Relevant Costs: Make or Buy?

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Relevant Costs Make or Buy?

• OVCManagerial Accounting, Fall 2002
• David B. Hamm, MBA, CPA

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Steps in the Decision-Making Process (the Five
Ds)

• Define the problem
• Develop alternatives
• Decide which alternative is best
• Do what is indicated
• Determine if the decision was a good one
  (feedback)

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Relevant Information

• Information is relevant if is pertinent to a
  decision problemit will directly affect, or be
  affected by, the decision
• Information must also be accurate
• Information must also be timely

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Cost considerations

• Sunk costs have already been incurred and can
  not be changed by any current or future decision.
  Therefore no longer relevant.
• Differential costs difference between the costs
  of two (or more) decision alternatives
• Incremental costs additional cost differential
  of one alternative
• Opportunity costs potential benefit that must be
  given up when an alternative is selected

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Accept or Reject

• We receive a special ordernot part of routine
  production/services. Do we accept the order?
• YES, if the orders contribution margin (Sales
  VC) will cover any incremental fixed costs or
  opportunity costs and still provide a net margin
  toward other operations
• NO, if the order does not

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Accept or RejectIllustration (text, p. 612)
WorldWide Airways is offered a special charter
flight paying 150,000. Its routine costs
assigned to each flight are 190,000 (VC
90,000, allocated FC100,000). Initially, WWA
considers declining the charter because of a
40,000 loss.
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Accept or Reject Illustration (2)
Butthe fixed costs are not incremental to this
flight they are fixed for all current
operations. Only the variable costs need be
considered. Also, since the charter doesnt
involve reservations or ticketing, there is a
variable cost savings
Since the CM of the special order is positive
and can contribute to other operations, the offer
should be accepted.
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Accept or Reject Illustration (3)

• Above illustration assumes there is excess
  production capacity, i.e., plane, crew,
  facilities are available for the flight.
• If there is no excess capacity and another job
  must be cancelled to accept the special order,
  the contribution margin of the alternative job
  becomes an opportunity cost that must be included
  in the special order. Now it may not be as
  attractive. (See p. 613)

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Make or Buy (Outsourcing)

• Involves a choice between producing a
  product/service in-house or outsourcing it.
• Decision criteria is the similar to special
  orders
• Allocate relevant costs to each alternative
• Compare for cost savings (or not)

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Make or BuyIllustration (p. 615)
WWA considers cost of making desserts vs.
outsourcing initial costs of making appear
higher because of FC allocation, but when
considering relevant costs
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Make or Buy Illustration (2)
Alternative evaluationconsider only incremental
costs savings
Conclusiondont assume outsourcing will
eliminate all current production costssome are
sunk costs!
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Add or Drop (Service / Product / Segment)

• This is identical to segment reportingmust
  consider the segment margin each product or
  service or department/division/segment
  contributes to the firm.
• Againdont assume all fixed costs will be
  eliminatedsome are sunk. Consider only
  incremental / relevant costs.

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Joint Products Sell or Process Further

• If a production process can result in two or more
  products, how do we allocate costs between/among
  them?
• Common allocation method is relative sales value
  method in which costs are allocated based on
  their sales values at the split-off point
• See pg. 619 for illustration of relative sales
  value allocation

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Joint Costs (2)

• Butwhen deciding whether to sell a product at
  split-off point, or whether to process it
  further, remember that the joint cost has
  already been incurredit is already sunk.
• Consider only incremental revenue from processing
  further less incremental (separable) processing
  costs required to earn that incremental revenue!
  (see pg. 620)

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Pitfalls to avoid in cost allocation

• Sunk costsignore them!
• Unitized fixed costs (FC per unit) bewaremay
  be a way to hide sunk costs
• Allocated fixed costsbewareidentify the
  avoidable costs, others are sunk
• Opportunity costsdont ignore these! Be sure to
  include in your analysis.

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Stop for Class Exercises