Relevant Cost Decisions

DECISION MAKING IN THE SHORT TERM

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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 1:Obtain

Information

Step 5:Evaluate

Performance

Step 4:Implement

TheDecision

Step 3:Choose

AnAlternative

Step 2:Make

PredictionsAboutFutureCosts

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?Should Acki accept the offer?

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Special Orders

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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) TL60.000Increase 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. 9Supervisor's salary 6General factory overhead 30Total cost per unit 90

TL/ uDirect materials 27 Direct labor 15 Variable overhead 3

Depreciation of special equip. 9Supervisor's salary 6General factory overhead 30Total 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?Should we accept the supplier’s offer?

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Cost Per Unit Cost of 20,000 Units

Make BuyOutside purchase price 70 1.400.000

Direct materials 27 540.000Direct labor 15 300.000Variable overhead 3 60.000Depreciation of equip. 9 0Supervisor's salary 6 120.000General factory overhead 30 0Total cost 90 1.020.000 1.400.000

The Make or Buy Decision

Not avoidable and is irrelevant. If the product is dropped, it will be reallocated to other products.

Not avoidable and is irrelevant. If the product is dropped, it will be reallocated to other products.

Sunk Cost

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The Make or Buy Decision

DECISION RULEIn deciding whether to accept the outside

supplier’s offer, MA isolated the relevant costs of making the part by eliminatingeliminating:

The sunk costs. The future costs that will not differ

between making or buying the parts.

DECISION RULEIn deciding whether to accept the outside

supplier’s offer, MA isolated the relevant costs of making the part by eliminatingeliminating:

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:

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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 Should UM focus its efforts on Product 1 or 2?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 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 ResourceLet’s calculate the contribution margin per unit of the

scarce resource, machine A1.Let’s see how this plan would work.Let’s see how this plan would work.

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.

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.Let’s 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

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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Utilization of a Constrained Resource

According to the plan, we will produce 2,200 units of According to the plan, we will produce 2,200 units of Product 2 and 1,300 of Product 1. Our Product 2 and 1,300 of Product 1. Our

contribution margin looks like this.contribution margin looks like this.

Product 1 Product 2Production 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 to process more

units through a resource

bottleneck

Produce only what 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 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 DiscontinuingBranches 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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Sales 1.000.000Less: variable expenses Variable mfg. costs 240.000 Variable shipping costs 10.000 Commissions 150.000 400.000Contribution 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 140.000 General admin. expenses 60.000 800.000Net loss (200.000)

Income Statement for 2007Digital Musical Instruments

Adding/Dropping Segments

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.

Should the company drop digital instruments division?

Should the company drop digital instruments division?

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Incremental Approach

DECISION RULEDECISION RULEUM should drop the digital instruments

division only if the avoided fixed costs of the division exceed lost

contribution margin of this division.

DECISION RULEDECISION RULEUM 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 MarginSolution

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 140.000 520.000Net disadvantage (80.000)

What about depreciation?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 ApproachSolution

Keep Digital Instrum ents

Drop Digital 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 0 150.000Total 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 70.000 General admin. expenses 60.000 60.000 0Total 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 end products are produced from a single raw material input.

Two or more products produced from a common input are called joint productsjoint products.

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

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Joint Products

JointInput

CommonProduction

Process

Split-OffSplit-OffPointPoint

JointJointCostsCosts Oil

Gasoline

Chemicals

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Joint Products

JointInput

CommonProduction

Process

SeparateProcessing

SeparateProcessing

FinalSale

FinalSale

FinalSale

Split-OffSplit-OffPointPoint

JointJointCostsCosts

SeparateSeparateProductProductCostsCosts

Oil

Gasoline

Chemicals

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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 relative sales valuesales 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.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 TL50Sales 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?”

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