Financial and Managerial
Accounting
Wild, Shaw, and Chiappetta
Fifth Edition
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 23
Relevant Costing for
Managerial Decisions
Conceptual Learning
Objectives
C1: Describe the importance of relevant
costs for short-term decisions.
23-3
Analytical Learning Objectives
A1: Evaluate short-term managerial
decisions using relevant costs.
A2: Determine product selling price
based on total costs.
23-4
Procedural Learning
Objectives
P1: Identify relevant costs and apply
them to managerial decisions.
23-5
C1
Decision Making
Decision making involves five steps:
 Define the decision task.
 Identify alternative courses of action.
 Collect relevant information and
evaluate each alternative.
 Select the preferred course of action.
 Analyze and assess decisions made.
23-6
C1
Relevant Costs




Are applicable
to a particular decision.
Should have a bearing on
which alternative a
manager selects.
Are avoidable.
Are future costs that differ
between alternatives.
23-7
P1
Identifying Relevant Costs
Historical costs are
generally not relevant to
decisions.
Instead the relevant costs
are the additional costs,
called incremental, or
avoidable, costs.
-These are costs incurred
if a company decides on
a specific course of action.
Sunk costs
Out-of-pocket costs
Opportunity costs
23-8
C1
Classification by Relevance:
Sunk Costs
All costs incurred in the past that cannot be changed
by any decision made now or in the future.
Sunk costs should not be considered in 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.
23-9
C1
Classification by Relevance:
Out-of-Pocket Costs
Future outlays of cash associated
with a particular decision.
Out-of-Pocket-Costs ARE relative for current
and future decision making.
Example: Considering the decision to take a
vacation or stay at home, you will have travel
costs (out-of-pocket costs) only if you choose a
vacation.
23-10
C1
Classification by Relevance:
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 $20,000 per
year.
Your opportunity cost of
attending college for one year is
$20,000.
23-11
A1
Accepting Additional Business
The decision to accept additional
business should be based on
incremental costs and incremental
revenues.
Incremental amounts are those that
occur if the company decides to accept
the new business.
Thanks for the offer!
Let me talk to our
management team and
I’ll let you know
tomorrow.
Management needs to know whether
accepting the offer will increase net
income
23-12
A1
Accepting Additional Business
(Exhibit 23.2)
FasTrac currently sells 100,000 units of its
product. The company has revenue and costs
as shown below:
Sales
Direct materials
Direct labor
Factory overhead
Selling expenses
Administrative expenses
Total expenses
Operating income
Per Unit
$ 10.00
3.50
2.20
1.10
1.40
0.80
$ 9.00
$ 1.00
$
$
$
Total
1,000,000
350,000
220,000
110,000
140,000
80,000
900,000
100,000
23-13
A1
Accepting Additional Business
FasTrac is approached by an overseas
company that offers to purchase
10,000 units at $8.50 per unit.
If FasTrac accepts the offer, total factory
overhead will increase by $5,000; total selling
expenses will increase by $2,000; and total
administrative expenses will increase
by $1,000.
Should FasTrac accept the offer?
23-14
A1
Accepting Additional Business
Per Unit
Total
Sales (10,000 additional units)
$8.50
$85,000
Total costs and expenses
(9.00)
(90,000)
$(0.50)
$(5,000)
Operating Loss
Sorry, we are going to reject the offer because the
selling price is less than the per unit cost to make
it.
This analysis leads to the
incorrect decision.
23-15
P1
Accepting Additional Business
(Exhibit 23.4)
Additional
Business
Sales
$ 85,000
Direct materials
(35,000)
Direct labor
(22,000)
Overhead
(5,000)
Selling expenses
(2,000)
Admin. expenses
(1,000)
Total expenses
(65,000)
Operating income $ 20,000
Current
Business
$1,000,000
(350,000)
(220,000)
(110,000)
(140,000)
(80,000)
(900,000)
$100,000
Combined
$1,085,000
(385,000)
(242,000)
(115,000)
(142,000)
(81,000)
(965,000)
$120,000
If they accept the offer, revenues will increase by
10,000 new units × $8.50 selling price = $85,000
23-16
P1
Accepting Additional Business
(Exhibit 23.4)
Additional
Business
Sales
$ 85,000
Direct materials
(35,000)
Direct labor
(22,000)
Overhead
(5,000)
Selling expenses
(2,000)
Admin. expenses
(1,000)
Total expenses
(65,000)
Operating income $ 20,000
Current
Business
$1,000,000
(350,000)
(220,000)
(110,000)
(140,000)
(80,000)
(900,000)
$100,000
Combined
$1,085,000
(385,000)
(242,000)
(115,000)
(142,000)
(81,000)
(965,000)
$120,000
Direct material costs will increase by
10,000 new units × $3.50 = $35,000
23-17
P1
Accepting Additional Business
(Exhibit 23.4)
Additional
Business
Sales
$ 85,000
Direct materials
(35,000)
Direct labor
(22,000)
Overhead
(5,000)
Selling expenses
(2,000)
Admin. expenses
(1,000)
Total expenses
(65,000)
Operating income $ 20,000
Direct labor costs will increase by
22,000 new units × $2.20 = $22,000
Current
Business
$1,000,000
(350,000)
(220,000)
(110,000)
(140,000)
(80,000)
(900,000)
$100,000
Combined
$1,085,000
(385,000)
(242,000)
(115,000)
(142,000)
(81,000)
(965,000)
$120,000
Overhead, selling expenses, and administrative
expenses are largely fixed costs that increase
but not in direct proportion to sales.
23-18
P1
Accepting Additional Business
(Exhibit 23.4)
Additional
Business
Sales
$ 85,000
Direct materials
(35,000)
Direct labor
(22,000)
Overhead
(5,000)
Selling expenses
(2,000)
Admin. expenses
(1,000)
Total expenses
(65,000)
Operating income $ 20,000
Current
Business
$1,000,000
(350,000)
(220,000)
(110,000)
(140,000)
(80,000)
(900,000)
$100,000
Combined
$1,085,000
(385,000)
(242,000)
(115,000)
(142,000)
(81,000)
(965,000)
$120,000
Even though the $8.50 selling price is less than the normal $10 selling price,
FasTrac should accept the offer because net income will increase by $20,000.
23-19
A1
Make or Buy Decisions



Incremental costs also are important in the
decision to make a component or purchase
it from a supplier.
The cost to produce an item must include
(1) direct materials, (2) direct labor, and (3)
incremental overhead.
We should not use the predetermined
overhead rate to determine product cost.
23-20
P1
Make or Buy Decisions
FasTrac currently makes part #417, assigning overhead at
100 percent of direct labor cost, with the following unit cost:
Cost to Make Part #417
Direct materials
Direct labor
Overhead
Make
$ 0.45
0.50
0.50
Total cost to make
$ 1.45
23-21
P1
Make or Buy Decisions
(Exhibit 23.5)
FasTrac can buy part #417 from a supplier for $1.20/per
unit. How much overhead do we have to eliminate
before we should buy this part?
Make vs. Buy Analysis
Direct materials
Direct labor
Overhead
Purchase price
Total incremental costs
Make
$ 0.45
0.50
?
---.95 + ?
Buy
---------$ 1.20
$ 1.20
23-22
P1
Make or Buy Decisions
FasTrac can buy part #417 from a supplier for $1.20/unit.
How much overhead do we have to eliminate before we
should buy this part?
We must be able to eliminate a minimum of $.25 per
unit of overhead.
Make vs. Buy Analysis
Direct materials
Direct labor
Factory overhead
Purchase price
Total incremental costs
Make
$ 0.45
0.50
0.25
---1.20
Buy
---------$ 1.20
$ 1.20
($1.20 - $0.95)
23-23
A1
Scrap or Rework
Costs incurred in manufacturing units of
product that do not meet quality standards
are sunk costs and cannot be recovered.
As long as rework costs are recovered
through sale of the product, and
rework does not interfere with normal
production, we should rework rather
than scrap products in process.
23-24
P1
Scrap or Rework
FasTrac has 10,000 defective units that
cost $1.00 each to make. The units can be
scrapped now for $.40 each or reworked at an
additional cost of $.80 per unit.
If reworked, the units can be sold for the
normal selling price of $1.50 each. Reworking
the defective units will prevent the production
of 10,000 new units that would also sell for
$1.50.
Should FasTrac scrap or rework?
23-25
P1
Scrap or Rework
Sale of defects
Less rework costs
Less opportunity cost
Net return
(Exhibit 23.6)
Scrap
Now
$ 4,000
$ 4,000
Rework
$ 15,000
Revenue from sale of the defective units =
10,000 units × $0.40 per unit
Revenue from the sale of the reworked units=
10,000 units × $1.50 per unit
23-26
P1
Scrap or Rework
(Exhibit 23.6)
Costs to rework the units =
10,000 units × $0.80 per unit
Sale of defects
Less rework costs
Less opportunity cost
Net return
Scrap
Now
$ 4,000
$ 4,000
Rework
$ 15,000
(8,000)
(5,000)
2,000
Opportunity cost of not making 10,000 units =
10,000 units × ($1.50 - $1.00) per unit
23-27
P1
Scrap or Rework Defects
(Exhibit 23.6)
The correct decision: FasTrac should scrap the units now.
Sale of Defects
Less rework costs
Less opportunity cost
Net return
Scrap
Now
$ 4,000
$ 4,000
Rework
$ 15,000
(8,000)
(5,000)
2,000
Note: If FasTrac fails to include the opportunity cost of $5,000, the
rework option would show a return of $7,000, mistakenly making
the rework option appear more favorable.
23-28
A1
Sell or Process


Businesses are often faced with the
decision to sell partially completed
products or to process them to
completion.
As a general rule, we process further
only if incremental revenues exceed
incremental costs.
23-29
A1
Sell or Process
FasTrac has 40,000 units of partially finished
product Q. Processing costs to date are
$30,000. The 40,000 unfinished units can be
sold as is for $50,000 or they can be processed
further to produce finished products X, Y, and
Z. The additional processing will cost $80,000
and result in the following revenues:
Continue
23-30
P1
Sell or Process
Product
X
Y
Z
Spoilage
Total
Price
$
4.00
6.00
8.00
-
(Exhibit 23.7)
Units
Revenue
10,000
22,000
6,000
2,000
40,000
$
40,000
132,000
48,000
$ 220,000
Remember:
The company would receive $50,000 for Product Q.
The incremental revenue from additional processing is $220,000- $50,000 = $170,000.
The incremental cost of processing is $80,000
Should FasTrac sell product Q or continue
processing into products X, Y, and Z?
23-31
P1
Sell or Process
Product
X
Y
Z
Spoilage
Total
Price
$
4.00
6.00
8.00
-
(Exhibit 23.7)
Units
Revenue
10,000
22,000
6,000
2,000
40,000
$ 40,000
132,000
48,000
$ 220,000
Remember:
The company
would receive
$50,000 for
Product Q.
Incremental revenue (220,000-50,000) =$170,000
Incremental cost = 80,000
Incremental revenue > Incremental cost
Decision…FasTrac should continue processing!
Note that the earlier $30,000 cost for producing Q is sunk and therefore
irrelevant to the decision.
23-32
A1
Sales Mix Selection
When a company sells a variety of products, some are
likely to be more profitable than others. They are wise to
concentrate sales efforts on more profitable products.
How do they identify the best sales mix?
To make an informed decision, management must consider . . .
•
•
•
The contribution margin of each product
The facilities required to produce each product and any
constraints on the facilities
The demand for each product.
23-33
P1
Sales Mix Selection
Demand Is Unlimited and Products Use SAME Inputs.
Consider the following data for two
products made and sold by FasTrac.
Per unit amounts
Selling price per unit
Variable costs per unit
Contribution margin per unit
Product
A
$
5.00
3.50
$
1.50
Product
B
$
7.50
5.50
$
2.00
If each product requires the same time to make, and the
demand is unlimited, FasTrac should produce only Product B
because it has the highest contribution margin.
23-34
Sales Mix Selection
P1
Demand Is Unlimited and Products Use Different Inputs.
(Exhibit 23.9)
Consider the following data for two products made and sold by
FasTrac. The company is operating at full capacity and the
products produced require a different amount of machine hours.
Per unit amounts
Selling price
Variable costs
Contribution margin
Machine hours required to
produce one unit
Contribution per machine hour
Product Product
In the time that it
A
B
takes to produce one
$
5.00 $
7.50 unit of Product B, we
can produce two units
3.50
5.50
of Product A.
$
1.50 $
2.00
$
1.0
1.50 $
2.0
1.00
Product B has a greater contribution margin than Product
A, but it requires more machine hours per unit to produce.
23-35
Sales Mix Selection
P1
Demand Is Unlimited and Products Use Different Inputs.
(Exhibit 23.9)
When a company faces unlimited demand and limited
capacity, only the most profitable product per input,
should be manufactured.
Per unit amounts
Selling price
Variable costs
Contribution margin
Machine hours required to
produce one unit
Contribution per machine hour
Product
A
$
5.00
3.50
$
1.50
Product
B
$
7.50
5.50
$
2.00
1.0
1.50
2.0
1.00
$
$
With unlimited demand for A and B, produce as many units of
A as possible since A provides more dollars per hour worked.
23-36
P1
Sales Mix Selection
Demand Is Limited (Exhibit 23.9)
Using the same information for FasTrac below but adding the
additional fact that the market for Product A is limited to 80,000 units.
Per unit amounts
Selling price
Variable costs
Contribution margin
Machine hours required to
produce one unit
Contribution per machine hour
Product
A
$
5.00
3.50
$
1.50
Product
B
$
7.50
5.50
$
2.00
1.0
1.50
2.0
1.00
$
$
If demand for A is limited, produce to meet that demand,
then use the remaining facilities to produce B.
23-37
A1
Segment Elimination
(Information from Exhibit 23.10)
A segment is a candidate for elimination
if its revenues are less than its
avoidable expenses.
FasTrac is considering eliminating its Treadmill
Division because total expenses of $48,300 are
greater than its sales of $47,800.
Continue
23-38
P1
Segment Elimination
FasTrac should eliminate the Treadmill Division if its revenues are less
than it avoidable expenses. Avoidable expenses are amounts the
company would not incur if it eliminated the segment..
Sales
Sales
Avoidable
Avoidable expenses
expenses
Decrease
Decrease in
in income
income
$$ 47,800
47,800
41,800
41,800
$$ 6,000
6,000
The Treadmill
Division sales
revenue is
greater than its
avoidable
expenses by
$6,000.
Do not eliminate
the Treadmill Division!
23-39
A1
Qualitative Decisions Factors
Qualitative factors are involved in most all
managerial decisions. For example:
 Quality.
 Delivery schedule.
 Supplier reputation.
 Employee morale.
 Effects on the company’s image.
23-40
A2
Setting Product Prices
Relevant costs are useful to management to
assist in determining prices for special shortterm decisions.
However, long-run pricing decisions also need to
cover both variable and fixed costs, and yield a profit.
There are several methods to help
management in setting prices
The “cost plus” method, where management adds a markup to the costs to reach a target price is most common.
23-41
A2
Four Steps Using the Total Cost Method
Total Cost Method:
1. Determine the total costs (production and
nonproduction).
2. Determine the total cost per unit.
3. Determine the markup per unit.
4. Determine the selling price per unit:
Total cost per unit + Markup per unit
23-42
End of Chapter 23
23-43