chapter thirteen short-run decision making: relevant costing copyright © 2012 nelson education ltd

Chapter ThirteenShort-Run Decision Making:

Relevant Costing

Chapter ThirteenShort-Run Decision Making:

Relevant Costing

COPYRIGHT © 2012 Nelson Education Ltd.


Learning ObjectivesLearning Objectives

1. Describe the short-run decision-making model, and explain how cost behaviour affects the information used to make decisions

2. Apply relevant costing and decision-making concepts in a variety of business situations

3. Choose the optimal product mix when faced with one constrained resource

4. Explain the impact of cost on pricing decisions

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OBJECTIVE OBJECTIVE 11

Describe the short-run decision-making model, and explain how cost behaviour affects the information used

to make decisions


Short-Run DecisionsShort-Run Decisions

• Small-scale actions that serve a larger purpose

• Decisions are made using a decision model– Used to structure the thinking process– Organizes information

• Consists of choosing among alternatives with an immediate or limited end in view

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Decision-Making ModelDecision-Making Model

1. Recognize and define the problem

2. Identify the alternatives

3. Identify the costs and benefits associated with each feasible alternative

4. Estimate the relevant costs and benefits for each alternative

5. Assess the qualitative factors

6. Select alternative with the greatest net benefit

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Relevant CostsRelevant Costs

• Can consist of both variable and fixed costs• Changes in supply and demand for resources

must be considered• Also known as differential or incremental costs• Practical interpretation

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Apply relevant costing decision-making

concepts in a variety of business situations


Make-or-Buy DecisionsMake-or-Buy Decisions

• Decisions involving a choice between internal and external production

• Decision process:– Identify feasible alternatives– Identify which costs are relevant– Compare total relevant costs of manufacturing with

cost of buying– Make a choice

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Example: Cornerstone 13-1Example: Cornerstone 13-1

Information:

Direct materials

Direct labour

Variable overhead

Fixed overhead

Unit CostTotal Cost

$10,000 $1.00

20,000 2.00

8,000 0.80

44,000 4.40

Total $82,000 $8.20

Determine if it would be cheaper to make 10,000 units of a component in-house or to purchase them from an outside supplier for $4.75 each

HOW TO Structure a Make-or-Buy Problem

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ExampleExample

Information continued:Fixed overhead will continue whether the component is produced internally or externally. No additional costs of purchasing will be incurred beyond the purchase price

1. What are the alternatives?2. List the relevant cost(s) of internal production and of

external purchase3. Which alternative is more cost effective and by how much? 4. Now assume that the fixed overhead includes $10,000 of

avoidable cost (if the component is purchased externally) Which alternative is more cost effective and by how much?

Required:

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ExampleExample

1. Alternatives:• Make the component in-house, or• Purchase the component from an outside supplier

2. Relevant costs:• Producing in-house

‒ Direct Materials‒ Direct Labour‒ Variable Overhead

• Purchasing the component externally‒ Purchase Price

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ExampleExample

Differential Cost to Make

Direct materials

Direct labour

Variable overhead

Purchase cost

BuyMake

$10,000 $10,000

20,000

8,000

Alternatives

----

----

----

20,000

8,000

Fixed overhead is not included in the analysis.It will remain the same under either alternative

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ExampleExample


Direct materials

Direct labour

Variable overhead

Purchase cost

BuyMake

$10,000 $10,000

20,000

8,000

Alternatives

----

----

----

20,000

8,000

The only cost under the “buy” alternative is the purchase cost

$47,500----

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ExampleExample


Direct materials

Direct labour

Variable overhead

Purchase cost

BuyMake

$10,000 $10,000

20,000

8,000

Alternatives

----

----

----

20,000

8,000

If they buy the component, they will incur $47,500 in additional costs

$47,500---- (47,500)

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ExampleExample


Direct materials

Direct labour

Variable overhead

Purchase cost

BuyMake

$10,000 $10,000

20,000

8,000

Alternatives

----

----

----

20,000

8,000$47,500---- (47,500)

Total $47,500$38,000 $(9,500)

It is cheaper to make the component in-house This alternative is better by $9,500

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ExampleExample


Direct materials

Direct labour

Variable overhead

Avoidable fixed overhead

BuyMake

$10,000 $10,000

20,000

8,000

Alternatives

----

----

----

20,000

8,000

Part 4: $10,000 of avoidable fixed overhead

If they make the component, fixed costs will increase by $10,000. If they buy it, the $10,000 in fixed costs will be avoided.

----10,000 10,000

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ExampleExample


Direct materials

Direct labour

Variable overhead

Avoidable fixed overhead

BuyMake

$10,000 $10,000

20,000

8,000

Alternatives

----

----

----

20,000

8,000

Part 4: $10,000 of avoidable fixed overhead

----10,000 10,000

$48,000Total $47,500

$47,500 (47,500)

$ 500

Now it is cheaper to purchase the component. This alternative is better by $500

Purchase cost ----

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Special Order DecisionsSpecial Order Decisions

• Focus on whether a specially priced order should be accepted or rejected

• Orders can be attractive– Especially when firm is operating below maximum

productive capacity

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• A new customer has offered to purchase 20,000 units of model TR8 @ $9 each

• New customer is geographically separated from company’s other customers

• Existing sales not affected• Normal production is 100,000 units per year

– Company plans to produce and sell 75,000 in the coming year

• Normal sales price is $14 per unit

Information:

HOW TO Structure a Special-Order Problem

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ExampleExample

Information continued:

Direct materialsDirect labourVariable overheadFixed overhead

Unit Cost$3.00

2.801.502.00

Total $9.30

1. What are the relevant costs and benefits of the two alternatives (accept or reject the special order)?

2. By how much will operating income increase or decrease if the order is accepted?

Required:

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ExampleExample

1. Relevant cost and benefits:• Accept the order

• Sales price of $9 (Benefit)• Direct materials (Cost)• Direct labour (Cost)• Variable overhead (Cost)

• Reject the order:• There are no relevant costs or benefits

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ExampleExample

Accept Reject

Differential Benefit to

Accept

Price

Direct Materials

Direct Labour

Variable Overhead

$9.00 $ --- $9.00

(3.00) --- (3.00)

(2.80) --- (2.80)

(1.50) (1.50) ---

Increase in operating income $1.70 $ 0 $1.70

Operating income will increase by $34,000 ($1.70 × 20,000 units) if the special order is accepted.

Per Unit:

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Keep-or-Drop DecisionsKeep-or-Drop Decisions

• Decision to keep or drop a segment such as a product line

• Variable costing segment financial reports provide information– Contribution margin– Segment margin

• Relevant costing provides structure to decision making

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• Roofing tile line has a contribution margin of $10,000 (sales of $150,000 less total variable costs of $140,000)

• All variable costs are relevant• Relevant fixed costs associated with this line include:

– Advertising $10,000– Supervision $35,000

Information:

HOW TO Structure a Keep-or-Drop Product Line Problem

1. List the alternatives being considered2. List the relevant benefits and costs for each alternative3. Which alternative is more cost effective? By how much?

Required:

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ExampleExample

1. Alternatives:• Keep roofing tile line OR Drop roofing tile line

2. Relevant costs and benefits:• Keep the order

• Sales of $150,000 (Benefit)• Variable costs of $140,000 (Cost)• Advertising $10,000 (Cost)• Supervision $35,000 (Cost)

• Reject the order:• None of the relevant costs or benefits will occur if

line is dropped

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ExampleExample

Keep Drop

Differential Amount to

Keep

SalesLess: Variable Expenses

Contribution MarginLess: Advertising

$150,000 $ --- $150,000140,000 --- 140,000

$ 10,000 --- $ 10,000(10,000) (10,000) ---

Cost of supervision

$ 0 $(35,000)

The difference is $35,000 in favour of dropping the roofing tile line

(35,000) --- (35,000)

Total relevant benefit (loss) $(35,000)

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HOW TO Structure a Keep-or-Drop Line Problem with Complementary Effects


Information: Blocks BricksSalesLess: Variable Expenses

Contribution MarginLess direct fixed expenses:

$500 $800250 480

$250 $320

(10) (10)Advertising

(40)(37) (40)

Segment margin $150

(53)Salaries

Depreciation

$230

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ExampleExample

• Dropping the roofing tile product line reduces:– Sales of blocks by 10%– Sales of bricks by 8%

• All other information remains the same

Information continued:

1. If the roofing tile line is dropped, what is the contribution margin: For the block line? For the brick line?

2. Which alternative (keep or drop the roofing tile line) is now more cost effective and by how much?

Required:

13-28


ExampleExample

Sales $500,000

Before dropping line

After dropping line

$450,000

Blocks

Less: Variable expenses 250,000 225,000Contribution Margin $250,000 $225,000

10% reduction in Block sales = $500,000 – 10% ($500,000) = $450,000

Variable expenses are also reduced by 10%, resulting in a 10% decrease in Contribution Margin

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ExampleExample

Sales $500,000

Before dropping line

After dropping line

$450,000

Blocks

Less: Variable expenses 250,000 225,000

Contribution Margin $250,000 $225,000

Sales $800,000 $736,000

Bricks

Less: Variable expenses 480,000 441,600


13-30


ExampleExample

Keep Drop


Keep


Blocks $225,000 + Bricks $294,400

Blocks $250,000 + Bricks $320,000 + Tile $10,000

13-31


ExampleExample

Keep Drop


Keep

Contribution Margin

Less: Advertising

Cost of supervision

$580,000 $519,400 $60,600

(30,000) (20,000) (10,000)

(112,000) (77,000) (35,000)

$15,600

Now the difference is $15,600 in favour of keeping tile line

Total $438,000 $422,400

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Further Processing of Joint ProductsFurther Processing of Joint Products

• Joint products– Include both common processes and costs up to

split-off point

• Split-off point– The point at which separate products become

distinguishable

• Common costs are not relevant to the decision making

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• Appletime must decide between– Selling the Grade B apples at split-off

• 120 two-kilogram bags• Selling price is $1.25 per bag

– If processed into apple pie filling• Generates 500 cans of filling• $0.24 additional cost to process• Selling price will be $0.90 per can

Information:

HOW TO Structure the Sell-or-Process-Further Decision

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ExampleExample

1. What is the contribution to income from selling the Grade B apples in two-kilogram bags?

2. What is the contribution to income from processing the Grade B applies into pie filling?

3. Should Appletime continue to sell the Grade B apples in bags or process them further into pie filling?

Required:

13-35


ExampleExample

1. Contribution to income from selling apples in bags

120 bags x $1.25 selling price

$150 revenue from selling apples in bags

There are no additional costs, so all the additional revenue is additional profit

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ExampleExample

2. Contribution to income from processing into pie filling…

Sales of the pie filling will bring in additional revenue

500 cans x $0.90 selling price = $450 revenue

But processing the apples, will add additional costs:

$0.24 per can x 500 cans = $120

$450 - $120 = $330 Income

13-37


ExampleExample

Selling the apples in two-kilogram bags would bring in an additional $150 in

revenue with no additional costs

Processing the apples into pie filling would contribute $330 in additional income

Appletime should process the apples into pie filling because it generates

the most income

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Choose the optimal product mix when faced with one

constrained resource

13-39


Product Mix DecisionsProduct Mix Decisions

• Organizations have wide flexibility in choosing their product mix– Mix has significant impact on profitability

• Maximizing total profit is the goal– Fixed cost will not change with mix, therefore not

relevant• Focus should be on maximizing total

contribution margin• Limitations on resources are called

“constraints”

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HOW TO Determine the Optimal Product Mix with One Constrained Resource


• Jorgenson Company produces two types of gears:X: Unit contribution margin of $25Requires 2 hours of machine time

Y: Unit contribution margin of $10Requires 0.5 hours of machine time

• Eight machines provide 40,000 machine hours per year

Information:

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ExampleExample

1. What is the contribution per hour of machine time for each gear?

2. What is the optimal mix of gears?

3. What is the total contribution margin earned for the optimal mix?

Required:

13-42


ExampleExample

Gear X Gear Y

Contribution margin per unit

Machine hours required per gear

Contribution margin per machine hour

$ 25 $ 10

÷ 2

$12.50 $20

÷ 0.5

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ExampleExample

Since Gear Y yields $20 of contribution margin per machine hour…..

ALL the machine time should be devoted to the production of Gear Y

40,000 machine hours / 0.5 hours per Gear Y = 80,000 units

Optimal mix

Gear Y = 80,000 units and Gear X = 0 units

Contribution Margin of Optimal Mix80,000 units × $10 = $800,000

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HOW TO Determine the Optimal Product Mix with One Constrained Resource and a Sales Constraint


• Jorgenson Company produces two types of gears:– X provides unit contribution margin $25, requires two

hours of machine time– Y provides unit contribution margin of $25, requires 0.5

hours of machine time• Eight machines provide 40,000 machine hours per year• Maximum sales of 60,000 units of each gear can be sold

Information:

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ExampleExample

1. What is the contribution per hour of machine time for each gear?

2. What is the optimal mix of gears?

3. What is the total contribution margin earned for the optimal mix?

Required:

13-46


ExampleExample

Gear X Gear Y

Contribution margin per unit

Machine hours required per gear

Contribution margin per machine hour

$ 25 $ 10÷ 2

$12.50 $20

÷ 0.5

13-47


ExampleExample


First priority is to produce ALL of Gear Y that the market will take

60,000 units × 0.5 hours = 30,000 hours

60,000 is the maximum sales for any gear. 60,000 units use 30,000 machine hours.

This leaves 10,000 hours of production time.

13-48


ExampleExample



60,000 units x 0.5 hours = 30,000 hours

10,000 hours will produce 5,000 units of Gear X

10,000 hours ÷ 2 hours per Gear X = 5,000 units

13-49


ExampleExample



60,000 units × 0.5 hours = 30,000 hours

10,000 hours ÷ 2 hours per Gear X = 5,000 units

Optimal mix: Gear Y = 60,000 units Gear X = 5,000 units

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ExampleExample

Optimal mix

Gear Y = 60,000 units and Gear X = 5,000 units

Contribution Margin of Optimal Mix

60,000 units Gear Y × $10 = $600,000

5,000 units Gear X × $25 = $125,000

Contribution Margin $725,000

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Explain the impact of cost on pricing decisions

13-52


Cost-Based PricingCost-Based Pricing

• Most companies start with cost to determine price

• Formula:Price = Product cost + Markup

Markup is percentage of base cost• Includes costs not in base cost & desired profit

• Advantage – Ease of use

13-53


HOW TO Calculate Price by Applying a Markup Percentage to Cost


• Elvin Company assembles and installs computers to customer specifications

• Jobs are priced at the cost of direct materials and direct labour plus 20%

• Job for a local vocational-technical school includes:– direct materials $65,000 – direct labour $4,000

Information:

Calculate the price charged by Elvin Company to the schoolRequired:

13-54


ExampleExample

Price = Cost + 20% (Cost)

Cost = Direct Materials + Direct Labour

Cost = $65,000 + $4,000

Cost = $69,000

Price = $69,000 + 20% ($69,000)

Price = $82,800

Price = $69,000 +$13,800

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Target Costing and PricingTarget Costing and Pricing

• Determining price based on what customers are willing to pay

• Company then must design and develop product– Cost must be low enough to allow for desired profit

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• Digitime’s new wristwatch plus PDA has a target price of $200

• Management requires a 15% profit on new products

Information:

Required:

1. Calculate the amount of desired profit2. Calculate the target cost

HOW TO Calculate a Target Cost

13-57


ExampleExample

Desired Profit

0.15 × Target Price

0.15 × $200

$30

Target Cost

Target Price – Desired Profit

$200 – $30

$170

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chapter thirteen short-run decision making: relevant costing copyright © 2012 nelson education ltd

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