Relevant%20Cost%20Decisions

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Relevant Cost Decisions

• DECISION MAKING IN THE SHORT TERM

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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.

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Five-Step Decision-Making Process
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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.

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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

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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

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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 long-run 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
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Special Orders

• If Acki accepts the offer, net income will
  increase by TL 12.000.

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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Potential Problems with Relevant-Cost Analysis

• Avoid incorrect general assumptions about
  information, especially
• All variable costs are relevant and all fixed
  costs are irrelevant
• There are notable exceptions for both costs

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Potential Problems with Relevant-Cost Analysis

• Problems with using unit-cost data
• Including irrelevant costs in error
• Using the same unit-cost with different output
  levels
• Fixed costs per unit change with different levels
  of output

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Avoiding Potential Problems with Relevant-Cost
Analysis

• Focus on Total Revenues and Total Costs, not
  their per-unit equivalents
• Continually evaluate data to ensure that they
  meet the requirements of relevant information

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Insourcing vs. Outsourcing

• Insourcing producing goods or services within
  an organization
• Outsourcing purchasing goods or services from
  outside vendors
• Also called the Make or Buy decision
• Decision Rule Select the option that will
  provide the firm with the lowest cost, and
  therefore the highest profit.

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Qualitative Factors

• Nonquantitative factors may be extremely
  important in an evaluation process, yet do not
  show up directly in calculations
• Quality Requirements
• Reputation of Outsourcer
• Employee Morale
• Logistical Considerations distance from plant,
  etc.

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Opportunity Costs

• Opportunity Cost is the contribution to operating
  income that is forgone by not using a limited
  resource in its next-best alternative use
• How much profit did the firm lose out on by
  not selecting this alternative?
• The economic benefits that are foregone as a
  result of pursuing some course of action.
  Opportunity costs are not actual dollar outlays
  and are not recorded in the accounts of an
  organization.
• Special type of Opportunity Cost Holding Cost
  for Inventory. Funds tied up in inventory are
  not available for investment elsewhere

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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

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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
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

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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 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.

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.

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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.

The total contribution margin for UM is TL 64,200.
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Managing Constraints
Produce only what can be sold.
Finding ways to process more units through a
resource bottleneck
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 DiscontinuingBranches 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
Should the company drop digital instruments
division?
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
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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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
Oil
Common Production Process
Joint Input
Gasoline
Chemicals
Split-Off Point
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Joint Products
Joint Costs
Final Sale
Separate Processing
Oil
Common Production Process
Joint Input
Final Sale
Gasoline
Separate Processing
Final Sale
Chemicals
Separate Product Costs
Split-Off Point
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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

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Sell or Process Further
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 self-serving behavior
  such as delaying needed equipment maintenance in
  order to meet their personal profitability quotas
  for bonus consideration