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MANAGERIAL MANAGERIAL ACCOUNTING ACCOUNTING

LECTURE 11LECTURE 11

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Learning ObjectivesLearning Objectives

• Identifying Relevant Costs and Benefits for decision making

• Adding/Dropping decisions for segments within a company

• The ‘make’ or ‘buy’ decision

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Relevant Costs for Decision Relevant Costs for Decision MakingMaking

• Making Decisions is one of the basic functions of a manager. But this is a difficult and complicated task because of the existence of many alternatives and massive amounts of data. However only some of the data may be relevant.

• Every decision involves choosing between at least two alternatives, and thebenefits and costs of each alternativemust be compared with those of the other.• A relevant cost is a cost that differs between alternatives.

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Distinguishing between relevant and irrelevant costs and benefits is critical for two reasons :

• 1. Irrelevant data can be ignored and not analyzed. This can save important time and effort.

• 2. Bad decisions can easily result from wrongly including irrelevant costs and benefit data when analyzing alternatives.

To be successful in decision making managers must be able to recognize the difference between relevant and irrelevant data and must be able to use correctly the relevant data when analyzing alternatives.

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FIRST RECALL 3 COST CONCEPTSFIRST RECALL 3 COST CONCEPTS

• 1.Opportunity cost is the potential benefit that is given up when one alternative is selected over another.

Example 1: Vicki has a part-time job that pays her €500 per week while attending college. She would like to spend a week at the beach during spring break and her employer has agreed to give her the time off, but without pay. The €500 in lost wages would be an opportunity cost of taking the week off to be at the beach.

Example 2: A company can invest a large amount of money in

land that may be a place for future store or in high-grade bonds. If the land is acquired the opportunity cost would be the investment income that could have been realized if the bonds had been purchased instead.

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• 2.Differential cost and revenue Decisions involve choosing between alternatives. In business

decisions, each alternative will have certain costs and benefits that must be compared to the costs and benefits of the other available alternatives. A difference in costs between any two alternatives is known as a differential cost. A difference in revenues between any two alternatives is known as a differential revenue. A differential cost is also known as incremental cost, if there is an increase in cost from one alternative to another, or decremental cost if there is a decrease in cost from one alternative to another

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• 3.A sunk cost is a cost that has already been incurred and that can not be changed or avoided regardless of what a manager decides to do.

Example: A company paid €50,000 several years ago for a special purpose machine to make a product. But in nowadays the specific product is old-fashioned and is no longer being sold. It would be folly to continue producing this product. Thus the cost of buying the machine has already been incurred and cannot be a differential cost in any future decision. For that reason this cost is sunk and should be ignored in decisions.

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Identifying Relevant Costs and Identifying Relevant Costs and benefitsbenefits

• Only those costs and benefits that differ in total between alternatives are relevant in a decision. If a cost will be the same regardless of the alternative selected, then the decision has no effect on the cost and it can be ignored.

• For example if you are trying to decide whether to go to a movie or rent a DVD for the evening, the rent on your apartment is irrelevant – because it will remain the same whatever decision you make. On the other hand, the cost of the movie ticket and cost of renting the DVD would be relevant in the decision because they are avoidable costs.

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• An avoidable Cost is a cost that can be eliminated in whole or in part by choosing one alternative over another.

In the previous example by choosing the alternative of going to the movie, the cost of renting the DVD can be avoided. By choosing the alternative of renting the DVD, the cost of the movie ticket can be avoided. On the other hand the rent is not an avoidable cost because you will continue rent your apartment whatever you decide.

• Avoidable costs are relevant costs.•Unavoidable costs are never relevant and

include two broad categories:Sunk costs.Future costs that do not differ between the

alternatives. Future costs that differ between alternatives are

relevant.

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Sunk Costs are always the same no matter what Sunk Costs are always the same no matter what alternatives are being considered: therefore they are alternatives are being considered: therefore they are irrelevant and should be ignored when making decisions.irrelevant and should be ignored when making decisions.

•Quick Check 1 In a decision of whether to buy a new car and exchange 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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Quick Check 2 In a decision of whether to buy a new car

and exchange 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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•Future costs that differ between alternatives are relevant.

For example when deciding whether to go to a movie or rent a DVD , the cost of buying the movie ticket and the cost of rending a DVD have not yet been incurred and so are future costs that differ between alternatives and therefore are relevant.

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• In managerial accounting the terms avoidable cost, differential cost ,incremental cost and relevant cost are identical-equivalent. In order to identify these costs 2 steps can be followed:

1.Eliminate costs and benefits that do not differ between alternatives . These irrelevant costs consist of a) sunk costs and b) future costs that do not differ between alternatives.

2. 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.

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Let’s look at the White Companyexample.

Total and Differential approachedTotal and Differential approached

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A manager at White Co. wants to rent a new labor-saving machine for €3000 per year. Data regarding the company’s annual sales and costs with and without the new machine are shown below:

Current Situation Situation with New Machine

Units produced and sold 5000 5000

Selling price per unit €40 €40

Direct Materials cost per unit €14 €14

Direct Labor costs per unit €8 €5

Variable overhead cost per unit €2 €2

Fixed costs general €62000 €62000

Fixed costs of new machine (rent) €3000

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Should the manager Rent the new machine?

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a)Look at the comparative cost and revenue analysisa)Look at the comparative cost and revenue analysis Total and Differential CostsTotal and Differential Costs

Current Situation

Situation with New Machine

Differential Cost and Benefits

Sales(5000*40) 200,000 200,000 0

Less Variable costs:

Direct Materials (5000*14) 70,000 70,000 0

Direct Labor (5000*8) (5000*5)

40,000 25,000 15,000

Variable overhead (5000*2)

10,000 10,000 0

Contribution Margin 80,000 95,000

Less Fixed Costs:

General 62,000 62,000 0

Rent of new machine 0 3000 (3,000)

Net Operating Income

18,000 30,000 12,000

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Observations:1. A positive number (+) in the Differential costs and

benefits column indicates that the difference between the alternatives favor the new machine, if the number was negative (-) it would mean that the difference favors the current situation.

2. A zero in the Differential costs and benefits column indicates that the total amount for the item is exactly the same for both alternatives. Any cost or benefit that is the same for both alternatives will have no impact on which alternative is preferred. This is the reason that costs and benefits that do not differ between alternatives are irrelevant and can be ignored.

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Relevant Cost AnalysisRelevant Cost Analysis

Let’s look at amore efficientway to analyzethis decision.

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Relevant Cost AnalysisRelevant Cost Analysis

Just focus on the costs that differ between alternatives.

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b)b) Relevant Cost Analysis:Relevant Cost Analysis: We would have arrive We would have arrive at the same solution much more quickly by at the same solution much more quickly by ignoring altogether the irrelevant cost and ignoring altogether the irrelevant cost and benefitsbenefits

Net advantage to rending the new machine

Decrease in direct labor costs (5000*3 savings)

15000

Increase in Fixed expenses (3000)

Net annual cost savings from renting the new machine

12000

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The selling price per unit and the numbers of units sold do not differ between the alternatives.

The direct materials cost and the variable overhead cost will be the same for the two alternatives and can be ignored.

The general Fixed expenses do not differ between the alternatives so they can be ignored as well.

The only costs that differ between the alternatives are direct labor costs and the fixed rental cost of the new machine. So these are the only relevant costs.

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Different Costs for Different Different Costs for Different PurposesPurposes

Costs that are relevant in one decision are not necessarily relevant in another.

• Managers need different costs for different purposes. For one purpose, a particular group of costs may be

relevant, for another purpose a completely different group of costs may be relevant.

• Thus, each decision situation must be carefully analyzed to isolate the relevant costs. Otherwise, irrelevant data may confuse the situation and lead to a bad decision

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Adding/Dropping SegmentsAdding/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. This kind of decisions are important

because there is an effect on the Net Profit.

Let’s see how relevant costs should be used in this decision.

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Example of 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.

Note that the equipment used to manufacture digital watches has no resale value or alternative use.

Should Lovell retain or drop the digital watch segment?

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  Segment (digital watches) Income Statement  

  Digital Watches    

  Sales of digital watches   $ 500.000  

  Less: variable expenses of digital watches      

  Variable mfg. costs $ 120.000    

  Variable shipping costs 5.000    

  Commissions 75.000 200.000  

  Contribution margin of digital watches   $ 300.000  

  Less: fixed expenses      

  Rent (allocation to this product) $ 60.000    

  Salary of line manager 90.000    

  Depreciation of equipment 50.000    

  Advertising – direct 100.000    

 

Insurance for the stock of digital watches 70.000    

 

General admin. Expenses (allocation to this product)

30.000 400.000  

  Net loss of digital watches   $ (100.000)  

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1. A Contribution Margin Approach to 1. A Contribution Margin Approach to solve the example:solve the example:

DECISION RULEDECISION RULELovell 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.Let’s look at this solution.

DECISION RULEDECISION RULELovell 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.Let’s look at this solution.

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• If the digital watch line is dropped the company will lose €300,000 per year in contribution margin but it will avoid some fixed costs.

• As we have seen not all costs are avoidable. For example some of the costs associated with a product line may be sunk costs like depreciation. Other costs may be allocated as common costs like rent or general administration expenses. These are future costs that will not change whether the digital line stop or not.

• If by dropping a line of product a company is able to avoid more fixed costs than it loses in contribution margin then it will be better off if the product line is eliminated since the Net Profit will be improved.

• On the other hand if the company is not able to avoid as much in fixed costs as it loses in contribution margin the problematic product line should be kept.

RULE of previous slide

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Not Avoidable costs:• 1. Depreciation: the equipment used to manufacture digital watches has no resale value if the digital

watches are dropped or alternative use because it is specially made for this company for this product line . So this is a sunk cost: it will happen in anyway.

• 2. Rent: the yearly rent it concerns the whole company and is under a long term lease agreement. It is allocated to the product lines on the basis of sales euro.

• 3. General Administrative expenses: are the cost of accounting and general management and they are allocated to the product lines on the basis of sales euro. These costs will not change if the digital watch line is dropped.

The manager is asking The manager is asking ‘ What costs can I avoid if I drop ‘ What costs can I avoid if I drop this product line?’this product line?’ as he knows that some expenses are as he knows that some expenses are not avoidable:not avoidable:

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A Contribution Margin ApproachA Contribution Margin ApproachContribution Margin

SolutionContribution margin lost if digital   watches are dropped (300.000)

Less fixed costs that can be avoided Salary of the line manager 90.000 Advertising - direct 100.000 Insurance for the stock of digital watches 70.000 260.000 Net disadvantage (40.000)

In this case the fixed costs that can be avoided by dropping the product line are less than the contribution margin that will be lost. Therefore based on the data given the digital line should not be stop.

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2. A Comparative Income Approach to 2. A Comparative Income Approach to solve the examplesolve the example

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 solution.Let’s look at this second solution.

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Comparative Segment Income Approach

Solution

  Keep Digital

Watches   Drop Digital

Watches   Difference

Sales $ 500.000   $ -   $ (500.000)

Less variable expenses:     -    

Mfg. expenses 120.000   -   120.000

Shipping Costs 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:          

Rent 60.000   60.000   -

Salary of line manager 90.000   -   90.000

Depreciation 50.000   50.000   -

Advertising - direct 100.000   -   100.000

Insurance for the stock of digital watches 70.000   -   70.000

General admin. expenses 30.000   30.000   -

Total fixed expenses 400.000   140.000   260.000

Net loss $(100.000)   $(140.000)   $ (40.000)

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If the digital watch line is dropped, the net book value of the equipment would be written off. The depreciation that

would have been taken will flow through the income statement as a loss instead.

But we wouldn’t need a manager for the product line anymore.

On the other hand, the rent would be the same. So this cost really isn’t relevant.

If the digital watch line is dropped, the company gives up its contribution margin

Thank youThank you

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