13 Relevant Costs forDecision Making

Chapter

Future revenues or costs

that differ among alternatives.

Is the cost of equipment

purchased in the pastrelevant?

The cost of new equipment?

Are fixed costs ever relevant?

Variable costs?

Cost Concepts for Decision Making

Avoidable cost

important to consider when comparing one alternative to another

Sunk cost

Differential costor

a cost of the past that cannot be avoided

Opportunity cost

a benefit (revenue or gain) of an alternative that is not chosen

Replacing Equipment

The cost of the old equipment is irrelevant.

And the loss on the sale of the old equipment is irrelevant.

Don’t get trapped by past mistakes!

Relevant factors

current market value of the old

cost & expected life of the new equipment

future output

future operating expenses

Keep Old

Oper. Costs (6 yrs)

Purchase of new

Sale of old

Net cash flow

Buy New

Impact of buying new

Old machine: $50,000 cost, $10,000 accum. depreciation; $7,000 market value

New machine: $25,000 cost; 6 year life

New machine will decrease annual operating costs from $10,000 to $6,000.

Adding and Dropping Segments

Keep Rnd

Revenue $1,000,000

Variable expenses (410,000)

Deprec – special equip (95,000)

General factory OH (200,000)

Income $ 60,000

Drop Rnd

Advertising - traceable (216,000)

Review Problem, p. 601

Impact of dropping R.I.

Depreciation on equip is irrelevant!

Supervisor salaries (19,000)

Beware of allocated fixed costs!

Make or Buy Decisions

Make

Outside purchase

DM

Variable MOH

Fixed MOH - common

Total

Buy

DL

Exer. 13-9, p. 608

Impact of outsourcing

Some fixed costs cannot be avoided

Fixed MOH - traceable

SpecialOrder

Revenue

DM

Variable selling & adm

Additional fixed costs

Total effect

if regular sales are unaffected, it’s easiest to look at the revenue and costs from special order only

Exer. 13-10, Part 1, p. 609

Special Sales Order

DL

Variable MOH

Information needed:

Number of extra units Selling price per unit Variable cost per unit Changes in fixed costs

May need to be

calculated.

Special Sales Order (cont.)

Utilization of a Constrained Resource

A

Sales $ 60.00

Variable: DL ($8/hr)

CM per unit

B

$ 90.00

Other

Exer. 13-5, p. 606

C

$ 80.00

Decision based not on CM per unit…

… but on CM per constrained resource.

Managing Constraints

“Bottleneck”: the machine or process that limits overall output

Managers should select product mix that maximizes total contribution margin.

Managers should try to increase capacity at the bottleneck: working overtime subcontracting of bottleneck process additional investment reducing defects

A

Sales value after $80,000

Incremental rev / unit

B

$150,000

Less: Sales value before

Exer. 13-6, p. 606

C

$75,000

Sell or Process Further

AgroCorp prepares fruit and vegetable products in a large processing plant.

Currently sells 28,000 bags of potatoes @ $2.10. Cost of potatoes=$25,200; cost of package=$0.03; DL=$9,000; MOH= DL x 1.2 = $10,800.

Possibility: process the potatoes further to prepare potato flakes.

35,000 boxes of flakes @ $1.80; 14,000 pounds of potato peels @ $0.02

Cost of potato flake box = $0.05

Direct labor cost will increase by $2,000

New rental equipment = $3,200 / year

Sell or Process Further

Bags

Sales ($2.10 / bag)

Packaging ($.03 / bag)

MOH allocated (DL x 1.2) (10,800)

Flakes

Raw materials

Profit $ 12,960

Impact of switching to flakes

Sales ($2.10 / bag; $1.90 / box)

Profit before allocated costs

Beware of allocated fixed costs!