Overview managerial accounting chapter 013

Identify relevant and irrelevant costs and benefits in a decision situation.. Only those costs and benefits that differ between alternatives are relevant in a decision.. If the special

Chapter 13

Relevant Costs for Decision Making

Learning Objectives

LO1 Identify relevant and irrelevant costs and benefits in a decision situation

LO2 Prepare an analysis showing whether a product line or other organizational segment

should be dropped or retained

LO3 Prepare a make or buy analysis

LO4 Prepare an analysis showing whether a special order should be accepted

LO5 Determine the most profitable use of a constrained resource and the value of obtaining

more of the constrained resource

LO6 Prepare an analysis showing whether joint products should be sold at the split-off point

or processed further

New in this Edition

• New In Business boxes have been added to the chapter

Chapter Overview

A Cost Concepts for Decision-Making. (Exercises 13-1, 13-7, and 13-13.) Every decision involves choosing from among at least two alternatives The costs and benefits of the alternatives should be compared

1 Identifying relevant costs Only those costs and benefits that differ between alternatives

are relevant in a decision Any cost or benefit that does not differ between the alternatives

is irrelevant and can be ignored This is a tremendously powerful concept that allows us to ignore mounds of data when making decisions since most things are not affected by any given decision

a All sunk costs (i.e., costs already irrevocably incurred) are irrelevant since they will be the same for any alternative All future costs that do not differ between alternatives are irrelevant

b Any cost that is avoidable is potentially relevant An avoidable cost is a cost that can be eliminated (in whole or in part) as a result of choosing one alternative over another

2 Different costs for different purposes Costs that are relevant in one decision are not

necessarily relevant in another In each situation the manager must examine the data and isolate the relevant costs

3 Human frailties Most of us have a great deal of difficulty ignoring irrelevant costs when

making decisions We are especially reluctant to ignore sunk costs when the sunk costs are

a consequence of a past decision that in retrospect was unwise We have a tendency to become committed to courses of action that have not worked out

B Adding or Dropping a Segment. (Exercises 13-2, 13-8, and 13-14.) Decisions related

to dropping old products (or segments) and adding new products (or segments) are among the most difficult that a manager makes Two basic approaches can be used to analyze data in this type of decision

1 Compare contribution margins and fixed costs A segment should be added only if the

increase in total contribution margin is greater than the increase in fixed cost A segment should be dropped only if the decrease in total contribution margin is less than the decrease

in fixed cost

2 Compare net operating incomes A second approach is to calculate the total net operating

income under each alternative The alternative with the highest net operating income is preferred This approach requires more information than the first approach since costs and revenues that don’t differ between the alternatives must be included in the analysis in order

to compute net operating incomes

3 Beware of allocated common costs Allocated common costs can make a profitable

segment look unprofitable Allocated common costs that would not be affected by a decision are irrelevant and should be ignored

C The Make or Buy Decision. (Exercises 13-3, 13-9, and 13-15.) A make or buy decision

is concerned with whether an item should be made internally or purchased from an external supplier

1 Advantages of making an item internally

a Producing a part internally reduces dependence on suppliers and may ensure a smoother flow of parts and material for production

b Quality control may be easier when parts are produced internally

c Profits can be realized on the parts and materials

2 Advantages of buying an item from an external supplier

a By pooling the requirements of a number of users, a supplier can realize economies of scale and may be able to move more quickly up the learning curve

b A specialized supplier may be able to respond more quickly and at less cost to changing future needs

c Changing technology may make producing one’s own parts riskier than purchasing from the outside

3 Opportunity Cost Opportunity costs should be considered in decisions The opportunity

cost of using a resource that has excess capacity is zero However, using a resource that has

no idle capacity (i.e., that is a constraint) does involve an opportunity cost The opportunity costs may be far larger than the costs typically recorded in accounting systems

D Special Order. (Exercises 13-4 and 13-10.) Special orders are one-time orders that do not affect a company’s normal sales As long as the incremental revenue from the order exceeds its incremental costs, the order should be accepted If the special order requires a constrained resource, opportunity costs should be included as part of the incremental costs

E Utilization of a Constrained Resource. (Exercises 13-5 and 13-11.) A constraint is whatever prevents an individual or organization from getting more of what it wants There is always a constraint as long as desires are unsatisfied The chapter focuses on one particular kind

of constraint—a production constraint A production constraint can be a raw material, a part, a machine, or a workstation If the constraint is a machine or workstation, it is called a bottleneck

1 Contribution Margin per Unit of the Constrained Resource Whenever demand exceeds

productive capacity, a production constraint exists The company is unable to fill all orders and some choices have to be made concerning which orders are filled and which are not filled The problem is how to most effectively use the constrained resource

a Regardless of which orders are filled, the fixed costs will usually be the same

Therefore, maximizing the total contribution margin will also maximize profit

b To maximize contribution margin, rank products on the basis of their contribution margins per unit of the constrained resource Starting at the top of the list, produce up

to demand or to the point where the constrained resource is exhausted—whichever comes first (This idea is generalized in the new Profitability Appendix.)

2 Managing constraints Ordinarily, a system has only one constraint The capacity of any

complete process is determined by the capacity of the constraint, which could be a single machine or work center In addition to making sure that the best product mix is chosen by ranking products based on the contribution margin per unit of the constrained resource, managers should seek ways to increase the effective capacity of the constraint

a Increasing the capacity of the constraint or bottleneck is called “relaxing the constraint”

or “elevating the constraint.” Conceptually, the capacity of the bottleneck can be increased by increasing the rate of output at the bottleneck or increasing the time available at the bottleneck Some specific examples of ways to elevate the constraint follow:

• Pay workers overtime to keep the bottleneck running after normal working hours As discussed below, the potential payoff from taking such an action is often well worth the additional expense In contrast, paying workers overtime to keep non-bottleneck processes running after normal working hours is a waste of money

• Shift workers from non-bottleneck areas to the bottleneck

• Hire more workers or acquire more machines specifically to augment the bottleneck

• Subcontract some of the production that would use the bottleneck If an unimportant part requires a lot of time on the bottleneck and can be purchased cheaply from an external supplier, this is a great way to increase profits The bottleneck can be shifted

to more profitable uses

• Streamline the production process at the bottleneck to eliminate wasted time Improvement programs such as TQM and Business Process Reengineering should focus on bottlenecks A decrease in processing time at the bottleneck can have an immediate and dramatic effect on profits A decrease in processing time at a non-

bottleneck is likely to have no immediate impact on profits; it just creates more excess capacity

• Reduce defects A part that is processed on the bottleneck and later rejected because

it is defective uses valuable bottleneck processing time

b The benefits from effectively managing constraints (i.e., bottlenecks) can be enormous Managers should be given information that signals this potential Decide how additional processing capacity at the bottleneck would be used if it were available In other words, what product or order would be produced that otherwise could not be produced? This is the marginal job The contribution margin per unit of the constrained resource for this marginal job is the value of elevating the constraint by one unit (It is also the opportunity cost of using the constrained resource.) Quite often these calculations reveal that the value of additional time is so valuable that some decisions can be made very easily—such as adding a shift on the bottleneck

F Joint Costs and the Contribution Approach. (Exercises 13-6 and 13-12.) In some manufacturing processes, several end products are produced from a single input Such end products are known as joint products The costs associated with making these products up to the point where they can be recognized as separate products (the split-off point) are called joint costs

1 The pitfalls of allocation Joint costs are really common costs that are incurred to

simultaneously produce a variety of end products Unfortunately, these common costs are routinely allocated to the joint products Allocated joint costs are often misinterpreted as costs that could be avoided by producing less of one of the joint products However, joint costs can only be avoided by producing less of all of the joint products simultaneously If any of the joint products is made, then all of the joint costs up to the split-off point will have to be incurred

2 Sell or process further decisions A decision may need to be made concerning whether to

sell a joint product as is or process it further for a higher price (This type of decision is not confined to joint products Any time a product could be sold as is or processed further for additional revenue, this kind of analysis is pertinent.)

a It is profitable to continue processing a joint product after the split-off point so long as the incremental revenue from such processing exceeds the incremental processing costs

b In such decisions, the joint costs incurred before the split-off point are not relevant They would be relevant in a decision to shut down the joint process, but they are irrelevant in any decision about what to do with the joint products once they have reached the split-off point

G Activity-Based Costing and Relevant Costs. Activity-based costing is a resource consumption model, not a spending model Activity-based costing gives an idea of the magnitude of resources involved in carrying out activities, but it should be used with a great deal

of caution in making particular decisions The costs assigned to products and other cost objects

are only potentially relevant costs Whether they are relevant or not in any particular situation

should be carefully considered

For example, in most activity-based costing systems the fixed depreciation costs of a sophisticated milling machine would be allocated to products based on their usage of that

resource Suppose you are trying to decide whether to drop a product that uses the milling machine The fact that the product uses the milling machine is relevant only if the milling machine is a bottleneck (and opportunity costs are involved in its use) or somehow future cash flows associated with the machine will be affected by how much it is used If the machine is not

a bottleneck and using some of its excess capacity has no effect on future spending, then using the machine costs nothing In this case, the costs assigned by the activity-based costing system to the product would not be relevant

Assignment Materials

Assignment Topic

Level of Difficulty

Suggested Time

Exercise 13-1 Identifying relevant costs Basic 15 min Exercise 13-2 Dropping or retaining a segment Basic 30 min Exercise 13-3 Make or buy a component Basic 30 min Exercise 13-4 Evaluating a special order Basic 15 min Exercise 13-5 Utilization of a constrained resource Basic 30 min Exercise 13-6 Sell or process further Basic 10 min Exercise 13-7 Identification of relevant costs Basic 20 min Exercise 13-8 Dropping or retaining a segment Basic 30 min Exercise 13-9 Make or buy a component Basic 20 min Exercise 13-10 Special order Basic 15 min Exercise 13-11 Utilization of a constrained resource Basic 15 min Exercise 13-12 Sell or process further Basic 10 min Exercise 13-13 Identification of relevant costs Basic 30 min Exercise 13-14 Dropping or retaining a segment Basic 10 min Exercise 13-15 Make or buy a component Basic 15 min Problem 13-16 Dropping or retaining a flight Basic 30 min Problem 13-17 Sell or process further Basic 15 min Problem 13-18 Close or retain a store Medium 60 min Problem 13-19 Make or buy analysis Medium 60 min Problem 13-20 Relevant cost analysis in a variety of situations Medium 45 min Problem 13-21 Shutting down or continuing to operate a plant Medium 45 min Problem 13-22 Make or buy decision Medium 60 min Problem 13-23 Accept or reject a special order Medium 30 min Problem 13-24 Utilization of a constrained resource Difficult 45 min Problem 13-25 Sell or process further Difficult 45 min Problem 13-26 Dropping or retaining a product Difficult 45 min Case 13-27 Ethics and the manager; shut down or continue operations Medium 60 min Case 13-28 Plant closing decision Difficult 60 min Case 13-29 Decentralization and relevant costs Difficult 75 min Case 13-30 Sell or process further decision Difficult 30 min Case 13-31 Integrative case; relevant costs; pricing Difficult 90 min Case 13-32 Make or buy; utilization of a constrained resource Difficult 120 min Essential Problems: Problem 13-16 or Problem 13-18, Problem 13-17, Problem 13-19 or Problem 13-22, Problem 13-23, Problem 13-24

Supplementary Problems: Problem 13-20, Problem 13-21, Problem 13-25, Problem 13-26, Case 13-27, Case 13-28, Case 13-29, Case 13-30, Case 13-31, Case 13-32

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Chapter 13 Lecture Notes

Helpful Hint: Before beginning the lecture, show students the 16 th segment from the third tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library This segment introduces students to many of the concepts discussed in chapter 13 The lecture notes reinforce the concepts introduced in the video

Chapter theme: Making decisions is one of the basic

functions of a manager To be successful in decision

making, managers must be able to tell the difference

between relevant and irrelevant data and must be able to correctly use the relevant data in analyzing alternatives

The purpose of this chapter is to develop these skills by illustrating their use in a wide range of decision-making situations

I Cost concepts for decision making

A Identifying relevant costs and benefits

i A relevant cost is a cost that differs between

alternatives

1 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

ii Two broad categories of costs are never

relevant in any decision:

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1 A sunk cost is a cost that has already been

incurred and cannot be avoided regardless of what a manager decides to do

2 A future cost that does not differ between alternatives is never a relevant cost

“In Business Insights”

Most people find it very difficult to ignore sunk costs when making decisions For example:

“It Isn’t Easy to Be Smart about Money” (page 603)

• Dan Seligman commented “Higher primates do

not like to admit, even to themselves, that they have screwed up.” Humans have “the deep- seated, egoistic human need – evidenced in numerous psychological experiments – to justify the sunk costs in one’s life.”

• Paula Zakoria reports: “If you put your house

on the market but refuse offers below the price you paid, you are guilty of ‘anchoring.’ The amount you paid is irrelevant; a house like a stock, is worth what the market will bear at the time of sale

iii Relevant cost analysis: a two-step process:

1 The first step is to eliminate costs and

benefits that do not differ between alternatives These irrelevant costs consist

of sunk costs and future costs that do not differ between alternatives

“In Business Insights”

Companies occasionally offer deep discount prices to make use of idle capacity The fixed costs associated

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with providing the capacity will not change whether new customers are acquired or not and therefore are viewed as irrelevant For example:

“Cruising on the Cheap” (page 606)

• Cruise ship operators, such as Princess Cruises,

sometimes offer deep discounts on popular cruises Recently, a 10-day Mediterranean cruise

on the Norwegian Dream was being offered at 75% off the list price Why such deep discounts?

• “An ambitious fleet expansion left the cruise

industry grappling with a tidal wave of capacity…Most cruise costs are fixed whether all the ship’s berths are filled or not, so it is better to sell cheap than not at all…In the current glut, discounting has made it possible for the cruise lines to keep berths nearly full.”

2 The second step is to use the remaining

costs and benefits that do differ between alternatives in making the decision The

costs that remain are the differential, or

avoidable, costs

“In Business Insights”

A decision analysis can be flawed by incorrectly including irrelevant costs such as sunk costs and future costs that do not differ between alternatives It can also

be flawed by omitting future costs that do differ between alternatives For example:

“Environmental Costs Add Up” (page 608)

• Consider the complications posed by a decision of

whether to install a solvent-based or based system for spray-painting parts

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• A solvent-based system can generate annual

compliance costs that exceed $140,000 per year for a painting facility that initially costs only

$400,000 to build

• A powder-based painting system avoids almost all

possible environmental costs Therefore, even though the cost of building a powder-based system may be higher than the cost of building a solvent-based system, over the long run the costs

of the powder-based system may be far lower due

to the high environmental costs of a solvent-based system

• Managers need to be aware of such

environmental costs and take them fully into account when making decisions

iv Different costs for different purposes

1 Costs that are relevant in one decision

situation may not be relevant in another

context Thus, in each decision situation, the manager must examine the data at hand and isolate the relevant costs

B An example of identifying relevant costs and

benefits

i Assume the following information with

respect to Cynthia, a Boston student who is considering visiting her friend in New York Cynthia is trying to decide whether it would

be less expensive to drive or take the train to

New York

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1 She has assembled the following information with respect to her automobile

2 She has also gathered the additional information as shown to aid in her decision

3 Which costs are relevant to her decision?

a The cost of the car is irrelevant to the

decision because it is a sunk cost

b The annual cost of auto insurance is

irrelevant because it does not differ

between alternatives

c The cost of the gasoline is relevant

because it is avoidable if she takes the train

d The cost of maintenance and repairs is

relevant because in the long-run these

costs depend upon miles driven

e The parking fee is irrelevant because

it is not a differential cost

f The decline in resale value is relevant

due to the additional miles driven

g The round trip train fare is relevant

because it is avoidable if she drives her car

h Relaxing on the train is relevant, but

difficult to quantify

i The kennel cost is irrelevant because

it is not a differential cost

j The cost of parking is relevant

because it is avoidable if she takes the train

k The benefits of having a car in New York and the problem of finding a

parking space are both relevant, but

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4 From a financial standpoint, Cynthia would

be better off taking the train

C Reconciling the total and differential approaches

i Assume the following information for a

company considering a new labor-saving

machine that rents for $3,000 per year

Notice:

1 The total approach requires constructing two

contribution format income statements –

one for each alternative

2 The difference between the two income

statements of $12,000 equals the differential

benefits shown at the bottom of the hand column

right-3 The most efficient means of analyzing this

decision is to use the differential approach

to isolate the relevant costs and benefits as shown

ii 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

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II Adding and dropping product lines and other segments

A One of the most important decisions managers make is

whether to add or drop a business segment

Ultimately, a decision to drop an old segment or add a new one is going to hinge primarily on the impact the

decision will have on net operating income To assess

this impact it is necessary to carefully analyze the costs

B Lovell Company – an example

i Assume that Lovell Company’s digital watch

line has not reported a profit for several years; accordingly, Lovell is considering

discontinuing this product line

1 To determine how dropping this line will affect the overall profits of the company,

Lovell will compare the contribution

margin that would be lost to the costs that would be avoided if the line was to be

dropped

ii Assume a segmented income statement for

the digital watches line is as shown Also, assume the following:

1 An investigation has revealed that the fixed general factory overhead and fixed general

administrative expenses will not be affected

by dropping the digital watch line

2 The equipment used to manufacture digital

watches has no resale value or alternative

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iii A contribution margin approach reveals that

the contribution margin lost ($300,000) exceeds the fixed costs avoided ($260,000) by

$40,000 Therefore, Lovell should retain the

digital watch segment

iv Comparative income statements can also be

prepared to help make the decision

1 These income statements show that if the digital watch line is dropped, the company

loses $300,000 in contribution margin

2 The general factory overhead ($60,000)

would be the same under both alternatives,

so it is irrelevant

3 The salary of the product line manager

($90,000) would disappear, so it is relevant

to the decision

4 The depreciation ($50,000) is a sunk cost

Also, remember that the equipment has no resale value or alternative use, so the

equipment and the depreciation expense

associated with it are irrelevant to the

decision

5 The complete comparative income statements reveal that Lovell would earn

$40,000 of additional profit by retaining the

digital watch line

v Lovell’s allocated fixed costs can distort the

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2 The answer lies in the way common fixed

costs are allocated to products

a Including unavoidable common fixed costs in the segmented income

statement makes the digital watch

product line appear to be unprofitable,

when in fact dropping the product line

would decrease the company’s overall

net operating income

III The make or buy decision

A Key terms and strategic aspects

i When a company is involved in more than

one activity in the entire value chain, it is

vertically integrated

1 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

Helpful Hint: Some critics charge that managers have habitually based make or buy decisions on per unit data without determining which costs are relevant and which are not Since the per unit costs typically include

allocated common fixed costs, they overstate the costs

of producing internally This creates a bias in favor of outsourcing production

ii Vertical integration provides certain

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1 An integrated company may be able to

ensure a smoother flow of parts and

materials for production than a

nonintegrated company

2 Some companies feel that they can control

quality better by producing their own parts

and materials

3 Integrated companies realize profits from

the parts and materials that they choose to make instead of buy

iii The primary disadvantage of vertical

integration is that a company may fail to take advantage of suppliers who can create an

economies of scale advantage by pooling

demand from numerous companies

1 While the economies of scale factor can be appealing, a company must be careful to retain control over activities that are

essential to maintaining its competitive position

“In Business Insights”

Make versus buy decisions are often thought of in a manufacturing context Nonetheless, make versus buy decisions can be made in nonmanufacturing settings For example:

“Employee Health Benefits – Make or Buy” (page 613)

• Quad/Graphics, a printing company with 14,000

employees, hired its own doctors and nurses to provide primary health-care on-site

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• By “making” its own health care for employees

rather than “buying” it through the purchase of insurance, the company claims that its health care costs have risen just 6% annually and that their spending on health care is now 17% less than the industry average

B Essex Company – an example

i Assume that Essex Company manufactures

part 4A with a unit product cost as shown

1 Also, assume the following information as shown with respect to part 4A Given these

additional assumptions, should Essex make

or buy part 4A?

ii The avoidable costs associated with making

part 4A include direct materials ($180,000), direct labor ($100,000), variable overhead ($20,000), and the supervisor’s salary ($40,000) Notice:

1 The depreciation of special equipment

represents a sunk cost Furthermore, the equipment has no resale value, thus the special equipment and its associated

depreciation expense are irrelevant to the

decision

2 The general factory overhead represents

future costs that will be incurred regardless

of whether Essex makes or buys part 4A;

hence, it is also irrelevant to the decision

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iii The total avoidable costs of $340,000 are less

than the $500,000 cost of buying the part,

thereby suggesting that Essex should

continue to make the part

C Opportunity cost

i An opportunity cost is the benefit that is

foregone as a result of pursuing a course of

action These costs do not represent actual

cash outlays and they are not recorded in the

formal accounts of an organization

ii In the Essex Company example that we just

completed, if Essex had an alternative use for the capacity that it used to make part 4A, there would have been an opportunity cost to factor into the analysis

1 The opportunity cost would have been equal

to the segment margin that could have

been derived from the best alternative use

of the space

“In Business Insights”

Opportunity costs are often a critical aspect of business decision making For example:

“Tough Choices” (page 616)

• Brad and Carole Karafil own and operate White

Grizzly Adventures, a snowcat skiing and snowboarding company in Meadow Creek, British Columbia

• While rare, sometimes guests are unable to ski

due to bad weather Since guests pay about $300

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per day, they are likely to be unhappy if skiing is cancelled even thought it is no fault of White Grizzly

• Brad and Carole wrestle with the issue of whether

they should handle these situations by offering a credit voucher good for a day of skiing at a later date

• Since Brad and Carole and fully booked far in

advance of the ski season, the biggest cost for them to consider when issuing credit vouchers is the opportunity cost of sacrificing $300 from a paying customer that is denied access to skiing because a credit voucher has been issued

IV Special orders

A Key terms and concepts

i A special order is a one-time order that is not

considered part of the company’s normal ongoing business

ii When analyzing a special order only the

incremental costs and benefits are relevant

Since the existing fixed manufacturing overhead costs would not be affected by the order, they are not relevant

Helpful Hint: Emphasize the incremental concept in the decision-making process If a company accepts a

special order to produce an item without carefully determining existing capacity, it might have to cut into regular production The effects of lost sales from

ongoing products might be devastating

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B Jet Inc – an example

i Assume the following information with

respect to a special order opportunity for Jet

Inc Should Jet accept the offer?

ii A contribution format income statement for

Jet Inc.’s normal sales of 5,000 units is as

shown

iii If Jet accepts the special order, the

incremental revenue of $30,000 will exceed the incremental costs of $24,000 by $6,000 This suggests that Jet should accept the order

Notice:

1 This answer assumes that the fixed costs are

unavoidable and that variable marketing

costs must be incurred on the special order

Quick Check – special order decision making

“In Business Insights”

Airlines regularly consider incremental revenues and costs when managing their flight capacity For

example:

“Fly the Friendly Aisles” (page 618)

• Shoppers at Safeway can earn United Airlines

frequent flier miles when they buy their groceries Airlines charge marketing partners such as

Safeway about 2¢ per mile

• Since airlines typically require 25,000 frequent

flier miles for a domestic round trip ticket, United

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