Relevant Cost Decisions

DECISION MAKING IN THE SHORT

TERM

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.

Five-Step
Decision-Making Process

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.

Identifying Relevant Costs

gather all costs associated with the

alternatives
eliminate all sunk costs
Eliminate all future costs that dont
differ between alternatives
left are the avoidable costs

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

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 longrun 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?

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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.

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

17

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.

19

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:

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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 suppliers offer?

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The Make or Buy Decision

Sunk Cost

Not
Not avoidable
avoidable and
and is
is irrelevant.
irrelevant. IfIf the
the product
product is
is dropped,
dropped, itit will
will
be
be reallocated
reallocated to
to other
other products.
products.
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The Make or Buy Decision

DECISION
DECISION RULE
RULE
In
In deciding
deciding whether
whether to
to accept
accept the
the outside
outside
suppliers
suppliers offer,
offer, MA
MA isolated
isolated the
the relevant
relevant
costs
eliminating
costs of
of making
making the
the part
part by
by eliminating:
eliminating:
eliminating

The
The sunk
sunk costs.
costs.
The
The future
future costs
costs that
that will
will not
not differ
differ
between
between making
making or
or buying
buying the
the parts.
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

Product 1 or 2?
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Utilization of a Constrained Resource

Lets 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
Resource
Lets calculate the contribution margin per unit of the
scarce resource, machine A1.
Lets see how this plan would work.

IfIf there
there are
are no
no other
other considerations,
considerations, the
the best
best plan
plan would
would be
be
to
to produce
produce to
to meet
meet current
current demand
demand for
for Product
Product 22 and
and then
then
use
use remaining
remaining capacity
capacity to
to make
make Product
Product 1.
1.
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Utilization of a Constrained
Resource
Lets see how this plan would work.

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Utilization of a Constrained
Resource
According to the plan, we will produce 2,200 units of
Product 2 and 1,300 of Product 1. Our
contribution margin looks like this.

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.
At the bottleneck itself:
Improve the process
Add overtime or another shift
Hire new workers or acquired
more machines
Subcontract production

Eliminate waste.
Streamline production process.
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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 dont drop

No drop or dont add

Decision is based on profitability of

the customer, not how much revenue
a customer generates
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Adding or Discontinuing
Branches or Segments

Decision Rule: Does adding or

discontinuing a branch or segment add
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 how much
revenue the branch or segment
generates
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Adding/Dropping Segments

Should
Should the
the company
company drop
drop digital
digital instruments
instruments
division?
division?
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.

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Incremental Approach
DECISION
DECISION RULE
RULE
UM
UM should drop the digital instruments
division
division only
only if
if the avoided fixed costs
of
of the
the division
division exceed
exceed lost
contribution
contribution margin
margin of
of this
this division.
division.

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Incremental Approach

What
What about
about depreciation?
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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42

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

Joint
Input

Joint
Costs

Oil

Common
Production
Process

Gasoline

Chemicals

Split-Off
Point
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Joint Products
Joint
Costs

Joint
Input

Common
Production
Process

Oil

Gasoline

Chemicals

Split-Off
Point

Separate
Processing

Final
Sale

Final
Sale

Separate
Processing

Separate
Product
Costs

Final
Sale

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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
sales 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.

Lets 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 Keres joint products includes:

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Sell or Process Further

Should
Should Kere
Kere process
process the
the lumber
lumber
further
further and
and sell
sell the
the sawdust
sawdust as
as is?
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
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