Chapter 12
Cost Concepts for Decision Making
A relevant cost is a cost that differs
between alternatives.
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.
Current and future costs that do not differ between the
alternatives.
Differential Revenues and Costs
Example: You have a job paying $1,500 per month in your
hometown. You have a job offer in a neighboring city that
pays $2,000 per month. The commuting cost to the city is
$300 per month.
Differential revenue:
$2,000 – $1,500 = $500
Differential cost:
$300
Net benefit:
$200
Opportunity Costs
The potential benefit that is
given up when one
alternative is selected over
another.
Example: If you were
not attending college,
you could be earning
$15,000 per year delivering
pizzas.
Your opportunity cost
of attending college for one
year is $15,000.
The Matter of Opportunity Cost
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.
Sunk Costs
Sunk costs cannot be changed by any decision. They are
not differential costs and should be ignored when
making decisions.
Example: You bought an automobile that cost
$10,000 two years ago. The $10,000 cost is sunk
because whether you drive it, park it, trade it, or
sell it, you cannot change the $10,000 cost.
Adding/Dropping Segments
One of the most important decisions managers
make is whether to add or drop a business
segment such as a product line, a store, or a
division.
Adding/Dropping Segments
DECISION RULE
A company should drop a segment
only if its fixed cost savings exceed
lost contribution margin.
Adding/Dropping Segments
DECISION RULE
Eliminate the segment only if overall profit
would increase.
Compare the contribution margin that would
be lost to the costs that would be avoided if
the segment is to be dropped.
Beware of Allocated Fixed Costs
Allocations can make
a segment look less
profitable than it
really is.
Differential Approach
Compare benefits of alternative(s)
under consideration to
related costs.
Focus only on relevant costs.
Comparative Income Statement
Approach
The solution can also be obtained by
preparing comparative income statements
showing results with and without the
segment.
Differential and Comparative Cost Approaches
The management of a company is considering a new labor saving machine
($15,000 in savings) that rents for $3,000 per year. Data about the
company’s annual sales and costs with and without the new machine are:
Sales (5,000 units @ $40 per unit)
Less variable expenses:
Direct materials (5,000 units @ $14 per unit)
Direct labor (5,000 units @ $8 and $5 per unit)
Variable overhead (5,000 units @ $2 per unit)
Total variable expenses
Contribution margin
Less fixed expense:
Current
Situation
$
200,000
Situation
With New
Machine
$
200,000
Differential
Costs and
Benefits
-
70,000
40,000
10,000
120,000
80,000
70,000
25,000
10,000
105,000
95,000
15,000
15,000
15,000
Differential and Comparative Cost Approaches
As you can see, the only costs that differ between the alternatives
are the direct labor costs savings and the increase in fixed rental
costs.
Situation
With New
Machine
$
200,000
Current
Situation
$
200,000
Sales (5,000 units @ $40 per unit)
Less variable expenses:
We can
analyze the70,000
decision by70,000
Direct materials (5,000
unitsefficiently
@ $14 per unit)
Direct labor (5,000
units @ at
$8 and
per unit) costs and
40,000
looking
the $5
different
revenues25,000
Variable overhead (5,000 units @ $2 per unit)
10,000
10,000
Total variable expenses and arrive at the same solution
120,000
105,000
Contribution margin
80,000
95,000
Net
Advantage
to
Renting
the
New
Machine
Less fixed expense:
Decrease in direct labor costs (5,000 units @ $3 per unit)
$
15,000
Other
62,000
62,000
Increase in fixed rental expenses
(3,000)
Rent on newNet
machine
3,000
annual cost saving from renting the new machine
$
12,000
Total fixed expenses
62,000
65,000
Net operating income
$
18,000
$
30,000
.
Differential
Costs and
Benefits
15,000
15,000
(3,000)
(3,000)
12,000
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 Make or Buy Decision
DECISION RULE
In deciding whether to accept an outside
supplier’s offer, isolate 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.
– Then compare the result to the supplier’s offer.
Special Orders
A special order is a one-time
order that is not considered part
of the company’s normal ongoing
business.
When analyzing a special order,
only the incremental costs and
benefits are relevant.
Since existing fixed
manufacturing overhead costs
would not be affected by the
order, they are not relevant.
Special Orders
Decision Rule
Accept the order if it results in positive
contribution margin and does not disrupt
the pricing of regular products.
Constrained Resources
When a limited resource of
some type restricts the
company’s ability to satisfy
demand, the company is
said to have a constraint.
The machine or process
that is limiting overall
output is called the
bottleneck – it is the
constraint.
Utilization of a Constrained
Resource-Decision Rule
•
•
•
When a constraint exists, a company should
select a product mix that maximizes the total
contribution margin earned since fixed costs
usually remain unchanged.
A company should not necessarily promote
those products that have the highest unit
contribution margin.
Rather, it should promote those products that
earn the highest contribution margin in relation
to the constraining resource.
Utilization of a Constrained
Resource: An Example
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
• Time on Machine A1 is the constrained
resource which 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?
Utilization of a Constrained
Resource
The key is the contribution margin per unit of the
constrained resource.
Product
2
1
Contribution margin per unit
Time required to produce one unit
Contribution margin per minute
$
÷
24
1.00 min. ÷
$
24
$
15
0.50 min.
$
30
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.
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.
Joint Products
Joint
Costs
Joint
Input
Common
Production
Process
Engine Oil
Gasoline
Chemicals
Split-Off
Point
Separate
Processing
Final
Sale
Final
Sale
Separate
Processing
Separate
Product
Costs
Final
Sale
Sell or Process FurtherDecision Rule
Joint costs are irrelevant in decisions
regarding what to do with a product from
the split-off point forward.
It will always be profitable to continue
processing a joint product after the splitoff point so long as the incremental
revenue exceeds the incremental
processing costs incurred after the split-off
point.
Sell or Process Further:
An Example
• 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
176
50
50
24
20
Sell or Process Further
Analysis of Sell or Process Further
Per Log
Sales value after further processing
Sales value at the split-off point
Incremental revenue
Cost of further processing
Profit (loss) from further processing
Lumber
Sawdust
$
$
$
270
140
130
50
80
$
50
40
10
20
(10)
End of Chapter 12