Chapter 13:
Short-Run Decision Making:
Relevant Costing
Cornerstones of Managerial Accounting, 4e
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Learning Objectives
1. Describe the short-run decision-making model, and explain
how cost behavior affects the information used to make
decisions.
2. Apply relevant costing and decision-making concepts in a
variety of business situations.
3. Choose the optimal product mix when faced with one
constrained resource.
4. Explain the impact of cost on pricing decisions.
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1
Short-Run Decision Making
► Short-run decision making consists of choosing among
alternatives with an immediate or limited end in view.
► Short-term decisions sometimes are referred to as tactical
decisions because they involve choosing between alternatives
with an immediate or limited time frame in mind.
► Accepting a special order for less than the normal selling price
to utilize idle capacity and to increase this year’s profits is an
example. Thus, some decisions tend to be short run in nature.
► However, it should be emphasized that short-run decisions
often have long-run consequences.
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1
The Decision-Making Model
► A decision model, a specific set of procedures that produces a
decision, can be used to structure the decision maker’s thinking and
to organize the information to make a good decision.
► The following is an outline of one decision-making model:
► Step 1. Recognize and define the problem.
► Step 2. Identify alternatives as possible solutions to the problem. Eliminate
alternatives that clearly are not feasible.
► Step 3. Identify the costs and benefits associated with each feasible
alternative. Classify costs and benefits as relevant or irrelevant, and eliminate
irrelevant ones from consideration.
► Step 4. Estimate the relevant costs and benefits for each feasible alternative.
► Step 5. Assess qualitative factors.
► Step 6. Make the decision by selecting the alternative with the greatest
overall net benefit.
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Step
1:
1
Recognize and Define the Problem
► The first step is to recognize and define a specific problem.
► For example, if the members of a management team recognized the
need for additional productive capacity as well as increased space for
raw materials and finished goods inventories, they would consider the
important dimensions of:
►The number of workers and the amount of space needed,
►The reasons for the need, and
►How the additional space would be used are all important dimensions of
the problem.
►However, the central question is how to acquire the additional capacity.
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1
Step 2: Identify the Alternatives
as Possible Solutions
► The second step is to list and consider possible solutions.
► Some alternatives are dismissed due to too much risk, they
are not proven, or are outside of cost constraints.
► One of the best strategies is to link the short-run decision
(like an increase in productive capacity) to the company’s
overall growth strategy by rejecting alternatives that involve
too much risk at a particular stage of a company’s
development.
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1
Step 3: Identify the Costs and Benefits
Associated with Each Feasible Alternative
► In the third step, the costs and benefits associated with each
feasible alternative are identified.
► At this point, clearly irrelevant costs can be eliminated from
consideration. (It is fine to include irrelevant costs and
benefits in the analysis as long as they are included for all
alternatives. We usually do not include them because
focusing only on the relevant costs and benefits reduces the
amount of data to be collected.)
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1
Step 4: Estimate the Relevant Costs and
Benefits for Each Feasible Alternative
► The differential cost is the difference between the summed
costs of two alternatives in a decision.
► Typically, a differential cost compares the sum of each
alternative’s relevant costs only.
► Emphasis on differential cost allows decision makers to
occasionally include irrelevant costs in the alternatives if they
choose to do so.
► However, the inclusion of irrelevant costs is acceptable only if
all irrelevant costs are included for each alternative.
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1
Step 5: Assess Qualitative Factors
► Qualitative factors can significantly affect the manager’s
decision. Qualitative factors are simply those factors that are
hard to put a number on, including things like political
pressure and product safety.
► Political Pressure: Some managers worry that such political pressure
from customers can have long-term negative effects on sales that
more than offset the labor cost savings that spurred the decision to
offshore.
► Product Safety: Product safety represents another key qualitative
factor for outsourcing organizations.
► Finally, truly qualitative factors, such as the impact of late orders on
customer relations, must be taken into consideration in the final
step of the decision-making model—the selection of the alternative
with the greatest overall benefit.
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1
Step 6: Make the Decision
► Once all relevant costs and benefits for each alternative have
been assessed and the qualitative factors weighed, a decision
can be made.
► Ethical concerns revolve around the way in which decisions
are implemented and the possible sacrifice of long-run
objectives for short-run gain.
► Relevant costs are used in making short-run decisions.
► However, decision makers should always maintain an ethical
framework.
► Whenever relevant costing is used, it is important to include
all costs that are relevant—including those involving ethical
ramifications.
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1
Relevant Costs Defined
► The decision-making approach just described emphasized the
importance of identifying and using relevant costs.
► Relevant costs possess two characteristics:
1. they are future costs AND
2. they differ across alternatives.
► All pending decisions relate to the future.
► Accordingly, only future costs can be relevant to decisions.
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1
Opportunity Costs
► Opportunity cost is the benefit sacrificed or foregone when
one alternative is chosen over another.
► An opportunity cost is relevant because it is both a future cost
and one that differs across alternatives.
► While an opportunity cost is never an accounting cost,
because accountants do not record the cost of what might
happen in the future (i.e., they do not appear in financial
statements), it is an important consideration in relevant
decision making.
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1
Sunk Costs
► A sunk cost is a cost that cannot be affected by any future
action.
► It is important to note the psychology behind managers’
treatment of sunk costs.
► Although managers should ignore sunk costs for relevant
decisions, it unfortunately is human nature to allow sunk
costs to affect these decisions.
► For example, depreciation, a sunk cost, is sometimes allocated to
future periods though the original cost is unavoidable. In choosing
between the two alternatives, the original cost of an asset and its
associated depreciation are not relevant factors.
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1
Cost Behavior and Relevant Costs
► Most short-run decisions require extensive consideration of
cost behavior.
► It is easy to fall into the trap of believing that variable costs
are relevant and fixed costs are not.
► But this assumption is not true.
► The key point is that changes in supply and demand for
resources must be considered when assessing relevance.
► If changes in demand and supply for resources across
alternatives bring about changes in spending, then the
changes in resource spending are the relevant costs that
should be used in assessing the relative desirability of the two
alternatives.
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2
Some Common
Relevant Cost Applications
►Relevant costing is of value in solving many different
types of problems. Traditionally, these applications
include decisions:
►to make or buy a component.
► to keep or drop a segment or product line.
►to accept a special order at less than the usual price.
► to further process joint products or sell them at the splitoff point.
►Though by no means an exhaustive list, many of the
same decision-making principles apply to a variety of
problems.
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2
Make-or-Buy Decisions
► Managers often face the decision of whether to make a particular
product (or provide a service) or to purchase it from an outside
supplier.
► Make-or-buy decisions are those decisions involving a choice
between internal and external production.
► One type of relevant cost that is becoming increasingly large due to
globalization and the green environmental movement concerns the
disposal costs associated with electronic waste (or e-waste).
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Cornerstone 13-1
2
Structuring a Make-or-Buy Problem
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Cornerstone 13-1
2
Structuring a Make-or-Buy Problem (continued)
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2
Special Order Decisions
► From time to time, a company may consider offering a product or
service at a price different from the usual price.
► Firms often have the opportunity to consider special orders from
potential customers in markets not ordinarily served.
►Special-order decisions focus on whether a specially priced order
should be accepted or rejected.
► These orders often can be attractive, especially when the firm is
operating below its maximum productive capacity.
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Cornerstone 13-2
2
Structuring a Special Order Problem
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Cornerstone 13-2
2
Structuring a Special Order Problem (continued)
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2
Keep-or-Drop Decisions
► Often, a manager needs to determine whether a segment,
such as a product line, should be kept or dropped.
► Segmented reports prepared on a variable-costing basis
provide valuable information for these keep-or-drop
decisions.
► Both the segment’s contribution margin and its segment
margin are useful in evaluating the performance of segments.
► However, while segmented reports provide useful
information for keep-or-drop decisions, relevant costing
describes how the information should be used to arrive at a
decision.
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Cornerstone 13-3
2
Structuring a Keep-or-Drop
Product Line Problem
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Cornerstone 13-3
2
Structuring a Keep-or-Drop
Product Line Problem (continued)
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2
Keep-or-Drop with
Complementary Effects
►Sometimes dropping one line would lower sales of
another line, as many customers buy both lines at
the same time.
►This information can affect the keep-or-drop
decision.
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Cornerstone 13-4
2
Structuring a Keep-or-Drop Product Line
Problem with Complementary Effects
The roofing tile line has a contribution margin of $10,000 (sales of $150,000 minus total variable
costs of $140,000). All variable costs are relevant. Relevant fixed costs associated with this line
include $10,000 in advertising and $35,000 in supervision salaries. Assume that dropping the
product line reduces sales of blocks by 10 percent and sales of bricks by 8 percent.
Required:
1. If the roofing tile line is dropped, what is the contribution margin for the block line? For the
brick line?
2. Which alternative (keep or drop the roofing tile line) is now more cost effective and by how
much?
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Cornerstone 13-4
2
Structuring a Keep-or-Drop Product Line
Problem with Complementary Effects (continued)
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2
You Decide
Relevant Decision Making
You are an elected official in a major city that is considering
whether or not to move forward with a proposed plan to
demolish the city’s existing professional sports stadium and
build an elaborate new stadium. One of the most difficult
aspects of this decision is estimating the new stadium’s
incremental revenues and costs that would result if it were
built.
What specific types of relevant revenues and costs would
you consider in making this important decision?
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2
You Decide
Relevant Decision Making (continued)
There are many stadium events for which the associated relevant revenues and costs must be
estimated accurately if the correct decision is to be made. These stadium events (and their
relevant revenues and costs) include:
• Main attraction sporting events (e.g., ticket revenues from baseball, basketball, and/or
football games for which the stadium would be built; additional staffing, cleanup, and insurance
costs)
• Concessions and other sales (e.g., contribution margins or fees earned from product and
service sales—most new stadiums boast as many high-end shopping opportunities as an
upscale mall!)
• Television contract terms (e.g., the amount and percentage of revenue brought in by
additional games being televised in the new stadium, perhaps in primetime slots)
• Offseason events (e.g., the ticket revenue from boxing matches, music concerts, etc.).
For this relevant stadium decision, estimating the relevant revenues might be even more
difficult than estimating the relevant costs. For instance, projecting how many more people will
want to attend games in a new stadium can be unclear, as well as how much money they
would be willing to spend for various seats located around the stadium.
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2
You Decide
Relevant Decision Making (continued)
Several New York City area stadiums experienced tremendous difficulty in accurately estimating
these same items. For example, the New York Yankees and New York Mets organizations built
new stadiums with price tags of over $1.2 billion and $800 million, respectively! However, in the new
Yankee stadium, many of the more expensive seats—the ones behind the batter and, thus, most
visible on television—remained empty because of their hefty $2,500 per seat price tag. In fact, the
Yankee organization decreased some of its highest ticket prices by 50 percent during the stadium’s
first season in an attempt to fill these high profile empty seats. In other words, decision makers
struggled to estimate the amount of incremental revenue that would result from some of the more
important seats in a new Yankee stadium. Undaunted by such challenging relevant analyses,
however, the New York area also built a $1.6 billion new Meadowlands Stadium to be shared by the
New York Jets and New York Giants.
In addition to the previously mentioned relevant items, some citizens raise objections to such
large amounts of money being spent on replacing existing fully functional sporting facilities with
gargantuan sports palaces. They argue that $1 billion could be better spent on different causes.
Such sentiments, whether you agree or disagree with them, represent potentially important
qualitative factors that effective managerial accountants should take into account when performing
relevant analyses for proposed new stadiums, especially when these citizens represent tax payers
or potential fans the stadium builders count on for purchasing expensive tickets in the future.
When making such an important decision, relevant costs for things like sporting events,
concessions, television contracts, and off-season events must be considered in addition to
qualitative factors like citizen sentiment.
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2
Further Processing of
Joint Products
► Joint products have common processes and costs of
production up to a split-off point. At that point, they become
distinguishable as separately identifiable products. The point
of separation is called the split-off point.
► Sometimes it is more profitable to process a joint product
further, beyond the split-off point, prior to selling it (sell orprocess-further decision).
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Cornerstone 13-5
2
Structuring the
Sell-or-Process Further Decision
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3
Product Mix Decisions
► Most of the time, organizations have wide flexibility in
choosing their product mix.
► Product mix refers to the relative amount of each product
manufactured (or service provided) by a company.
► Decisions about product mix can have a significant impact on
an organization’s profitability.
► Every firm faces limited resources and limited demand for
each product. These limitations are called constraints.
► A manager must choose the optimal mix given the constraints
found within the firm.
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3
Cornerstone 13-6
Determining the Optimal Product Mix
with One Constrained Resource
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3
Cornerstone 13-6
Determining the Optimal Product Mix
with One Constrained Resource (continued)
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3
Cornerstone 13-7
Determining the Optimal Product Mix
with One Constrained Resource
and a Sales Constraint
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Cornerstone 13-7
3
Determining the Optimal Product Mix with One
Constrained Resource and a Sales Constraint (continued)
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3
Multiple Constrained Resources
► The presence of only one constrained resource might not be
realistic.
► Organizations often face multiple constraints, including:
► limitations of raw materials
► limitations of skilled labor
► limited demand for each product
► The solution of the product mix problem in the presence of
multiple constraints is considerably more complicated and
requires the use of a specialized mathematical technique
known as linear programming, which is reserved for advanced
cost management courses.
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4
Cost-Based Pricing
► Demand is one side of the pricing equation; supply is the other side.
► Since revenue must cover all costs for the firm to make a profit,
many companies start with cost to determine price.
► That is, they calculate product cost and add the desired profit.
► The mechanics of this approach are straightforward. Usually, there
is a cost base and a markup.
► The markup is a percentage applied to the base cost.
► It includes desired profit and any costs not included in the base
cost.
► Companies that bid for jobs routinely base bid price on cost.
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Cornerstone 13-8
4
Calculating Price by Applying a
Markup Percentage to Cost
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4
Target-Costing and Pricing
► Many American and European firms set the price of a new
product as the sum of the costs and the desired profit. The
rationale is that the company must earn sufficient revenues
to cover all costs and yield a profit.
► Target costing is a method of determining the cost of a
product or service based on the price (target price) that
customers are willing to pay.
► The marketing department determines what characteristics
and price for a product are most acceptable to consumers.
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Cornerstone 13-9
4
Calculating a Target Cost
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