Relevant Cost Decisions

DECISION MAKING IN THE SHORT TERM By : Dr. Pranav Saraswat

Decisions
A decision model is a formal method of making a choice, often involving both quantitative and qualitative analyses

A relevant cost is a cost that differs between alternatives.

Five-Step Decision-Making Process

Step 2: Make Predictions About Future Costs

Step 1: Obtain Information

Step 3: Choose An Alternative

Step 4: Implement The Decision

Step 5: Evaluate Performance

Feedback

Relevance
Relevant Information has two characteristics:
It occurs in the future It differs among the alternative courses of action

Relevant Costs expected future costs Relevant Revenues expected future revenues
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Identifying Relevant Costs

Costs that can be eliminated (in whole or in part) by choosing one alternative over another are avoidable costs. Avoidable costs are relevant costs. Unavoidable costs are never relevant and include:
Sunk costs. Future costs that do not differ between the alternatives.

Identifying Relevant Costs

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

Irrelevance
Historical costs are past costs that are irrelevant to decision making
Also called Sunk Costs- cost that has already been incurred and that cannot be avoided regardless of what a manager decides to do

Types of Information
Quantitative factors are outcomes that can be measured in numerical terms Qualitative factors are outcomes that are difficult to measure accurately in numerical terms, such as satisfaction
Are just as important as quantitative factors even though they are difficult to measure
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Terminology
Incremental Cost the additional total cost incurred for an activity Differential Cost the difference in total cost between two alternatives Incremental Revenue the additional total revenue from an activity Differential Revenue the difference in total revenue between two alternatives
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Types of Decisions
One-Time-Only Special Orders Insourcing vs. Outsourcing Make or Buy Product-Mix Customer Profitability Branch / Segment: Adding or Discontinuing Equipment Replacement
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One-Time-Only Special Orders

Accepting or rejecting special orders when there is idle production capacity and the special orders have no longrun implications Decision Rule: does the special order generate additional operating income?
Yes accept No reject
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One-Time-Only Special Orders

Compares relevant revenues and relevant costs to determine profitability

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Special Orders
Acki Company receives a one-time order that is not considered part of its normal ongoing business. Acki Company only produces one type of silver key chain with a unit variable cost of TL 16. Normal selling price is TL 40 per unit. A company in KKTC offers to purchase 3,000 units for TL 20 per unit. Annual capacity is 10,000 units, and annual fixed costs total TL78,000, but Acki company is currently producing and selling only 5,000 units.

Should Acki accept the offer?

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Special Orders
Acki Company Contribution Income Statement Revenue (5,000 TL40) TL200.000 Variable costs: Direct materials TL40.000 Direct labor 10.000 Manufacturing overhead 20.000 Marketing costs 10.000 Total variable costs 80.000 Contribution margin 120.000 Fixed costs: Manufacturing overhead TL78.000 Marketing costs 25.000 Total fixed costs 103.000 Net income TL17.000
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Special Orders
If Acki accepts the offer, net income will increase by TL 12.000.
Increase in revenue (3,000 TL20) Increase in costs (3,000 TL16 variable cost) Increase in net income TL60.000 48.000 TL12.000

Using the incremental approach: Special order contribution margin = TL20 TL 16 = TL 4 Change in income = TL 4 3,000 units = TL 12.000.

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The Make or Buy Decision

A decision concerning whether an item should be produced internally or purchased from an outside supplier is called a make or buy decision.

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The Make or Buy Decision

MA Company is thinking of buying a part that is currently used in one of its products from outside. The unit cost to make this part is:
Direct materials Direct labor Variable overhead Depreciation of special equip. Supervisor's salary General factory overhead Total cost per unit TL/ u 27 15 3 9 6 30 90

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The Make or Buy Decision

General factory overhead is allocated on the basis of direct labor hours and is not going to change if the parts are bought from outside. The 90TL unit cost is based on 20,000 parts produced each year. An outside supplier has offered to provide the 20,000 parts at a cost of 70TL per part.

Should we accept the suppliers offer?

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The Make or Buy Decision

Sunk Cost
Outside purchase price Direct materials Direct labor Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost
Cost Per Unit

70 27 15 3 9 6 30 90

Cost of 20,000 Units Buy Make 1.400.000 540.000 300.000 60.000 0 120.000 0 1.020.000

1.400.000

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

DECISION RULE In deciding whether to accept the outside suppliers offer, MA isolated the relevant costs of making the part by eliminating:
The sunk costs. The future costs that will not differ between making or buying the parts.

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Product-Mix Decisions
The decisions made by a company about which products to sell and in what quantities Decision Rule (with a constraint): choose the product that produces the highest contribution margin per unit of the constraining resource

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Utilization of a Constrained Resource

Firms often face the problem of deciding how to best utilize a constrained resource. Usually, fixed costs are not affected by this particular decision, so management can focus on maximizing total contribution margin.
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Utilization of a Constrained Resource

UM Company produces two products and selected data is shown below:
Product Selling price per unit Less variable expenses per unit Contribution margin per unit Current demand per week (units) Contribution margin ratio Processing time required on machine A1 per unit 1 TL60 36 TL24 2.000 40% 1,00 min. 2 TL50 35 TL15 2.200 30% 0,50 min.

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Utilization of a Constrained Resource

Machine A1 is the constrained resource. There is excess capacity on all other machines. Machine A1 is being used at 100% of its capacity, and has a capacity of 2,400 minutes per week.

Should UM focus its efforts on Product 1 or 2?

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Utilization of a Constrained Resource

Lets calculate the contribution margin per unit of the constrained resource, machine A1.
Product Contribution margin per unit Time required to produce one unit Contribution margin per minute 1 TL24 1,00 min. TL24 min. 2 TL15 0,50 min. TL30 min.

Product 2 should be emphasized. Provides more valuable use of the constrained resource machine A1, yielding a contribution margin of TL 30 per minute as opposed to TL 24 for Product 1.
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Utilization of a Constrained Resource

Lets calculate the contribution margin per unit of the scarce resource, machine A1. Lets see how this plan would work.
Product Contribution margin per unit Time required to produce one unit Contribution margin per minute 1 TL24 1,00 min. TL24 min. 2 TL15 0,50 min. TL30 min.

If there are no other considerations, the best plan would be to produce to meet current demand for Product 2 and then use remaining capacity to make Product 1.

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Utilization of a Constrained Resource

Lets see how this plan would work.
Allocation of Constrained Resource

Weekly demand for Product 2 Time required per unit Total time required to make Product 2 Total time available Time used to make Product 2 Time available for Product 1 Time required per unit Production of Product 1

2.200 units 0,50 min. 1.100 min. 2.400 1.100 1.300 1,00 1.300 min. min. min. min. units

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Utilization of a Constrained Resource

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

Production and sales (units) Contribution margin per unit Total contribution margin

Product 1 1.300 TL24 TL31.200

Product 2 2.200 TL15 TL33.000

The total contribution margin for UM is TL 64,200.

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Managing Constraints
Finding ways to process more units through a resource bottleneck

Produce only what can be sold.

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

Eliminate waste.
Streamline production process.
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Adding or Dropping Customers

Decision Rule: Does adding or dropping a customer add operating income to the firm?
Yes add or dont drop No drop or dont add

Decision is based on profitability of the customer, not how much revenue a customer generates
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Adding or Discontinuing Branches or Segments

Decision Rule: Does adding or discontinuing a branch or segment add operating income to the firm?
Yes add or dont discontinue No discontinue or dont add

Decision is based on profitability of the branch or segment, not how much revenue the branch or segment generates
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Adding/Dropping Segments
Digital Musical Instruments Income Statement for 2007 Sales 1.000.000 Less: variable expenses Variable mfg. costs 240.000 Variable shipping costs 10.000 Commissions 150.000 400.000 Contribution margin 600.000 Less: fixed expenses General factory overhead 120.000 Salary of line manager 180.000 Depreciation of equipment 100.000 Advertising - direct 200.000 Should the company drop digital instruments Rent - factory space 140.000 division? General admin. expenses 60.000 800.000 Net loss (200.000)
General Factory Overhead and General Administrative Expenses are unavoidable costs.
Assume that the equipment used in manufacturing digital instruments has no resale value or alternative use.
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Incremental Approach
DECISION RULE UM should drop the digital instruments division only if the avoided fixed costs of the division exceed lost contribution margin of this division.

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Incremental Approach
Contribution Margin Solution Contribution margin lost if digital instrument division is dropped Less fixed costs that can be avoided Salary of the line manager 180.000 Advertising - direct 200.000 Rent - factory space 140.000 Net disadvantage

(600.000)

520.000 (80.000)

What about depreciation?

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Comparative Income Approach

Prepare comparative income statements showing results with and without the digital instruments division.

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Comparative Income Approach Solution

Keep Digital Instrum ents

Drop Digital Instrum ents

Sales Less variable expenses: Mfg. expenses Freight out Commissions Total variable expenses Contribution margin Less fixed expenses: General factory overhead Salary of line manager Depreciation Advertising - direct Rent - factory space General admin. expenses Total fixed expenses Net loss

1.000.000 240.000 10.000 150.000 400.000 600.000 120.000 180.000 100.000 200.000 140.000 60.000 800.000 (200.000)

0 0 0 0 0 0 0 120.000 0 100.000 0 0 60.000 280.000 (280.000)

Difference (1.000.000) 240.000 10.000 150.000 400.000 (600.000) 0 90.000 0 100.000 70.000 0 260.000 (340.000)

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Joint Product Costs

In some industries, a number of end products are produced from a single raw material input. Two or more products produced from a common input are called joint products. The point in the manufacturing process where each joint product can be recognized as a separate product is called the split-off point.
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Joint Products
Joint Costs
Joint Input Common Production Process Oil

Gasoline

Chemicals

Split-Off Point
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Joint Products
Joint Costs
Common Production Process Oil Separate Processing Final Sale

Joint Input

Gasoline

Final Sale

Chemicals

Separate Processing

Final Sale

Split-Off Point

Separate Product Costs

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The Pitfalls of Allocation of Joint Costs

Joint costs are really common costs incurred to simultaneously produce a variety of end products. Joint costs are often allocated to end products on the basis of the relative sales value of each product or on some other basis.

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Sell or Process Further

Decision Rule: It will always profitable to continue processing a joint product after the split-off point so long as the incremental revenue exceeds the incremental processing costs incurred after the split-off point.

Lets look at the Kere example.

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Sell or Process Further

Kere Company cuts logs from which unfinished lumber and sawdust are the immediate joint products. Unfinished lumber is sold as is or processed further into finished lumber. Sawdust can also be sold as is to gardening wholesalers or processed further into ready-logs.

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Sell or Process Further

Data about Keres joint products includes:
Per Log Lumber Sawdust TL140 TL40 270 176 50 50 24 20

Sales value at the split-off point Sales value after further processing Allocated joint product costs Cost of further processing

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Sell or Process Further

Analysis Per Log
Lumber Sawdust

Sales value after further processing Sales value at the split-off point Incremental revenue Cost of further processing Profit (loss) from further processing

TL270 140 130 50 TL80

TL50 40 10 20 (TL10)

Should Kere process the lumber further and sell the sawdust as is?
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Behavioral Implications
Despite the quantitative nature of some aspects of decision making, not all managers will choose the best alternative for the firm Managers could engage in selfserving behavior such as delaying needed equipment maintenance in order to meet their personal profitability quotas for bonus consideration
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