Unit 10
Short-Term Decision Making
Reporters: Axel Rose Jimenez & Rizelle Gutierrez
Learning
Objective 1
Identify relevant and irrelevant
costs and benefits in a
Decision.
COST CONCEPTS FOR DECISION MAKING
• Relevant costs are those
costs that will make a
difference in a decision.
Relevant costs are future
costs that will differ
among alternatives.
COST CONCEPTS FOR DECISION MAKING
• Avoidable Cost is a cost
that can be eliminated in
whole or in part by
choosing one alternative
over another.
COST CONCEPTS FOR DECISION MAKING
•Avoidable Costs are
relevant costs.
•Unavoidable costs
are irrelevant costs.
COST CONCEPTS FOR DECISION MAKING
• Sunk Cost is a cost that
has already been incurred
and cannot be changed
by any decision made
now or in the future.
COST CONCEPTS FOR DECISION MAKING
• Differential Cost is any
cost that differs between
alternatives in a decisionmaking situation.
• This term is synonymous
with avoidable cost and
relevant cost.
To identify the costs that are avoidable in a
particular decision situation and are therefore
relevant, these steps should be followed:
1. Eliminate costs and benefits that do not differ
between alternatives. These irrelevant costs
consist of (a) sunk costs and (b) future costs that
do not differ between alternatives.
2. Use the remaining costs and benefits that do
differ between alternatives in making the
decision. The costs that remain are the
differential, or avoidable, costs.
IDENTIFYING RELEVANT COSTS & BENEFITS
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
$
0.100
0.138
0.065
0.036
$
0.619
$2.70 per gallon ÷ 27 MPG
$24,000 cost – $10,000 resale value ÷ 5 years
IDENTIFYING RELEVANT COSTS
Automobile Costs
1
2
3
4
5
6
7
8
9
10
11
12
13
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
Annual Cost
of Fixed Items
$
2,800
1,380
360
Additional Data
Reduction in resale value of car per mile of wear
Round-trip 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
Cost per
Mile
$
0.280
0.100
0.138
0.065
0.036
$
0.619
$ 0.026
$
104
?
$
40
?
?
$
25
IDENTIFYING RELEVANT COSTS
Which costs and benefits are relevant in Cynthia’s decision?
The cost of the car is a
sunk cost and is not
relevant to the current
decision.
The annual cost of
insurance is not relevant.
It will remain the same if
she drives or takes the
train.
However, the cost of gasoline is clearly relevant if she decides to drive. If
she takes the drive the cost would now be incurred, so it varies depending
on the decision.
IDENTIFYING RELEVANT COSTS
Which costs and benefits are relevant in Cynthia’s decision?
The cost of maintenance and repairs
is relevant. In the long-run these
costs depend upon miles driven.
The monthly school
parking fee is not relevant
because it must be paid if
Cynthia drives or takes the
train.
At this point, we can see that some of the average cost of $0.619 per mile are
relevant and others are not.
IDENTIFYING RELEVANT COSTS
Automobile Costs
1
2
3
4
5
6
7
8
9
10
11
12
13
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
Annual Cost
of Fixed Items
$
2,800
1,380
360
Additional Data
Reduction in resale value of car per mile of wear
Round-trip 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
Cost per
Mile
$
0.280
0.100
0.138
0.065
0.036
$
0.619
$ 0.026
$
104
?
$
40
?
?
$
25
IDENTIFYING RELEVANT COSTS
Which costs and benefits are relevant in Cynthia’s decision?
The decline in resale value due to
additional miles is a relevant cost.
Relaxing on the train is relevant
even though it is difficult to assign a
dollar value to the benefit.
The round-trip train fare is clearly
relevant. If she drives the cost can
be avoided.
The kennel cost is not relevant
because Cynthia will incur the cost if
she drives or takes the train.
IDENTIFYING RELEVANT COSTS
Which costs and benefits are relevant in Cynthia’s decision?
The cost of parking is relevant
because it can be avoided if she
takes the train.
The benefits of having a car in New York and the problems of finding a
parking space are both relevant but are difficult to assign a dollar
amount.
IDENTIFYING RELEVANT COSTS
From a financial standpoint, Cynthia would be better off taking the
train to visit her friend. Some of the non-financial factor may
influence her final decision.
Relevant Financial Cost of Driving
Gasoline (460 x $0.100 per mile)
Maintenance (460 x $0.065 per mile)
Reduction in resale (460 x $0.026 per mile)
Parking in New York (2 days x $25 per day)
Total
$
46.00
29.90
11.96
50.00
$ 137.86
Relevant Financial Cost of Taking the Train
Round-trip ticket
$ 104.00
TOTAL AND DIFFERENTIAL APPROACHES
Oak Harbor Woodworks is considering a new labor-saving machine that rents for $3,000 per
year. Data about the company’s annual sales and costs with and without the new machine are:
TOTALAND DIFFERENTIALCOST APPROACHES
•
•
As you see, the only costs that differ between the- alternatives
are the direct labor costs savings and the increase in fixed rental
costs.
We can efficiently analyze the decision by looking at the different
costs and revenues and arrive at the same solution
Learning
Objective 2
Prepare an analysis
showing whether a
product line or other
business segment
should be dropped or
retained.
Adding and Dropping Product
Lines and Other Segments
As a rule, product lines or business segments should be evaluated
based on traceable revenues and costs. Allocated fixed costs should
be removed from the analysis of income since the company will
incur in the entire amount with or without the product line or
segment. 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.
EXHIBIT
13-2
Discount
Drug
Company
Product
Lines
Exhibit 13–2 provides sales and cost information for the preceding month for the
Discount Drug Company and its three major product lines—drugs, cosmetics, and
housewares. A quick review of this exhibit suggests that dropping the housewares
segment would increase the company’s overall net operating income by $8,000.
However, this would be a flawed conclusion because the data in Exhibit 13–2 do not
distinguish between fixed expenses that can be avoided if a product line is dropped and
common fi xed expenses that cannot be avoided by dropping any particular product line.
EXHIBIT
13-2
Discount
Drug
Company
Product
Lines
If the housewares line is dropped, then the company will lose $20,000 per month in
contribution margin, but by dropping the line it may be possible to avoid some fixed
costs such as salaries or advertising costs. If dropping the housewares line enables the
company to avoid more in fixed costs than it loses in contribution margin, then its overall
net operating income will improve by eliminating the product line. On the other hand, if
the company is not able to avoid as much in fixed costs as it loses in contribution margin,
then the housewares line should be kept.
EXHIBIT
13-2
Discount
Drug
Company
Product
Lines
In short, the manager should ask,
“What costs can I avoid if I drop this
product line?”
With this information, management can
determine that $15,000 of the fixed expenses
associated with the housewares product line are
avoidable and $13,000 are not.
Dropping the housewares product line
would result in a $5,000 reduction in net
operating income.
EXHIBIT 13-3
A Comparative
Format for
Product-Line
Analysis
In this case, the fixed costs that can be avoided by dropping the
housewares product line ($15,000) are less than the contribution margin
that will be lost ($20,000). Therefore, based on the data given, the
housewares line should not be discontinued unless a more profitable use
can be found for the floor and counter space that it is occupying.
EXHIBIT 13-3
A Comparative
Format for
Product-Line
Analysis
A Comparative Format
This decision can also be approached by preparing comparative income
statements showing the effects of either keeping or dropping the product line.
Exhibit 13–3 contains such an analysis for the Discount Drug Company. As
shown in the last column of the exhibit, if the housewares line is dropped, then
overall company net operating income will decrease by $5,000 each period.
BEWARE OF ALLOCATED FIXED COSTS
Why should we keep the
housewares segment when
it’s showing a loss?
BEWARE OF ALLOCATED FIXED COSTS
The answer lies in the
way we allocate
common fixed costs to
our products.
BEWARE OF ALLOCATED FIXED COSTS
Our allocations
can make a
segment look
less profitable
than it really is.
Learning
Objective 3
Prepare a make or buy
analysis
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.
The company Mountain Goat Cycles, is now producing the heavy-duty gear shifters
used in its most popular line of mountain bikes. The company’s Accounting
Department reports the following costs of producing 8,000 units of the shifter
internally each year:
An outside supplier has offered to
sell 8,000 shifters a year to
Mountain Goat Cycles at a price of
only $19 each. Should the
company stop producing the
shifters internally and buy them
from the outside supplier?
The Make or Buy Decision
8,000 × $19 per unit =
$152,000
The Make or Buy Decision
The equipment has no salvage value and is a sunk cost.
The Make or Buy Decision
Irrelevant because they do not differ
between the make or buy alternatives
The Make or Buy Decision
Should Mountain Goat Cycles make or buy Shifters?
The Make or Buy Decision
Because it costs $40,000 less to make the shifters internally than to buy
them from the outside supplier, Mountain Goat Cycles should reject the
outside supplier’s offer.
OPPORTUNITY COST
Assume that the space now being used to produce shifters could be
used to produce a new cross-country bike that would generate a
segment margin of $60,000 per year.
Under these conditions, Mountain Goat Cycles should accept the
supplier’s offer and use the available space to produce the new
product line.
• Opportunity costs are not recorded in the organization’s general ledger because
they do not represent actual dollar outlays.
• They represent economic benefits that are forgone as a result of pursuing some
course of action.
• The opportunity cost for Mountain Goat Cycles is suffi ciently large in this case to
change the decision.
Learning
Objective 4
Prepare an analysis
showing whether a
special order should
be accepted.
Special Orders
A special order is a one-time order that is not considered part of the company’s
normal ongoing business.
To illustrate, Mountain Goat Cycles has just received a request from the
Seattle Police Department to produce 100 specially modified mountain
bikes at a price of $558 each. The bikes would be used to patrol some of
the more densely populated residential sections of the city. Mountain
Goat Cycles can easily modify its City Cruiser model to fit the
specifications of the Seattle Police. The normal selling price of the City
Cruiser bike is $698, and its unit product cost is $564 as shown below:
Modifications requested by the Seattle Police Department consist of
welded brackets to hold radios, nightsticks, and other gear. These
modifications would require $34 in incremental variable costs.
In addition, the company would have to pay a graphics design studio
$2,400 to design and cut stencils that would be used for spray painting the
Seattle Police Department’s logo and other identifying marks on the bikes.
What effect would accepting this order have on the
company’s net operating income?
• Only the incremental costs and benefits are relevant
• The existing fixed manufacturing overhead costs would not be affected by the order,
so they are not relevant.
Therefore, even though the $558 price on the special order is below the normal $564 unit
product cost and the order would require additional costs, the order would increase net
operating income.
Learning
Objective 5
Determine the most
profitable use of a
constrained resource
and the value of
obtaining more of the
constrained resource.
Utilization of a Constrained Resource
•Companies usually have limited resources, such as limits on
space, on the number of workers, or even on the machine
capacity needed to produce goods. This reality means that in
order to best use limited production capabilities, managers must
choose which products to make and sell.
•Managerial accountants use a simple technique of dividing
contribution margin by a measure of the constrained resource to
indicate which products squeeze the most profitability out of
constrained resources.
•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.
Contribution Margin per Unit of the
Constrained Resource
In addition to its other products, Mountain Goat Cycles makes
saddlebags for bicycles called panniers. These panniers come in two
models—a touring model and a mountain model. Cost and revenue data
for the two models of panniers follow:
Utilization of a Constrained Resource
•
•
•
•
At Mountain Goat Cycles, the constraint is a stitching machine
The mountain pannier requires 2 mins. of stitching time per unit
The touring pannier requires 1 min. of stitching time per unit
The stitching machine is a bottleneck, the stitching machine
does not have enough capacity to satisfy the existing demand
for mountain panniers and touring panniers
Which product is less profitable and
should be deemphasized?
Contribution Margin per Unit of the
Constrained Resource
The key is the contribution margin per unit of the constrained resource.
Touring Pannier should be emphasized. Provides the larger contribution
margin in relation to the constrained resource stitching machine,
yielding a contribution margin of $12.00 per minute as opposed to
$7.50 per minute of Mountain Pannier.
Contribution Margin per Unit of the
Constrained Resource
To verify that the touring model is indeed the more profitable product, suppose an
hour of additional stitching time is available and that unfilled orders exist for both
products.
The additional hour on the stitching machine could be used to make either
 30 mountain panniers (60 minutes/2 minutes per mountain pannier) or
 60 touring panniers (60 minutes 1 minute per touring pannier)
Contribution Margin per Unit of the
Constrained Resource
Because the additional contribution margin would be $720 for the
touring panniers and only $450 for the mountain panniers, the
touring panniers make the most profitable use of the company’s
constrained resource—the stitching machine.
MANAGING CONSTRAINTS
• Constraints are anything that
limits a system from achieving
higher performance. On the
highway, accidents that prevent
you from driving 65 miles per
hour to work in the morning are
constraints.
Constraints can
occur in any process, whether
in manufacturing or service
industries.
Learning
Objective 6
Determine the most
profitable use of a
constrained resource
and the value of
obtaining more of the
constrained resource.
Joint Product Costs and the
Contribution Approach
• In accounting, a joint cost is a cost
incurred in a joint process. Joint costs
may include direct material, direct
labor, and overhead costs incurred
during a joint production process.
• A joint process is a production process
in which one input yields multiple
outputs. It is a process in which seeking
to create one type of output product
automatically also creates other types
of output product.
• 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.
Joint Product Costs and the Contribution Approach
The company, Santa Maria
Wool Cooperative, buys
raw wool from local
sheepherders, separates
the wool into three
grades—coarse, fine, and
superfine—and then dyes
the wool using traditional
methods that rely on
pigments from local
materials.
At Santa Maria Wool
Cooperative, coarse wool,
fi ne wool, and superfine
wool are produced from
one input—raw wool.
Joint Product Costs and the Contribution Approach
The joint costs are the
$200,000 cost of the raw
wool and the $40,000 cost
of separating the wool.
The undyed wool is called
an intermediate product
because it is not finished
at this point.
Nevertheless, a market
does exist for undyed
wool—although at a
significantly lower
price than finished, dyed
wool
THE PITFALLS OF ALLOCATION
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.
Sell or Process Further Decisions
It is profitable to continue processing a joint product
after the split-off point so long as the incremental
revenue from such processing exceeds the
incremental processing cost incurred after the split-off
point. Joint costs that have already been incurred up to
the split-off point are always irrelevant in decisions
concerning what to do from the split-off point forward.
To provide a detailed example of the sell or process
further decision, return to the data for Santa Maria
Wool Cooperative in Exhibit 13–6.
Sell or Process Further Decisions
Is the company making
money if it runs the entire
process from beginning to
end?
Sell or Process Further Decisions
Assuming there are no costs other than those displayed in Exhibit 13–6,
the company is indeed making money as follows:
•
•
Joint costs of buying the wool and separating the wool are relevant when
considering the profitability of the entire operation because these joint costs could
be avoided if the entire operation were shut down.
These joint costs are not relevant when considering the profitability of any one
product
Sell or Process Further Decisions
If the company buys wool and runs the separation process, it will get all three
intermediate products. Each of these products can be sold as is without further
processing. It may be that the company would be better off selling one or more
of the products prior to dyeing to avoid the dyeing costs. The appropriate way to
make this choice is to compare the incremental revenues to the incremental
costs from further processing as follows:
Sell or Process Further Decisions
The company would be better off selling the undyed coarse wool as
is rather than processing it further. The other two products should
be processed further and dyed before selling them.
Sell or Process Further Decisions
 The joint costs of the wool ($200,000) and of the wool separation process ($40,000)
play no role in the decision to sell or further process the intermediate products.
 These joint costs are relevant in a decision of whether to buy wool and to run the wool
separation process, but they are not relevant in decisions about what to do with the
intermediate products once they have been separated.