Chapter 12: Relevant Costs for Decision Making

Decision making involves leading to outcomes that contribute to achieving performance goals in the organization’s strategic objectives.

Relevant Cost – Cost that differs among the alternatives in a particular decision and will be incurred in the future.

A.k.a. Avoidable Cost or Differential Cost

Objective 1 – Distinguish between relevant and irrelevant costs in decision making.

Cost Concepts for Decision Making

Identifying Relevant Costs and Benefits

Costs and benefits that differ in total among alternatives and incurred in the future are relevant in a decision.
Costs that are the same (can’t change with decisions) are irrelevant.
Avoidable Cost – Any cost that can be eliminated (in whole or in part) by choosing one alternative over another in a decision-making situation.
Irrelevant Costs
Sunk Costs – Cost that has already been incurred and can’t be avoided regardless of decision.
Future Costs (Same) – Costs that cannot differ between alternatives and do not affect the decision.
Identifying Relevant Costs and benefits
Eliminate costs that do not differ between alternatives.
Use remaining costs and benefits that do differ between alternatives in making the decision.

Different Costs for Different Purposes

Costs relevant in one decision may not be relevant in another.
Different costs are used in different cases – irrelevant data may mislead a manager.

An Example of Identifying Relevant Costs and Benefits

Fundamentally - Only costs and benefits that differ between alternatives are relevant – everything else is ignored.
Example - Choose to drive a car or ride the train on a vacation.
Relevant Costs - Cost of gasoline, cost of maintenance and repairs, Train ticket, cost/benefit of having the car at the vacation spot.
Irrelevant Costs - Original cost of car, annual cost of auto insurance, monthly university parking fee, Cost of Kennel for Pet
Both - Average Cost per Kilometre has some relevant cost and some irrelevant cost.

Reconciling the Total and Differential Approaches

Comparing the net operating income for two alternatives shows the advantageous solution.
Costs that are the same in both alternatives are ignored.
Alternatively, we can isolate the Relevant costs and get the same answer through obtaining a net annual cost savings figure.

Why Isolate Relevant Costs?

Information is not typically provided to prepare a detailed income statement for both alternatives.
Combining irrelevant costs with relevant costs may cause confusion and distract attention from the matters that are critical.

Objective 2 – Prepare Analyses for Various Decision Situations

Analysis of Various Decision Situations

Adding and Dropping Product Lines and Other Segments

Considers both qualitative and quantitative factors, hinging primarily on the impact on operating income.
Dropping a Product Line with operating loss will decrease the contribution margin but allow the company to decrease fixed costs.
If by dropping the line, decrease in fixed costs > decrease in contribution margin, then company is better off dropping it.

Activity Based Costing – Use it to determine if expenses are avoidable, this way management can identify the costs that can be avoided when dropping the line.
Find effect on Profits
Contribution Margin if Product Line Dropped
Less - Fixed Costs that can be Avoided if Product Line Dropped
Increase/Decrease in Overall Company Operating Income

A Comparative Format

In a comparative format income statement, the sales and expenses are shown for the situations in which the Product Line is kept, Product Line is dropped, and the Difference - Operating Income or (Decrease).

Beware of Allocated Fixed Costs

Allocations of fixed may make a product line appear unprofitable by displaying a net loss.
Separating fixed costs into traceable and less common shows the Product-Line Segment Margin before fixed expenses that are shared by all product lines.
Unprofitable products may be retained if it serves as a magnet to attract customers or if it boosts sales of other products.
E.g. Bread is expected in a supermarket and increases sales of other segments.

Keep or Drop a Product/Segment

Relevant Costs and Benefits

Contribution Margin (CM) lost if dropped.
Fixed Costs avoided if dropped.
CM lost/gained on other products/segments

Irrelevant Costs

Allocated Common Costs
Sunk Costs

Decision Rule

Keep if - CM lost (all products/segments) > Fixed Costs avoided + CM gained (other products/segments)
Drop if - CM lost (all products/segments) < Fixed Costs avoided + CM gained (other products/segments)

The Make or Buy Decision

According to the value chain, raw materials must be obtained, processed, converted to be usable, manufacturing must take place, and the product must then be distributed.
Vertical Integration – The involvement by a single company in more than one of the steps of the value chain, from production to manufacture and distribution of the finished product.
Make or Buy Decision – A decision as to whether an item should be produced internally or purchased from an outside supplier.

Strategic Aspects of the Make or Buy Decision

Make Decision - Integration provides advantages: independence from suppliers and a potentially smoother flow of parts and materials, and possibly better control over quality.
Buy Decision - A supplier may be able to realize economies of scale in R&D and manufacturing for higher quality and lower cost materials.

Example of Make or Buy

A company produces gear shifters for bicycles and reports costs of internal production.
Identify the differential costs by eliminating non-avoidable costs (sunk and future same).
Examples of non-avoidable costs: depreciation of equipment already purchased, allocated overhead costs common to all items produced.
Examples of differential costs - variable costs of production.
If avoidable costs < outside purchase price, then the company should continue to manufacture the shifters.

Opportunity Cost

If the space being used to produce would otherwise be idle, then the opportunity cost is the segment margin derived from the best alternative use of the space.
E.g. Could produce another product and earn X amount of revenue instead.
Opportunity costs are not recorded in the accounts as they represent benefits forgone rather than dollar outlays.

Make or Buy

Relevant Costs

Incremental costs of making the product (variable & fixed).
Opportunity Cost of utilizing space to make the product.
Outside Purchase Price.

Irrelevant Costs

Allocated Common Costs
Sunk Costs

Total Relevant Costs of Making = Incremental Costs + Opportunity Costs.

Decision Rule

Make if - Total Relevant costs of making < Outside Purchase Price
Buy if - Total Relevant costs of making > Outside Purchase Price

Special Orders

A one-time order that is not considered part of the company’s normal ongoing business.
Objective: setting a price to achieve positive incremental operating income.
Only incremental costs and benefits are relevant – if MOH costs are not affected by the order then they are not relevant.
Confirm that there is idle capacity and that the special order does not affect other sales.
Otherwise, sum up the Contribution Margin forgone and the total relevant costs to get a total Opportunity Cost.
Profitable when incremental revenue > incremental costs of the order.

Special Orders

Relevant Costs and benefits

Incremental costs of filling the order (variable and fixed)
Opportunity Cost of filling the order
Incremental Revenues from the Order

Irrelevant Costs

Allocated Common Costs
Sunk Costs

Total Relevant Costs of Making = Incremental Costs + Opportunity Costs.

Decision Rule

Accept if - Incremental Revenues > Total Relevant Costs
Reject if - Incremental Revenues < Total Relevant Costs

Joint Product Costs and the Sell or Process Further Decision

Joint Products – Two or more items that are produced from a common input.
Joint Product Costs – Costs that are incurred up to the split-off point in producing joint products.
Split-Off Point – The point in the manufacturing process where some or all of the joint products can be recognized as individual products.

The Pitfalls of Allocation

Joint product costs are common costs incurred simultaneously to produce a variety of end products.
They are sunk costs, so they should not be used to make decisions on what to do with joint products beyond split-off.

Sell or Process Further Decisions

Decision as to whether a joint product should be sold at the split-off point or processed further and sold at a later time in a different form.
It will always be profitable to process the joint product after the split-off point as long as incremental revenue from such processing exceeds the incremental processing cost incurred after split-off point.
Joint costs of activities prior to split-off are relevant when considering the profitability of the entire operation because they are avoidable if the operation is shut down.
The company has the option of selling products prior to split-off activities rather than processing it further if a greater profit is yielded.

Sell or Process Further

Relevant Costs and benefits

Incremental costs of further processing
Incremental Revenues from further processing

Irrelevant Costs

Allocated joint product costs

Decision Rule

Process Further if - Incremental Revenues > Incremental costs of further processing.
Sell at split-off point if - Incremental Revenues < Incremental costs of further processing.

Objective 3 – Determine the most profitable use of a constrained resource and the value of obtaining more of the constrained resource.

Utilization of a Constrained Resource

Constraint – A limitation under which a company must operate (e.g. limited machine time or raw materials) that restricts the company’s ability to satisfy demand for its products or services.
Theory of Constraints (TOC) – A management approach that emphasizes the importance of managing constraints.
Challenge - Utilize the constrained resource to maximize profits.
Fixed costs are usually unaffected by allocation of constrained resource in short run, so the focus is on contribution margin.

Contribution Margin in Relation to a Constrained Resource

Maximize total contribution margin by promoting products and accepting orders that provide highest unit contribution margin in relation to constrained resource.
Bottlenecks - If the plant is operating at capacity, then there is a machine that is operating at capacity and therefore is limiting overall output.
Profitability Index = Contribution Margin Per Unit / Quantity of Constrained Resource Required per unit.
Demand must be satisfied for the product with a higher profitability index, allocating capacity that remains to the product with the second-highest index and so on.

Managing Constraints

Relaxing (or Elevating) the Constraint – Increasing the capacity of a bottleneck.
Managers should focus much of their attention on managing bottlenecks, emphasizing products that are most profitably utilizing the constrained resource.
Products should be processed smoothly through bottlenecks with minimal lost time.
Methods of Increasing Capacity
Working Overtime.
Subcontracting processing done at the bottleneck.
LOW COST - Shifting workers from processes that are not bottlenecks to the process that is a bottleneck.
LOW COST - Focusing business process improvement efforts such as total quality management and business process re-engineering.
LOW COST - Reducing defective units.