Chapter 13

Relevant Costs for Decision Making

Solutions to Questions
13-1 A relevant cost is a cost that differs in total between the alternatives in a decision. 13-2 An incremental cost (or benefit) is the change in cost (or benefit) that will result from some proposed action. An opportunity cost is the benefit that is lost or sacrificed in rejecting some course of action. A sunk cost is a cost that has already been incurred and that cannot be changed by any future decision. 13-3 No. Variable costs are relevant costs only if they differ in total between the alternatives under consideration. 13-4 No. Not all fixed costs are sunk only those for which the cost has already been irrevocably incurred. A variable cost can be a sunk cost! if it has already been incurred. 13-5 No. A variable cost is a cost that varies in total amount in direct proportion to changes in the level of activity. A differential cost measures the difference in cost between two alternatives. "f the level of activity is the same for the two alternatives! a variable cost will be unaffected and it will be irrelevant. 13-6 No. #nly those future costs that differ between the alternatives under consideration are relevant. 13#nly those costs that can be avoided as a result of dropping the product line are relevant in the decision. $osts that will not differ regardless of whether the line is retained or discontinued are irrelevant. 13-! Not necessarily. An apparent loss may be the result of allocated common costs or of sunk costs that cannot be avoided if the product line is dropped. A product line should be discontinued only if the contribution margin that will be lost as a result of dropping the line is less than the fixed costs that can be avoided. %ven in that situation there may be arguments in favor of retaining the product line if its presence promotes the sale of other products. 13-" Allocations of common fixed costs can make a product line (or other segment) appear to be unprofitable! whereas in fact it may be profitable. 13-1# "f a company decides to make a part internally rather than to buy it from an outside supplier! then a portion of the company&s facilities have to be used to make the part. 'he company&s opportunity cost is measured by the benefits that could be derived from the best alternative use of the facilities. 13-11 Any resource that is re(uired to make products and get them into the hands of customers could be a constraint. )ome examples are machine time! direct labor time! floor space! raw materials! investment capital! supervisory time! and storage space. *hile not covered in the text! constraints can also be intangible and often take the form of a formal or informal policy that prevents the organi+ation from furthering its goals. 13-12 Assuming that fixed costs are not affected! profits are maximi+ed when the total contribution margin is maximi+ed. A company can maximi+e its contribution margin by focusing on the products with the greatest amount of contribution margin per unit of the constrained resource. 13-13 ,oint products are two or more products that are produced from a common input. ,oint costs are the costs that are incurred up to the

- 'he .c/raw01ill $ompanies! "nc.! 2334. All rights reserved. )olutions .anual! $hapter 56 56

split0off point. 'he split0off point is the point in the manufacturing process where joint products can be recogni+ed as individual products. 13-14 ,oint costs should not be allocated among joint products. "f joint costs are allocated among the joint products! then managers may think they are avoidable costs of the end products. 1owever! the joint costs will continue to be incurred as long as the process is run regardless of what is done with one of the end products. 'hus! when making decisions about the end products! the joint costs are not avoidable and are irrelevant. 13-15 As long as the incremental revenue from further processing exceeds the incremental

costs of further processing! the product should be processed further. 13-16 .ost costs of a flight are either sunk costs! or costs that do not depend on the number of passengers on the flight. 7epreciation of the aircraft! salaries of personnel on the ground and in the air! and fuel costs! for example! are the same whether the flight is full or almost empty. 'herefore! adding more passengers at reduced fares at certain times of the week when seats would otherwise be empty does little to increase the total costs of making the flight! but can do much to increase the total contribution and total profit.

- 'he .c/raw01ill $ompanies! "nc.! 2334. All rights reserved. )olutions .anual! $hapter 56 58

$%ercise 13-1 (59 minutes) Case 1 Not Relevant Relevant : : : : : : : : : : : : : : : : : : Case 2 Not Relevant Relevant : : : : : :

a. b. c. d. e. f. g. h. i. j. k. l.

Item )ales revenue 7irect materials 7irect labor Variable manufacturing overhead 7epreciation .odel ;533 machine ;ook value .odel ;533 machine 7isposal value .odel ;533 machine .arket value .odel ;633 machine (cost) <ixed manufacturing overhead Variable selling expense <ixed selling expense /eneral administrative overhead

$%ercise 13-2 (63 minutes) 5. No! production and sale of the racing bikes should not be discontinued. "f the racing bikes were discontinued! then the net operating income for the company as a whole would decrease by =55!333 each (uarter> ?ost contribution margin.................................... <ixed costs that can be avoided> Advertising! traceable..................................... )alary of the product line manager................ 7ecrease in net operating income for the company as a whole...................................... =(2@!333) = 4!333 53!333 54!333 =(55!333)

'he depreciation of the special e(uipment is a sunk cost and is not relevant to the decision. 'he common costs are allocated and will continue regardless of whether or not the racing bikes are discontinuedA thus! they are not relevant to the decision. Alternative )olution> Difference: Net Operating Income Increase or (Decrease) =(43!333) 66!333 (2@!333) 4!333 3 53!333 3 54!333 = (55!333)

)ales ?ess variable expenses $ontribution margin ?ess fixed expenses> Advertising! traceable 7epreciation on special e(uipmentC )alaries of product managers $ommon allocated costs 'otal fixed expenses Net operating income

Total If Racing Current Bikes Are Total Dropped =633!333 =283!333 523!333 B@!333 5B3!333 596!333 63!333 26!333 69!333 43!333 58B!333 = 62!333 28!333 26!333 29!333 43!333 562!333 = 25!333

C"ncludes pro0rated loss on the special e(uipment if it is disposed of.

$%ercise 13-2 (continued) 2. 'he segmented report can be improved by eliminating the allocation of the common fixed expenses. <ollowing the format introduced in $hapter 52 for a segmented income statement! a better report would be> Dirt ountain Racing Total Bikes Bikes Bikes =633!333 =D3!333 =593!333 =43!333 43!333 D3!333 58!333 D!333 56!333 64!333 98!333 66!333 2@!333 4!333 B!333 53!333 28!333 =6!333

)ales ?ess variable manufacturing and selling expenses 523!333 2@!333 $ontribution margin 5B3!333 46!333 ?ess traceable fixed expenses> Advertising 63!333 53!333 7epreciation of special e(uipment 26!333 4!333 )alaries of the product line managers 69!333 52!333 'otal traceable fixed expenses BB!333 2B!333 Eroduct line segment margin D2!333 =69!333 = ?ess common fixed expenses 43!333 Net operating income =62!333

$%ercise 13-3 (63 minutes) 5. !er "nit Differential Costs #$%&&& units ake Bu' ake Bu' =69 =929!333 =58 =253!333 53 593!333 6 89!333 2 63!333

$ost of purchasing....................... 7irect materials............................ 7irect labor.................................. Variable manufacturing overhead <ixed manufacturing overhead! traceable5.................................. <ixed manufacturing overhead! common.................................... 'otal costs.................................... 7ifference in favor of continuing to make the carburetors............

=2D =69 =869!333 =929!333 =4 =D3!333

#nly the supervisory salaries can be avoided if the carburetors are purchased. 'he remaining book value of the special e(uipment is a sunk costA hence! the =8 per unit depreciation expense is not relevant to this decision. ;ased on these data! the company should reject the offer and should continue to produce the carburetors internally. 2. $ost of purchasing (part 5).............................. $ost of making (part 5).................................... #pportunity cost segment margin foregone on a potential new product line..................... 'otal cost......................................................... 7ifference in favor of purchasing from the outside supplier............................................ ake =869!333 593!333 =9B9!333 =929!333 =43!333 Bu' =929!333

'hus! the company should accept the offer and purchase the carburetors from the outside supplier.

$%ercise 13-4 (59 minutes) #nly the incremental costs and benefits are relevant. "n particular! only the variable manufacturing overhead and the cost of the special tool are relevant overhead costs in this situation. 'he other manufacturing overhead costs are fixed and are not affected by the decision. Total for (& !er "nit Bracelets "ncremental revenue............................... =54D.D9 =6!6DD.33 "ncremental costs> Variable costs> 7irect materials................................. = B8.33 5!4B3.33 7irect labor........................................ 89.33 D33.33 Variable manufacturing overhead..... 8.33 B3.33 )pecial filigree................................... 2.33 83.33 'otal variable cost................................ =569.33 2!@33.33 <ixed costs> Eurchase of special tool.................... 293.33 'otal incremental cost............................ 2!D93.33 "ncremental net operating income.......... = 88D.33 %ven though the price for the special order is below the companyFs regular price for such an item! the special order would add to the companyFs net operating income and should be accepted. 'his conclusion would not necessarily follow if the special order affected the regular selling price of bracelets or if it re(uired the use of a constrained resource.

$%ercise 13-5 (63 minutes) 5. (5) (2) (6) (8) (9) $ontribution margin per unit.............................. 7irect material cost per unit............................... 7irect material cost per pound........................... Eounds of material re(uired per unit (2) G (6).... $ontribution margin per pound (5) G (8)............ A B =98 =53B =28 =@2 =B =B 6 D =5B =52 C =43 =62 =B 8 =59

2. 'he company should concentrate its available material on product A> A $ontribution margin per pound (above)... Eounds of material available................... 'otal contribution margin......................... B C = 5B = 52 = 59 H 9!333 H 9!333 H 9!333 =D3!333 =43!333 =@9!333

Although product A has the lowest contribution margin per unit and the second lowest contribution margin ratio! it is preferred over the other two products since it has the greatest amount of contribution margin per pound of material! and material is the company&s constrained resource. 6. 'he price ;arlow $ompany would be willing to pay per pound for additional raw materials depends on how the materials would be used. "f there are unfilled orders for all of the products! ;arlow would presumably use the additional raw materials to make more of product A. %ach pound of raw materials used in product A generates =5B of contribution margin over and above the usual cost of raw materials. 'herefore! ;arlow should be willing to pay up to =24 per pound (=B usual price plus =5B contribution margin per pound) for the additional raw material! but would of course prefer to pay far less. 'he upper limit of =24 per pound to manufacture more product A signals to managers how valuable additional raw materials are to the company. "f all of the orders for product A have been filled! ;arlow $ompany would then use additional raw materials to manufacture product $. 'he company should be willing to pay up to =26 per pound (=B usual price plus =59 contribution margin per pound) for the additional raw materials to manufacture more product $! and up to =23 per pound (=B usual price plus =52 contribution margin per pound) to manufacture more product ; if all of the orders for

product $ have been filled as well.

$%ercise 13-6 (53 minutes) A )elling price after further processing. . . )elling price at the split0off point.......... "ncremental revenue per pound or gallon................................................ 'otal (uarterly output in pounds or gallons............................................... 'otal incremental revenue.................... 'otal incremental processing costs...... 'otal incremental profit or loss............. =23 54 =8 B =56 B =9 C =62 29 =@

H59!333 H23!333 H8!333 =43!333 =533!333 =2B!333 46!333 B3!333 64!333 =(6!333) = 23!333 =(B!333)

'herefore! only product ; should be processed further.

$%ercise 13- (23 minutes) 5. <ixed cost per mile (=9!333C G 93!333 miles)...... Variable cost per mile.......................................... Average cost per mile......................................... C "nsurance........................... =5!433 ?icenses............................. 293 'axes................................. 593 /arage rent........................ 5!233 7epreciation....................... 5!B33 'otal................................... =9!333 'his answer assumes the resale value of the truck does not decline because of the wear and tear that comes with use. 2. 'he insurance! the licenses! and the variable costs (gasoline! oil! tires! and repairs) would all be relevant to the decision! since these costs are avoidable by not using the truck. (1owever! the owner of the garage might insist that the truck be insured and licensed if it is left in the garage. "n that case! the insurance and licensing costs would not be relevant since they would be incurred regardless of the decision.) 'he taxes would not be relevant! since they must be paid regardless of useA the garage rent would not be relevant! since it must be paid to park the truckA and the depreciation would not be relevant! since it is a sunk cost. 1owever! any decrease in the resale value of the truck due to its use would be relevant. 6. #nly the variable costs of =3.3@ would be relevant! since they are the only costs that can be avoided by having the delivery done commercially. 8. "n this case! only the fixed costs associated with the second truck would be relevant. 'he variable costs would not be relevant! since they would not differ between having one or two trucks. ()tudents are inclined to think that variable costs are always relevant in decision0making! and to think that fixed costs are always irrelevant. 'his re(uirement helps to dispel that notion.) =3.53 3.3@ =3.5@

$%ercise 13-! (63 minutes) No! the bilge pump product line should not be discontinued. 'he computations are> $ontribution margin lost if the line is dropped......... I(843!333) <ixed costs that can be avoided> Advertising......................................................... I2@3!333 )alary of the product line manager.................... 62!333 "nsurance on inventories.................................... B!333 653!333 Net disadvantage of dropping the line.................. I(593!333) 'he same solution can be obtained by preparing comparative income statements> Difference: Net Operating )eep Drop Income !roduct !roduct Increase or *ine *ine (Decrease) )ales................................................... IB93!333 I 3 I(B93!333) ?ess variable expenses> Variable manufacturing expenses.... 663!333 3 663!333 )ales commissions.......................... 82!333 3 82!333 )hipping........................................... 5B!333 3 5B!333 'otal variable expenses...................... 6D3!333 3 6D3!333 $ontribution margin............................. 843!333 3 (843!333) ?ess fixed expenses> Advertising....................................... 2@3!333 3 2@3!333 7epreciation of e(uipment............... B3!333 B3!333 3 /eneral factory overhead................. 539!333 539!333 3 )alary of product line manager........ 62!333 3 62!333 "nsurance on inventories.................. B!333 3 B!333 Eurchasing department expenses.... 89!333 89!333 3 'otal fixed expenses........................... 983!333 263!333 653!333 Net operating loss............................... I (B3!333) I(263!333) I(593!333)

$%ercise 13-" (23 minutes) 'he costs that are relevant in a make0or0buy decision are those costs that can be avoided as a result of purchasing from the outside. 'he analysis for this exercise is> !er "nit Differential Costs ake Bu' =25.33

$ost of purchasing.................... $ost of making> 7irect materials....................... =6.43 7irect labor............................. 53.33 Variable overhead................... 2.83 <ixed overhead....................... 6.33 C 'otal cost................................... =5D.33 =25.33

+&%&&& "nits ake Bu' =463!333 =53B!333 633!333 @2!333 D3!333 =9@3!333 =463!333

'he remaining =4 of fixed overhead cost would not be relevant! since it will continue regardless of whether the company makes or buys the parts. 'he =B3!333 rental value of the space being used to produce part )04 represents an opportunity cost of continuing to produce the part internally. 'hus! the completed analysis would be> 'otal cost! as above............................................ Jental value of the space (opportunity cost)....... 'otal cost! including opportunity cost.................. Net advantage in favor of buying........................... ake =9@3!333 B3!333 =493!333 Bu' =463!333 =463!333

=23!333

$%ercise 13-1# (59 minutes) 5. Annual profits will be increased by =6D!333> #$%&&& !er "nit "nits =58.33 =253!333 9.53 @4!933 6.B3 9@!333 5.33 59!333 5.93 22!933 55.83 5@5!333 =2.43 =6D!333

"ncremental sales................................... "ncremental costs> 7irect materials................................... 7irect labor.......................................... Variable manufacturing overhead........ Variable selling and administrative...... 'otal incremental costs........................... "ncremental profits..................................

'he fixed costs are not relevant to the decision! since they will be incurred regardless of whether the special order is accepted or rejected. 2. 'he relevant cost is =5.93 (the variable selling and administrative expenses). All other variable costs are sunk! since the units have already been produced. 'he fixed costs would not be relevant! since they will not change in total as a conse(uence of the price charged for the left0over units.

$%ercise 13-11 (59 minutes) 'he company should accept orders first for $! second for A! and third for ;. 'he computations are> (5) (2) (6) (8) (9) 7irect materials re(uired per unit....... $ost per pound................................... Eounds re(uired per unit (5) G (2)...... $ontribution margin per unit............... $ontribution margin per pound of materials used (8) G (6).................... A =28 =6 B =62 B =59 =6 9 =58 C =D =6 6 =25

=8.33 =2.B3 =@.33

)ince $ uses the least amount of material per unit of the three products! and since it is the most profitable of the three in terms of its use of materials! some students will immediately assume that this is an infallible relationship. 'hat is! they will assume that the way to spot the most profitable product is to find the one using the least amount of the constrained resource. 'he way to dispel this notion is to point out that product AK uses more material (the constrained resource) than does product ;! but yet it is preferred over product ;. T,e ke' factor is not ,o- muc, of a constrained resource a product uses% .ut rat,er ,o- muc, contri.ution margin t,e product generates per unit of t,e constrained resource/

$%ercise 13-12 (53 minutes) )ales value if processed further (@!333 units H =52 per unit)..................................... )ales value at the split0off point (@!333 units H =D per unit)....................................... "ncremental revenue.................................................. ?ess cost of processing further.................................. Net advantage of processing further......................... =B8!333 46!333 25!333 D!933 =55!933