Relevant Costs for Decision

Making
Cost Concepts for Decision Making

A relevant cost is a cost that differs

between alternatives.

2
1
 Identifying Relevant Costs
An avoidable cost is a cost that can be eliminated, in
whole or in part, by choosing one alternative over
another. Avoidable costs are relevant costs.
Unavoidable costs are irrelevant costs.

Two broad categories of costs are never relevant in

any decision. They include:
Sunk costs.
Future costs that do not differ between the alternatives.
 Relevant Cost Analysis: A Two-Step
Process
Step 1 Eliminate costs and benefits that do not differ between
alternatives.
Step 2 Use the remaining costs and benefits that differ
between alternatives in making the decision. The costs
that remain are the differential, or avoidable, costs.
Different Costs for Different Purposes
Costs that are relevant in
one decision situation
may not be relevant in
another context. Thus, in
each decision situation,
the manager must
examine the data at
hand and isolate the
relevant costs.
 Identifying Relevant Costs
Cynthia, a Boston student, is considering visiting her friend in New York. She
can drive or take the train. By car, it is 230 miles to her friend’s apartment. She
is trying to decide which alternative is less expensive and has gathered the
following information:
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

$45
$45 per
per month
month ×× 88 months
months $2.70
$2.70 per
per gallon
gallon ÷÷ 27
27 MPG
MPG

$24,000
$24,000 cost
cost –– $10,000
$10,000 salvage
salvage value
value ÷÷ 55 years
years
 Identifying Relevant Costs
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

Some Additional Information

7 Reduction in resale value of car per mile of wear $ 0.026
8 Round-tip train fare $ 104
9 Benefits of relaxing on train trip ????
10 Cost of putting dog in kennel while gone $ 40
11 Benefit of having car in New York ????
12 Hassle of parking car in New York ????
13 Per day cost of parking car in New York $ 25
 Identifying Relevant Costs
From a financial standpoint, Cynthia would be better off
taking the train to visit her friend. Some of the non-financial
factor may influence her final decision.
Relevant Financial Cost of Driving
Gasoline (460 @ $0.100 per mile) $ 46.00
Maintenance (460 @ $0.065 per mile) 29.90
Reduction in resale (460 @ $0.026 per mile) 11.96
Parking in New York (2 days @ $25 per day) 50.00
Total $ 137.86

Relevant Financial Cost of Taking the Train

Round-trip ticket $ 104.00
 Total and Differential Cost Approaches

The management of a company is considering a new labor saving machine

that rents for $3,000 per year. Data about the company’s annual sales and
costs with and without the new machine are:
Situation Differential
Current With New Costs and
Situation Machine Benefits
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
 Total and Differential Cost Approaches

As you can see, the only costs that differ between the alternatives
are the direct labor costs savings and the increase in fixed rental
costs.
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
We can
Direct materials (5,000 unitsefficiently analyze the70,000
@ $14 per unit) decision by 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000
looking at the different costs and revenues25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses and arrive at the same solution 120,000. 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:Net Advantage to Renting the New Machine
Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Other 62,000 62,000 -
Increase in fixed rental expenses (3,000)
Rent on newNet machine
annual cost saving from renting the new machine
- $
3,000
12,000
(3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000
 Total and Differential Cost Approaches

Using the differential approach is desirable for two

reasons:
1. Only rarely will enough information be available to
prepare detailed income statements for both
alternatives.
2. Mingling irrelevant costs with relevant costs may
cause confusion and distract attention away from
the information that is really critical.
 Adding/Dropping Segments
One of the most important
decisions managers make
is whether to add or drop a
business segment.
Ultimately, a decision to
drop an old segment or
add a new one is going to
hinge primarily on the
impact the decision will To assess this impact,
have on net operating it is necessary to
income. carefully analyze
the costs.
 Adding/Dropping Segments

Due to the declining popularity of digital

watches, Lovell Company’s digital watch line
has not reported a profit for several years.
Lovell is considering discontinuing this
product line.
 A Contribution Margin Approach
DECISION RULE
Lovell should drop the digital watch segment only
if its profit would increase.
Lovell will compare the contribution margin that
would be lost to the costs that would be
avoided if the line was to be dropped.
Let’s look at this solution.
 Keeping/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
 Keeping/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less:
Anvariable expenses
investigation has
An investigation has revealed
revealed that that the
the fixed
fixed
Variable manufacturing costs $ 120,000
general
general
Variable
factory overhead
overhead and
factorycosts
shipping and fixed
fixed general
5,000 general
administrative
administrative expenses
Commissions expenses will will not
not be
be affected
75,000 affected by
by
200,000
dropping
dropping the
Contribution digital
digital watch
margin
the watch line.
line. The
The fixed
fixed general
$ 300,000
general
Less: fixed expenses
factory
factory overhead
overhead and
and general
general administrative
administrative
General factory overhead $ 60,000
expensesof line assigned
expenses
Salary manager to
assigned to this
this product
90,000 would
product would be be
reallocated
reallocated
Depreciation to
to other
of equipment other product
product lines.
50,000lines.
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
 Keeping/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
The
The equipment
Variableequipment used
used to
manufacturing to manufacture
manufacture
costs $ 120,000
Variabledigital
digital watches
watches
shipping has
has no
costs no resale
resale5,000
Commissions 75,000 200,000
value or
Contribution margin
alternative use.
value or alternative use. $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipmentShould
Should Lovell
Lovell retain
retain or
50,000 or drop
drop
Advertising - direct the
the digital
digital watch
100,000segment?
watch segment?
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
 Keeping/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead
Salary of line manager 90,000
Depreciation of equipment
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 260,000
Net operating loss $ 40,000
 The Make or Buy Decision
When a company is involved in more than one activity
in the entire value chain, it is vertically integrated.
A decision to carry out one of the activities in the
value chain internally, rather than to buy externally
from a supplier is called a “make or buy” decision.
Vertical Integration- Advantages

Smoother flow of parts

and materials

Better quality control

Realize profits
 Vertical Integration- Disadvantage
Companies may fail to
take advantage of
suppliers who can create
economies of scale
advantage by pooling
demand from numerous
companies.

While the economics of scale factor can be appealing, a

company must be careful to retain control over activities
that are essential to maintaining its competitive
position.
The Make or Buy Decision: An Example
• Essex Company manufactures part 4A that is
used in one of its products.
• The unit product cost of this part is:

Direct materials $ 9
Direct labor 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary 2
General factory overhead 10
Unit product cost $ 30
 The Make or Buy Decision
• The special equipment used to manufacture part 4A
has no resale value.
• The total amount of general factory overhead,
which is allocated on the basis of direct labor hours,
would be unaffected by this decision.
• The $30 unit product 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 $25 per part.

Should we accept the supplier’s offer?

 The Make or Buy Decision
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The avoidable
The avoidable costs
costs associated
associated with
with making
making part
part 4A
4A include
include direct
direct
materials,
materials, direct
direct labor,
labor, variable
variable overhead,
overhead, and
and the
the supervisor’s
supervisor’s salary.
salary.
 The Make or Buy Decision
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The
The depreciation
depreciation of
of the
the special
special equipment
equipment represents
represents aa sunk
sunk
cost.
cost. The
The equipment
equipment has
has no
no resale
resale value,
value, thus
thus its
its cost
cost and
and
associated
associated depreciation
depreciation are
are irrelevant
irrelevant to
to the
the decision.
decision.
 The Make or Buy Decision
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

Not
Not avoidable;
avoidable; irrelevant.
irrelevant. IfIf the
the product
product is
is dropped,
dropped, itit
will
will be
be reallocated
reallocated toto other
other products.
products.
 The Make or Buy Decision
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

Should we make or buy part 4A? Given that the total avoidable costs
are less than the cost of buying the part, Essex should continue to
make the part.
 Opportunity Cost
An opportunity cost is the benefit that is foregone as a
result of pursuing some course of action.
Opportunity costs are not actual cash outlays and are
not recorded in the formal accounts of an
organization.

How would this concept potentially relate to the Essex

Company?
 Key Terms and Concepts
A special order is a one-time order
that is not considered part of the
company’s normal ongoing
business.

When analyzing a special order,

only the incremental costs and
benefits are relevant.
Since the existing fixed
manufacturing overhead costs
would not be affected by the
order, they are not relevant.
 Special Orders
 Jet, Inc. makes a single product whose normal selling price is
$20 per unit.
 A foreign distributor offers to purchase 3,000 units for $10 per
unit.
 This is a one-time order that would not affect the company’s
regular business.
 Annual capacity is 10,000 units, but Jet, Inc. is currently
producing and selling only 5,000 units.

Should Jet accept the offer?

 Special Orders
Jet, Inc.
Contribution Income Statement
Revenue (5,000 × $20) $ 100,000
Variable costs:
Direct materials $ 20,000
Direct labor 5,000
Manufacturing overhead 10,000 $8 variable cost
Marketing costs 5,000
Total variable costs 40,000
Contribution margin 60,000
Fixed costs:
Manufacturing overhead $ 28,000
Marketing costs 20,000
Total fixed costs 48,000
Net operating income $ 12,000
 Special Orders
If Jet accepts the special order, the incremental revenue
will exceed the incremental costs. In other words, net
operating income will increase by $6,000. This suggests
that Jet should accept the order.

Increase in revenue (3,000 × $10) $ 30,000

Increase in costs (3,000 × $8 variable cost) 24,000
Increase in net income $ 6,000

Note: This answer assumes that the fixed costs are unavoidable
and that variable marketing costs must be incurred on the special
order.
 Key Terms and Concepts
When a limited resource of some
type restricts the company’s
ability to satisfy demand, the
company is said to have a
constraint.

The machine or process

that is limiting overall
output is called the
bottleneck – it is the
constraint.
 Utilization of a Constrained Resource

• Fixed costs are usually unaffected in these situations, so the

product mix that maximizes the company’s total contribution
margin should ordinarily be selected.
• A company should not necessarily promote those products
that have the highest unit contribution margins.
• Rather, total contribution margin will be maximized by
promoting those products or accepting those orders that
provide the highest contribution margin in relation to the
constraining resource.
Utilization of a Constrained Resource:
An Example
Ensign Company produces two products and
selected data are shown below:
Product
1 2
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 required
on machine A1 per unit 1.00 min. 0.50 min.
Utilization of a Constrained Resource:
An Example
• Machine A1 is the constrained resource and is
being used at 100% of its capacity.
• There is excess capacity on all other machines.
• Machine A1 has a capacity of 2,400 minutes per
week.

Should Ensign focus its efforts on Product

1 or Product 2?
 Utilization of a Constrained Resource
The key is the contribution margin per unit of the
constrained resource.
P roduct
1 2
Contri buti on m a rgi n pe r uni t $ 24 $ 15
Ti m e re qui re d to produce one uni t ÷ 1. 00 m i n. ÷ 0. 50 m i n.
Contri buti on m a rgi n pe r m i nute $ 24 $ 30

Ensign should emphasize Product 2 because it

generates a contribution margin of $30 per minute
of the constrained resource relative to $24 per
minute for Product 1.
 Utilization of a Constrained Resource
The key is the contribution margin per unit of the
constrained resource.
P roduct
1 2
Contri buti on m a rgi n pe r uni t $ 24 $ 15
Ti m e re qui re d to produce one uni t ÷ 1. 00 m i n. ÷ 0. 50 m i n.
Contri buti on m a rgi n pe r m i nute $ 24 $ 30

Ensign
Ensign can
can maximize
maximize its
its contribution
contribution margin
margin
by
by first
first producing
producing Product
Product 22 to
to meet
meet customer
customer
demand
demand and
and then
then using
using any
any remaining
remaining
capacity
capacity to
to produce
produce Product
Product 1.
1. The
The
calculations
calculations would
would bebe performed
performed as as follows.
follows.
 Managing Constraints
Produce only what
can be sold.
Finding ways to
process more units At the bottleneck itself:
through a resource •Improve the process
bottleneck • Add overtime or another shift
• Hire new workers or acquire
more machines
• Subcontract production
Eliminate waste.
Streamline production process.
 Joint 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.
• The point in the manufacturing process
where each joint product can be recognized
as a separate product is called the split-off
point.
 Joint Products
For example, in
Oil the petroleum
refining industry, a
large number of
Common products are
Joint
Input
Production Gasoline extracted from
Process crude oil, including
gasoline, jet fuel,
home heating oil,
Chemicals
lubricants, asphalt,
and various organic
chemicals.
Split-Off
Point
 Joint Products
Joint costs
are incurred
up to the Oil
Separate Final
split-off point Processing Sale

Common
Joint Final
Production Gasoline
Input Sale
Process

Separate Final
Chemicals
Processing
Sale

Split-Off Separate
Point Product
Costs
 Sell or Process Further
Joint costs are irrelevant.

Decision Rule: If incremental revenue from further

processing > the incremental processing costs incurred after
the split-off point, then process further.
Sell or Process Further: An Example
• Sawmill, Inc. 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 “presto-logs.”
 Sell or Process Further
Data about Sawmill’s joint products includes:
Per Log
Lumber Sawdust
Sales value at the split-off point $ 140 $ 40

Sales value after further processing 270 50

Allocated joint product costs 176 24
Cost of further processing 50 20
 Sell or Process Further
Analysis of Sell or Process Further
Per Log
Lumber Sawdust

Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing
Profit (loss) from further processing
 Sell or Process Further
Analysis of Sell or Process Further
Per Log
Lumber Sawdust

Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing 50 20
Profit (loss) from further processing $ 80 $ (10)
 Sell or Process Further
Analysis of Sell or Process Further
Per Log
Lumber Sawdust

Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing 50 20
Profit (loss) from further processing $ 80 $ (10)

The lumber should be processed

further and the sawdust should be
sold at the split-off point.