relevant costs 2007

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Relevant Cost Decisions

DECISION MAKING IN THE SHORTTERM



2

Decisions A decision model is a formal method

of making a choice, often involving

both quantitative and qualitativeanalyses

A relevant cost is a cost thatdiffers between alternatives.



3

Five-Step

Decision-Making Process



5

Identifying Relevant Costs

Costs that can be eliminated (in whole or inpart) by choosing one alternative overanother are avoidable costs. Avoidable

costs are relevant costs.

Unavoidable costs are never relevant andinclude:

Sunk costs.

Future costs that do not diff er between thealternatives.



6

Identifying Relevant Costs

gather all costs associated with thealternatives

eliminate all sunk costs

Eliminate all f uture costs that don¶tdiff er between alternatives

lef t are the avoidable costs



7

Irrelevance Historical costs are past costs that

are irrelevant to decision making

Also called Sunk Costs- cost that hasalready been incurred and that cannot beavoided regardless of what a managerdecides to do



8

Types of Information Quantitative factors are outcomes

that can be measured in numerical

terms Qualitative factors are outcomes that

are difficult to measure accurately innumerical terms, such as satisfaction

Are just as important as quantitativefactors even though they are difficult tomeasure



9

Terminology Incremental Cost ± the additional

total cost incurred for an activity

Differential Cost ± the difference intotal cost between two alternatives

Incremental Revenue ± the additionaltotal revenue from an activity

Differential Revenue ± the differencein total revenue between twoalternatives



10

Types of Decisions One-Time-Only Special Orders

Insourcing vs. Outsourcing

Make or Buy Product-Mix

Customer Profitability

Branch / Segment: Adding orDiscontinuing

Equipment Replacement



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One-Time-Only Special Orders Accepting or rejecting special orders

when there is idle production capacity

and the special orders have no long-run implications

Decision Rule: does the special ordergenerate additional operating

income? Yes ± accept

No ± reject



12

One-Time-Only Special Orders Compares relevant revenues and

relevant costs to determine

profitability



13

Special Orders

Acki Company receives a one-time order thatis not considered part of its normal ongoing business.

Acki Company only produces one type of silver key chain with a unit variable cost of TL 16. Normal selling price is TL 40 per unit.

A company in KKTC off ers to purchase 3,000units f or TL 20 per unit.

Annual capacity is 10,000 units, and annualfixed costs total TL78,000, but Acki companyis currently producing and selling only 5,000units.

Should Acki accept the offer?Should Acki accept the offer?



14

Special Orders

Acki Company

Contribution Income Statement

Revenue ( , × TL4 ) TL .

Variable costs:

Direct materials TL4 .Direct labor 1 .

Manufacturing overhead .

Marketing costs 1 .

Total variable costs .

Contribution margin 1 .

Fixed costs:

Manufacturing overhead TL .

Marketing costs .

Total fixed costs 1 . Net income TL1 .



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Special Orders

If Acki accepts the offer, net income willincrease by TL 12.000.

1

1

U h n m n pp h:

Sp d n b n m g n = TL20 ± TL 1 = TL 4

Ch ng n n m = TL 4 × 3,000 n s = TL 12.000.



16

Potential Problems with

Relevant-Cost Analysis Avoid incorrect general assumptions

about information, especially:

³All variable costs are relevant and allfixed costs are irrelevant´

There are notable exceptions for bothcosts



17

Potential Problems with

Relevant-Cost Analysis Problems with using unit-cost data:

Including irrelevant costs in error

Using the same unit-cost with differentoutput levels

Fixed costs per unit change with differentlevels of output



18

Avoiding Potential Problems with

Relevant-Cost Analysis Focus on Total Revenues and Total

Costs, not their per-unit equivalents

Continually evaluate data to ensurethat they meet the requirements of relevant information



19

Insourcing vs. Outsourcing Insourcing ± producing goods or

services within an organization

Outsourcing ± purchasing goods orservices from outside vendors

Also called the ³Make or Buy´ decision

Decision Rule: Select the option that

will provide the firm with the lowestcost, and therefore the highest profit.



20

Qualitative Factors Nonquantitative factors may be

extremely important in an evaluation

process, yet do not show up directlyin calculations:

Quality Requirements

Reputation of Outsourcer

Employee Morale Logistical Considerations ± distance from

plant, etc.



21

Opportunity Costs Opportunity Cost is the contribution to operating

income that is forgone by not using a limited resourcein its next-best alternative use

³How much profit did the firm µlose out on¶ by not

selecting this alternative?´ The economic benefits that are foregone as a result

of pursuing some course of action. Opportunity costsare not actual dollar outlays and are not recorded inthe accounts of an organization.

Special type of Opportunity Cost: Holding Cost forInventory. Funds tied up in inventory are notavailable for investment elsewhere



22

The Make or Buy Decision

A decision concerning whether an itemshould be produced internally or

purchased from an outside supplier iscalled a ³make or buy´ decision.



23


MA Company is thinking of buying a part that iscurrently used in one of its products fromoutside.

The unit cost to make this part is:

TL/ uDirect materials 27

Direct labor 15

Variable overhead 3

Depreciation of special equip. 9Supervisor's salary 6

General factory overhead 30Total cost per unit 90



24


General factory overhead is allocated on thebasis of direct labor hours and is not going tochange if the parts are bought from outside.

The 90TL unit cost is based on 20,000 partsproduced each year.

An outside supplier has offered to providethe 20,000 parts at a cost of 70TL per part.

Should we accept the supplier¶s offer?Should we accept the supplier¶s offer?



25

Pe

U 20 000 U

ake B y

O e c a e ce 70 1 400 000

ec a e a 27 540 000

ec a 15 300 000

a a e ve ea 3 60 000

e ec a eq 9 0

e v ' a a y 6 120 000

Ge e a ac y ve ea 30 0a c 90 1 020 000 1 400 000


Not avoidable and is irrelevant. If the product is dropped, it will

be reallocated to other products.

Sunk Cost



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DECISION RULE

In deciding whether to accept the outside

supplier¶s offer, MA isolated the relevantcosts of making the part by eliminatingeliminating:

The sunk costs.

The future costs that will not differ

between making or buying the parts.



27

Product-Mix Decisions The decisions made by a company

about which products to sell and in

what quantities Decision Rule (with a constraint):

choose the product that produces thehighest contribution margin per unit

of the constraining resource



28

Utilization of a ConstrainedResource

Firms often face the problem of deciding how to best utilize aconstrained resource.

Usually, fixed costs are not affectedby this particular decision, somanagement can focus on

maximizing total contributionmargin.



29


UM Company produces two products andselected data is shown below:

2

TL50

Less variable expenses per unit 36 35

Contribution margin per unit TL24 TL15

Current demand per week (units) 2.000 2.200

Contribution margin ratio 40% 30%

Processing time requiredon machine A1 per unit 1,00 min. 0,50 min.



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Machine A1 is the constrained resource.There is excess capacity on all othermachines. Machine A1 is being used at

100% of its capacity, and has a capacityof 2,400 minutes per week.

Should UM focus its efforts onShould UM focus its efforts onProduct 1 or 2?Product 1 or 2?



31

Utilization of a Constrained Resource

Let¶s calculate the contribution margin per unit of theconstrained resource, machine A1.

roduct 2 hould e e pha ized. Provides morevaluable use of the constrained resource machine A1,

yielding a contribution margin of TL 30 per minute as

opposed to TL 24 for Product 1.

Product

1 2Contribution margin per unit TL24 TL15

Time required to produce one unit ÷ 1,00 min. ÷ 0,50 min.

Contribution margin per minute TL24 min. TL30 min.



32


Let¶s calculate the contribution margin per unit of thescarce resource, machine A1.

Let¶s see how this plan would work.Let¶s see how this plan would work.

f there are o other co ideratio the e t pla would e

to produce to eet curre t de a d for Product 2 a d the

u e re ai i g capacity to ake Product 1

Product

1 2

o tri utio argi per u it 2 TL15

Time required to produce one unit ÷ 1,00 min. ÷ 0,50 min.

Contribution margin per minute TL24 min. TL30 min.



36

Adding or Dropping Customers

Decision Rule: Does adding ordropping a customer add operating

income to the firm? Yes ± add or don¶t drop

No ± drop or don¶t add

Decision is based on profitability of

the customer, not how much revenuea customer generates



37

Adding or DiscontinuingBranches or Segments

Decision Rule: Does adding ordiscontinuing a branch or segment

add operating income to the firm? Yes ± add or don¶t discontinue

No ± discontinue or don¶t add

Decision is based on profitability of

the branch or segment, not howmuch revenue the branch or segmentgenerates



38

8

-

-8

Income Statement for 2007

Adding/Dropping Segments

General Factory Overhead and General Administrative Expenses are unavoidablecosts.

A u e that the e uip e t u ed i a ufacturi g digital i tru e t ha o re ale alue or

alter ati e u e

Should the co pa y drop digital i tru e tdi i io ?



40

Incremental Approach

00 000

0 000

00 000

40 000 0 000

0 000

W ?



41

Comparative Income Approach

Prepare comparative income statementsshowing results with and without the

digital instruments division.



42

K

24 24

4 4

2 2

2

4

2 2

2 2 4



43

Joint Product Costs

In some industries, a number of endproducts are produced from a single rawmaterial input.

Two or more products produced from acommon input are called joint products joint products.

The point in the manufacturing process

where each joint product can berecognized as a separate product iscalled the splitsplit--off pointoff point.



44

Joint Products

JointInput

CommonProduction

Process

SplitSplit-- ff ff

Poi tPoi t

Joi tJoi t

Co tCo tOil

Gasoline

Chemicals



45

Joint Products

JointInput

CommonProduction

Process

Separate

Processing

Separate

Processing

Final

Sale

Final

Sale

FinalSale

SplitSplit-- ff ff

Poi tPoi t

Joi tJoi t

Co tCo t

SeparateSeparate

ProductProduct

Co tCo t

Oil

Gasoline

Chemicals



46

The Pitfalls of Allocation of JointCosts

Joint costs are really common costsincurred to simultaneously produce avariety of end products.

Joint costs are often allocated to endproducts on the basis of the relativerelativesales valuesales value of each product or on

some other basis.



47

Sell or Process Further

Decision Rule:

It will always profitable to continueprocessing a joint product after the

split-off point so long as theincremental revenue exceeds theincremental processing costs incurredafter the split-off point.

Let¶s look at the Kere example.Let¶s look at the Kere example.



49


Data about Kere¶s joint products includes:

w

4 4

j 4



50


0 50

0 0

0 0

50 0

0 0

K

³ ?´



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Behavioral Implications

Despite the quantitative nature of some aspects of decision making, notall managers will choose the best

alternative for the firm Managers could engage in self-

serving behavior such as delayingneeded equipment maintenance in

order to meet their personalprofitability quotas for bonusconsideration

relevant costs 2007

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