ACCT 2302
Fundamentals of Accounting II
Spring 2011
Lecture 17
Professor Jeff Yu
Chapter 13: Relevant Costs
Relevant costs are those costs that differ between two (or
more) decision alternatives.
An avoidable cost can be eliminated (in whole or in part)
by choosing one alternative over another.
Avoidable costs are relevant costs. Unavoidable costs are
irrelevant costs.
Relevant Cost = Avoidable Cost = Differential Cost
Relevant Cost Analysis
A Two-Step Process:
 Step 1: Eliminate costs and benefits that DO NOT differ
between alternatives.
Examples:
(1) Sunk costs;
(2) Future costs that do not differ between alternatives
 Step 2: Use the remaining costs and benefits that DO differ
between alternatives (Differential Costs and Benefits) in
making the decision.
Practice Problem: Equipment Replacement
A manager at White Co. wants to replace an old machine with a new
machine. The old machine’s original cost was $72,000. Currently, it has a
5-year remaining life, a net book value of $60,000 and a disposal value of
$15,000. The new machine’s list price is $90,000, with a 5-year expected
life. White’s sales are $200,000 per year. Annual variable expenses are
$80,000 using the new machine and $100,000 using the old machine.
Fixed expenses, other than depreciation, are $70,000 per year.
We are thinking about replacing old equipment with more
efficient new equipment. Do you think we should?
Q: What are the relevant costs in this equipment
replacement decision? Should the old machine
be replaced with the new machine?
Decision to Add or Drop Segments
In making a decision to add or drop a segment, many qualitative
and quantitative factors must be considered. Our focus is on the
impact such a decision has on NOI.
Differential Benefit to add or retain a segment:
Segment Contribution Margin
Differential Costs to add or retain a segment :
Traceable fixed costs.
Recall: Common fixed costs are unavoidable, hence
irrelevant in the decision.
Practice Problem
Boyle Co. has two departments, Bath and Kitchen. The projected
operating results for next month is as follows:
Bath
Kitchen
Sales
$ 1,000
$ 4,000
Variable Expenses
300
1,600
Fixed Expenses
900
1,800
If the Bath department is dropped, $370 of the allocated fixed expenses
(e.g. general factory overhead and general admin. expenses) cannot be
eliminated, and the sales of the Kitchen department will decrease by
10%.
Q: How will the company’s overall NOI for next month change if the Bath
department is dropped?
Transfer Pricing Decision
A transfer price is the price charged when one segment provides
goods or services to another segment of the company.
The transfer price affects the profit measure for both the selling
segment and the buying segment.
The objective in setting transfer prices is to motivate managers to
act in the best interests of the overall company.
Negotiated Transfer Prices
Transfer price results from negotiations between the
selling and buying divisions.
Advantages:
1.
They preserve the
autonomy of the
divisions.
2.
The managers
negotiating the
transfer price are
likely to have much
better information
than others.
Range of Acceptable Transfer Prices
Upper limit is set by the
buying division.
Lower limit is set by the
selling division.
Negotiated Transfer Prices
Buyer’s perspective:
Transfer Price <= best price from outside suppliers
Or, if an outside supplier does not exist: Transfer Price <= NOI per unit
(not considering the transfer price in the calculation of NOI)
Seller’s perspective:
Transfer Price >= VC per unit + Opportunity cost per unit
Opportunity cost per unit = Total CM on lost sales / # of units transferred
Note: if some of the units transferred could have been sold to external customers
for a profit, then the opportunity cost of internal transfer is the total
contribution margin given up on lost sales.
Negotiated Transfer Prices
Minimum transfer price = VC per unit + Opportunity cost per unit
Opportunity cost depends on the idle capacity. Idle capacity is the
difference between the segment’s production capacity and its
budgeted production (meeting both external sales & inventory needs),
and by definition the idle capacity has no alternative use.
(1) If idle capacity = 0, then opportunity cost per unit = CM per unit,
minimum transfer price = Market price
(2) If idle capacity >= units transferred, then opportunity cost per unit = 0,
minimum transfer price = VC per unit
(3) If 0< idle capacity <= units transferred, then
min. transfer price = w*VC per unit + (1-w)*Market price
where the weight: w = idle capacity ÷ units transferred.
Practice Problem
The Battery Division makes a standard 12-volt battery.
Production capacity
300,000 units
Selling price per battery
$40 (to outsiders)
Variable costs per battery
$18
Fixed costs per battery
$ 7 (at 300,000 units)
The Auto Division would like to use 100,000 units of these batteries in
its X-7 model. They can buy a similar battery from an outside vendor for
$35 per unit, but only if they buy all 100,000 units.
Q: (1) If Battery division has no idle capacity, what is the lowest
acceptable transfer price? (2) If Battery division has an idle capacity of
150,000 units, what is the lowest acceptable transfer price? (3) If
Battery division only has an idle capacity of 60,000 units, what is the
lowest acceptable transfer price? (4) Identify the range of acceptable
transfer prices, if any, for the above three cases.
Evaluation: Negotiated Transfer Prices
If a transfer within a company would result in higher overall
profits for the company, there is always a range of transfer
prices within which both the selling and buying divisions
would have higher profits if they agree to the transfer.
However, if managers are evaluated against each other
rather than a reasonable benchmark, a non-cooperative
atmosphere is almost guaranteed.
Evaluation: Transfers at the Cost
Many companies set transfer prices at either
the variable cost or full (absorption) cost
incurred by the selling division.
Simple to apply, but serious drawbacks:
1. Using full cost as the transfer price can lead to decisions
that are not in the best interest of the overall company.
2. Cost-based transfer prices do not provide incentives to
control costs.
Evaluation: Transfers at Market Price
A market price approach works best when the selling
division has no idle capacity. The selling segment will not
lose anything by making the transfer, while the buying
segment will get the correct signal how much it costs the
company for the transfer to take place.
However, a market price approach does NOT work well when the
selling division has idle capacity.
Practice Problem
Hrubec Inc. operates a Pulp Division with the following data for a ton of pulp:
selling price per ton is $70, variable cost per ton is $42, fixed cost per ton
based on a capacity of 50,000 tons per year is $18. The newly acquired
Carton Division is buying 5,000 tons of pulp per year from a outside supplier
at a cost of $70 per ton less a 10% discount.
Q: (1) If Pulp Division can sell all of its pulps produced externally at $70 per ton,
can an acceptable transfer price be worked out voluntarily? What will be the
effects on the profits of the company as a whole if the CEO forces Pulp
Division to match the supplier’s price?
(2) If Pulp Division could only sell 30,000 tons of pulp each year to external
customers at $70 per ton, can an acceptable transfer price be worked out
voluntarily? Assume that due to inflexible policies, the Carton Division is
required to buy 5,000 tons of pulp each year from Pulp Division at $70 per
ton, what will be the effect on profits of the two divisions and the company as
a whole?
(3) What is the minimum transfer price if idle capacity is only 3,000 tons?
Special Order
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 the existing fixed costs would not be affected
by the order, they are not relevant.
But fixed costs traceable only to the special order
(e.g. special equipments required) are relevant.
Decision to Accept or Reject a Special Order
Similar to Transfer pricing:
With ample idle capacity . . .
Relevant costs are the variable costs associated with
the special order.
Without enough idle capacity . . .
Relevant costs: variable costs and the opportunity
cost of using the firm’s facilities for the special order.
Practice Problem
Your firm has the capacity to produce 10,000 pencils
annually. It’s December 15th. To date your firm has
produced 7,000 pencils. You don’t anticipate getting any
more regular orders until next January. A special order
comes in that offers you $5 per pencil for 2,000 pencils.
Your cost and revenue information is as follows:
Sales price per pencil
$
10
Variable cost per pencil
3
Total fixed costs
28,000
Q: Should you take this deal? What if the special order
is $5 per pencil for 4,000 pencils?
Practice Problem
Imperial Jewelers is considering a special order for 20 handcrafted
gold bracelets at $170 each as wedding party gifts. The normal
selling price for the gold bracelet is $190. To produce each gold
bracelet, DM cost is $84, DL cost is $45, variable OH cost is $4, and
fixed OH cost is $16. The special order further requires special
filigree to be applied to the bracelet, which requires additional
materials costing $2 per bracelet and buying a special tool costing
$250 that have no other use. This order would not affect the
company’s regular sales and the company have ample idle capacity
to fill this order.
Q: How will the company’s NOI change if this special order is accepted?
For Next Class
 Continue on Chapter 13
 Attempt the assigned HW problems.
Homework Problem 1
Sales
Variable costs
Contribution margin
Traceable fixed costs
Allocated common fixed costs
Net operating income (loss)
West
Division
$600,000
310,000
290,000
110,000
90,000
$ 90,000
Troy
Division
$300,000
200,000
100,000
70,000
45,000
($ 15,000)
If Troy Division is dropped, sales of West Division will decrease by 5%.
Q: if Troy Division is dropped, how would that affect the overall
company’s NOI?
Homework Problem 2
Valve Division of Collyer Inc. makes a regular valve at variable cost of
$16 per unit. The valve can be sold at market price of $30 or
transferred internally to Pump Division, which is buying 10,000
valves per year from an overseas supplier at $29 per valve.
Q:
(1) If Valve Division has ample idle capacity to handle Pump Division’s
needs, what is the acceptable range for the transfer price?
(2) What if Valve Division has 8,000 units of idle capacity?
(3) What If Valve Division has no idle capacity and $3 per unit of
variable selling expense can be avoided on internal transfers?
(4) If Valve Division receives a special order from Pump Division for
20,000 high-pressure valves, and to make these special valves,
Valve Division has to incur $20 variable cost per unit and reduce its
production of regular valves from 100,000 units to 70,000 units, what
is the lowest acceptable transfer price?