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 CostsCost 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.

Image result for product line contribution format

  • 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.

Image result for make or buy analysis

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.

The Problem of Multiple Constraints

  • If there is more than one potential constraint, there must be a proper mix of products using linear programming.

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