BU8101 Accounting: A User Perspective

Lecture 10
Relevant Costs, Incremental Analysis

Recommended Reading:
WHB 16
th
edition
Chapter 21
Other Reference:
Financial and Managerial Accounting: Information for Decisions
John J Wild, Barbara Chiapetta
Chapter 23
10-1
Lecture Date: 25 March 2013
Lecture Outline
Relevant Costs
+ Definition
+ Relevant cost and decision-making
+ Total vs. incremental approach
Incremental Analysis
+ Types of Business Decisions
1. Special Order Decisions
2. Production Constraint (Product Mix) Decisions
3. Make or Buy Decisions
4. Sell, Scrap or Rebuild Decisions
5. Joint Product Decisions
+ Non-Financial Considerations
10-2
Relevant Costs for Decision Making
A relevant cost is a cost that differs between
alternatives.
A relevant cost is likely to have a bearing on
the future.
10-3
Relevant Irrelevant
Differential Cost (aka Relevant Cost) Allocated Cost -- a common cost that
-- will differ according to alternative has been arbitrarily assigned to a
activities being considered. product or activity.
Likely a future cost.
Opportunity Cost -- benefits foregone Sunk Cost -- has already been incurred
by choosing one alternative over and will not change.
another.
Cost Concepts for Decision Making
Lets take a closer look at
Opportunity Cost &
Sunk Cost
10-4
Opportunity Cost (Benefits Forgone )
The benefit that could have been attained by
pursuing an alternative course of action.
Example: If you are not attending college, you
could be earning $20,000 per year. Your
opportunity cost of attending college for one
year includes the $20,000 salary foregone.
Opportunity costs are not recorded in the
accounting records, but are relevant to decisions
because they are a real sacrifice.
10-5
Sunk Cost
10-6
Costs that have already been incurred.
They do not affect any future cost and cannot be
changed by current or future action.
Sunk costs are irrelevant to decisions.

Example: You bought a car that cost $10,000 two years
ago. The $10,000 cost is sunk because whether you
drive it, park it, trade it, or sell it, you cannot change the
$10,000 cost.

Cost = $10,000
two years ago
Cost = $25,000
today
Trade ?
Sunk Cost
Whats the trade-in value for the old car?
10-7
The dealer will trade for $20,000 plus your car.
What amount is relevant to your decision,
the $10,000 sunk cost of your car or the
$20,000 out-of-pocket cash differential?

OLD CAR NEW CAR
Relevant Cost and Decision Making
Decision making involves 5 steps:
O Define the problem.
O Identify the alternatives.
O Collect information on alternatives.
O Eliminate irrelevant information.
O Make a decision with the remaining relevant
information.
10-8
Relevant Cost Example
10-9
1. Going to Florida for spring break.
2. Alternatives: Will you drive or fly to Florida for spring break?
3. You have gathered the following information to help you with
the decision.
Motel cost is $80 per night.
Meal cost is $20 per day.
Your car insurance is $100 per month.
Kennel cost for your dog is $5 per day.
Round-trip cost of gasoline for your car is $200.
Round-trip airfare and rental car for a week is $500.
Driving requires two days, with an overnight stay, cutting your
time in Florida by two days.

Florida Spring Break
Drive/Fly Analysis
Cost Drive Fly
Motel 640 $ 640 $
Eating out costs 160 160
Kennel cost 40 40
Car insurance 100 100
Gasoline 200 -
Airfare/rental car - 500
8 days @ $80
8 days @ $20
8 days @ $5
Relevant Cost Example
10-10
Florida Spring Break
Drive/Fly Analysis
Cost Drive Fly
Motel 640 $ 640 $
Eating out costs 160 160
Kennel cost 40 40
Car insurance 100 100
Gasoline 200 -
Airfare/rental car - 500
4. Irrelevant information
Costs do not differ,
so they are
irrelevant to decision
Also, car insurance
is irrelevant to
the decision as it
is a past/sunk cost.
Relevant Cost Example
10-11
5. Relevant Information
Transportation
costs differ between
the two alternatives,
so they are relevant
to the decision
Are the extra two
days in Florida
worth the $300
extra cost to fly?
Florida Spring Break
Drive/Fly Analysis
Cost Drive Fly
Motel 640 $ 640 $
Eating out costs 160 160
Kennel cost 40 40
Car insurance 100 100
Gasoline 200 -
Airfare/rental car - 500
Relevant Cost Example
10-12
Total and Incremental Cost Approach
The management of a company is considering a new labor-saving
machine that rents for $3,000 per year. Data about the companys
annual sales and costs with and without the new machine are:
Current
Situation
Situation
With New
Machine Variance
Sales (5,000 units @ $40 per unit) 200,000 $ 200,000 $ -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income 18,000 $ 30,000 $ 12,000
10-13
TOTAL APPROACH
The only costs that differ between the two alternatives are the direct
labor cost savings and the increase in machine rental costs.
We can efficiently analyze the decision by
looking at the differential costs and benefits
and arrive at the same solution.




Decrease in direct labor costs (5,000 units @ $3 per unit) 15,000 $
Increase in machine rental expenses (3,000)
Net annual cost savings from renting the new machine 12,000 $
Net Advantage to Renting the New Machine
10-14
Total and Incremental Cost Approach
INCREMENTAL APPROACH

(1) Special Order Decisions
The decision to accept additional business should
be based on
incremental costs and incremental revenues.

Incremental amounts are those that occur only if
the company decides to accept the new business.
differ between alternatives

Special consideration:
Does the company have excess capacity?
10-15
Special Order Decisions
Victory Co. currently sells 100,000 units of a product. The company
has revenues and costs as shown below:
Per Unit Total
Sales 10.00 $ 1,000,000 $
Direct materials 3.50 350,000
Direct labor 2.20 220,000
Factory overhead 1.10 110,000
Selling expenses 1.40 140,000
Administrative expenses 0.80 80,000
Total expenses 9.00 $ 900,000 $
Operating income 1.00 $ 100,000 $
10-16
Special Order Decisions
Victory Co. is approached by an overseas company that offers to
purchase 10,000 units at $8.50 per unit.
If Victory Co. accepts the offer, total factory overhead will
increase by $5,000; total selling expenses will increase by
$2,000; and total administrative expenses will increase by
$1,000.
Victory Co. has a production capacity of 120,000 units.

Should Victory accept the offer?
10-17
Our cost is $9.00
per unit. I cant sell
for $8.50 per unit.
Special Order Decisions
10-18
First, lets look at incorrect reasoning
that leads to an incorrect decision.

Current
Business
Additional
Business Combined
Sales 1,000,000 $ 85,000 $ 1,085,000 $
Direct materials 350,000 $ 35,000 $ 385,000 $
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses 900,000 $ 65,000 $ 965,000 $
Operating income 100,000 $ 20,000 $ 120,000 $
10,000 new units $8.50 selling price = $85,000
Special Order Decisions
10,000 new units $3.50 = $35,000
10,000 new units $2.20 = $22,000
10-19
Has excess capacity
Current
Business
Additional
Business Combined
Sales 1,000,000 $ 85,000 $ 1,085,000 $
Direct materials 350,000 $ 35,000 $ 385,000 $
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses 900,000 $ 65,000 $ 965,000 $
Operating income 100,000 $ 20,000 $ 120,000 $
Even though the $8.50 selling price is less than the
normal $10 selling price, Victory Co. should accept the
offer because net income will increase by $20,000.
10-20
DECISION RULE
Accept the special order when theres incremental benefits for
the company.
Special Order Decisions
We can also look at this decision
using the contribution margin method
Per Unit
10,000
units
Special order revenue 8.50 $
Direct materials 3.50
Direct labor 2.20
Contribution margin 2.80 $ 28,000 $
Increase in fixed costs:
Factory overhead 5,000 $
Selling expenses 2,000
Administrative expenses 1,000
Special order profit 20,000 $
10-21
Special Order Decisions
Victory Co. has a production capacity of 100,000 units.
Should Victory accept the offer?
Per Unit Total
10,000 units
Special order revenue 8.50 $
Direct materials 3.50
Direct labor 2.20
Contribution margin 2.80 $ 28,000 $
Increase in f ixed costs:
Factory overhead 5,000 $
Selling expenses 2,000
Administrative expenses 1,000
8,000
Loss of CM on regular sales 43,000
10,000 units x CM $4.30 ($10 - $3.50 - $2.20)
Special order loss (23,000) $
10-22
No excess capacity
Managers often face the problem of deciding how scarce
resources are going to be utilized.
Usually, fixed costs are not affected by this particular
decision, so management can focus
on maximizing total contribution margin.

Lets look at the Kaiser Company example.

(2) Production Constraint Decisions
How to maximize contribution margin when one
factor limits production capacity?
10-23
Production Constraint Decisions
Kaiser Company produces two products and selected data
is shown below:
Products
A
B
Selling price per unit $ 60 $ 50
Less: variable expenses per unit 36 35
Contribution margin per unit
24 $ 15 $
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time (per unit)
required on Machine X 1.00 min. 0.50 min.
10-24
Production Constraint Decisions
Machine X is the scarce resource because there is
excess capacity on other machines. Machine X is
being used at 100% of its capacity.
Machine X capacity is 2,400 minutes per week.
Should Kaiser focus its efforts on Product A or B?
10-25
Products
A
B
Contribution margin per unit $ 24 $ 15
Time required to produce one unit 1.00 min. 0.50 min.
Contribution margin per minute 24 $ 30 $
10-26
Lets calculate the contribution margin per unit of the scarce
resource, machine X.
Product B should be emphasized. It makes more valuable use
of the scarce resource (Machine X), yielding a higher
contribution margin of $30 per minute as opposed to $24 for
Product A.

If there are no other considerations, the best plan would be
to produce to meet current demand for Product B and then
use any capacity that remains to make Product A.

Allotting Scarce Resource (Machine X)
Weekly demand for Product B 2,200 units
Time required per unit 0.50 min.
Total time required to make
Product B
1,100 min.
Total machine time available 2,400 min.
Time used to make Product B 1,100 min.
Time available for Product A 1,300 min.
Time required per unit 1.00 min.
Production of Product A
1,300 units
Production Constraint Decisions
Lets see how this plan would work.
10-27
Current demand for A is 2,000 units
Production Constraint Decisions
According to the plan, we will produce 2,200 units of Product
B and 1,300 units of Product A.
Product A Product B
Production and sales (units) 1,300 2,200
Contribution margin per unit 24 $ 15 $
Total contribution margin 31,200 $ 33,000 $
10-28
DECISION RULE
Priority is given to the product with the highest
contribution margin per unit of scarce resource
The total contribution margin for Kaiser is $64,200.
Any other combination would result in a lesser CM.

Should I
continue to make
the part, or should
I buy it?
I suppose I
should compare
the outside purchase
price with the additional
costs to manufacture
the part.
What will I
do with my
idle facilities if
I buy the part?

(3) Make or Buy Decisions
10-29

Make or Buy Decisions
Outsourcing
Outsourcing - Definition
O The decision to buy or subcontract a component product or service
rather than produce it in-house.
O May lead to reduced control over delivery time or product quality.
O Outsourcing is a regular feature of companies with limited resources.
Why Outsource?
O Cost savings.
O Focus on core business.
O Knowledge: access to intellectual property, wider experience.
O Access to talent.
Factors to Consider:
O Reliability of supplier delivery, quality, price etc.
O Flexibility to adapt to changing conditions.
10-30
Make or Buy Decisions
10-31
Incremental costs are also important in the decision
to make a product or buy it from a supplier.
The cost to produce an item must include
(1) direct materials (usually avoidable VC)
(2) direct labor (avoidable VC)
(3) incremental overhead (unavoidable v. avoidable F.C.)
We should NOT use the predetermined overhead rate
to determine product cost.

Make or Buy Decisions
Unit Costs
Direct Materials 9.00 $
Direct Labor 5.00
Variable Overhead 1.00
Fixed Overhead 13.00
Total 28.00 $
10-32
Excel makes computer chips used in
one of its products. Unit costs, based on production of
20,000 chips per year, are:
Make or Buy Decisions
An outside supplier has offered to provide the
20,000 chips at a cost of $25 per chip. Fixed
overhead costs will not be avoided if the chips
are purchased.

Excel has no alternative use for the facilities.
Should Excel accept the offer?
10-33
Irrelevant cost: same under both alternatives
Make or Buy Decisions
Make Buy
Direct Material 9.00 $ - $
Direct Labor 5.00 -
Variable Overhead 1.00 -
0
Purchase costs - 25.00
Total 15.00 $ 25.00 $
10-34
Incremental costs = $10
DECISION RULE
Outsource if there is incremental benefits
Excel should not pay $25 per unit to an outside supplier to
avoid the $15 per unit differential cost of making the part.
Unavoidable fixed costs are irrelevant.

Make Buy
Direct Material 9.00 $ - $
Direct Labor 5.00 -
Variable Overhead 1.00 -
0
Purchase costs - 25.00
Avoidable Fixed Overhead - (3.00)
Total 15.00 $ 22.00 $
10-35
Avoidable Fixed Cost
Fixed Overhead $13, out of which $3 is avoidable.
Incremental costs = $7
Make Buy
Direct Material 9.00 $ - $
Direct Labor 5.00 -
Variable Overhead 1.00 -
0
Purchase costs - 25.00
Avoidable Fixed Overhead 3.00 -
Total 18.00 $ 25.00 $
10-36
Incremental costs = $7
Avoidable Fixed Cost
Fixed Overhead $13, out of which $3 is avoidable.
QUESTION
What is the maximum price that the company can pay
the external supplier for the outsourced part?


(4) Sell, Scrap, or Rebuild Decisions
Costs incurred in manufacturing units of product
that do not meet quality standards are sunk costs
and cannot be recovered.


As long as rebuild costs are recovered
through sale of the product, and
rebuilding does not interfere with normal
production, we should rebuild.
10-37
Sell, Scrap, or Rebuild Decisions
Servo has 10,000 defective units that cost $1.00 each to
make. The units can be scrapped now for $.40 each or
rebuilt at an additional cost of $.80 per unit.
If rebuilt, the units can be sold for the normal selling price
of $1.50 each. Rebuilding the 10,000 defective units will
prevent the production of 10,000 new units that would
also sell for $1.50.
Should Servo scrap or rebuild?
10-38
Scrap
Now Rebuild
Sale of defects 4,000 $ 15,000 $
Less rebuild costs -
Less opportunity cost -
Net return 4,000 $
Sell, Scrap, or Rebuild Decisions
10-39
10,000 units $0.40 per unit

10,000 units $1.50 per unit

Scrap
Now Rebuild
Sale of defects 4,000 $ 15,000 $
Less rebuild costs - (8,000)
Less opportunity cost - (5,000)
Net return 4,000 $ 2,000
Sell, Scrap, or Rebuild Decisions
10-40
10,000 units $0.80 per unit

Benefits foregone: CM for 10,000 new products
10,000 units (Selling Price $1.50 Cost $1.00)

Servo should scrap the units now. Servo should scrap the units now.
DECISION RULE
Choose the option with the highest incremental
benefits
Product 2
Joint Costs
Product 1
Product 3

(5) Joint Product Decisions
10-41
Joint costs are
the costs of
processing prior to
the split-off point

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

The split-off point is the point in a process where
joint products can be recognized as separate products

Further
Processing
Further
Processing
Final
Sale
Final
Sale
Final
Sale
Joint
Input
Common
Production
Process
Split-Off
Point
Oil
Gasoline
Chemicals
Joint costs
are incurred
up to the
split-off point
For example, in the petroleum refining industry, a large number of
products are extracted from crude oil, including gasoline, jet fuel, home heating
oil, lubricants, asphalt, and various organic chemicals.
10-42
Joint Product Decisions
Businesses are often faced with the decision to sell
partially completed products at the split-off point or to
process them to completion.
DECISION RULE
Process further if
incremental revenues > incremental costs
10-43
Ames Co. produces two products, A and B, from this process.
Should the products be
sold at split-off or
process further?
Common
Production
Process
Final
Sale
$120,000
Split-Off
Point
Joint
Cost
$100,000
Revenue
$70,000
Additional
Processing
Cost
$40,000
A
B
Additional
Processing
Cost
$20,000
Final
Sale
$65,000
Revenue
$50,000
Joint Product Decisions
10-44
Incremental Incremental
Product Revenue Cost Difference
A 50,000 $ 40,000 $ 10,000 $
B 15,000 20,000 (5,000)
Product A incremental revenue = $120,000 - $70,000 = $50,000 Product A incremental revenue = $120,000 - $70,000 = $50,000
Incremental revenue $50,000 > Incremental cost $40,000

Product B incremental revenue = $65,000 - $50,000 = $15,000
Incremental revenue $15,000 < Incremental cost $20,000
Joint Product Decisions
Joint costs are not relevant in decisions regarding what to do with a
product after the split-off point.
Joint costs are really common costs incurred to simultaneously produce a
variety of end products.

10-45
Process product A, but sell product B at the split-off point.

Non-financial Considerations
It would be irresponsible
for me to base my
decision entirely on revenue
and cost figures.
10-46
Reputation
Environmental
impacts

Legal
issues

Ethical
implications

(1)
Special
order
decisions
(2)
Production
constraint
decisions
(3)
Make
or buy
decisions
(5)
Joint
product
decisions

Non-Financial Considerations
Impact on
regular
customers
Undercutting
by special-
order
customers
High CM but
low demand
Complementary
Products
Product
quality /
availability
Supplier
relationship
(4)
Sell, Scrap
or Rebuild
decisions
Market
Demand
Cannibalize
other
products
10-47
Review Questions
1. Which of the following is true?
a. Fixed costs are always irrelevant.
b. Variable costs are always relevant.
c. Joint costs are always irrelevant.
d. All of the above.

2. In the sell-or-process further decision,
a. Joint costs are always relevant.
b. Total costs of joint processing and further processing are
relevant.
c. All costs incurred prior to the split-off point are relevant.
d. The most profitable outcome can be to further process some
separately identifiable products beyond the split-off point, but
sell others at the split-off point.
10-48
Check List
Do you have a good understanding of:
- Types of relevant cost
- Five types of decisions and the decision rules
- Non-financial factors to consider when making
decisions
END
10-49