance from
plant, etc.

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Opportunity Costs
 Opportunity Cost is the contribution to operating
income that is forgone by not using a limited resource
in its next-best alternative use
 “How much profit did the firm ‘lose out on’ by not
selecting this alternative?”
 The economic 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.
 Special type of Opportunity Cost: Holding Cost for
Inventory. Funds tied up in inventory are not
available for investment elsewhere

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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.

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The Make or Buy Decision
 MA Company is thinking of buying a part that is
currently used in one of its products from
outside.
 The unit cost to make this part is:
TL/ u
Direct materials 27
Direct labor 15
Variable overhead 3

Depreciation of special equip. 9

Supervisor's salary 6
General factory overhead 30
Total cost per unit 90

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The Make or Buy Decision
 General factory overhead is allocated on the
basis of direct labor hours and is not going to
change if the parts are bought from outside.
 The 90TL unit 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 70TL per part.

Should we accept the supplier’s offer?

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The Make or Buy Decision
Cost
Per
Sunk Cost Unit Cost of 20,000 Units
Make Buy
Outside purchase price 70 1.400.000

Direct materials 27 540.000

Direct labor 15 300.000
Variable overhead 3 60.000
Depreciation of equip. 9 0
Supervisor's salary 6 120.000
General factory overhead 30 0
Total cost 90 1.020.000 1.400.000

Not avoidable and is irrelevant. If the product is dropped, it will

be reallocated to other products.
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The Make or Buy Decision

DECISION RULE
In deciding whether to accept the outside
supplier’s offer, MA 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.

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Product-Mix Decisions
 The decisions made by a company
about which products to sell and in
what quantities
 Decision Rule (with a constraint):
choose the product that produces the
highest contribution margin per unit
of the constraining resource

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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.

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Utilization of a Constrained
Resource
UM Company produces two products and
selected data is shown below:
Product
1 2
Selling price per unit TL60 TL50
Less variable expenses per unit 36 35
Contribution margin per unit TL24 TL15
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.

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Utilization of a Constrained
Resource
 Machine A1 is the constrained resource.
There is excess capacity on all other
machines. Machine A1 is being used at
100% of its capacity, and has a capacity
of 2,400 minutes per week.

Should UM focus its efforts on

Product 1 or 2?

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 Utilization of a Constrained Resource

Let’s calculate the contribution margin per unit of the

constrained resource, machine A1.
Product
1 2
Contribution margin per unit TL24 TL15
Time required to produce one unit ÷ 1,00 min. ÷ 0,50 min.
Contribution margin per minute TL24 min. TL30 min.

Product 2 should be emphasized. Provides more

valuable use of the constrained resource machine A1,
yielding a contribution margin of TL 30 per minute as
opposed to TL 24 for Product 1.
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Utilization of a Constrained
Resource
Let’s calculate the contribution margin per unit of the
scarce resource, machine A1.
Let’s see how this plan would work.
Product
1 2
Contribution margin per unit TL24 TL15
Time required to produce one unit ÷ 1,00 min. ÷ 0,50 min.
Contribution margin per minute TL24 min. TL30 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.

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Utilization of a Constrained
Resource
Let’s see how this plan would work.
Allocation of Constrained Resource

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

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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 TL24 TL15
Total contribution margin TL31.200 TL33.000

The total contribution margin for UM is TL 64,200.

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 Managing Constraints

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

Eliminate waste.
Streamline production process.
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Adding or Dropping Customers
 Decision Rule: Does adding or
dropping a customer add operating
income to the firm?
 Yes – add or don’t drop
 No – drop or don’t add
 Decision is based on profitability of
the customer, not how much revenue
a customer generates

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Adding or Discontinuing
Branches or Segments
 Decision Rule: Does adding or
discontinuing a branch or segment
add operating income to the firm?
 Yes – add or don’t discontinue
 No – discontinue or don’t add
 Decision is based on profitability of
the branch or segment, not how
much revenue the branch or segment
generates
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 Adding/Dropping Segments
Digital Musical Instruments
Income Statement for 2007
Sales 1.000.000
Less: variable expenses
Variable mfg. costs 240.000
Variable shipping costs 10.000
Commissions 150.000 400.000
Contribution margin 600.000
Less: fixed expenses
General factory overhead 120.000
Salary of line manager 180.000
Depreciation of equipment 100.000
Advertising - direct 200.000
Should the company
Rent - factory space drop digital instruments
140.000
General admin. expenses division?
60.000 800.000
Net loss (200.000)
General Factory Overhead and General Administrative Expenses are unavoidable
costs.
Assume that the equipment used in manufacturing digital instruments has no resale value or
alternative use. 38
Incremental Approach

DECISION RULE
UM should drop the digital instruments
division only if the avoided fixed costs
of the division exceed lost
contribution margin of this division.

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Incremental Approach
Contribution Margin
Solution
Contribution margin lost if digital
instrument division is dropped (600.000)
Less fixed costs that can be avoided
Salary of the line manager 180.000
Advertising - direct 200.000
Rent - factory space 140.000 520.000
Net disadvantage (80.000)

What about depreciation?

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Comparative Income Approach

Prepare comparative income statements

showing results with and without the
digital instruments division.

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 Comparative Income Approach
Solution

Keep Digital Drop Digital

Instrum ents Instrum ents Difference
Sales 1.000.000 0 (1.000.000)
Less variable expenses: 0
Mfg. expenses 240.000 0 240.000
Freight out 10.000 0 10.000
Commissions 150.000 0 150.000
Total variable expenses 400.000 0 400.000
Contribution margin 600.000 0 (600.000)
Less fixed expenses:
General factory overhead 120.000 120.000 0
Salary of line manager 180.000 0 90.000
Depreciation 100.000 100.000 0
Advertising - direct 200.000 0 100.000
Rent - factory space 140.000 0 70.000
General admin. expenses 60.000 60.000 0
Total fixed expenses 800.000 280.000 260.000
Net loss (200.000) (280.000) (340.000)

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Joint Product 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.
 The point in the manufacturing process
where each joint product can be
recognized as a separate product is
called the split-off point.

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Joint Products
Joint
Oil
Costs

Common
Joint
Production Gasoline
Input
Process

Chemicals

Split-Off
Point
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Joint Products
Joint
Separate Final
Costs Oil
Sale
Processing

Common
Joint Final
Production Gasoline
Input Sale
Process

Separate Final
Chemicals
Processing Sale

Split-Off Separate
Point Product
Costs
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The Pitfalls of Allocation of Joint
Costs
 Joint costs are really common costs
incurred to simultaneously produce a
variety of end products.
 Joint costs are often allocated to end
products on the basis of the relative
sales value of each product or on
some other basis.

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Sell or Process Further

Decision Rule:
 It will always 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.
Let’s look at the Kere example.

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Sell or Process Further
 Kere Company 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 “ready-logs.”

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Sell or Process Further

Data about Kere’s joint products includes:

Per Log
Lumber Sawdust
Sales value at the split-off point TL140 TL40

Sales value after further processing 270 50

Allocated joint product costs 176 24
Cost of further processing 50 20

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Sell or Process Further
Analysis
Per Log
Lumber Sawdust

Sales value after further processing TL270 TL50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing 50 20
Profit (loss) from further processing TL80 (TL10)

Should Kere process the lumber

further and sell the sawdust “as is?”

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Behavioral Implications
 Despite the quantitative nature of
some aspects of decision making, not
all managers will choose the best
alternative for the firm
 Managers could engage in self-
serving behavior such as delaying
needed equipment maintenance in
order to meet their personal
profitability quotas for bonus
consideration
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