relevant costs-2007 - copy

7/30/2019 Relevant Costs-2007 - Copy

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Relevant Cost Decisions

DECISION MAKING IN THE SHORTTERM

By : Dr. Pranav Saraswat


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Decisions

A decision model is a formal methodof making a choice, often involvingboth quantitative and qualitativeanalyses

A relevant costis a cost thatdiffers between alternatives.


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Five-StepDecision-Making Process

Step 1:

Obtain

Information

Step 5:

Evaluate

Performance

Step 4:

Implement

TheDecision

Step 3:

Choose

AnAlternative

Step 2:

Make

Predictions

AboutFuture

Costs

Feedback


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Relevance

Relevant Information has twocharacteristics:

It occurs in the future

It differs among the alternative coursesof 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 inpart) by choosing one alternative overanother are avoidable costs. Avoidable

costs are relevant costs.Unavoidable costs are never relevant and

include:

Sunk costs.

Future costs that do not differbetween thealternatives.


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Identifying Relevant Costs

gather all costs associated with thealternatives

eliminate all sunk costs Eliminate all future costs thatdont

differ between alternatives

left are the avoidable costs


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Irrelevance

Historical costs are past costs thatare irrelevant to decision making

Also called Sunk Costs- cost that hasalready been incurred and that cannot beavoided regardless of what a managerdecides to do


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Types of Information

Quantitative factors are outcomesthat can be measured in numericalterms

Qualitative factors are outcomes thatare difficult to measure accurately innumerical terms, such as satisfaction

Are just as important as quantitativefactors even though they are difficult tomeasure


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Terminology

Incremental Cost the additionaltotal 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 differencein total revenue between twoalternatives


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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 orDiscontinuing

Equipment Replacement


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Accepting or rejecting special orderswhen there is idle production capacityand the special orders have no long-run implications

Decision Rule: does the special ordergenerate additional operating

income? Yes accept

No reject


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Compares relevant revenues andrelevant costs to determineprofitability


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Special Orders

Acki Company receives a one-time order thatis not considered part of its normal ongoingbusiness.

Acki Company only produces one type of

silver key chain with a unit variable cost ofTL 16. Normal selling price is TL 40 per unit.

A company in KKTC offers to purchase 3,000units for TL 20 per unit.

Annual capacity is 10,000 units, and annualfixed costs total TL78,000, but Acki companyis currently producing and selling only 5,000units.

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 103.000Net income TL17.000


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Special Orders

If Acki accepts the offer, net income willincrease by TL 12.000.

Increase in revenue (3,000 TL20) TL60.000Increase in costs (3,000 TL16 variable cost) 48.000Increase in net income TL12.000

Using the incremental approach:Special order contribution margin = TL20 TL 16 = TL 4Change in income = TL 4 3,000 units = TL 12.000.


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The Make or Buy Decision

A decision concerning whether an itemshould be produced internally or

purchased from an outside supplier iscalled a make or buy decision.


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MA Company is thinking of buying a part that iscurrently used in one of its products fromoutside.

The unit cost to make this part is:TL/ u

Direct materials 27

Direct labor 15

Variable overhead 3

Depreciation of special equip. 9Supervisor's salary 6

General factory overhead 30Total cost per unit 90


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General factory overhead is allocated on thebasis of direct labor hours and is not going tochange if the parts are bought from outside.

The 90TL unit cost is based on 20,000 partsproduced each year.

An outside supplier has offered to providethe 20,000 parts at a cost of 70TL per part.

Should we accept the suppliers offer?


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Cost

Per

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 0Total 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.

Sunk Cost


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DECISION RULE

In deciding whether to accept the outsidesuppliers offer, MA isolated the relevantcosts 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 companyabout which products to sell and inwhat quantities

Decision Rule (with a constraint):choose the product that produces thehighest contribution margin per unit

of the constraining resource


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Utilization of a ConstrainedResource

Firms often face the problem ofdeciding how to best utilize aconstrained resource.

Usually, fixed costs are not affectedby this particular decision, somanagement can focus on

maximizing total contributionmargin.


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UM Company produces two products andselected data is shown below:

Product

1 2Selling 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 requiredon machine A1 per unit 1,00 min. 0,50 min.


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Machine A1 is the constrained resource.There is excess capacity on all othermachines. Machine A1 is being used at

100% of its capacity, and has a capacityof 2,400 minutes per week.

Should UM focus its efforts onProduct 1 or 2?


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Utilization of a Constrained Resource

Lets calculate the contribution margin per unit of theconstrained resource, machine A1.

Product 2 should be emphasized. Provides morevaluable use of the constrained resource machine A1,

yielding a contribution margin of TL 30 per minute as

opposed to TL 24 for Product 1.

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.


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Lets calculate the contribution margin per unit of thescarce resource, machine A1.

Lets see how this plan would work.

If there are no other considerations, the best plan would beto produce to meet current demand for Product 2 and then

use remaining capacity to make Product 1.

Product

1 2Contribution 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.


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Lets see how this plan would work.

Allocation of Constrained Resource

Weekly demand for Product 2 2.200 unitsTime 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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According to the plan, we will produce 2,200 units ofProduct 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 TL15Total contribution margin TL31.200 TL33.000

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


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Managing Constraints

Finding ways toprocess more unitsthrough a resource

bottleneck

Produce onlywhat can be sold.

Streamline production process.

Eliminate waste.

At the bottleneck itself:Improve the process Add overtime or another shift

Hire new workers or acquired

more machines Subcontract production


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Adding or Dropping Customers

Decision Rule: Does adding ordropping a customer add operatingincome to the firm?

Yes add or dont drop

No drop or dont add

Decision is based on profitability of

the customer, not how much revenuea customer generates


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Adding or DiscontinuingBranches or Segments

Decision Rule: Does adding ordiscontinuing a branch or segmentadd operating income to the firm?

Yes add or dont discontinue

No discontinue or dont add

Decision is based on profitability of

the branch or segment, not howmuch revenue the branch or segmentgenerates


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Sales 1.000.000

Less: variable expenses

Variable mfg. costs 240.000

Variable shipping costs 10.000

Commissions 150.000 400.000

Contribution margin 600.000Less: fixed expenses

General factory overhead 120.000

Salary of line manager 180.000

Depreciation of equipment 100.000

Advertising - direct 200.000

Rent - factory space 140.000General admin. expenses 60.000 800.000

Net loss (200.000)

Income Statement for 2007

Digital Musical Instruments

Adding/Dropping Segments

General Factory Overhead and General Administrative Expenses are unavoidablecosts.

Assume that the equipment used in manufacturing digital instruments has no resale value or

alternative use.

Should the company drop digital instrumentsdivision?


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Incremental Approach

DECISION RULE

UM should drop the digital instrumentsdivision only if the avoided fixed costs

of the division exceed lostcontribution 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 statementsshowing results with and without the

digital instruments division.


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Comparative Income Approach

Solution

Keep Digital

Instruments

Drop Digital

Instruments DifferenceSales 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 0 400.000Contribution 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 70.000General admin. expenses 60.000 60.000 0

Total fixed expenses 800.000 280.000 260.000Net loss (200.000) (280.000) (340.000)


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Joint Product Costs

In some industries, a number of endproducts are produced from a single rawmaterial input.

Two or more products produced from acommon input are calledjoint products.

The point in the manufacturing processwhere each joint product can berecognized as a separate product iscalled the split-off point.


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Joint Products

JointInput

Common

ProductionProcess

Split-OffPoint

JointCosts

Oil

Gasoline

Chemicals


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Joint Products

JointInput

Common

ProductionProcess

Separate

Processing

Separate

Processing

Final

Sale

Final

Sale

FinalSale

Split-OffPoint

JointCosts

SeparateProductCosts

Oil

Gasoline

Chemicals


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The Pitfalls of Allocation of JointCosts

Joint costs are really common costsincurred to simultaneously produce avariety of end products.

Joint costs are often allocated to endproducts on the basis of the relativesales value of each product or on

some other basis.


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Sell or Process Further

Decision Rule:

It will always profitable to continueprocessing a joint product after the

split-off point so long as theincremental revenue exceeds theincremental processing costs incurredafter the split-off point.

Lets look at the Kere example.


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Kere Company cuts logs from whichunfinished lumber and sawdust are theimmediate joint products.

Unfinished lumber is sold as is orprocessed further into finished lumber.

Sawdust can also be sold as is togardening wholesalers or processed

further into ready-logs.


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Data about Keres 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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Analysis

Per Log

Lumber Sawdust

Sales value after further processing TL270 TL50

Sales value at the split-off point 140 40Incremental revenue 130 10

Cost of further processing 50 20Profit (loss) from further processing TL80 (TL10)

Should Kere process the lumberfurther and sell the sawdust as is?


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Behavioral Implications

Despite the quantitative nature ofsome aspects of decision making, notall managers will choose the best

alternative for the firm Managers could engage in self-

serving behavior such as delayingneeded equipment maintenance in

order to meet their personalprofitability quotas for bonusconsideration

relevant costs-2007 - copy

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