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Relevant Costs for Decision Making
Making correct decisions is one of the most important important tasks of a successful manager. Every decision involves a choice between between at least two alternatives. alternatives. The decision process may be complicated by volumes of data, irrelevant data, incomplete information, information, an unlimited array of alternatives, alternatives, etc. The role of the managerial managerial accountant in in this process is often that that of a gatherer and summarizer of relevant information rather than the ultimate decision maker. The costs and benefits of the alternatives need to be compared and contrasted before making a decision. The decision should be based only on RELEVANT information. Relevant information includes the predicted future costs and revenues that differ among the alternatives. Any cost or benefit that does not differ between alternatives is irrelevant and can be ignored in a decision. All future revenues and/or costs that do not differ between the alternatives are irrelevant. Sunk costs (costs already irrevocably irrevocably incurred) are always irrelevant irrelevant since they will be the same for any alternative. To identify which costs are relevant in a particular situation, take this three step approach: 1. Eliminate sunk costs 2. Eliminate costs and and benefits benefits that do do not differ between alternatives 3. Compare the remaining remaining costs costs and benefits that do differ between alternatives to make the proper decision. Five separate types of decisions are discussed as follows: (I) Adding and Dropping Product Lines and Other Segments (ii) Make or Buy Decisions (iii) Special Orders (iv) Utilization of Scarce Resources (v) Sell or Process further Decisions Adding and Dropping Product Lines and Other Segments: In order to make the correct decision regarding dropping a product line, we need to compare lost contribution margin margin with avoidable fixed costs. If the avoidable fixed costs are greater than lost contribution margin then it is better off dropping the Product Line. A segment should be added only if the increase in total contribution margin is greater than the increase in fixed costs. A segment should be dropped dropped only if the decrease in total contribution margin is less than the decrease in fixed costs. Make or Buy Decisions A make or buy decision relates to whether an item should be made internally or purchased from an external supplier. Special Orders Special orders are one-time one-time orders that do not affect a company’s normal normal sales. The profit from a special order equals the incremental incremental revenue less the incremental incremental costs. As long as
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the incremental revenue exceeds the incremental costs and present sales are unaffected, the special order should be accepted. Utilization of a Constrained Resources Whenever demand exceeds productive capacity, a production constraint (bottleneck) exists. This means that the company is unable to fill all orders and some some choices have to be made concerning which orders orders are filled and which are not filled. Total contribution margin will be maximized by promoting those products or accepting those orders that provide the highest unit contribution margin in relation to the constrained resource. Sell or Process Further Decisions In some manufacturing processes, several intermediate products are produced from a single input. Such products are known as joint products. products. The costs associated associated with making making these products up to the point where they can be recognized as separate products (the split-off point) are called joint product costs. A decision often must be made about selling a joint product as is or processing it further. It is profitable to continue processing processing a joint product after the split-off split-off point so long as the incremental revenue from such processing exceeds the incremental processing costs. In such decisions, the joint joint product costs incurred before before the split-off point are irrelevant and should be ignored. The more common types types of costs costs which which you will meet meet when when evalua evaluatin tingg differ different ent decisions are incremental, incremental, non-incremental and spare capacity capacity costs. Are these likely to be relevant or non-relevant?
Suggested Solution •
Incremental costs: An incremental cost can be defined as a cost which is specifically
incurred by following a course of action and which is avoidable if such action is not taken. Incremental Incremental costs are, by definition, definition, relevant costs costs because they are are directly affected by the decision (i.e. they will be incurred if the decision goes ahead and they will will not be incur incurred red if the decisi decision on is scrap scrapped ped). ). For exampl example, e, if an enterp enterpris risee is deciding whether or not to accept a special order for its product, the extra variable costs (i.e. number of units in special order x variable cost per unit) which would be incurred in filling the order are an incremental cost because they would not be incurred if the special order were to be rejected. •
Non-incremental costs: These are costs which will not be affected by the decision at
hand. Non-incremental Non-incremental costs are non-relevant non-relevant costs because they are not not related to the decision at hand (i.e. non-incremental costs stay the same no matter what decision is taken). An example of non-incremental non-incremental costs costs would be fixed fixed costs which by their very nature should not be be affected by decisions decisions (at least in the short term). If, however, a decision gives rise to a specific increase in fixed costs then the increase in fixed costs would be an incremental and, hence, hence, relevant cost. For example, in a decision on whether whether
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to extend the factory floor area of an enterprise, the extra rent to be incurred would be a relevant cost for that decision. •
Spare Spare capaci capacity ty costs costs:
Beca Becaus usee of the the rece recent nt adva advanc ncem emen ents ts in manu manufa fact ctur urin ingg technology most enterprises have greatly increased their efficiency and as a result are often often operatin operatingg at below full capacity capacity.. Operat Operating ing with spare spare capaci capacity ty can have a significant impact on the relevant costs for any short-term production decision the management of such an enterprise might have to make. If spare capacity exists in an enterprise, some costs which are generally considered incremental may in fact be non-incremental and thus, non-relevant, in the short term. For example, if an enterprise is operating at less than full capacity then its work force is probably under utilized. utilized. If it is the policy of the enterprise enterprise to maintain the level of its work force in the short term, until activity increases, then the labor cost of this work force would be a non-relevant cost for a decision on whether to accept or reject a once-off special order. order. The labor cost is non-relevant because because the wages will have to be paid whether the order order is accepted or not. not. If the special order order involved and element of overtime then the cost of such overtime would of course be a relevant cost (as it is an incremental cost) for the decision.
Two further types of costs that have to be considered are opportunity costs and sunk costs. •
opportunity cost is a level of profit profit or benefit benefit foregone by the Opportunity costs : An opportunity pursuit pursuit of a particula particularr course of action. In other words, words, it is the value of an option, which which cannot be taken as a result result of following following a differen differentt option. For example, example, if an enterprise has a quantity of raw material in stock which cost $7 per kg and it plans to use this material in the filling of a special order then you would normally incorporate $7 per kg as part of your cost calculations calculations for filling the order. order. If, however, this this quantity of materi material al could could be resold resold witho without ut furth further er proce processi ssing ng for $8 per per kg, then then the opportunity cost of using using this material in the special special order is $8 per kg; by filling the order you forego the $8 per kg which was available for a straight sale of the material. Opportunity costs are, therefore, the ‘real’ economic costs of taking one course of action as opposed to another. In the above decision-making situation it is the opportunity cost which is the relevant cost and, hence, the cost which should be incorporated into your cost-versus-benefit analysis. It is because the loss of the $8 per kg is directly directly related to the filling filling of the order and the the opportunity cost is greater than than the book cost. Opportunity costs costs are relevant costs for a decision only when they exceed the costs of the same item in the option to the decision under consideration. consideration.
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Sunk costs: a sunk cost is a cost that has already been incurred and cannot be altered
by any future decision. decision. If sunk costs are not affected by a decision decision then they must be non-relevant costs for for decision-making decision-making purposes. Common examples examples of sunk costs are market research costs and development expenditure incurred by enterprises in getting
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a product or service ready ready for sale. The final decision on whether whether to launch the product or serv servic icee woul would d rega regard rd thes thesee cost costss as ‘sunk ‘sunk’’ (i.e (i.e.. irre irreco cove vera rabl ble) e) and and thus thus,, not not incorporate them into the launch decision. Sunk Costs are the opposite to opportunity costs in that they are not incorporated in the decision making process even though they have already been recorded in the books and records of the enterprise .
Every decision involves choosing from among at least two alternatives.
A relevant cost or benefit is a cost or benefit that differs, in total, between the alternatives. Any cost or benefit that does not differ between the alternatives is irrelevant and can be ignored. Relevant costs and benefits are also known as differential differential costs and benefits. Avoidable costs are those costs that can be eliminated in whole or in part by choosing one alternative over another. Avoidable costs are relevant costs. Two broad categories of costs are never relevant in decisions: 1.
Sunk Sunk costs costs
2. Futur Futuree costs costs that that do not differ differ betwe between en altern alternati atives ves..
To make a decision: 1.
Eliminate Eliminate costs and benefits benefits that do not not differ differ,, in total, total, between between alternati alternatives. ves.
2.
Base Base the deci decisio sionn on the the remai remainin ningg costs costs and and benef benefits its.. DROP OR RETAIN A SEGMENT
EXAMPLE: Due to the declining popularity of digital watches, Sweiz Company’s digital watch line has not reported a profit for several years. An income statement for last year follows: Segment Income Statement—Digital Watches
Sales................................................................................... Less variable expenses: Vari Variab able le manu manufa fact ctur urin ingg costs costs........................................... .......... ............... Vari Variab able le ship shippping ing cost costss.... ........................................................................................ Comm Commis issi sion ons. s.... ...... ...... ...... ...... .......... .......... ...... ...... ...... .......... ...... ....... ....... ....... ....... ....... ........ .... Contribution margin........................................................ Less fixed expenses: Gene Genera rall fact factor oryy ove overh rheead* ad*.... .......................................................................... Sala Salarry of produ oduct line ine man manager ager.............................................................. Dep Depreci reciaation tion of equip uipment ment** **...................................................................... Prod Produc uctt line line adve advert rtis isin ing. g................................................ .............. .......... ............... Rent— ent—ffacto actorry sp space** ce***. *....................................................................................... Gene Genera rall admi admini nist stra rati tive ve expe expens nse* e*... ...... ...... ...... ...... ...... ...... ....... ....... ... Net operating loss..........................................................
Should the company retain or drop the digital watch line?
$ 50 500,000 $120 $120,0 ,000 00 5,000 ,000 75,0 75,000 00
60,0 60,000 00 90,0 90,000 00 50,0 50,000 00 100, 100,00 000 0 70,0 70,000 00 30,0 30,000 00
200, 200,00 000 0 300,000
400, 400,00 000 0 $(100,000)
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DROP OR RETAIN A SEGMENT (cont’d)
Approach #1: If by dropping digital watches the company is able to avoid more in fixed costs than it loses in contribution margin, then it will be better off if the product line is eliminated. The solution would be: Contribution margin lost if digital watches are dropped. Less fixed costs that can be avoided: Sala Salary ry of the the prod produc uctt line line mana manage ger. r................................ .............. .............. ....... Prod Produc uctt line line adve advert rtis isin ing. g........................................................................................ .............. ....... Rent Rent—f —fac acto tory ry spac space. e........................................................................................ .............. .......... ......... Net disadvantage of dropping the line.................................
$(300,000) $ 90,0 90,000 00 100, 100,00 000 0 70,0 70,000 00
260, 260,00 000 0 $( 40,000)
The digital watch line should not be dropped. If it is dropped, the company will be $40,000 worse off each year. Note the following points: • Depreciat Depreciation ion on the old old equipmen equipmentt is not relevant relevant to to the decision decision.. It relates relates to a sunk cost. • General General factory factory overhead overhead and genera generall administra administrative tive expense expense are are allocated allocated common common costs that would not be avoided if the digital watch line were dropped. These costs would be reallocated to other product lines. DROP OR RETAIN A SEGMENT (cont’d)
Approach #2: The solution can also be obtained by preparing comparative income statements showing results with and without the digital watch line. Keep Digital Watches
Sales. Sales..... ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........... ........... .... Less variable expenses: Variable manufacturing expense...... ...... .... .... .... .... .... .. Variable shipping costs.......................... .......... ..... Comm Commis issi sion ons. s.... ...... ...... .......... ...... ...... ...... ...... ...... ...... ...... .......... ...... ...... ...... ....... ...... Total Total vari variab able le expe expens nses es... ...... .......... ...... ...... ...... .......... ...... ...... ....... ....... ... Cont Contri ribu buti tion on marg margin in... ...... ...... .......... .......... ...... ...... ...... ...... ....... ....... ....... ....... ... Less fixed expenses: General factory overhead..... .......... ...... ........ ...... ........ ...... .... .... .. Salary of product line manager....... ......... ......... .... Dep Deprecia eciattion ion.... ........................................................................................................ Prod Produuct lin line adve dvertis rtisin ingg.... ................................................................ Rent—factory ory space... ....... ...... ........ ...... ........ ...... ........ .......... ...... .... .... ....
$ 500 500,00 ,000 0
D ro p Digital Watches
$
Difference: Increase or (Decrease)
0
$(500, $(500,000 000))
120,000 5,000 75,0 75,000 00 200, 200,00 000 0 300, 300,00 000 0
0 0 0 0 0
120,000 5,000 75,0 75,000 00 200, 200,00 000 0 (300 (300,0 ,000 00)
60,000 90,000 50,0 50,000 00 100 100,000 ,000 70,000
60,000 0 50,0 50,000 00 0 0
0 90,000 0 100, 100,00 000 0 70,000
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Gene Genera rall admi admini nist stra rati tive ve expe expens nsee..... ................ .......... ....... Total Total fixe fixed d expe expens nses es... ...... ...... ...... ...... ...... ...... ...... ...... ...... .......... ...... ...... ....... Net operating loss................................................
30,0 30,000 00 400, 400,00 000 0 $(100,000)
30,0 30,000 00 140, 140,00 000 0 $(140,000)
0 260, 260,00 000 0 $ (4 (40,000)
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. EXAMPLE: Essex Company is presently making a part that is used in one of its products. The unit product cost is: Dire Direct ct mate materi rial als. s.... ...... ...... ...... ...... ...... ...... ...... .......... ...... ...... ...... ...... ...... ...... ...... ....... ....... ....... ....... ....... Direct labor Vari Variab able le manu manufa fact ctur urin ingg over overhe head ad................................... .......... .............. ............. Depr Deprec ecia iati tion on of spec specia iall equ equip ipme ment nt*. *............................................................ ..... Supe Superv rvis isor or’s ’s sala salary ry... .......... .......... ...... ...... ...... .......... ...... ...... ...... ...... ...... ...... ...... .......... ...... ...... ....... .... Gene Genera rall fac facto tory ry over overhe head ad** **... ...... .......... .......... ...... ...... ...... .......... ...... ...... ...... ...... ....... .... Total Total unit unit produc productt cost.. cost...... ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ......... .....
$9 5 1 3 2 10 $30
* The spe specia ciall equip equipmen mentt has has no res resale ale valu value. e. ** Common Common costs costs alloca allocated ted on on the basis of direct direct labor-hour labor-hours. s. The costs above are based on 20,000 parts produced each year. An outside supplier has offered to provide the 20,000 parts for only $25 per part. Should this offer be accepted? MAKE OR BUY DECISION (cont’d) The solution to Essex Company’s make or buy decision follows: Total Differential Costs of 20,000 units Make Buy
Outside purchase price.......................................................... Dire Direct ct mate materi rial als. s.... ...... ...... ...... ...... ...... ...... ...... .......... ...... ...... ...... ...... ...... ...... ...... .......... ...... ...... ...... ...... ...... ... Direct labor Vari Variab able le manu manufa fact ctur urin ingg over overhe head ad............................................................... .............. ... Depreciation of equipment (not relevant)......................... Supe Superv rvis isor or’s ’s sala salary ry................................................................................................... .............. .......... ......... General factory overhead (not relevant)........................... Total cost
$500,000 $180 $180,0 ,000 00 100,000 20,0 20,000 00 40,0 40,000 00 $340,000
$ 50 0 , 00 0
This solution assumes that none of the general factory overhead costs will be saved if the parts are purchased from the outside; these costs would be reallocated to other items made by the company.
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SPECIAL ORDERS
A special order is a one-time order that does not affect the company’s normal sales. EXAMPLE: Jamestown Candle works has just received a request from the Williamsburg Foundation for 800 candles to be used in a special event for major donors. The candles will be used as the only illumination in the reception room and will be given out as gifts to the donors as they leave. The candles will be imprinted with the Williamsburg Foundation Foundation logo. This sale will have no effect on the company’s normal sales to retail outlets. The normal selling price of a candle of about the size and weight of the special candles is $3.95 and its unit product cost is $2.30, as shown below: Dire Direct ct mat mater eria ials ls............................................... .............. .......... ......... Direct labor Mannufact Ma factuuring ing ove overrhead ead.... .............................................. Unit Unit prod produc uctt cost cost................................................................... .........
$1.3 $1.35 5 0.15 0.80 0.80 $2.3 $2 .30 0
The variable portion of the manufacturing overhead is $0.05 per candle; the other $0.75 represents fixed manufacturing manufacturing costs that would not be affected by this special order. Jamestown Candle works would have to order a special candle mold in which the Williamsburg Foundation logo is inscribed. Such a mold would cost $800. In addition, the Williamsburg Foundation wants a special wick containing gold-like thread that would add $0.20 to the cost of each candle. Because of the large size of the order and the charitable nature of the work, the Williamsburg Foundation has asked to pay only $2.95 each for this candle. If accepted, what effect would this order have on the company’s net operating income? SPECIAL ORDERS
Only the incremental costs and benefits are relevant. The existing fixed manufacturing overhead costs would not be affected by the order and are irrelevant. Per Unit
Incremental revenue................................................... ...... Incremental costs: Variable costs: Direct materials.................................................... Direct labor............................................................ Variable ma manufacturing ov overhead..................... Spec Specia iall wick wick................................................................................................... .......... ........... Total variable cost..................................................... Fixed cost: Special mold........................................................... Total incremental cost.................................................. Incremental net operating income.............................
Total for 800 Candles
$2.95
$ 2 , 3 60
1 . 35 0.15 0.05 0.20 0.20 $1.75
1 , 0 80 1 20 40 160 160 1 ,400 80 0 2,200 $ 1 60
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UTILIZATION OF CONSTRAINED RESOURCES
• Anything Anything that that prevents prevents an organiz organizatio ationn from getting getting more more of what what it wants wants (for exampl example, e, profits) is a constraint. • A particular particular machin machinee may not have have enough enough capacity capacity to satisfy satisfy curre current nt demand. demand. • Supplies Supplies of a critica criticall part may not not be sufficie sufficient nt to satisfy satisfy current current deman demand. d. • When the the constrai constraint nt is a machin machinee or a work work center, center, it it is called called a bottlene bottleneck. ck. • When capaci capacity ty is not suffici sufficient ent to satisfy satisfy demand demand,, something something must must be cut back. back. Which products should be cut back and by how much? • Fixed Fixed costs are are not usually usually affect affected ed by the decisi decision on of which which products products should should be emphasized in the short run. All of the machines and other fixed assets are in place— it is just a question of how they should be used. • When fixed fixed costs costs are unaffe unaffected cted by the the choice choice of which which product product to emphasi emphasize, ze, maximizing the total contribution margin will maximize total profits. • The total total contribut contribution ion margin margin is maximiz maximized ed by emphasi emphasizing zing the the products products with with the greatest contribution margin per unit of the constrained resource.
UTILIZATION OF CONSTRAINED RESOURCES (cont’d)
EXAMPLE: Ensign Company makes two products, X and Y. The current constraint is Machine N34. Selected data on the products follow: Selling price per unit.................................................. Less variable expenses per unit.......... ......... ......... ......... ..... Contribution margin.................................................... Contribution margin ratio.......................................... Current demand per week (units)............................ Processing time required on Machine N34 per unit
X
Y
$ 60 36 $ 24 40% 2,000
$ 50 35 $1 5 30% 2,200
1.0 minute
0.5 minute
Machine N34 is available for 2,400 minutes per week, which is not enough capacity to satisfy demand for both product X and product Y. Should the company focus its efforts on product X or product Y?
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CM PER UNIT OF THE CONSTRAINED RESOURCE Contribution margin per unit (a).............................. Constrained resource required to produce one unit (b)....................................................................... Contribution margin per unit of the constrained resour ource (a (a)÷ (b)...... ...... ........ .......... ...... ........ ...... ........ ...... .... .... .... .... .... .... .... .... .... ....
X
Y
$ 24
$1 5
1.0 minute
0.5 minute
$24 pe per mi minute
$30 pe per mi minute
UTILIZATION OF CONSTRAINED RESOURCES (cont’d)
• Product Product Y should should be emphasiz emphasized ed since since it has the the larger larger contributi contribution on margin margin per unit unit of the constrained resource. resource. A minute of processing time on Machine N34 can be used to make 1 unit of Product X, with a contribution margin of $24, or 2 units of Product Y, with a combined contribution margin of $30. • In the absenc absencee of other other considera considerations tions (such (such as satisfy satisfying ing an importa important nt customer customer), ), the best plan would be to produce to meet current demand for Product Y and then use any remaining capacity to make Product X.
ALLOTING THE CONSTRAINED RESOURCE Tota Totall time time avai availa labl blee on on Ma Mach chin inee N3 N34 4 (a). (a).... ...... ...... .......... .......... ...... ...... ...... .......... ...... ...... ...... ...... ... Plan Planne ned d prod produc ucti tion on and and sale saless of Prod Produc uctt Y.... Y....... ...... ...... ...... ...... ...... ...... .......... ...... ...... ...... ...... ... Time Time requi required red to proce process ss one unit. unit..... ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ .... Tota Totall time time req requi uire red d to mak makee Prod Produc uctt Y (b). (b)........................................................ .............. ........... Time Time ava avail ilab able le to to proc proces esss Prod Produc uctt X (a) (a) – (b). (b).................................................... .............. ....... Time Time requi equire red d to to pro proce cess ss one one uni unit. t................................................................................................................. Plan Planne ned d prod produc ucti tion on and and sal sales es of of Prod Produc uctt X... X...................................................... .............. ...........
2,40 2,400 0 2,20 2,200 0 × 0.5 1,10 1,100 0 1,30 1,300 0 ÷1
minu minute tess unit unitss minute minute minu minute tess minu minute tess minu minute te per per unit 1,30 1,300 0 unit unitss
RESULTS OF FOLLOWING THE ABOVE PLAN X
Planned pr production an and sa sales (un (units)................................. Cont Contri ribu buti tion on marg margin in per per unit unit... ...... .......... .......... ...... ...... ...... .......... ...... ...... ...... ....... ....... ..... Total contribution margin..... .......... ...... ........ ...... ........ .......... ...... ........ ...... .... .... .... .... .... .... .... ..
1 ,300 × $2 $24 4 $31,200
Y
2,200 × $15 $15 $33,000
Total
$64,200
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UTILIZATION OF CONSTRAINED RESOURCES (cont’d) MANAGING CONSTRAINTS
Processing more units through the bottleneck that customers want is a key to increased profits: • Prod Produc ucee only only wha whatt can can be sol sold. d. • Pay workers workers overti overtime me to keep keep the bottlene bottleneck ck running running after after normal normal working working hours. hours. • Shift workers workers from from non-b non-bottle ottleneck neck areas areas to to the bottle bottleneck neck.. • Hire more more worker workerss or acquire acquire more more machin machines es for the the bottlen bottleneck. eck. • Subcontra Subcontract ct some of of the produc production tion that that would would use the the bottlene bottleneck. ck. • Focus Focus business business process process impro improveme vement nt efforts efforts on the bottlene bottleneck. ck. • Reduce duce def defects ects.. The potential payoff to effectively managing the constraint can be enormous. EXAMPLE: Suppose the available time on Machine N34 can be increased by paying the machine’s operator to work overtime. Would this be worthwhile? ANSWER: Since the additional time would be used to make more of Product X, each minute of overtime is worth $24 to the company and hence each hour is worth $1,440 (60 minutes × $24 per minute)!
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