Ninth Canadian Edition
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
Copyright © 2012 McGraw-Hill Ryerson Limited
12-1

Cost Concepts for Decision Making
A relevant cost is a cost that differs between alternatives.
12-2
LO 1
Copyright © 2012 McGraw-Hill Ryerson Limited

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.
12-3
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
Copyright © 2012 McGraw-Hill Ryerson Limited

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.
12-4
LO 1
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Different Costs for Different Purposes
12-5
LO 1
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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 Annual straight-line depreciation on car
2 Cost of gasoline
3 Annual cost of auto insurance and license
4 Maintenance and repairs
5 Parking fees at school
6 Total average cost
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
$45 per month × 8 months
Copyright © 2012 McGraw-Hill Ryerson Limited
$1.60 per gallon ÷ 32 MPG
$18,000 cost – $4,000 salvage value ÷ 5 years
LO 1
12-6

Identifying Relevant Costs
Automobile Costs (based on 10,000 kilometers driven per year)
1 Annual straight-line depreciation on car
2 Cost of gasoline
3 Annual cost of auto insurance and license
4 Maintenance and repairs
5 Parking fees at school
6 Total average cost
Annual Cost of Fixed Items Cost per km
$ 2,800 $ 0.280
1,380
360
0.050
0.138
0.065
0.036
$ 0.569
Some Additional Information
7 Reduction in resale value of car per km of wear
8 Round-tip train fare
9 Benefits of relaxing on train trip
10 Cost of putting dog in kennel while gone
11 Benefit of having car in Waterloo
12 Hassle of parking car in Waterloo
13 Per day cost of parking car in Waterloo
$ 0.026
$ 104
????
$ 40
????
????
$ 25
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 1
12-7

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.
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 1
12-8

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.
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 1
12-9

12-10
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.
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.
Copyright © 2012 McGraw-Hill Ryerson Limited
The kennel cost is not relevant because
Cynthia will incur the cost if she drives or takes the train.
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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.
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 1

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
12-12
LO 1
Copyright © 2012 McGraw-Hill Ryerson Limited

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:
Current
Situation
Situation
With New
Machine
Differential
Costs and
Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
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
70,000
40,000
10,000
120,000
80,000
62,000
-
62,000
$ 18,000
70,000
25,000
10,000
105,000
95,000
62,000
3,000
65,000
$ 30,000
-
15,000
-
-
15,000
-
(3,000)
(3,000)
12,000
LO 1
Copyright © 2012 McGraw-Hill Ryerson Limited

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 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
70,000
40,000
10,000
120,000
80,000
Less fixed expense:
We can efficiently analyze the decision by
62,000
Rent on new machine looking at the different costs and revenues
Operating income
-
62,000
$ 18,000 and arrive at the same solution .
Situation
With New
Machine
$ 200,000
70,000
25,000
10,000
105,000
95,000
62,000
3,000
65,000
$ 30,000
Differential
Costs and
Benefits
-
-
15,000
-
-
15,000
-
(3,000)
(3,000)
12,000
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
Copyright © 2012 McGraw-Hill Ryerson Limited

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.
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 1

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 type of decision.
12-16
LO 2
Copyright © 2012 McGraw-Hill Ryerson Limited

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. Lovell is considering discontinuing this product line.
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LO 2
Copyright © 2012 McGraw-Hill Ryerson Limited

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.
12-18
LO 2
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12-19
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
$ 120,000
5,000
75,000
$ 60,000
90,000
50,000
100,000
70,000
30,000
Copyright © 2012 McGraw-Hill Ryerson Limited
$ 500,000
200,000
$ 300,000
400,000
$ (100,000)
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12-20
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Investigation has revealed that total fixed general factory overhead and general administrative expenses would not be affected if
Contribution margin $ 300,000 the digital watch line is dropped. The fixed
Less: fixed expenses
General factory overhead $ 60,000 administrative expenses assigned to this product
Advertising – direct
Rent – factory space
General admin. expenses
Net operating loss
Copyright © 2012 McGraw-Hill Ryerson Limited
100,000
70,000
30,000 400,000
$ (100,000)
LO 2

12-21
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales
Less: variable expenses
Variable manufacturing costs
Variable shipping costs
$ 120,000
The equipment used to manufacture
5,000
Commissions 75,000 value or alternative use.
Less: fixed expenses
General factory overhead
Salary of line manager
$ 60,000
90,000
Advertising – direct
Rent – factory space
General admin. expenses
Net operating loss
Copyright © 2012 McGraw-Hill Ryerson Limited
70,000
30,000
$ 500,000
200,000
$ 300,000
400,000
$ (100,000)
LO 2

A Contribution Margin Approach
Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped
Less fixed costs that can be avoided
Salary of the line manager
Advertising – direct
Rent – factory space
Net disadvantage
$ 90,000
100,000
70,000
$ (300,000)
260,000
$ (40,000)
12-22
LO 2
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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.
12-23
LO 2
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12-24
Comparative Income Approach
Solution
Keep
Digital
Drop
Digital
Watches
$ 500,000 Sales
Less variable expenses:
Manufacturing expenses 120,000
Watches
$ -
-
-
Shipping
Commissions
Total variable expenses
Contribution margin
Less fixed expenses:
General factory overhead
Salary of line manager
Depreciation
Advertising – direct
Rent – factory space
General admin. expenses
Total fixed expenses
Net operating loss
5,000
75,000
200,000
300,000
$
60,000
90,000
50,000
100,000
70,000
30,000
400,000
(100,000)
-
-
-
-
Difference
$ (500,000)
120,000
5,000
75,000
200,000
(300,000)
If the digital watch line is dropped, the company gives up its contribution margin.
LO 2
Copyright © 2012 McGraw-Hill Ryerson Limited

12-25
Comparative Income Approach
Solution
Keep
Digital
Drop
Digital
Watches
$ 500,000 Sales
Less variable expenses:
Manufacturing expenses 120,000
Watches
$ -
-
-
Shipping
Commissions
Total variable expenses
Contribution margin
Less fixed expenses:
General factory overhead
Salary of line manager
Depreciation
Advertising – direct
Rent – factory space
General admin. expenses
Total fixed expenses
Net operating loss
5,000
75,000
200,000
300,000
60,000
90,000
-
-
-
-
60,000
Difference
$ (500,000)
120,000
5,000
75,000
200,000
(300,000)
-
50,000
On the other hand, the general same. So this cost really isn’t
400,000
$ (100,000) relevant.
LO 2
Copyright © 2012 McGraw-Hill Ryerson Limited

12-26
Sales
Less variable expenses:
Manufacturing expenses
Shipping
Commissions
Total variable expenses
Contribution margin
Less fixed expenses:
General factory overhead
Salary of line manager
Depreciation
Advertising – direct
Rent – factory space
General admin. expenses
Total fixed expenses
Net operating loss
Comparative Income Approach
Solution
Keep
Digital
Drop
Digital
Watches
$ 500,000
Watches
$ -
120,000
-
But we wouldn’t need a anymore.
-
200,000
300,000
60,000
90,000
50,000
100,000
70,000
30,000
400,000
$ (100,000)
-
-
60,000
-
Copyright © 2012 McGraw-Hill Ryerson Limited
Difference
$ (500,000)
120,000
5,000
75,000
200,000
(300,000)
-
90,000
LO 2

12-27
Comparative Income Approach
Solution
Keep
Digital
Drop
Digital
Sales
Watches
$ 500,000
Watches
$ -
-
Difference
$ (500,000)
Manufacturing expenses 120,000 120,000 of the equipment would be written off. The depreciation
Shipping 5,000
75,000
-
-
5,000
75,000
Contribution margin
200,000
300,000
-
-
200,000
(300,000)
Less fixed expenses:
General factory overhead
Salary of line manager
Depreciation
Advertising – direct
Rent – factory space
General admin. expenses
Total fixed expenses
Net operating loss
60,000
90,000
50,000
100,000
70,000
30,000
400,000
$ (100,000)
60,000
-
50,000
-
90,000
-
LO 2
Copyright © 2012 McGraw-Hill Ryerson Limited

12-28
Comparative Income Approach
Solution
Keep
Digital
Drop
Digital
Watches
$ 500,000 Sales
Less variable expenses:
Manufacturing expenses 120,000
Watches
$ -
-
-
Shipping
Commissions
Total variable expenses
Contribution margin
Less fixed expenses:
General factory overhead
Salary of line manager
Depreciation
Advertising – direct
Rent – factory space
General admin. expenses
Total fixed expenses
Net operating loss
5,000
75,000
200,000
300,000
100,000
$
60,000
90,000
50,000
70,000
30,000
400,000
(100,000)
-
-
-
-
60,000
$
-
50,000
-
-
30,000
140,000
(140,000)
Copyright © 2012 McGraw-Hill Ryerson Limited
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 ?
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 2

12-30
Beware of Allocated Fixed Costs
The answer lies in the way we allocate common fixed costs to our products.
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 2

Beware of Allocated Fixed Costs
Our allocations can make a segment look less profitable than it really is.
12-31
LO 2
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The Make or Buy Decision
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 a “make or buy” decision.
12-32
LO 2
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12-33
Vertical Integration – Advantages
Smoother flow of parts and materials
Better quality control
Realize profits
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LO 2

12-34
Vertical Integration – Disadvantage
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LO 2

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:
12-35
Direct materials
Direct labour
Variable overhead
Depreciation of special equip.
Supervisor's salary
General factory overhead
Unit product cost
$ 9
5
1
3
2
10
$ 30
LO 2
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12-36
The Make or Buy Decision
 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?
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 2

The Make or Buy Decision
Outside purchase price
Direct materials
Direct labour
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost
Cost
Per
Unit
$ 25
$ 9
5
1
3
2
10
$ 30
Cost of 20,000 Units
Make Buy
$ 500,000
180,000
100,000
20,000
-
40,000
-
$ 340,000 $ 500,000
12-37
20,000 × $9 per unit = $180,000
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 2

12-38
The Make or Buy Decision
Outside purchase price
Cost
Per
Unit
$ 25
Cost of 20,000 Units
Make Buy
$ 500,000
Direct materials
Direct labour
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost
$ 9
5
1
3
2
10
$ 30
180,000
100,000
20,000
-
40,000
-
$ 340,000
The special equipment has no resale value and is a sunk cost.
$ 500,000
LO 2
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12-39
The Make or Buy Decision
Outside purchase price
Cost
Per
Unit
$ 25
Cost of 20,000 Units
Make Buy
$ 500,000
Direct materials
Direct labour
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost
$ 9
5
1
3
2
10
$ 30
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
Copyright © 2012 McGraw-Hill Ryerson Limited

The Make or Buy Decision
Outside purchase price
Direct materials
Direct labour
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost
Cost
Per
Unit
$ 25
$ 9
5
1
3
2
10
$ 30
Cost of 20,000 Units
Make Buy
$ 500,000
180,000
100,000
20,000
-
40,000
-
$ 340,000 $ 500,000
12-40
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 2

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.
12-41
How would this concept potentially relate to the
Essex Company?
LO 2
Copyright © 2012 McGraw-Hill Ryerson Limited

12-42
Key Terms and Concepts
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.
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 2

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.
12-43
LO 2
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12-44
Special Orders
Jet, Inc.
Contribution Income Statement
Revenue ( 5,000 × $20 )
Variable costs:
$ 100,000
$ 20,000 Direct materials
Direct labour
Manufacturing overhead
Marketing costs
Total variable costs
Contribution margin
Fixed costs:
Manufacturing overhead
Marketing costs
Total fixed costs
Net operating income
5,000
10,000
$
5,000
28,000
20,000
$8 variable cost
60,000
$
40,000
48,000
12,000
LO 2
Copyright © 2012 McGraw-Hill Ryerson Limited

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.
12-45
Increase in revenue (3,000 × $10) $ 30,000
Increase in costs (3,000 × $8 variable cost) 24,000
Increase in net operating income $ 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
Copyright © 2012 McGraw-Hill Ryerson Limited

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
Xlens 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)
12-46
LO 2
Copyright © 2012 McGraw-Hill Ryerson Limited

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
Copyright © 2012 McGraw-Hill Ryerson Limited
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 $100,000
Additional fixed cost + 50,000
Total relevant cost
Number of units
Average cost per unit =
$150,000
10,000
$15
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 2

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.
12-49
LO 2
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12-50
Joint Products
Oil
Joint
Input
Common
Production
Process
Gasoline
Split-Off
Point
Chemicals
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 2

12-51
Joint Products
Joint
Costs Oil
Separate
Processing
Joint
Input
Common
Production
Process
Gasoline
Final
Sale
Split-Off
Point
Chemicals
Separate
Processing
Separate
Product
Costs
Copyright © 2012 McGraw-Hill Ryerson Limited
Final
Sale
Final
Sale
LO 2

12-52
The Pitfalls of Allocation
Copyright © 2012 McGraw-Hill Ryerson Limited
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

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 .
12-53
LO 2
Copyright © 2012 McGraw-Hill Ryerson Limited

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.”
12-54
LO 2
Copyright © 2012 McGraw-Hill Ryerson Limited

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
12-55
LO 2
Copyright © 2012 McGraw-Hill Ryerson Limited

Sell or Process Further
Analysis of Sell or Process Further
Lumber
Per Log
Sawdust
Sales value after further processing
Sales value at the split-off point
Incremental revenue
$ 270
140
130
$ 50
40
10
12-56
LO 2
Copyright © 2012 McGraw-Hill Ryerson Limited

Sell or Process Further
Analysis of Sell or Process Further
Lumber
Per Log
Sawdust
Sales value after further processing
Sales value at the split-off point
Incremental revenue
Cost of further processing
Profit (loss) from further processing
$ 270
140
130
50
$ 80
$ 50
40
10
20
$ (10)
12-57
LO 2
Copyright © 2012 McGraw-Hill Ryerson Limited

Sell or Process Further
Analysis of Sell or Process Further
Lumber
Per Log
Sawdust
Sales value after further processing
Sales value at the split-off point
Incremental revenue
Cost of further processing
Profit (loss) from further processing
$ 270
140
130
50
$ 80
Should we process the lumber further and sell the sawdust “as is?”
$ 50
40
10
20
$ (10)
12-58
LO 2
Copyright © 2012 McGraw-Hill Ryerson Limited

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.
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 3

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.
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LO 3
Copyright © 2012 McGraw-Hill Ryerson Limited

Utilization of a Constrained Resource: An
Example
Ensign Company produces two products and selected data are shown below:
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
Product
1
$ 60
36
$ 24
2
$ 50
35
$ 15
2,000
40%
2,200
30%
1.00
min.
0.50
min.
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LO 3
Copyright © 2012 McGraw-Hill Ryerson Limited

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.
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LO 3
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Quick Check 
How many units of each product can be processed through Machine A1 in one minute?
Product 1 Product 2 a. 1 unit 0.5 unit b. 1 unit 2.0 units c. 2 units 1.0 unit d. 2 units 0.5 unit
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LO 3
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Quick Check 
How many units of each product can be processed through Machine A1 in one minute?
Product 1 Product 2 a. 1 unit 0.5 unit b. 1 unit 2.0 units c. 2 units 1.0 unit d. 2 units 0.5 unit
I was just checking to make sure you are with us.
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 3

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.
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LO 3
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Quick Check 
With one minute of machine A1, we could make 1 unit of Product 1, with a contribution
12-66 process Product 2?
a. Product 1
2 × $15 = $30 > $24 b. Product 2 c. They both would generate the same profit.
d. Cannot be determined.
LO 3
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Utilization of a Constrained Resource
The key is the contribution margin per unit of the constrained resource.
Contribution margin per unit
Time required to produce one unit ÷
Contribution margin per minute
Product
1
$ 24
1.00
$ 24 min. ÷
2
$ 15
0.50
$ 30 min.
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.
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 3

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Utilization of a Constrained Resource
The key is the contribution margin per unit of the constrained resource.
Contribution margin per unit
Time required to produce one unit ÷
Contribution margin per minute
Product
1
$ 24
1.00
$ 24 min. ÷
2
$ 15
0.50
$ 30 min.
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.
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 3

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.
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LO 3
Copyright © 2012 McGraw-Hill Ryerson Limited

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.
Total time available
Time used to make Product 2
Time available for Product 1
2,400
1,100
1,300 min.
min.
min.
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LO 3
Copyright © 2012 McGraw-Hill Ryerson Limited

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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.
Total time available
Time used to make Product 2
Time available for Product 1
Time required per unit
Production of Product 1
÷
2,400
1,100
1,300
1.00
1,300 min.
min.
min.
min.
units
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 3

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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.
Product 1
Production and sales (units) 1,300
Contribution margin per unit
Total contribution margin
$
$
24
31,200
Product 2
2,200
$ 15
$ 33,000
The total contribution margin for Ensign is $64,200.
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 3

Quick Check 
Colonial Heritage makes reproduction colonial furniture from select hardwoods.
Selling price per unit
Chairs Tables
$80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100
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
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LO 3
Copyright © 2012 McGraw-Hill Ryerson Limited

Quick Check 
Colonial Heritage makes reproduction colonial furniture from select hardwoods.
Selling price per unit
Chairs Tables
$80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100
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
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LO 3
Copyright © 2012 McGraw-Hill Ryerson Limited

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Quick Check 
Selling price per unit
Chairs
$80
Tables
$400
Variable cost per unit $30 $200
Board feet per unit
Monthly demand
2
600
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
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 3

Quick Check 
Chairs Tables
Selling price $ 80
Chairs Tables
$80 $400
30
$ 400
200
Contribution margin
Monthly demand
2
600
CM per board foot
$200
10
100
50
2
$ 25
$ 200
10
$ 20
The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. What plan would maximize profits?
1,200 a. 500 chairs and 100 tables
800
10 Board feet per table b. 600 chairs and 80 tables
Production of tables c. 500 chairs and 80 tables
80 d. 600 chairs and 100 tables
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LO 3
Copyright © 2012 McGraw-Hill Ryerson Limited

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
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LO 3
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Quick Check 
As before, Colonial Heritage’s supplier of
12-78 a. $40 per board foot b. $25 per board foot c. $20 per board foot d. Zero
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LO 3

Managing Constraints
The theory of constraints (TOC) maintains that effectively managing a constraint is important to the financial success of an organization.
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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
•
Add workers transferred from non-bottleneck departments
LO 3
Copyright © 2012 McGraw-Hill Ryerson Limited

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.
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LO 3
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Copyright © 2012 McGraw-Hill Ryerson Limited
LO 4

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)
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LO 4
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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.
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LO 4
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Setting a Target Selling Price
Here is information provided by the management of
Ritter Company.
Direct materials
Direct labour
Variable manufacturing overhead
Fixed manufacturing overhead
Variable S & A expenses
Fixed S & A expenses
Per Unit
$ 6
4
3
2
Total
$ 70,000
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.
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 4

Setting a Target Selling Price
Direct materials
Direct labour
Variable manufacturing overhead
Fixed manufacturing overhead
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.
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LO 4
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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
Variable manufacturing overhead
Fixed manufacturing overhead
Unit product cost
50% markup
Target selling price
Per Unit
$ 6
4
3
7
$ 20
10
$ 30
LO 4
Copyright © 2012 McGraw-Hill Ryerson Limited

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
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LO 4
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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.
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LO 4
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Determining the Markup Percentage
Markup % on absorption cost
=
(20% × $100,000) + ($2
Variable SG&A per unit
×
10,000 + $60,000)
10,000 × $20
Total fixed SG&A
Markup % on absorption cost
=
($20,000 + $80,000)
$200,000
= 50%
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LO 4
Copyright © 2012 McGraw-Hill Ryerson Limited

Problems with the Absorption Costing Approach
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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
Copyright © 2012 McGraw-Hill Ryerson Limited

Problems with the Absorption Costing Approach
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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
$ 210,000
161,000
$
49,000
74,000
(25,000)
ROI =
$ (25,000)
$ 100,000
= -25%
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 4

Problems with the Absorption Costing Approach
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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.
Income Statement approach only if customers choose to buy at
Gross margin
SG&A expenses
Net operating loss they would buy.
161,000
49,000
74,000
$ (25,000)
ROI =
$ (25,000)
$ 100,000
= -25%
Copyright © 2012 McGraw-Hill Ryerson Limited
LO 4

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
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LO 5
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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.
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LO 5
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Reasons for Using Target Costing
.
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LO 5
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Reasons for Using Target Costing
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LO 5
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Target Costing
Handy Appliance feels there is a niche for a hand mixer with certain features. The
Marketing Department believes that a price of
$30 would be about right and that about
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
Copyright © 2012 McGraw-Hill Ryerson Limited

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.
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LO 5
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End of Chapter 12
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