Garrison9ce_Ch12

```12-1
MANAGERIAL
ACCOUNTING
GARRISON, CHESLEY, CARROLL, WEBB, LIBBY
Relevant Costs for Decision Making
Chapter 12
PowerPoint Author:
Robert G. Ducharme, MAcc, CA
University of Waterloo, School of Accounting and Finance
12-2
Cost Concepts for Decision Making
A relevant cost is a cost that differs between
alternatives.
LO 1
12-3
Identifying Relevant Costs
An avoidable cost is a cost that can be
eliminated, in whole or in part, by choosing
one alternative over another.
Avoidable costs are relevant costs.
Unavoidable costs are irrelevant costs.
Two broad categories of costs are never
relevant in any decision. They include:
Sunk costs.
 Future costs that do not differ between the alternatives.

LO 1
12-4
Relevant Cost Analysis: A Two-Step Process
Step 1 Eliminate costs and benefits that do not differ
between alternatives.
Step 2 Use the remaining costs and benefits that
differ between alternatives in making the
decision. The costs that remain are the
differential, or avoidable, costs.
LO 1
12-5
Different Costs for Different Purposes
Costs that are
relevant in one
decision situation
may not be relevant
in another context.
LO 1
12-6
Identifying Relevant Costs
Cynthia, an Ottawa student, is considering visiting her friend in
Waterloo. She can drive or take the train. By car, it is 230 kilometers 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
LO 1
12-7
Identifying Relevant Costs
Automobile Costs (based on 10,000 kilometers 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 km
\$
0.280
0.050
0.138
0.065
0.036
\$
0.569
Reduction in resale value of car per km 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 Waterloo
Hassle of parking car in Waterloo
Per day cost of parking car in Waterloo
\$ 0.026
\$
104
????
\$
40
????
????
\$
25
LO 1
12-8
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 train,
the cost would now be incurred, so it varies
depending on the decision.
LO 1
12-9
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 \$0.569 per kilometer are relevant and others
are not.
LO 1
12-10
Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?
The decline in resale
miles is a relevant
cost.
The round-trip train
fare is clearly relevant.
If she drives the cost
can be avoided.
Relaxing on the train is
relevant even though it
is difficult to assign a
dollar value to the
benefit.
The kennel cost is not
relevant because
Cynthia will incur the
cost if she drives or
takes the train.
LO 1
12-11
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 Waterloo and
the problems of finding a parking space are
both relevant but are difficult to assign a
dollar amount.
LO 1
12-12
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 @ \$0.050 per km)
Maintenance (460 @ \$0.065 per km)
Reduction in resale (460 @ \$0.026 per km)
Parking in Waterloo (2 days @ \$25 per day)
Total
\$ 23.00
29.90
11.96
50.00
\$ 114.86
Relevant Financial Cost of Taking the Train
Round-trip ticket
\$ 104.00
LO 1
12-13
Total and Differential Cost Approaches
The management of a company is considering a new labour 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:
Sales (5,000 units @ \$40 per unit)
Less variable expenses:
Direct materials (5,000 units @ \$14 per unit)
Direct labour (5,000 units @ \$8 and \$5 per unit)
Variable overhead (5,000 units @ \$2 per unit)
Total variable expenses
Contribution margin
Less fixed expense:
Other
Rent on new machine
Total fixed expenses
Operating income
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
62,000
62,000
18,000
62,000
3,000
65,000
30,000
(3,000)
(3,000)
12,000
\$
\$
LO 1
12-14
Total and Differential Cost Approaches
As you can see, the only costs that differ between the alternatives are
the direct labour costs savings and the increase in fixed rental costs.
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
We can efficiently analyze the decision by 62,000
62,000
looking at the different costs and revenues
\$
18,000
and arrive at the same solution.
62,000
3,000
65,000
30,000
(3,000)
(3,000)
12,000
Sales (5,000 units @ \$40 per unit)
Less variable expenses:
Direct materials (5,000 units @ \$14 per unit)
Direct labour (5,000 units @ \$8 and \$5 per unit)
Variable overhead (5,000 units @ \$2 per unit)
Total variable expenses
Contribution margin
Less fixed expense:
Other
Rent on new machine
Total fixed expenses
Operating income
\$
Net Advantage to Renting the New Machine
Decrease in direct labour costs (5,000 units @ \$3 per unit)
Increase in fixed rental expenses
Net annual cost saving from renting the new machine
\$
\$
15,000
(3,000)
12,000
LO 1
12-15
Total and Differential Cost Approaches
Using the differential approach is desirable for
two reasons:
1. Only rarely will enough information be
available to prepare detailed income
statements for both alternatives.
2. Mingling irrelevant costs with relevant costs
may cause confusion and distract attention
away from the information that is really
critical.
LO 1
12-16
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 type of decision.
LO 2
12-17
Due to the declining popularity of digital
watches, Lovell Company’s digital watch
line has not reported a profit for several
years. Lovell is considering discontinuing
this product line.
LO 2
12-18
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.
LO 2
12-19
Segment Income Statement
Digital Watches
Sales
Less: variable expenses
Variable manufacturing costs
Variable shipping costs
Commissions
Contribution margin
Less: fixed expenses
Salary of line manager
Depreciation of equipment
Rent – factory space
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)
LO 2
12-20
Segment Income Statement
Digital Watches
Sales
\$ 500,000
Less: variable expenses
Investigation
has revealed
total fixed general
Variable manufacuring
costs that
\$ 120,000
Variable shipping
5,000
factory costs
Commissions expenses would 75,000
200,000
not be affected
if
Contribution margin
\$ 300,000
the digital watch line is dropped. The fixed
Less: fixed expenses
general
general
General
factoryfactory
\$ and
60,000
expenses assigned
to this product
Salary of line manager
90,000
Depreciation
of equipmentto other50,000
would be reallocated
product lines.
100,000
Rent – factory space
70,000
30,000
400,000
Net operating loss
\$ (100,000)
LO 2
12-21
Segment Income Statement
Digital Watches
Sales
\$ 500,000
Less: variable expenses
Variable manufacturing costs \$ 120,000
The equipment used to manufacture
Variable shipping costs
5,000
digital watches has no resale
Commissions
75,000
200,000
value
or alternative use.
Contribution
margin
\$ 300,000
Less: fixed expenses
\$ 60,000
Salary of line manager
90,000
Depreciation of equipment
50,000
Should Lovell
retain or drop
Advertising – direct the digital watch
100,000 segment?
Rent – factory space
70,000
30,000
400,000
Net operating loss
\$ (100,000)
LO 2
12-22
A Contribution Margin Approach
Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped
\$ (300,000)
Less fixed costs that can be avoided
Salary of the line manager
Rent – factory space
260,000
\$ (40,000)
\$
90,000
100,000
70,000
LO 2
12-23
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.
LO 2
12-24
Comparative Income Approach
Solution
Keep
Drop
Digital
Digital
Watches
Watches
Difference
Sales
\$ 500,000
\$
\$ (500,000)
Less variable expenses:
Manufacturing expenses
120,000
120,000
Shipping
5,000
5,000
Commissions
75,000
75,000
Total variable expenses
200,000
200,000
Contribution margin
300,000
(300,000)
Less fixed expenses:
60,000
Salary of line manager
90,000
If the digital watch
Depreciation
50,000
line is dropped, the
100,000
company gives up
Rent – factory space
70,000
30,000
its contribution
Total fixed expenses
400,000
margin.
Net operating loss
\$ (100,000)
LO 2
12-25
Comparative Income Approach
Solution
Keep
Drop
Digital
Digital
Watches
Watches
Difference
Sales
\$ 500,000
\$
\$ (500,000)
Less variable expenses:
Manufacturing expenses
120,000
120,000
Shipping
5,000
5,000
Commissions
75,000
75,000
Total variable expenses
200,000
200,000
Contribution margin
300,000
(300,000)
Less fixed expenses:
60,000
60,000
Salary of line manager
90,000
Depreciation
50,000
On 100,000
the other hand, the general
factory
Rent – factory space
70,000
30,000
same.
So this cost really isn’t
Total fixed expenses
400,000
Net operating loss
\$ (100,000) relevant.
LO 2
12-26
Comparative Income Approach
Solution
Keep
Drop
Digital
Digital
Watches
Watches
Sales
\$ 500,000
\$
Less variable expenses:
But we wouldn’t
need -a
Manufacturing expenses
120,000
Shipping
manager for5,000
the product -line
Commissions
75,000
anymore.
Total variable expenses
200,000
Contribution margin
300,000
Less fixed expenses:
60,000
60,000
Salary of line manager
90,000
Depreciation
50,000
100,000
Rent – factory space
70,000
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)
90,000
LO 2
12-27
Comparative Income Approach
Solution
Keep
Drop
Digital
Digital
Watches
Watches
Difference
Sales
\$ 500,000
\$
\$ (500,000)
Less
expenses:
If variable
the digital
watch line is dropped, the net -book value
Manufacturing expenses
120,000
120,000
of
the
equipment
would
be
written
off.
The
depreciation
Shipping
5,000
5,000
that would have been taken
will flow through
the75,000
Commissions
75,000
Total variable expenses
200,000
200,000
income statement as
Contribution margin
300,000
(300,000)
Less fixed expenses:
60,000
60,000
Salary of line manager
90,000
90,000
Depreciation
50,000
50,000
100,000
Rent – factory space
70,000
30,000
Total fixed expenses
400,000
Net operating loss
\$ (100,000)
LO 2
12-28
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:
60,000
60,000
Salary of line manager
90,000
Depreciation
50,000
50,000
100,000
Rent – factory space
70,000
30,000
30,000
Total fixed expenses
400,000
140,000
Net operating loss
\$ (100,000)
\$ (140,000)
Difference
\$ (500,000)
120,000
5,000
75,000
200,000
(300,000)
90,000
100,000
70,000
260,000
\$ (40,000)
LO 2
12-29
Beware of Allocated Fixed Costs
Why should we keep the
digital watch segment
when it’s showing a
\$100,000 loss?
LO 2
12-30
Beware of Allocated Fixed Costs
way we allocate
common fixed costs to
our products.
LO 2
12-31
Beware of Allocated Fixed Costs
Our allocations can
make a segment look
less profitable than it
really is.
LO 2
12-32
When a company is involved in more than one
activity in the entire value chain, it is vertically
integrated. A decision to carry out one of the
activities in the value chain internally, rather
than to buy externally from a supplier is called
LO 2
12-33
Smoother flow of
parts and materials
Better quality
control
Realize profits
LO 2
12-34
Companies may fail
suppliers who can
create economies of
pooling demand from
numerous
companies.
LO 2
12-35
The Make or Buy Decision: An Example


Essex Company manufactures part 4A that is used in
one of its products.
The unit product cost of this part is:
Direct materials
Direct labour
Depreciation of special equip.
Supervisor's salary
Unit product cost
\$
9
5
1
3
2
10
\$ 30
LO 2
12-36




The special equipment used to manufacture part
4A has no resale value.
The total amount of general factory overhead,
which is allocated on the basis of direct labour
hours, would be unaffected by this decision.
The \$30 unit product 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 \$25 per part.
Should we accept the supplier’s offer?
LO 2
12-37
Cost
Per
Unit
Outside purchase price
\$ 25
Direct materials
Direct labour
Depreciation of equip.
Supervisor's salary
Total cost
\$
9
5
1
3
2
10
\$ 30
Cost of 20,000 Units
Make
\$ 500,000
180,000
100,000
20,000
40,000
\$ 340,000
\$ 500,000
20,000 × \$9 per unit = \$180,000
LO 2
12-38
Cost
Per
Unit
Outside purchase price
\$ 25
Direct materials
Direct labour
Depreciation of equip.
Supervisor's salary
Total cost
\$
9
5
1
3
2
10
\$ 30
Cost of 20,000 Units
Make
\$ 500,000
180,000
100,000
20,000
40,000
\$ 340,000
\$ 500,000
The special equipment has no resale
value and is a sunk cost.
LO 2
12-39
Cost
Per
Unit
Outside purchase price
\$ 25
Direct materials
Direct labour
Depreciation of equip.
Supervisor's salary
Total cost
\$
9
5
1
3
2
10
\$ 30
Cost of 20,000 Units
Make
\$ 500,000
180,000
100,000
20,000
40,000
\$ 340,000
\$ 500,000
Not avoidable; irrelevant. If the product is
dropped, it will be reallocated to other products.
LO 2
12-40
Cost
Per
Unit
Outside purchase price
\$ 25
Direct materials
Direct labour
Depreciation of equip.
Supervisor's salary
Total cost
\$
9
5
1
3
2
10
\$ 30
Cost of 20,000 Units
Make
\$ 500,000
180,000
100,000
20,000
40,000
\$ 340,000
\$ 500,000
Should we make or buy part 4A?
LO 2
12-41
Opportunity Cost
An opportunity cost is the benefit that is foregone
as a result of pursuing some course of action.
Opportunity costs are not actual dollar outlays
and are not recorded in the formal accounts of
an organization.
How would this concept potentially relate to the
Essex Company?
LO 2
12-42
Key Terms and Concepts
A special order is a one-time
order that is not considered
part of the company’s normal
When analyzing a special
order, only the incremental
costs and benefits are
relevant.
LO 2
12-43
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
 Annual capacity is 10,000 units, but Jet, Inc. is
currently producing and selling only 5,000 units.

Should Jet accept the offer?
LO 2
12-44
Special Orders
Jet, Inc.
Contribution Income Statement
Revenue (5,000 × \$20)
\$ 100,000
Variable costs:
Direct materials
\$ 20,000
Direct labour
5,000
10,000 \$8 variable cost
Marketing costs
5,000
Total variable costs
40,000
Contribution margin
60,000
Fixed costs:
Marketing costs
20,000
Total fixed costs
48,000
Net operating income
\$ 12,000
LO 2
12-45
Special Orders
If Jet accepts the special order, the incremental revenue will
exceed the incremental costs. In other words, net operating
income will increase by \$6,000. This suggests that Jet
should accept the order.
Increase in revenue (3,000 × \$10)
Increase in costs (3,000 × \$8 variable cost)
Increase in net operating income
\$ 30,000
24,000
\$ 6,000
Note: This answer assumes that the fixed costs are
unavoidable and that variable marketing costs must be
incurred on the special order.
LO 2
12-46
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)
LO 2
12-47
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 and the imprinting
machine has no further use after this order.
a. \$50
b. \$10
c. \$15
d. \$29
LO 2
12-48
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 and the imprinting
machine has no further use after this order.
a. \$50
b. \$10
c. \$15
d. \$29
Variable production cost
Total relevant cost
Number of units
Average cost per unit =
\$100,000
+ 50,000
\$150,000
10,000
\$15
LO 2
12-49
Joint 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.
LO 2
12-50
Joint Products
Oil
Joint
Input
Common
Production
Process
Gasoline
Chemicals
Split-Off
Point
LO 2
12-51
Joint Products
Joint
Costs
Joint
Input
Common
Production
Process
Oil
Gasoline
Chemicals
Split-Off
Point
Separate
Processing
Final
Sale
Final
Sale
Separate
Processing
Final
Sale
Separate
Product
Costs
LO 2
12-52
The Pitfalls of Allocation
Joint costs are often
allocated to end products on
the basis of the relative
sales value of each product
or on some other basis.
Although allocation is needed for
some purposes such as balance
sheet inventory valuation,
allocations of this kind are very
dangerous for decision making.
LO 2
12-53
Sell or Process Further
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 split-off point so long as
the incremental revenue exceeds the
incremental processing costs incurred after the
split-off point.
LO 2
12-54
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.”
LO 2
12-55
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
LO 2
12-56
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
Lumber
Sawdust
\$
\$
270
140
130
50
40
10
LO 2
12-57
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)
LO 2
12-58
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)
Should we process the lumber further
and sell the sawdust “as is?”
LO 2
12-59
Key Terms and Concepts
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.
LO 3
12-60
Utilization of a Constrained Resource
 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.
LO 3
12-61
Utilization of a Constrained Resource: An
Example
Ensign Company produces two products and
selected data are 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.
LO 3
12-62
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 Product 2?
LO 3
12-63
Quick Check 
How many units of each product can be
processed through Machine A1 in one minute?
a.
b.
c.
d.
Product 1
1 unit
1 unit
2 units
2 units
Product 2
0.5 unit
2.0 units
1.0 unit
0.5 unit
LO 3
12-64
Quick Check 
How many units of each product can be
processed through Machine A1 in one minute?
a.
b.
c.
d.
Product 1
1 unit
1 unit
2 units
2 units
Product 2
0.5 unit
2.0 units
1.0 unit
0.5 unit
I was just checking to make sure
you are with us.
LO 3
12-65
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.
LO 3
12-66
Quick Check 
With one minute of machine A1, we could
What
more profit
thea company,
makegenerates
1 unit of Product
1, for
with
contribution
using
oneof
minute
of 2machine
to process
margin
\$24, or
units ofA1
Product
2, each
Product
1 ora using
one minute
of machine
with
contribution
margin
of \$15.A1 to
process Product 2?
2 × \$15 = \$30 > \$24
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.
LO 3
12-67
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
\$
30
Product 2 should be emphasized. Provides more
valuable use of the constrained resource machine A1,
yielding a contribution margin of \$30 per minute as
opposed to \$24 for Product 1.
LO 3
12-68
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
\$
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.
LO 3
12-69
Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)
Weekly demand for Product 2
Time required per unit
Total time required to make
Product 2
×
2,200 units
0.50 min.
1,100 min.
LO 3
12-70
Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting Our Constrained Resource (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
×
2,200 units
0.50 min.
1,100 min.
2,400 min.
1,100 min.
1,300 min.
LO 3
12-71
Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting Our Constrained Resource (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
×
2,200 units
0.50 min.
1,100 min.
÷
2,400
1,100
1,300
1.00
1,300
min.
min.
min.
min.
units
LO 3
12-72
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
Product 2
2,200
\$
15
\$ 33,000
The total contribution margin for Ensign is \$64,200.
LO 3
12-73
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
LO 3
12-74
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 (2 × 600) + (10 × 100 ) = 2,200 > 2,000
LO 3
12-75
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
LO 3
12-76
Quick Check 
Chairs Tables
Selling price
\$ 80 \$ 400
Chairs Tables
Variable
200
Selling price per
unit cost\$80
\$400 30
Variable cost Contribution
per unit
\$30
margin \$200
\$ 50 \$ 200
Board feet per unit
2
10
Board feet
2
10
Monthly demand
600
100
CM per board foot
\$ 25 \$ 20
The company’s supplier of hardwood will only be
Production
chairs
600 What
able to supply 2,000
board of
feet
this month.
Board
feet required
1,200
plan would maximize
profits?
Board feet remaining
800
a. 500 chairs and 100 tables
Board feet per table
10
b. 600 chairs and Production
80 tables of tables
80
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
LO 3
12-77
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
LO 3
12-78
Quick Check 
As before, Colonial Heritage’s supplier of
hardwood
will only
be able
to supply
2,000
The
wood
would
be used
to board
make
feet
this month.
Assume
the company
follows
tables.
In this
use, each
board foot
of the
plan we have
proposed.
Upthe
to how
much should
wood
will allow
company
to earn
Heritage
to pay above
the and
anColonial
\$20be
of willing
contribution
margin
usual price to obtain profit.
more hardwood?
a. \$40 per board foot
b. \$25 per board foot
c. \$20 per board foot
d. Zero
LO 3
12-79
Managing Constraints
The theory of constraints (TOC) maintains that effectively
managing a constraint is important to the financial success
of an organization.
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
• Reduce amount of defective
units produced
non-bottleneck departments
LO 3
12-80
Activity-Based Costing and Relevant Costs
ABC can be used to help identify potentially
relevant costs for decision-making purposes.
However, before making a
decision, managers must
decide which of the potentially
relevant costs are actually
avoidable.
LO 3
12-81
Pricing Products and Services
Appendix 12A
LO 4
12-82
Cost-Plus Pricing
The usual approach in pricing is to mark up
cost. A product’s markup is the difference
between its selling price and its cost. The
markup is usually expressed as a percentage
of cost.
Selling Price = Cost + (Markup percentage × Cost)
LO 4
12-83
The Absorption Costing Approach
Under the absorption approach to cost-plus
pricing, the cost base is the absorption costing
unit product cost rather than the variable cost.
LO 4
12-84
Setting a Target Selling Price
Here is information provided by the management of
Ritter Company.
Direct materials
Direct labour
Variable S & A expenses
Fixed S & A expenses
Per Unit
\$
6
4
3
Total
\$ 70,000
2
60,000
Assuming Ritter will produce and sell 10,000
units of the new product, and that Ritter typically
uses a 50% markup percentage, let’s determine
the unit product cost.
LO 4
12-85
Setting a Target Selling Price
Direct materials
Direct labour
Unit product cost
Per Unit
\$
6
4
3
7
\$
20
(\$70,000 ÷ 10,000 units = \$7 per unit)
Ritter has a policy of marking up unit product costs
by 50%. Let’s calculate the target selling price.
LO 4
12-86
Setting a Target Selling Price
Ritter would establish a target selling price to cover
selling, general, and administrative expenses and
contribute to profit \$30 per unit.
Direct materials
Direct labour
Unit product cost
50% markup
Target selling price
Per Unit
6
\$
4
3
7
20
\$
10
30
\$
LO 4
12-87
Determining the Markup Percentage
The markup percentage can be based on an
industry “rule of thumb,” company tradition, or it
can be explicitly calculated. The equation to
calculate the markup percentage is:
Markup %
on absorption
cost
=
(Required ROI × Investment) + SG&A expenses
Unit sales × Unit product cost
LO 4
12-88
Determining the Markup Percentage
Let’s assume that Ritter must invest \$100,000 in the
product and market 10,000 units of product each
year. The company requires a 20% ROI on all
investments. Let’s determine Ritter’s markup
percentage on absorption cost.
LO 4
12-89
Determining the Markup Percentage
Markup %
(20% × \$100,000) + (\$2 × 10,000 + \$60,000)
on absorption =
10,000 × \$20
cost
Variable SG&A per unit
Total fixed SG&A
Markup %
on absorption
cost
=
(\$20,000 + \$80,000)
\$200,000
=
50%
LO 4
12-90
Problems with the Absorption Costing Approach
The absorption costing approach assumes that
customers need the forecasted unit sales and will
pay whatever price the company decides to
charge. This is flawed logic simply because
customers have a choice.
LO 4
12-91
Problems with the Absorption Costing Approach
Let’s assume that Ritter sells only 7,000 units at
\$30 per unit, instead of the forecasted 10,000
units. Here is the income statement.
RITTER COMPANY
Income Statement
For the Year Ended December 31, 2013
Sales (7,000 units × \$30)
Cost of goods sold (7,000 units × \$23)
Gross margin
SG&A expenses
Net operating loss
ROI =
\$
\$
210,000
161,000
49,000
74,000
(25,000)
\$
\$
(25,000)
=
100,000
-25%
LO 4
12-92
Problems with the Absorption Costing Approach
Let’s assume that Ritter sells only 7,000 units at
\$30 per unit, instead of the forecasted 10,000
units. Here is the income statement.
RITTER
COMPANY to pricing is a safe
Absorption costing
approach
Income Statement
approach
only
customers
For the
YearifEnded
December choose
31, 2013
least
as
many
forecasted
Sales
(7,000
units units
× \$30) as managers
\$
210,000
Cost of goods sold (7,000 units × \$23)
161,000
they
would
Gross margin
49,000
SG&A expenses
Net operating loss
ROI =
\$
74,000
(25,000)
\$
\$
(25,000)
=
100,000
-25%
LO 4
12-93
Target Costing
Target costing is the process of determining the
maximum allowable cost for a new product and then
developing a prototype that can be made for that
maximum target cost figure. The equation for
determining the target price is shown below:
Target cost = Anticipated selling price – Desired profit
LO 5
12-94
Reasons for Using Target Costing
Two characteristics of prices and product costs:
1. The market (i.e., supply and demand)
determines price.
2. Most of the cost of a product is determined
in the design stage.
Target costing was developed in recognition of
these two characteristics.
LO 5
12-95
Reasons for Using Target Costing
Target costing was developed in
recognition of the two characteristics
shown on the previous screen. More
specifically, Target costing begins the
product development process by
recognizing and responding to existing
market prices.
LO 5
12-96
Reasons for Using Target Costing
Target costing focuses a company’s
cost reduction efforts in the product
design stage of production.
LO 5
12-97
Target Costing
Handy Appliance feels there is a niche for a
hand mixer with certain features. The
Marketing Department believes that a price of
40,000 mixers could be sold. An investment of
\$2,000,000 is required to gear up for
production. The company requires a 15% ROI
on invested funds.
Let see how we determine the target cost.
LO 5
12-98
Target Costing
Projected sales (40,000 units × \$30)
Desired profit (\$2,000,000 × 15%)
Target cost for 40,000 mixers
\$ 1,200,000
300,000
\$ 900,000
Target cost per mixer (\$900,000 ÷ 40,000)
\$
22.50
Each functional area within Handy Appliance
would be responsible for keeping its actual costs
within the target established for that area.
LO 5
12-99
End of Chapter 12
```

– Cards

– Cards

– Cards

– Cards

– Cards