Mowen ch8 Seventh Edition

Examples of Managerial Accounting
Seventh Edition
Chapter 8
Short-Run
Decision Making:
Relevant Costing
© 2019 Cengage. All rights reserved.

Learning Objectives
1. Describe the short-run decision-making model, and

explain how cost behavior affects the information used
to make decisions
2. Apply relevant costing and decision-making concepts
in a variety of business situations
3. Choose the optimal product mix when faced with one
constrained resource
4. Explain the impact of cost on pricing decisions

Short-Run Decision Making
• Short-run decision making consists of choosing among
alternatives with an immediate or limited end in view
• Also referred to as tactical decisions because they
involve choosing between alternatives with an
immediate or limited time frame in mind
• Example: Accepting a special order for less than the
normal selling price to utilize idle capacity and to
increase this year’s profits
• Some decisions tend to be short run in nature
• Short-run decisions often have long-run consequences

The Decision-Making Model (1 of 2)
• A decision model, a specific set of procedures that
produces a decision, can be used to structure the
decision maker’s thinking and to organize the
information to make a good decision
• The following is an outline of one decision-making
model:
– Step 1. Recognize and define the problem
– Step 2. Identify alternatives as possible solutions to the
problem. Eliminate alternatives that clearly are not
feasible

The Decision-Making Model (2 of 2)
– Step 3. Identify the costs and benefits associated with each
feasible alternative. Classify costs and benefits as relevant
or irrelevant, and eliminate irrelevant ones from
consideration
– Step 4. Estimate the relevant costs and benefits for each
feasible alternative
– Step 5. Assess qualitative factors
– Step 6. Make the decision by selecting the alternative with
the greatest overall net benefit

Here’s How It’s Used: IN YOUR COLLEGE
TOWN (1 of 3)
As an inquisitive undergraduate business major, Jack
wondered if the relevant decisions mentioned in his
managerial accounting class could actually be observed in
his college town. He quickly identified a number of exciting
relevant decisions at work in the uptown businesses he
frequented near campus. For instance, Jack noticed
numerous product-line additions (i.e., keep-or-drop
decisions), including the unveiling of two additional
Starbucks cafes, Chipotle’s initial entry into town, and
even the arrival of an Apple Store! He also noticed that the
Target pharmacy where he used to fill all of his
prescriptions

TOWN (2 of 3)
had been converted into a CVS Pharmacy even though it
was still located within the Target store! Examples of
relevant decisions also cropped up on campus. When
Jack’s senior pre-med roommate, Daniel, registered for his
capstone course, he was told that it had been outsourced
(i.e., make-or-buy decisions) to an online university that
specialized in certain senior-level medical courses. The
dean informed Daniel that it was much cheaper for the
university to allow its few pre-med students to take the
course from another university rather than hire the
specialized instructors necessary to teach the course

TOWN (3 of 3)
in-house. Finally, Jack was disappointed when his
intramural basketball tournament was moved away from
the university arena to make way for the local high school
graduation. After some investigation, he learned that the
university often rented out its high-end capacity assets
(e.g., auditorium, sports arenas, business school atrium)
to outside organizations (i.e., special sales decisions). To
Jack’s surprise, relevant decisions were quite common in
his college town, which excited him to study this useful
topic!

Step 1: Recognize and Define the Problem
• The first step is to recognize and define a specific

problem.
– For example, if the members of a management team
recognized the need for additional productive capacity
as well as increased space for raw materials and
finished goods inventories, they would consider:
 The number of workers and the amount of space needed
 The reasons for the need
 How the additional space would be used
 However, the central question is how to acquire the
additional capacity

Step 2: Identify the Alternatives as Possible
Solutions
• The second step is to list and consider possible
solutions
• Some alternatives are dismissed either because they
involve too much risk, or they are not proven, or they
are outside of cost constraints
• One of the best strategies is to link the short-run
decision (like an increase in productive capacity) to the
company’s overall growth strategy by rejecting
alternatives that involved too much risk at a particular
stage of a company’s development

Step 3: Identify the Costs and Benefits
Associated with Each Feasible Alternative
• In the third step, the costs and benefits associated with
each feasible alternative are identified
• At this point, clearly irrelevant costs can be eliminated
from consideration
• It is fine to include irrelevant costs and benefits in the
analysis as long as they are included for all
alternatives. We usually do not include them because
focusing only on the relevant costs and benefits
reduces the amount of data to be collected

Step 4: Estimate the Relevant Costs and
Benefits for Each Feasible Alternative
• The differential cost is the difference between the
summed costs of two alternatives in a decision
– Compares the sum of each alternative’s relevant costs
only
– Emphasis on differential cost allows decision makers to
occasionally include irrelevant costs in the alternatives if
they choose to do so
• The inclusion of irrelevant costs is acceptable only if all
irrelevant costs are included for each alternative

Step 5: Assess Qualitative Factors (1 of 2)
• Qualitative factors can significantly affect the

manager’s decision
– Political Pressure: Some managers worry that such
political pressure from customers can have long-term
negative effects on sales that more than offset the labor
cost savings that spurred the decision to offshore
– Product Safety: Product safety represents another key
qualitative factor for outsourcing organizations

Step 5: Assess Qualitative Factors (2 of 2)
• Qualitative factors, such as the impact of late orders

on customer relations, must be taken into
consideration in the final step of the decision-making
model—the selection of the alternative with the
greatest overall benefit

Step 6: Make the Decision (1 of 2)
• Once all relevant costs and benefits for each

alternative have been assessed and the qualitative
factors weighed, a decision can be made
• Ethical concerns revolve around the way in which
decisions are implemented and the possible sacrifice
of long-run objectives for short-run gain
• Relevant costs are used in making short-run decisions

Step 6: Make the Decision (2 of 2)
• Decision makers should always maintain an ethical

framework
• Whenever relevant costing is used, it is important to
include all costs that are relevant—including those
involving ethical ramifications

Relevant Costs Defined
• The decision-making approach just described

emphasized the importance of identifying and using
relevant financial items
• Relevant costs (and revenues) possess two
characteristics:
– they are future items AND
– they differ across alternatives
• All pending decisions relate to the future
• Accordingly, only future costs and future revenues can
be relevant to decisions

Opportunity Costs
• Opportunity cost is the benefit sacrificed or foregone

when one alternative is chosen over another
• An opportunity cost is relevant because it is both a
future cost and one that differs across alternatives
• An opportunity cost is never an accounting cost,
because accountants do not record the cost of what
might happen in the future (i.e., they do not appear in
financial statements)

Here’s How It’s Used: IN YOUR
LIFE (1 of 4)
Finding ways to generate extra cash appeals to almost
everyone, especially college students. At the end of each
semester, Allyson has to make an important decision
regarding what to do with her textbooks—either keep them
or sell them back to the university bookstore. After taking
her last exam, she ran to the bookstore and learned that
each of her five textbooks could be sold for $25 per book.
She quickly calculated that the opportunity cost of her
keeping the books (i.e., not selling them back to the
bookstore) was $125, which would go a long way for some
end-of-the-semester beverages

LIFE (2 of 4)
or Christmas presents for friends and family. However, as
she placed her books upon the buyback counter, she
quickly wondered if there was an opportunity cost of
selling (i.e., not keeping) them that she should estimate
before collecting her cash. And if there was an opportunity
cost of selling the books, how would she estimate this
cost? Allyson will need to determine the likelihood that she
will want to access any of the information in the books
during her remaining courses or upcoming professional
internship.

LIFE (3 of 4)
If so, she also will need to estimate the amount of time
she would need to spend finding such information when
she no longer has access to her old textbooks, plus the
monetary value she places on her time spent searching
for this needed information. For example, Allyson believes
that her roommate asked to borrow one of her textbooks
while on an Apple internship this semester to help
prepare geographically segmented income statements.
Suddenly, Allyson wasn’t so sure that the opportunity cost
of selling back her textbooks was $0.

LIFE (4 of 4)
Increasingly, she wondered whether she might even be
better off financially by keeping her textbooks this
semester because the opportunity cost of selling them
back to the bookstore could actually be higher than the
opportunity cost of keeping them!

Sunk Costs (1 of 2)
• A sunk cost is a cost that cannot be affected by any

future action
• It is important to note the psychology behind
managers’ treatment of sunk costs
• Although managers should ignore sunk costs for
relevant decisions, it unfortunately is human nature to
allow sunk costs to affect these decisions

Sunk Costs (2 of 2)
• For example, depreciation, a sunk cost, is sometimes

allocated to future periods though the original cost is
unavoidable
• In choosing between the two alternatives, the original
cost of an asset and its associated depreciation are
not relevant factors

Cost Behavior and Relevant Costs (1 of 2)
• Most short-run decisions require extensive

consideration of cost behavior
• It is easy to fall into the trap of believing that variable
costs are relevant and fixed costs are not
• But this assumption is not true
• The key point is that changes in supply and demand
for resources must be considered when assessing
relevance

Cost Behavior and Relevant Costs (2 of 2)
• If changes in demand and supply for resources across

alternatives bring about changes in spending, then the
changes in resource spending are the relevant costs
that should be used in assessing the relative
desirability of the two alternatives

Some Common Relevant Cost Applications
• Relevant costing is of value in solving many different

types of problems. Traditionally, these applications
include decisions:
– to make or buy a component
– to keep or drop a segment or product or service line
– to accept a special order at less than the usual price
– to further process joint products or sell them at the split-
off point
• Though by no means an exhaustive list, many of the
same decision-making principles apply to a variety of
problems

Make-or-Buy Decisions
• Managers face the decision of whether to make a

particular product (or provide a service) or to purchase
it from an outside supplier
• Make-or-buy decisions are those decisions involving
a choice between internal and external production

Here’s How It’s Used: AT NAVISTER,INC.
(1 of 3)
Let’s return briefly to Navistar, Inc.’s use of relevant
analysis in making the make-or-buy decision for its
additional axle needs. In question was whether it should
manufacture (i.e., “make”) the additional axles it needed or
purchase (i.e., “buy”) them from an external vendor. After
a careful discussion with a cross-functional team
representing personnel from Human Resources,
Accounting, Purchasing, and Finance, managers decided
that the key costs on the “make” side included one-time
capital and start-up expenditures on machines and
ongoing expenditures for labor, repairs and maintenance,

(2 of 3)
utilities, depreciation, and insurance. Key costs on the
“buy” side included one-time vendor tooling expenditures
and ongoing expenditures for freight, logistics, inventory
storage and movement, and training. In addition,
managers considered important qualitative characteristics
such as ensuring high quality, which was particularly
relevant for the training costs because Navistar wanted to
be sure that any purchased axles were of a high quality
and delivered to the right place at the appropriate time.

(3 of 3)
After these relevant costs were identified, quantified, and
analyzed, Navistar confidently elected to outsource its
additional axle production.

Example 8.1:How to Structure a
Make-or-Buy Problem (1 of 5)
Swasey Manufacturing needed to determine if it
would be cheaper to make 10,000 units of a
component in-house or to purchase them from an
outside supplier for $4.75 each. Cost information on
internal production includes the following:

Example 8.1:How to Structure a Make-or-
Buy Problem (2 of 5)
Fixed overhead will continue whether the component is
produced internally or externally. No additional costs of
purchasing will be purchasing will be incurred beyond the
purchase price.
Required:
1. What are the alternatives for Swasey Manufacturing?
2. List the relevant cost(s) of internal production and of
external purchase.
3. Which alternative is more cost effective and by how
much?

Example 8.1:How to Structure a Make-or-
Buy Problem (3 of 5)
4. Now assume that fixed overload includes $10,000 of
cost that can be avoided if the component is
purchased externally. Which alternative is more cost
effective and by how much?
Solution:
5. There are two alternatives: make the component in-
house or purchase it externally.
6. Relevant cost of making the component in-house
include direct materials, direct labor, and variable
overhead. Relevant costs of purchasing the
component externally include the purchase price.

3. It is cheaper (by $9,500) to make the component

in-house.


Here’s How It’s Used: SUSTAINABILITY AT
HEWLETT-PACKARD (1 of 2)
One type of relevant cost that is becoming increasingly
large due to globalization and the green environmental
movement concerns the disposal costs associated with
electronic waste (or e-waste). Increasingly, government
agencies are assessing manufacturers of computers,
televisions, digital music devices, etc., a costly fee at
production to cover product disposal costs that public
landfills eventually incur once the products reach the end
of their life cycle, become obsolete, and are thrown out to
pollute the environment.

Here’s How It’s Used: SUSTAINABILITY AT
HEWLETT-PACKARD (2 of 2)
Hewlett-Packard Co. has taken a strategic leadership
position by recycling approximately 10%of its sales as a
more cost-effective means than incurring the
aforementioned governmental fees at production. Some
experts estimate annual global e-waste at approximately 50
million tonnes. Not all companies are as business savvy or
environmentally responsible as Hewlett-Packard, as
evidenced by the $19 billion estimated value of illegally
traded and dumped e-waste. The failure to properly forecast
e-waste levels and consider their relevant life cycle costs
can cause the make side of the make-or-buy analysis to
appear more attractive (i.e., less costly) than it is in reality.

Special Order Decisions
• A company may consider offering a product or service
at a price different from the usual price
• Firms have the opportunity to consider special orders
from potential customers in markets not ordinarily
served
– Special-order decisions focus on whether a specially
priced order should be accepted or rejected
– These orders often can be attractive, especially when
the firm is operating below its maximum productive
capacity

Example 8.2: How to Structure a Special-
Order Problem (1 of 3)
Leibnitz Company has been approached by a new
customer with an offer to purchase 20,000 units of model
TR8 at a price of $89 each. The new customer is
geographically separated from the company's other
customers, and existing sales would not be affected.
Leibnitz normally produces 100,000 units of TR8 per year
but only plans to produce and sell 75,000 in the coming
year. The normal sales price is $14 pet unit. Unit cost
information for the normal level of activities is as follows:

Example 8.2: How to Structure a
Special-Order Problem (2 of 3)
Fixed overhead will not be affected by whether or not

the special order is accepted.
Required:
1. What are the relevant costs and benefits of the two
alternatives (accept or reject the special order)?
2. By how much will operating income increase or
decrease if the order is accepted?
Example 8.2: How to Structure a
Special-Order Problem (3 of 3)
1. Relevant costs and benefits of accepting the special
order include the sales price of $89, direct materials,
direct labor, and variable overhead. No Relevant costs
or benefits are attached to rejecting the order.
2. If the problem is analyzed on a unit basis:
Operating income will increase by $34,000 ($1.70 × 20,000

units) if the special order is accepted.
Keep-or-Drop Decisions (1 of 2)
• A manager needs to determine whether a segment,

such as a particular product or service line or a
geographic sales region, should be kept or dropped
• Making effective keep-or-drop decisions requires
that managers identify and consider only the relevant
information of the business segment in question
• A segment is a subunit of a company of sufficient
importance to warrant the production of performance
reports

Keep-or-Drop Decisions (2 of 2)
• Segmented reports prepared on a variable-costing

basis are important because they provide managers
with this valuable information
• Both the contribution margin and the segment margin
shown on a segmented income statement are useful in
evaluating the performance of segments and, in
particular, identifying the relevant information
necessary for making effective keep-or-drop decisions

Segmented Income Statements Using
Variable Costing
• Variable costing is useful in preparing segmented
income statements because it gives useful information
on variable and fixed expenses
• In segmented income statements, fixed expenses are
broken down into two categories:
– direct fixed expenses and
– common fixed expenses

Direct Fixed Expenses
• Direct fixed expenses are fixed expenses that are

directly traceable to a segment
• These are sometimes referred to as avoidable fixed
expenses or traceable fixed expenses because they
vanish if the segment is eliminated
– For example, if the segments were sales regions, a
direct fixed expense for each region would be the rent
for the sales office

Common Fixed Expenses
• Common fixed expenses are jointly caused by two or

more segments
• These expenses persist even if one of the segments to
which they are common is eliminated
– For example, depreciation on the corporate
headquarters building or the salary of the CEO would be
a common fixed expense for most large companies

Example 8.3: How to Prepare a
Segmented Income Statement (1 of 3)
• Audiomatronics Inc. produces MP3 players and
smartphones in a single factory. The following
information was provided for the coming year:
MP3 Players Smartphones

Sales $400,000 $290,000
Variable cost of 200,000 150,000
goods sold
Direct fixed 30,000 20,000
overhead

Example 8.3: How to Prepare a Segmented
Income Statement (2 of 3)
A 5% sales commission is paid for each of the product
lines. Direct fixed selling and administrative expense was
estimated to be $10,000 for the MP3 line and $15,000 for
the smartphone line. Common fixed overhead for the
factory was estimated to be $100,000; common selling
and administrative expense was estimated to be $20,000.
Required:
Prepare a segmented income statement for
Audiomatronics Inc. for the coming year, using variable
costing.

Example 8.3: How to Prepare a
Segmented Income Statement (3 of 3)

Here’s How It’s Used: AT FOLSOM
MANUFACTURING (1 of 3)
You are the Financial Vice President for Folsom Company,
which sells three products, Alpha, Beta, and Gamma. You
have just received the income statement shown in Panel A
of the information provided in slide 53. Clearly, Gamma is
unprofitable. In fact, the company is losing $13,740 a year
on Gamma.
Should you drop Gamma? Will income go up if you
do?
Take a closer look at the income statement.

Observe that both the direct fixed costs and the allocated
common fixed costs are subtracted from each segment’s
contribution margin. This observation is misleading; it
seems that dropping any segment would result in losing
the operating income associated with the segment.
However, if one segment is dropped, the allocated
common fixed costs will remain.
A more useful income statement—one that is segmented
—is presented in Panel B in slide 53. Here, the segment
margin for all three products is positive, as is overall
income.

While Gamma is not as profitable as Alpha and Beta, it is
profitable. Dropping Gamma will result in a decrease in
operating income of $12,000, the amount of the segment
margin.
Separating the direct fixed costs from the common
fixed costs, and focusing on the segment margin, will
give a truer picture of a segment’s profitability.

Comparison of Segmented Income
Statement With and Without Allocated
Common Fixed Expense

Example 8.4: How to Structure a Keep-
or-Drop Product-Line Problem (1 of 4)
• Shown below is a segmented income statement for

Norton Materials Inc.’s three product lines:

Example 8.4: How to Structure a Keep-or-
Drop Product-Line Problem (2 of 4)
The roofing tile line has a contribution margin of $10,000
(sales of $150,000 minus total variable costs of $140,000).
All variable costs are relevant. Relevant fixed costs
associated with this line include $10,000 in advertising and
$35,000 in supervision salaries.
Required:
1. List the alternatives being considered with respect to
the roofing tile line.
2. List the relevant benefits and costs for each alternative.
3. Which alternative is more cost effective and by how
much?

Example 8.4: How to Structure a Keep-or-
Drop Product-Line Problem (3 of 4)
Solution:
1. The two alternatives are to keep the roofing tile line or
to drop it.
2. The relevant benefits and costs of keeping the roofing
tile line include sales of $150,000, variable costs of
$140,000, advertising cost of $10,000, and supervision
cost of $35,000. None of the relevant benefits and
costs of keeping the roofing tile line would occur under
the drop alternative.

Example 8.4: How to Structure a Keep-
or-Drop Product-Line Problem (4 of 4)
The difference is $35,000 in favor of dropping the

roofing tile line.
Keep or Drop with Complementary Effects
• A potential complication of a keep-or-drop analysis is

the implication such a decision might have on other
aspects of the business
• Such implications must be included in the analysis
before making a final decision
• Sometimes dropping one line would lower sales of
another line, as many customers buy both lines at the
same time
• This information can affect the keep-or-drop decision

Example 8.5: How to Structure a Keep-or-Drop-Product
Line Problem with Complementary Effects (1 of 4)
Refer to Norton Materials’ segmented income statement in

Example 8.4 (p. 412). Assume that dropping the product
line reduces sales of blocks by 10% and sales of bricks by
8%. All other information remains the same.
Required:
1. If the roofing tile line is dropped, what is the
contribution margin for the block line? For the brick
line?
2. Which alternative (keep or drop the roofing tile line) is
now more cost effective and by how much?

Solution:
1. Previous contribution margin of blocks was $250,000.
A 10% decrease in sales implies a 10% decrease in
total variable costs, so the contribution margin
decreases by 10%.
New Contribution Margin for Blocks = $250,000 –
0.10($250,000) = $225,000
The reasoning is the same for the brick line, but the
decrease is 8%.
New Contribution Margin for Bricks = $320,000 –
0.08($320,000) = $294,400

Example 8.5: How to Structure a Keep-or-Drop-
Product Line Problem with Complementary
Effects (3 of 4)
Therefore, if the roofing tile product line were dropped,
the resulting total contribution margin for Norton
Materials would equal $519,400 ($225,000 +
$294,400).

Notice that the contribution margin for the drop alternative

equals the new contribution margins of the block and brick
lines ($225,000 + $294,400). Also, advertising and
supervision remain relevant across these alternatives.
Now the analysis favors keeping the roofing tile line. In
fact, company income will be $15,600 higher if all three
lines are kept as opposed to dropping the roofing tile line.

Here’s How It’s Used: DATA ANALYTICS
AND YANKEE STADIUM (1 of 7)
You are an elected official in a major city that is
considering whether or not to move forward with a
proposed plan to demolish the city’s existing professional
sports stadium and build an elaborate new stadium. One
of the most difficult aspects of this decision is estimating
the new stadium’s incremental revenues and costs that
would result if it were built.
What specific types of relevant revenues and relevant
costs would you consider in making this important
decision?

• There are many stadium events for which the
associated relevant revenues and relevant costs must
be estimated accurately if the correct decision is to be
made. These stadium events (and their relevant
revenues and costs) include:
– Main attraction sporting events (e.g., ticket revenues
from baseball, basketball, and/or football games for
which the stadium would be built; additional staffing,
cleanup, and insurance costs)
– Concessions and other sales (e.g., contribution margins
or fees earned from product and service sales—most
new stadiums

boast as many high-end shopping opportunities as an
upscale mall!)
– Television contract terms (e.g., the amount and percentage
of revenue brought in by additional games being televised
in the new stadium, perhaps in primetime slots)
– Offseason events (e.g., the ticket revenue from boxing
matches, music concerts, etc.)
• For this relevant stadium decision, estimating the
relevant revenues might be even more difficult than
estimating the relevant costs. For instance, projecting
how many more people

will want to attend games in a new stadium can be
unclear, as well as how much money they would be willing
to spend for various seats located around the stadium.
Increasingly, all parties involved in these high-priced
stadium deals rely on data analytics to estimate the
relevant revenues and costs as accurately as possible.
Several New York City area stadiums experienced
difficulty in accurately estimating these relevant financial
items.

In other words, decision makers struggled to estimate the
amount of incremental revenue that would result from
some of the more important seats in a new Yankee
stadium. Undaunted by such challenging relevant
analyses, however, the New York area also built a $1.6
billion new Meadowlands Stadium to be shared by the
New York Jets and New York Giants.
In addition to the previously mentioned relevant items,
some citizens raise objections to such large amounts of
money being spent on replacing existing fully functional
sporting facilities

with gargantuan sports palaces. They argue that $1 billion
could be better spent on different causes. Such
sentiments, whether you agree or disagree with them,
represent potentially important qualitative factors that
effective managerial accountants should take into account
when performing relevant analyses for proposed new
stadiums, especially when these citizens represent
taxpayers or potential fans the stadium builders count on
for purchasing expensive tickets in the future.

Data analytics are very helpful in estimating the relevant
costs and revenues for such stadiums, including offseason
events, as well as additional qualitative factors like citizen
sentiment toward the team and the local community.

Further Processing of Joint Products
• Joint products have common processes and costs of

production up to a split-off point. At that point, they
become distinguishable as separately identifiable
products
• The point of separation is called the split-off point
• Sometimes it is more profitable to process a joint
product further, beyond the split-off point, prior to
selling it (sell or-process-further decision)

Example 8.6: How to Structure the Sell-
or-Process-Further Decision (1 of 3)
• Appletime grows apples and then sorts them into one
of three grades, A, B, or C, based on their condition.
Appletime must decide whether to sell the Grade B
apples at split-off or to process them into apple pie
filling. The company normally sells the Grade B apples
in 120 five-pound bags at a per-unit price of $1.25. If
the apples are processed into pie filling, the result will
be 500 cans of filling with additional costs of $0.24 per
can. The buyer will pay $0.90 per can.
Required:
1. What is the contribution to income from selling the
Grade B apples in five-pound bags?
2. What is the contribution to income from processing the
Grade B apples into pie filling?
3. Should Appletime continue to sell the Grade B apples
in bags or process them further into pie filling?

Solution:
1. Revenue from Apples in Bags = $1.25 × 120 = $150
2. Revenue from Further Processing = $0.90 × 500 =
$450 Further Processing Cost = $0.24 × 500 = $120
Income from Further Processing = $450 – $120 = $330
3. Appletime should process the Grade B apples into pie
filling because the company will make $330 versus the
$150 it would make by selling the apples in bags.

Product Mix Decisions (1 of 2)
• Organizations have wide flexibility in choosing their

product mix
• Product mix refers to the relative amount of each
product manufactured (or service provided) by a
company
• Decisions about product mix can have a significant
impact on an organization’s profitability

Product Mix Decisions (2 of 2)
• Every firm faces limited resources and limited demand

for each product. These limitations are called
constraints
• A manager must choose the optimal mix given the
constraints found within the firm

Example 8.7: How to Determine the Optimal Product
Mix with One Constrained Resource (1 of 2)
Jorgenson Company produces two types of gears, X and

Y, with unit contribution margins of $25 and $10,
respectively. Each gear must be notched by a special
machine. The firm ownseight machines that together
provide 40,000 hours of machine time per year. Gear X
requires 2 hours of machine time, and Gear Y requires 0.5
hour of machine time. There are no other constraints.
Required:
1. What is the contribution margin per hour of machine
time for each gear?
2. What is the optimal mix of gears?

Example 8.7: How to Determine the
Optimal Product Mix with One Constrained
Resource (2 of 2)
3. What is the total contribution margin earned for the optimal mix?
2. Since Gear Y yields $20 of contribution margin per hour of machine

time, all machine time should be devoted to the production of Gear Y.
Units Gear Y = 40,000 total hours/0.5 hour per Gear Y = 80,000 units
The optimal mix is Gear Y = 80,000 units and Gear X = 0 units.
3. Total Contribution Margin of Optimal Mix = (80,000 units Gear Y) $10
= $800,000

Mix with One Constrained Resource and a Sales
Constraint (1 of 4)
Jorgenson Company produces two types of gears, X and
Y, with unit contribution margins EXAMPLE 8 . 8 of $25
and $10, respectively. Each gear must be notched by a
special machine. The firm owns eight machines that
together provide 40,000 hours of machine time per year.
Gear X requires 2 hours of machine time, and Gear Y
requires 0.5 hour of machine time. A maximum of 60,000
units of each gear can be sold.

Example 8.8: How to Determine the Optimal
Product Mix with One Constrained Resource
and a Sales Constraint (2 of 4)
Required:
1. What is the contribution margin per hour of
machine time for each gear?
2. What is the optimal mix of gears?
3. What is the total contribution margin earned for the
optimal mix?

Constraint (3 of 4)
2. Since Gear Y yields $20 of contribution margin per hour
of machine time, the first priority is to produce all of
Gear Y that the market will take (i.e., demands).
Machine Time Required for Maximum Amount of Gear Y
= 60,000 units × 0.5 machine hour required for each Gear
Y unit
= 30,000 hours needed to manufacture 60,000 Gear Y
units
Remaining Machine Time for Gear X = 40,000 – 30,000
hours
= 10,000 hours

Constraint (4 of 4)
Units of Gear X to Be Produced in Remaining 10,000
Hours = 10,000 hours/2 hour per Gear X unit
= 5,000 Gear X units
Now the optimal mix is 60,000 units of Gear Y and 5,000
units of Gear X. This mix will precisely exhaust the
machine time available.
3. Total Contribution Margin of Optimal Mix = (60,000
units Gear Y × $10) + (5,000 units Gear X × $25)
=$725,000

Multiple Constrained Resources (1 of 2)
• The presence of only one constrained resource might

not be realistic
• Organizations often face multiple constraints, including:
– limitations of raw materials
– limitations of skilled labor
– limited demand for each product

Multiple Constrained Resources (2 of 2)
• The solution of the product mix problem in the

presence of multiple constraints is more complicated
and requires the use of a specialized mathematical
technique known as linear programming, which is
reserved for advanced cost management courses

Cost-Based Pricing (1 of 2)
• Demand is one side of the pricing equation; supply is

the other side
• Since revenue must cover all costs for the firm to make
a profit, many companies start with cost to determine
price
• That is, they calculate product (or service) cost and add
the desired profit
• The mechanics of this approach involve a cost base
and a markup

Cost-Based Pricing (2 of 2)
• The markup is a percentage applied to the base cost

• It includes desired profit and any costs not included in
the base cost
• Companies that bid for jobs routinely base bid price on
cost

Example 8.9: How to Calculate Price by Applying a
Markup Percentage to Cost (1 of 2)
Elvin Company assembles and installs computers to

customer specifications. Elvin has decided to price its jobs
at the cost of direct materials and direct labor plus 20%.
The job for a local vocational-technical school included the
following costs:
Direct materials $65,000
Direct labor (assembly and installation) 4,000
Required:
Calculate the price charged by Elvin Company to the
vocational-technical school.

Example 8.9: How to Calculate Price by Applying a
Markup Percentage to Cost (2 of 2)
Solution:
Price = Cost + (Markup Percentage × Cost)
= $69,000 + 0.20($69,000)
= $69,000 + $13,800
= $82,800

Target Costing and Pricing
• Many firms set the price of a new product as the sum of

the costs and the desired profit
• The company must earn sufficient revenues to cover all
costs and yield a profit
• Target costing is a method of determining the cost of a
product or service based on the price (target price) that
customers are willing to pay
• The marketing department determines what
characteristics and price for a product are most
demanded by consumers

Example 8.10: How to Calculate a Target
Cost (1 of 2)
Digitime manufactures wristwatches and is designing a
new watch model that incorporates a PDA, which Digitime
hopes consumers will view as a fun and valuable design
feature. As such, the new PDA watch has a target price of
$200. Management requires a 15% profit on new product
revenues.
Required:
1. Calculate the amount of desired profit.
2. Calculate the target cost.

Example 8.10: How to Calculate a Target
Cost (2 of 2)
Solution:
1. Desired Profit = 0.15 × Target Price
= 0.15 × $200
= $30
2. Target Cost = Target Price – Desired Profit
= $200 – $30
= $170

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Examples of Managerial Accounting

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1. Describe the short-run decision-making model, and

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• The first step is to recognize and define a specific

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• Qualitative factors can significantly affect the

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• Qualitative factors, such as the impact of late orders

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• Once all relevant costs and benefits for each

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• Decision makers should always maintain an ethical

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• The decision-making approach just described

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• Opportunity cost is the benefit sacrificed or foregone

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• A sunk cost is a cost that cannot be affected by any

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• For example, depreciation, a sunk cost, is sometimes

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• Most short-run decisions require extensive

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• If changes in demand and supply for resources across

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• Relevant costing is of value in solving many different

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• Managers face the decision of whether to make a

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3. It is cheaper (by $9,500) to make the component

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Fixed overhead will not be affected by whether or not

Operating income will increase by $34,000 ($1.70 × 20,000

• A manager needs to determine whether a segment,

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• Segmented reports prepared on a variable-costing

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