Chapter
11
Relevant Costs for
Decision Making
Cost Concepts for Decision Making
A relevant cost is a cost that differs
between alternatives.
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Identifying Relevant Costs
Costs that can be eliminated (in whole or in
part) by choosing one alternative over
another are avoidable costs. Avoidable
costs are relevant costs.
Unavoidable costs are never relevant and
include:
Sunk costs.
Future costs that do not differ between the
alternatives.
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Identifying Relevant Costs
Sunk cost -- a cost that has already
been incurred and that cannot be
avoided regardless of what a manager
decides to do.
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Identifying Relevant Costs
Well, I’ve assembled
all the costs associated
with the alternatives
we are considering.
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Identifying Relevant Costs
Great! The first
thing we need to
do is eliminate all
the sunk costs.
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Quick Check 
In a decision of whether to buy a new car and
trade-in your old car or just keep your old car,
which of the following are sunk costs?
a. The cost of licensing the new car.
b. The cost of licensing your old car next year if
you keep it.
c. The amount you paid for your old car.
d. The amount you paid to repair your old car
last month in case you wanted to sell it.
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Identifying Relevant Costs
Now that we have eliminated the
sunk costs, we need to eliminate
the future costs that don’t differ
between alternatives.
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Quick Check 
In a decision of whether to buy a new car and
trade-in your old car or just keep your old car,
which of the following are future costs that don’t
differ between the alternatives?
a. Monthly parking fees.
b. Auto insurance.
c. Theater tickets.
d. Driver’s license renewal fee.
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Identifying Relevant Costs
The decision will be
easier now. All we
have left are the
avoidable costs.
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Note
 Do not underestimate the importance and
power of the relevant cost idea.
 Most costs (and benefits) do not differ between
alternatives. This allows you to focus on the
few things that matter.
 This principle also helps avoid mistakes.
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Sunk Costs are not Relevant Costs
Let’s look at
the White
Company
example.
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Sunk Costs are not Relevant Costs
A manager at White Co. wants to replace an old
machine with a new, more efficient machine.
New machine:
List price
Annual variable expenses
Expected life in years
Old machine:
Original cost
Remaining book value
Disposal value now
Annual variable expenses
Remaining life in years
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$ 90,000
80,000
5
$ 72,000
60,000
15,000
100,000
5
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Sunk Costs are not Relevant Costs
 White’s sales are $200,000 per year.
 Fixed expenses, other than depreciation, are
$70,000 per year.
Should the manager purchase the new
machine?
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Incorrect Analysis
The manager recommends that the
company not purchase the new
machine since disposal of the old
machine would result in a loss:
Remaining book value
Disposal value
Loss from disposal
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$ 60,000
(15,000)
$ 45,000
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Correct Analysis
Look at the comparative cost and revenue for the next
five years.
For Five Years
Sales
Variable expenses
Other fixed expenses
Depreciation - new
Depreciation - old
Disposal of old machine
Total net income
Keep Old
Machine
$ 1,000,000
(500,000)
Purchase
New
Machine
Difference
$200,000 per year × 5 years
$100,000 per year × 5 years
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Correct Analysis
Look at the comparative cost and revenue for the next
five years.
For Five Years
Sales
Variable expenses
Other fixed expenses
Depreciation - new
Depreciation - old
Disposal of old machine
Total net income
Keep Old
Machine
$ 1,000,000
(500,000)
(350,000)
Purchase
New
Machine
Difference
$70,000 per year × 5 years
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Correct Analysis
Look at the comparative cost and revenue for the next
five years.
For Five Years
Sales
Variable expenses
Other fixed expenses
Depreciation - new
Depreciation - old
Disposal of old machine
Total net income
Keep Old
Machine
$ 1,000,000
(500,000)
(350,000)
Purchase
New
Machine
Difference
(60,000)
$
90,000
The remaining book
value of the old machine.
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Correct Analysis
Look at the comparative cost and revenue for the next
five years.
For Five Years
Sales
Variable expenses
Other fixed expenses
Depreciation - new
Depreciation - old
Disposal of old machine
Total net income
Keep Old
Machine
$ 1,000,000
(500,000)
(350,000)
Purchase
New
Machine
$ 1,000,000
(400,000)
Difference
$
100,000
(60,000)
$
90,000
$80,000 per year × 5 years
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Correct Analysis
Look at the comparative cost and revenue for the next
five years.
For Five Years
Sales
Variable expenses
Other fixed expenses
Depreciation - new
Depreciation - old
Disposal of old machine
Total net income
Keep Old
Machine
$ 1,000,000
(500,000)
(350,000)
Purchase
New
Machine
$ 1,000,000
(400,000)
(350,000)
(90,000)
Difference
$
100,000
(90,000)
(60,000)
$
90,000
The total cost will be depreciated
over the five year period.
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Correct Analysis
Look at the comparative cost and revenue for the next
five years.
For Five Years
Sales
Variable expenses
Other fixed expenses
Depreciation - new
Depreciation - old
Disposal of old machine
Total net income
Keep Old
Machine
$ 1,000,000
(500,000)
(350,000)
(60,000)
$
90,000
Purchase
New
Machine
$ 1,000,000
(400,000)
(350,000)
(90,000)
(60,000)
15,000
$ 115,000
Difference
$
100,000
(90,000)
15,000
$ 25,000
The remaining book value of the old
machine is a sunk cost and is not
relevant to the decision.
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Correct Analysis
Look at the comparative cost and revenue for the next
five years.
For Five Years
Sales
Variable expenses
Other fixed expenses
Depreciation - new
Depreciation - old
Disposal of old machine
Total net income
Keep Old
Machine
$ 1,000,000
(500,000)
(350,000)
(60,000)
$
90,000
Purchase
New
Machine
$ 1,000,000
(400,000)
(350,000)
(90,000)
(60,000)
15,000
$ 115,000
Difference
$
100,000
(90,000)
15,000
$ 25,000
Would you recommend purchasing the new
machine?
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Relevant Cost Analysis
Let’s look at a
more efficient
way to analyze
this decision.
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Relevant Cost Analysis
Just focus on
the costs that
differ between
alternatives.
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Relevant Cost Analysis
Relevant Cost Analysis
Savings in variable expenses
provided by the new machine
($20,000 × 5 yrs.)
$ 100,000
Net effect
$100,000 - $80,000 = $20,000 variable cost savings
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Relevant Cost Analysis
Relevant Cost Analysis
Savings in variable expenses
provided by the new machine
($20,000 × 5 yrs.)
$ 100,000
Cost of the new machine
(90,000)
Disposal value of old machine
15,000
Net effect
$
25,000
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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 decision.
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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. An income statement for last year
is shown on the next screen.
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Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales
Less: variable expenses
Variable mfg. 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 loss
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$ 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)
© The McGraw-Hill Companies, Inc., 2002
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales
$ 500,000
Investigation has revealed that total fixed
Less: variable expenses
general
factory
general
Variable
mfg.
costs overhead
$ and
120,000
Variable
shipping costs
5,000not be
administrative
expenses would
Commissions
75,000
200,000
affected
if the digital watch line
is dropped.
Contribution margin
$ 300,000
Thefixed
fixed
general factory overhead and
Less:
expenses
general
administrative
assigned
General factory
overhead expenses
$
60,000
Salary
of line
manager
90,000
to this
product
would be reallocated
to
Depreciation of equipment
50,000
other product lines.
Advertising - direct
100,000
Rent - factory space
70,000
General admin. expenses
30,000
400,000
Net loss
$ (100,000)
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Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales
$ 500,000
Less: variable expenses
Variable
mfg. costs
$ 120,000
The
equipment
used to manufacture
Variable shipping costs
5,000
digital watches has no resale
Commissions
75,000
200,000
valuemargin
or alternative use.
Contribution
$ 300,000
Less: fixed expenses
General factory overhead
$
60,000
Salary of line manager
90,000
Depreciation of equipment
50,000retain or drop
Should Lovell
Advertising - direct
100,000
the digital
watch segment?
Rent - factory space
70,000
General admin. expenses
30,000
400,000
Net loss
$ (100,000)
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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.
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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
$
90,000
Advertising - direct
100,000
Rent - factory space
70,000
Net disadvantage
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$ (300,000)
260,000
$ (40,000)
© The McGraw-Hill Companies, Inc., 2002
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.
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Comparative Income Approach
Solution
Keep
Drop
Digital
Digital
Watches
Watches
Difference
Sales
$ 500,000
$
$ (500,000)
Less variable expenses:
Mfg. expenses
120,000
120,000
Freight out
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:
General factory overhead
60,000
Salary of line manager
90,000
Depreciation
50,000
If the digital watch
Advertising - direct
100,000
line is dropped, the
Rent - factory space
70,000
company gives up
General admin. expenses
30,000
Total fixed expenses
400,000
its contribution
Net loss
$ (100,000)
margin.
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Comparative Income Approach
Solution
Keep
Drop
Digital
Digital
Watches
Watches
Difference
Sales
$ 500,000
$
$ (500,000)
Less variable expenses:
Mfg. expenses
120,000
120,000
Freight out
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:
General factory overhead
60,000
60,000
Salary of line manager
90,000
Depreciation
50,000
On 100,000
the other hand, the general
Advertising - direct
Rent - factory space
70,000
factory
overhead would be the
General admin. expenses
30,000
same.
So this cost really isn’t
Total fixed expenses
400,000
Net loss
$ (100,000) relevant.
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Comparative Income Approach
Solution
Keep
Drop
Digital
Digital
Watches
Watches
Sales
$ 500,000
$
But
we
wouldn’t
need
Less variable expenses:
-a
manager for
the product-line
Mfg. expenses
120,000
Freight out
5,000
anymore.
Commissions
75,000
Total variable expenses
200,000
Contribution margin
300,000
Less fixed expenses:
General factory overhead
60,000
60,000
Salary of line manager
90,000
Depreciation
50,000
Advertising - direct
100,000
Rent - factory space
70,000
General admin. expenses
30,000
Total fixed expenses
400,000
Net loss
$ (100,000)
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Difference
$ (500,000)
120,000
5,000
75,000
200,000
(300,000)
90,000
© The McGraw-Hill Companies, Inc., 2002
Comparative Income Approach
Solution
Keep
Drop
Digital
Digital
Watches
Watches
Difference
Sales
$ 500,000
$
$ (500,000)
If variable
the digital
watch line is dropped, the net- book value
Less
expenses:
Mfg.
expenses
120,000 off. The -depreciation
120,000
of
the
equipment would be written
Freight out
5,000
5,000
that
would
have
been
taken
will
flow
through
the
Commissions
75,000
75,000
Total variable expenses
200,000
200,000
income statement as
a loss instead.
Contribution margin
300,000
(300,000)
Less fixed expenses:
General factory overhead
60,000
60,000
Salary of line manager
90,000
90,000
Depreciation
50,000
50,000
Advertising - direct
100,000
Rent - factory space
70,000
General admin. expenses
30,000
Total fixed expenses
400,000
Net loss
$ (100,000)
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Comparative Income Approach
Solution
Keep
Drop
Digital
Digital
Watches
Watches
Sales
$ 500,000
$
Less variable expenses:
Mfg. expenses
120,000
Freight out
5,000
Commissions
75,000
Total variable expenses
200,000
Contribution margin
300,000
Less fixed expenses:
General factory overhead
60,000
60,000
Salary of line manager
90,000
Depreciation
50,000
50,000
Advertising - direct
100,000
Rent - factory space
70,000
General admin. expenses
30,000
30,000
Total fixed expenses
400,000
140,000
Net loss
$(100,000)
$(140,000)
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Difference
$ (500,000)
120,000
5,000
75,000
200,000
(300,000)
90,000
100,000
70,000
260,000
$ (40,000)
© The McGraw-Hill Companies, Inc., 2002
Beware of Allocated Fixed Costs
Why should we keep
the digital watch
segment when it’s
showing a loss?
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Beware of Allocated Fixed Costs
The answer lies in the
way we allocate
common fixed costs
to our products.
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Beware of Allocated Fixed Costs
Our allocations can
make a segment
look less profitable
than it really is.
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The Make or Buy Decision
A decision concerning whether an item
should be produced internally or
purchased from an outside supplier is
called a “make or buy” decision.
Let’s look at the Essex Company example.
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The Make or Buy Decision
 Essex manufactures part 4A that is currently
used in one of its products.
 The cost per unit of this part is:
Direct materials
$ 9
Direct labor
5
Variable overhead
1
Depreciation of special equip.
3
Supervisor's salary
2
General factory overhead
10
Total cost per unit
$ 30
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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 labor
hours, would be unaffected by this decision.
 The $30 total cost per unit 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?
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The Make or Buy Decision
Cost
Per Unit
Outside purchase price
$ 25
Direct materials
Direct labor
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost
$
9
5
1
3
2
10
$ 30
Cost of 20,000 Units
Buy
Make
$ 500,000
180,000
100,000
20,000
40,000
$ 340,000
$ 500,000
20,000 × $9 per unit = $180,000
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The Make or Buy Decision
Cost
Per Unit
Outside purchase price
$ 25
Direct materials
Direct labor
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost
$
9
5
1
3
2
10
$ 30
Cost of 20,000 Units
Buy
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.
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The Make or Buy Decision
Cost
Per Unit
Outside purchase price
$ 25
Direct materials
Direct labor
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost
$
9
5
1
3
2
10
$ 30
Cost of 20,000 Units
Buy
Make
$ 500,000
180,000
100,000
20,000
40,000
$ 340,000
$ 500,000
Not avoidable and is irrelevant. If the product is
dropped, it will be reallocated to other products.
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The Make or Buy Decision
Cost
Per Unit
Outside purchase price
$ 25
Direct materials
Direct labor
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost
$
9
5
1
3
2
10
$ 30
Cost of 20,000 Units
Buy
Make
$ 500,000
180,000
100,000
20,000
40,000
$ 340,000
$ 500,000
Should we make or buy part 4A?
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The Make or Buy Decision
DECISION RULE
In deciding whether to accept the outside
supplier’s offer, Essex isolated the relevant
costs of making the part by eliminating:
The sunk costs.
The future costs that will not differ between
making or buying the parts.
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The Matter of Opportunity Cost
The benefits that are foregone as a result of
pursuing some course of action.
Opportunity costs are not actual dollar outlays
and are not recorded in the accounts of an
organization.
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Quick Check 
Which of the following are opportunity costs of
attending the university?
a. Tuition.
b. Books.
c. Lost wages.
d. Not enough time for other interests.
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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.
Should Jet accept the offer?
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Special Orders
Jet, Inc.
Contribution Income Statement
Revenue (5,000 × $20)
$ 100,000
Variable costs:
Direct materials
$ 20,000
Direct labor
5,000
Manufacturing overhead
10,000 $8 variable cost
Marketing costs
5,000
Total variable costs
40,000
Contribution margin
60,000
Fixed costs:
Manufacturing overhead
$ 28,000
Marketing costs
20,000
Total fixed costs
48,000
Net income
$ 12,000
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Special Orders
If Jet accepts the offer, net income will
increase by $6,000.
Increase in revenue (3,000 × $10)
Increase in costs (3,000 × $8 variable cost)
Increase in net income
$ 30,000
24,000
$ 6,000
Note: This answer assumes that fixed costs are
unaffected by the order and that variable marketing
costs must be incurred on the special order.
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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)
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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.
a. $50
b. $10
c. $15
d. $29
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Utilization of a Constrained Resource
 Firms often face the problem of deciding how
to best utilize a constrained resource.
 Usually fixed costs are not affected by this
particular decision, so management can focus
on maximizing total contribution margin.
Let’s look at the Ensign Company example.
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Utilization of a Constrained Resource
Ensign Company produces two products and
selected data is shown below:
Product
2
1
Selling price per unit
Less variable expenses per unit
Contribution margin per unit
Current demand per week (units)
Contribution margin ratio
Processing time required
on machine A1 per unit
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$
60
36
$ 24
2,000
40%
1.00 min.
$
50
35
$ 15
2,200
30%
0.50 min.
© The McGraw-Hill Companies, Inc., 2002
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 2?
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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
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Product 2
0.5 unit
2 units
1 unit
0.5 unit
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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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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 min.
$ 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.
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Utilization of a 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 min.
$ 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.
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Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting Our Constrained Recource (Machine A1)
Weekly demand for Product 2
Time required per unit
Total time required to make
Product 2
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×
2,200 units
0.50 min.
1,100 min.
© The McGraw-Hill Companies, Inc., 2002
Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting Our Constrained Recource (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
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×
2,200 units
0.50 min.
1,100 min.
2,400 min.
1,100 min.
1,300 min.
© The McGraw-Hill Companies, Inc., 2002
Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting Our Constrained Recource (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
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×
2,200 units
0.50 min.
1,100 min.
÷
2,400
1,100
1,300
1.00
1,300
min.
min.
min.
min.
units
© The McGraw-Hill Companies, Inc., 2002
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.
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Quick Check 
Colonial Heritage makes reproduction colonial
furniture from select hardwoods.
Chairs
Sellilng 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
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Quick Check 
Chairs
Sellilng 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
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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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Quick Check 
As before, Colonial Heritage’s supplier of
hardwood will only be able to supply 2,000
board feet this month. Assume there is unlimited
demand for chairs. 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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Managing Constraints
Produce only
what can be sold.
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 acquired
more machines
• Subcontract production
Eliminate waste.
Streamline production process.
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End of Chapter 11
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