1
CHAPTER 11
RELEVANT COSTS FOR
DECISION MAKING
Five-Step Decision-Making Process
Step 1:
Obtain
Information
Step 2:
Make
Predictions
About
Future
Costs
Step 3:
Choose
An
Alternative
Feedback
Step 4:
Implement
The
Decision
Step 5:
Evaluate
Performance
Requirements for accounting information
3
Accounting information is useful for decision
making if it is
Reliable,
Timely,
Relevant.
Relevant cost
A relevant cost is a cost that differs
between alternatives.

There are 3 main recognition criteria:
• Cash-flows
• Future costs
• Incremental costs
Mr. Kiệm’s journey
5

Mr. Kiệm bought a Hue - Hanoi return ticket from Vietnam
airlines. He arrived at Hanoi on Monday and will return to
Hue on Friday. He doesn’t know that his company’s
leaders flew to Hanoi in this week and are going to fly back
to Hue on Friday, too. Mr. Kiệm thought that he should
help his company save some money so he required
Vietnam Airlines to refund his return ticket and flew in his
company’s helicopter. Is his decision correct?
 Is cost of the Hanoi – Hue journey by the company’s
helicopter relevant?
 Is cost of the Hanoi – Hue journey by Vietnam Airlines
relevant?
 What do the company’s shareholders want Mr. Kiệm to
do?
Mr. Kiệm’s journey
6
Mr. Kiệm is a manager in his company and he is
evaluated based on his division’s reporting
profit. When Mr. Kiệm received his division’s
monthly income statement, he discovered that
he was allocated cost of the Hanoi-Hue
helicopter journey twice as much as cost of
Vietnam Airlines one. Mr. Kiệm asked the
company’s accountants and knew that all
passengers were allocated the journey’s cost.
Mr. Kiệm was allocated the same cost as the
Vice President who required that journey. Is Mr.
Kiệm’s decision correct?
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)
1
2
3
4
5
6
Annual straight-line depreciation on car
Cost of gasoline
Annual cost of auto insurance and license
Maintenance and repairs
Parking fees at school
Total average cost
$45 per month × 8 months
Annual Cost
of Fixed Items
$
2,800
1,380
360
Cost per
Mile
$
0.280
0.050
0.138
0.065
0.036
$
0.569
$1.60 per gallon ÷ 32 MPG
$18,000 cost – $4,000 salvage value ÷ 5 years
Identifying Relevant Costs
Automobile Costs (based on 10,000 miles driven per year)
1
2
3
4
5
6
Annual straight-line depreciation on car
Cost of gasoline
Annual cost of auto insurance and license
Maintenance and repairs
Parking fees at school
Total average cost
7
8
9
10
11
12
13
Annual Cost
of Fixed Items
$
2,800
1,380
360
Cost per
Mile
$
0.280
0.050
0.138
0.065
0.036
$
0.569
Some Additional Information
Reduction in resale value of car per mile of wear
Round-tip train fare
Benefits of relaxing on train trip
Cost of putting dog in kennel while gone
Benefit of having car in New York
Hassle of parking car in New York
Per day cost of parking car in New York
$ 0.026
$
104
????
$
40
????
????
$
25
Types of Decisions






One-Time-Only Special Orders
Make or Buy
Insourcing vs. Outsourcing
Branch / Segment: Adding or Discontinuing
Product-Mix (Utilization of constraint resources)
Equipment Replacement
One-Time-Only Special Orders


Accepting or rejecting special orders when there is
idle production capacity and the special orders has
no long-run implications
Decision Rule: does the special order generate
additional operating income?
 Yes
– accept
 No – reject

Compares relevant revenues and relevant costs to
determine profitability
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
Increase in revenue
Increase in costs
Increase in net income
Quick Check 
Northern Optical ordinarily sells the X-lens for $50.
The variable production cost is $10, the fixed
production cost is $18 per unit, and the variable
selling cost is $1. A customer has requested a special
order for 10,000 units of the X-lens to be imprinted
with the customer’s logo. This special order would not
involve any selling costs, but Northern Optical would
have to purchase an imprinting machine for $50,000.
(see the next page)
Quick Check 
What is the rock bottom minimum price below which
Northern Optical should not go in its negotiations with
the customer? In other words, below what price would
Northern Optical actually be losing money on the
sale? There is ample idle capacity to fulfill the order.
a. $50
b. $10
c. $15
d. $29
Quick Check 
A company is evaluating an one-off contract that requires two
types of material (T and V). Data relating to the material
requirements are as follows:
Material
Quantity needed
type
for project
T
V
kg
500
400
Quantity
currently
in stock
kg
100
200
Original cost of
quantity in stock
£/kg
40
55
Current
Current
purchase resale
price
price
£/kg
45
52
£/kg
44
40
Material T is regularly used by the company in normal production. Material V is
no longer in use by the company and has no alternative use within the business.
What is the total relevant cost of materials for the contract?
A £40,400
B £40,900
C £43,400
D £43,900
Quick Check 
All of a company's skilled labour, which is paid £8 per hour, is fully employed
manufacturing a product to which the following data refer:
£ per unit
£ per Unit
Selling price
60
Less Variable costs:
Skilled labour
20
Others
15
(35)
Contribution
25
The one-off contract requires 90 skilled labour hours to complete. No other
supplies of skilled labour are available.
What is the total relevant skilled labour cost of the contract?
A £720
B £900
C £1,620
D £2,160
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.
Let’s look at Rạng Đông Company example.
The Make or Buy Decision


Rạng Đông manufactures thermos-flask. Department
A manufactures silvered inner containers.
The unit product cost of this part is:
Direct materials
Direct labor
Variable overhead
Depreciation of special equip.
Supervisor's salary
General factory overhead
Unit product cost
$
9
5
1
3
2
10
$ 30
The Make or Buy Decision




The special equipment used to manufacture inner
containers 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 units
produced each year.
A Chinese supplier has offered to provide the 20,000
units at a cost of $25 per unit.
Should we accept the supplier’s offer?
The Make or Buy Decision
Cost
Per
Unit
Outside purchase price
$ 25
Direct materials
Direct labor
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost
$
9
5
1
3
2
10
$ 30
Cost of 20,000 Units
Buy
Make
$ 500,000
$
-
$ 500,000
Should we make or buy inner containers?
The Make or Buy Decision
DECISION RULE
In deciding whether to accept the outside
supplier’s offer, Rạng Đông 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.
Adding/Dropping Segments
One of the most important decisions managers make
is whether to add or drop a business segment such
as a product or a store.
Let’s see how relevant costs should be
used in this decision.
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. An income
statement for last year is shown on the next
screen.
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales
Less: variable expenses
Variable manufacturing costs
Variable shipping costs
Commissions
Contribution margin
Less: fixed expenses
General factory overhead
Salary of line manager
Depreciation of equipment
Advertising - direct
Rent - factory space
General admin. expenses
Net operating loss
$ 500,000
$ 120,000
5,000
75,000
$ 60,000
90,000
50,000
100,000
70,000
30,000
200,000
$ 300,000
400,000
$ (100,000)
Adding/Dropping Segments
• Investigation has revealed that total fixed general
factory overhead and general administrative expenses
would not be affected if the digital watch line is
dropped.
• The fixed general factory overhead and general
administrative expenses assigned to this product
would be reallocated to other product lines.
• The equipment used to manufacture digital watches
has no resale value or alternative use.
Should Lovell retain or drop
the digital watch segment?
A Contribution Margin Approach
DECISION RULE
Lovell should drop the digital watch segment only if
its profit would increase. This would only happen if
the fixed cost savings exceed the lost contribution
margin.
Let’s look at this solution.
A Contribution Margin Approach
Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped
Less fixed costs that can be avoided
Net disadvantage
$
-
Comparative Income Approach
The Lovell solution can also be obtained by preparing
comparative income statements showing results with
and without the digital watch segment.
Let’s look at this second approach.
Comparative Income Approach
Solution
Keep
Drop
Digital
Digital
Watches
Watches
Sales
$ 500,000
$
Less variable expenses:
Manufacturing expenses
120,000
Shipping
5,000
Commissions
75,000
Total variable expenses
200,000
Contribution margin
300,000
Less fixed expenses:
General factory overhead
60,000
Salary of line manager
90,000
Depreciation
50,000
Advertising - direct
100,000
Rent - factory space
70,000
General admin. expenses
30,000
Total fixed expenses
400,000
Net operating loss
$ (100,000)
Difference
$ 500,000
120,000
5,000
75,000
200,000
300,000
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.
Let’s look at the Ensign Company example.
Utilization of a Constrained Resource
Ensign Company produces two products and selected
data is shown below:
Product
2
1
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
$
60
36
$ 24
2,000
40%
1.00 min.
$
50
35
$ 15
2,200
30%
0.50 min.
Utilization of a Constrained Resource



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 2?
Quick Check 
How many units of each product can
be processed through Machine A1 in
one minute?
Product 1
a.
b.
c.
d.
1
1
2
2
unit
unit
units
units
Product 2
0.5
2.0
1.0
0.5
unit
units
unit
unit
Quick Check 
What generates more profit for the company, using
one minute of machine A1 to process Product 1 or
using one minute of machine A1 to process Product 2?
a. Product 1
b. Product 2
c. They both would generate the same profit
d. Cannot be determined
Utilization of a Constrained Resource
The key is the contribution margin per unit of the
constrained resource.
Product
1
Contribution margin per unit
Time required to produce one unit
Contribution margin per minute
$
÷
2
24
$
15
1.00 min. ÷
0.50 min.
$ 24 min.
$ 30 min.
Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting Our Constrained Recource (Machine A1)
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
×
units
min.
min.
÷
min.
min.
min.
min.
units
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
$
24
$ 31,200
The total contribution margin for Ensign is $64,200.
Product 2
2,200
$
15
$ 33,000
Linear programming – multiple
constrained resources
Linear programming is a technique for solving problems of profit
maximisation or cost minimisation and resource allocation.
 Usefull in the cases of multiple constrained resources
Steps:
1. Define variables
2. Establish constraints
3. Construction objective function
4. Graph the constraints
5. Establish feasible region
6. Add iso-profit/contribution line
7. Determine optimal solution
Utilization of a Constrained Resource
39





Units of product 1 = X; Units of product 1 = Y
X + 0,5Y <(=)2400
Contribution = 24X +15Y
X< (=)2000; Y<(=)2200
X>=0; Y>=0
Utilization of a Constrained Resource
40
X
Y<(=)2200
Area of feasible solutions
24X+15Y
X + 0,5Y<(=)2400
2400
X <(=)2000
2000
Y
2200
4800
Quick Check 
Colonial Heritage makes reproduction colonial
furniture from select hardwoods.
Chairs
Selling price per unit
$80
Variable cost per unit
$30
Board feet per unit
2
Monthly demand
600
Tables
$400
$200
10
100
The company’s supplier of hardwood will only be
able to supply 2,000 board feet this month. Is this
enough hardwood to satisfy demand?
a. Yes
b. No
Quick Check 
Chairs
Selling price per unit
$80
Variable cost per unit
$30
Board feet per unit
2
Monthly demand
600
Tables
$400
$200
10
100
The company’s supplier of hardwood will only be able to
supply 2,000 board feet this month. What plan would
maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
Quick Check 
As before, Colonial Heritage’s supplier of hardwood will
only be able to supply 2,000 board feet this month.
Assume the company follows the plan we have proposed.
Up to how much should Colonial Heritage be willing to
pay above the usual price to obtain more hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero
Managing Constraints
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 acquire
more machines
• Subcontract production
Sell or Process Further
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.
Let’s look at the Sawmill, Inc. example.
Sell or Process Further



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 “prestologs.”
Sell or Process Further
Data about Sawmill’s joint products includes:
Sales value at the split-off point
Sales value after further processing
Allocated joint product costs
Cost of further processing
Per Log
Lumber
Sawdust
$
140
$
40
270
88
50
50
12
20
Sell or Process Further
Analysis of Sell or Process Further
Per Log
Lumber
Sales value after further processing
Sales value at the split-off point
Incremental revenue
Cost of further processing
Profit (loss) from further processing
Sawdust
Equipment-Replacement Decisions

Sometimes difficult due to amount of information at
hand that is irrelevant:
 Cost,
Accumulated Depreciation and Book Value of
existing equipment
 Any potential Gain or Loss on the transaction – a
Financial Accounting phenomenon only

Decision Rule: Select the alternative that will
generate the highest operating income
Equipment-Replacement Decisions





In 2013 Honda Vietnam bought an Asimo robot system
used in Assembly department. The acquisition cost is
VND 2.1 billions. The estimated useful life is 6 years.
In 2014 there is a new version of Asimo robots which is
much more efficient than the old one. The company
can save 70% of annual operating costs if it uses the
new version.
The purchase price of the new version is VND 4
billions. The estimated useful life is 5 years.
If the company buy the new vesion, the current robot
system can be disposed at the value of VND 1 bil.
The current annual operating cost is VND 900 millions.
Should Honda Vietnam buy the new version?
50
End of Chapter 11