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Relevant Costs for Decision Making
Making correct decisions is one of the most important tasks of a successful manager. Every decision involves a choice between at least two alternatives. The decision process may be complicated by volumes of data, irrelevant data, incomplete information, an unlimited array of alternatives, etc. The role of the managerial accountant in this process is often that of a gatherer and summarizer of relevant information rather than the ultimate decision maker. The costs and benefits of the alternatives need to be compared and contrasted before making a decision. The decision should be based only on RELEVANT information. Relevant information includes the predicted future costs and revenues that differ among the alternatives. Any cost or benefit that does not differ between alternatives is irrelevant and can be ignored in a decision. All future revenues and/or costs that do not differ between the alternatives are irrelevant. Sunk costs (costs already irrevocably incurred) are always irrelevant since they will be the same for any alternative. To identify which costs are relevant in a particular situation, take this three step approach: 1. Eliminate sunk costs 2. Eliminate costs and benefits that do not differ between alternatives 3. Compare the remaining costs and benefits that do differ between alternatives to make the proper decision.
Five separate types of decisions are discussed as follows: (I) Adding and Dropping Product Lines and Other Segments (ii) Make or Buy Decisions (iii) Special Orders (iv) Utilization of Scarce Resources (v) Sell or Process further Decisions
Adding and Dropping Product Lines and Other Segments:In order to make the correct decision regarding dropping a product line, we need to compare lost contribution margin with avoidable fixed costs. If the avoidable fixed costs are greater than lost contribution margin then it is better off dropping the Product Line.
A segment should be added only if the increase in total contribution margin is greater than the increase in fixed costs. A segment should be dropped only if the decrease in total contribution margin is less than the decrease in fixed costs.
Make or Buy DecisionsA make or buy decision relates to whether an item should be made internally or purchased from an external supplier.
Special OrdersSpecial orders are one-time orders that do not affect a company’s normal sales. The profit from a special order equals the incremental revenue less the incremental costs. As long as the incremental revenue exceeds the incremental costs and present sales are unaffected, the special order should be accepted.
Utilization of a Constrained ResourcesWhenever demand exceeds productive capacity, a production constraint (bottleneck) exists. This means that 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. Total contribution margin will be maximized by promoting those products or accepting
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those orders that provide the highest unit contribution margin in relation to the constrained resource.
Sell or Process Further DecisionsIn some manufacturing processes, several intermediate products are produced from a single input. Such 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 product costs. A decision often must be made about selling a joint product as is or processing it further. 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. In such decisions, the joint product costs incurred before the split-off point are irrelevant and should be ignored.
The more common types of costs which you will meet when evaluating different decisions are incremental, non-incremental and spare capacity costs. Are these likely to be relevant or non-relevant?
Suggested Solution
Incremental costs: An incremental cost can be defined as a cost which is specifically incurred by following a course of action and which is avoidable if such action is not taken. Incremental costs are, by definition, relevant costs because they are directly affected by the decision (i.e. they will be incurred if the decision goes ahead and they will not be incurred if the decision is scrapped). For example, if an enterprise is deciding whether or not to accept a special order for its product, the extra variable costs (i.e. number of units in special order x variable cost per unit) which would be incurred in filling the order are an incremental cost because they would not be incurred if the special order were to be rejected.
Non-incremental costs: These are costs which will not be affected by the decision at hand. Non-incremental costs are non-relevant costs because they are not related to the decision at hand (i.e. non-incremental costs stay the same no matter what decision is taken). An example of non-incremental costs would be fixed costs which by their very nature should not be affected by decisions (at least in the short term). If, however, a decision gives rise to a specific increase in fixed costs then the increase in fixed costs would be an incremental and, hence, relevant cost. For example, in a decision on whether to extend the factory floor area of an enterprise, the extra rent to be incurred would be a relevant cost for that decision.
Spare capacity costs: Because of the recent advancements in manufacturing technology most enterprises have greatly increased their efficiency and as a result are often operating at below full capacity. Operating with spare capacity can have a significant impact on the relevant costs for any short-term production decision the management of such an enterprise might have to make.
If spare capacity exists in an enterprise, some costs which are generally considered incremental may in fact be non-incremental and thus, non-relevant, in the short term. For example, if an enterprise is operating at less than full capacity then its work force is probably under utilized. If it is the policy of the enterprise to maintain the level of its work force in the short term, until activity
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increases, then the labor cost of this work force would be a non-relevant cost for a decision on whether to accept or reject a once-off special order. The labor cost is non-relevant because the wages will have to be paid whether the order is accepted or not. If the special order involved and element of overtime then the cost of such overtime would of course be a relevant cost (as it is an incremental cost) for the decision.
Two further types of costs that have to be considered are opportunity costs and sunk costs.
Opportunity costs: An opportunity cost is a level of profit or benefit foregone by the pursuit of a particular course of action. In other words, it is the value of an option, which cannot be taken as a result of following a different option. For example, if an enterprise has a quantity of raw material in stock which cost $7 per kg and it plans to use this material in the filling of a special order then you would normally incorporate $7 per kg as part of your cost calculations for filling the order. If, however, this quantity of material could be resold without further processing for $8 per kg, then the opportunity cost of using this material in the special order is $8 per kg; by filling the order you forego the $8 per kg which was available for a straight sale of the material. Opportunity costs are, therefore, the ‘real’ economic costs of taking one course of action as opposed to another.
In the above decision-making situation it is the opportunity cost which is the relevant cost and, hence, the cost which should be incorporated into your cost-versus-benefit analysis. It is because the loss of the $8 per kg is directly related to the filling of the order and the opportunity cost is greater than the book cost. Opportunity costs are relevant costs for a decision only when they exceed the costs of the same item in the option to the decision under consideration.
Sunk costs: a sunk cost is a cost that has already been incurred and cannot be altered by any future decision. If sunk costs are not affected by a decision then they must be non-relevant costs for decision-making purposes. Common examples of sunk costs are market research costs and development expenditure incurred by enterprises in getting a product or service ready for sale. The final decision on whether to launch the product or service would regard these costs as ‘sunk’ (i.e. irrecoverable) and thus, not incorporate them into the launch decision. Sunk
Costs are the opposite to opportunity costs in that they are not incorporated in the decision making process even though they have already been recorded in the books and records of the enterprise.
Every decision involves choosing from among at least two alternatives.
A relevant cost or benefit is a cost or benefit that differs, in total, between the alternatives. Any cost or benefit that does not differ between the alternatives is irrelevant and can be ignored. Relevant costs and benefits are also known as differential costs and benefits.
Avoidable costs are those costs that can be eliminated in whole or in part by choosing one alternative over another. Avoidable costs are relevant costs.
Two broad categories of costs are never relevant in decisions:
1. Sunk costs 2. Future costs that do not differ between alternatives.
To make a decision:
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1. Eliminate costs and benefits that do not differ, in total, between alternatives.
2. Base the decision on the remaining costs and benefits.
DROP OR RETAIN A SEGMENT
EXAMPLE: Due to the declining popularity of digital watches, Sweiz Company’s digital watch line has not reported a profit for several years. An income statement for last year follows:
Segment Income Statement—Digital Watches
Sales................................................................. $ 500,000 Less variable expenses:
Variable manufacturing costs........................ $120,000Variable shipping costs.................................. 5,000Commissions.................................................. 75,000 200,000
Contribution margin.......................................... 300,000 Less fixed expenses:
General factory overhead*............................. 60,000Salary of product line manager...................... 90,000Depreciation of equipment**......................... 50,000Product line advertising................................. 100,000Rent—factory space***.................................. 70,000General administrative expense*................... 30,000 400,000
Net operating loss............................................. $(100,000)
Should the company retain or drop the digital watch line?
DROP OR RETAIN A SEGMENT (cont’d)
Approach #1:
If by dropping digital watches the company is able to avoid more in fixed costs than it loses in contribution margin, then it will be better off if the product line is eliminated.
The solution would be:
Contribution margin lost if digital watches are dropped $(300,000)
Less fixed costs that can be avoided:Salary of the product line manager....................... $ 90,000Product line advertising......................................... 100,000Rent—factory space.............................................. 70,000 260,000
Net disadvantage of dropping the line...................... $( 40,000)
The digital watch line should not be dropped. If it is dropped, the company will be $40,000 worse off each year. Note the following points:
• Depreciation on the old equipment is not relevant to the decision. It relates to a sunk cost.
• General factory overhead and general administrative expense are allocated common costs that would not be avoided if the digital watch line were dropped.
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These costs would be reallocated to other product lines.
DROP OR RETAIN A SEGMENT (cont’d)
Approach #2:
The solution can also be obtained by preparing comparative income statements showing results with and without the digital watch line.
Keep Drop Difference:Digital Digital Increase or
Watches Watches (Decrease)Sales........................................................ $ 500,000 $ 0 $(500,000)Less variable expenses:
Variable manufacturing expense.......... 120,000 0 120,000 Variable shipping costs......................... 5,000 0 5,000 Commissions........................................ 75,000 0 75,000
Total variable expenses........................... 200,000 0 200,000 Contribution margin................................. 300,000 0 (300,000 )Less fixed expenses:
General factory overhead..................... 60,000 60,000 0 Salary of product line manager............ 90,000 0 90,000 Depreciation......................................... 50,000 50,000 0 Product line advertising........................ 100,000 0 100,000 Rent—factory space............................. 70,000 0 70,000 General administrative expense........... 30,000 30,000 0
Total fixed expenses................................ 400,000 140,000 260,000 Net operating loss.................................... $(100,000) $(140,000) $ (40,000 )
MAKE OR BUY DECISION
A decision concerning whether an item should be produced internally or purchased from an outside supplier is called a “make or buy” decision.
EXAMPLE: Essex Company is presently making a part that is used in one of its products. The unit product cost is:
Direct materials................................................... $ 9Direct labor 5Variable manufacturing overhead........................ 1Depreciation of special equipment*..................... 3Supervisor’s salary............................................... 2General factory overhead**................................. 10 Total unit product cost......................................... $30
* The special equipment has no resale value.
** Common costs allocated on the basis of direct labor-hours.
The costs above are based on 20,000 parts produced each year. An outside supplier has offered to provide the 20,000 parts for only $25 per part. Should this offer be accepted?
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MAKE OR BUY DECISION (cont’d)
The solution to Essex Company’s make or buy decision follows:
Total Differential Costs of 20,000 units
Make BuyOutside purchase price........................................... $500,000Direct materials...................................................... $180,000Direct labor 100,000Variable manufacturing overhead.......................... 20,000Depreciation of equipment (not relevant)............... Supervisor’s salary................................................. 40,000General factory overhead (not relevant)................. Total cost $340,000 $500,000
This solution assumes that none of the general factory overhead costs will be saved if the parts are purchased from the outside; these costs would be reallocated to other items made by the company.
SPECIAL ORDERS
A special order is a one-time order that does not affect the company’s normal sales.
EXAMPLE: Jamestown Candle works has just received a request from the Williamsburg Foundation for 800 candles to be used in a special event for major donors. The candles will be used as the only illumination in the reception room and will be given out as gifts to the donors as they leave. The candles will be imprinted with the Williamsburg Foundation logo. This sale will have no effect on the company’s normal sales to retail outlets. The normal selling price of a candle of about the size and weight of the special candles is $3.95 and its unit product cost is $2.30, as shown below:
Direct materials.............................. $1.35Direct labor 0.15Manufacturing overhead................. 0.80 Unit product cost............................. $2.30
The variable portion of the manufacturing overhead is $0.05 per candle; the other $0.75 represents fixed manufacturing costs that would not be affected by this special order.
Jamestown Candle works would have to order a special candle mold in which the Williamsburg Foundation logo is inscribed. Such a mold would cost $800. In addition, the Williamsburg Foundation wants a special wick containing gold-like thread that would add $0.20 to the cost of each candle.
Because of the large size of the order and the charitable nature of the work, the Williamsburg Foundation has asked to pay only $2.95 each for this candle.
If accepted, what effect would this order have on the company’s net operating income?
SPECIAL ORDERS
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Only the incremental costs and benefits are relevant. The existing fixed manufacturing overhead costs would not be affected by the order and are irrelevant.
Per UnitTotal for 800
CandlesIncremental revenue........................................ $2.95 $2,360Incremental costs:
Variable costs:Direct materials........................................ 1.35 1,080Direct labor.............................................. 0.15 120Variable manufacturing overhead............ 0.05 40Special wick.............................................. 0.20 160
Total variable cost........................................ $1.75 1,400 Fixed cost:
Special mold............................................. 800 Total incremental cost..................................... 2,200 Incremental net operating income................... $ 160
UTILIZATION OF CONSTRAINED RESOURCES
• Anything that prevents an organization from getting more of what it wants (for example, profits) is a constraint.
• A particular machine may not have enough capacity to satisfy current demand.
• Supplies of a critical part may not be sufficient to satisfy current demand.
• When the constraint is a machine or a work center, it is called a bottleneck.
• When capacity is not sufficient to satisfy demand, something must be cut back. Which products should be cut back and by how much?
• Fixed costs are not usually affected by the decision of which products should be emphasized in the short run. All of the machines and other fixed assets are in place—it is just a question of how they should be used.
• When fixed costs are unaffected by the choice of which product to emphasize, maximizing the total contribution margin will maximize total profits.
• The total contribution margin is maximized by emphasizing the products with the greatest contribution margin per unit of the constrained resource.
UTILIZATION OF CONSTRAINED RESOURCES (cont’d)
EXAMPLE: Ensign Company makes two products, X and Y. The current constraint is Machine N34. Selected data on the products follow:
X YSelling price per unit..................................... $60 $50Less variable expenses per unit.................... 36 35 Contribution margin...................................... $24 $15Contribution margin ratio.............................. 40% 30%Current demand per week (units)................. 2,000 2,200Processing time required on Machine N34 1.0 minute 0.5 minute
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per unit
Machine N34 is available for 2,400 minutes per week, which is not enough capacity to satisfy demand for both product X and product Y. Should the company focus its efforts on product X or product Y?
CM PER UNIT OF THE CONSTRAINED RESOURCE
X YContribution margin per unit (a)................... $24 $15Constrained resource required to produce
one unit (b)................................................ 1.0 minute 0.5 minuteContribution margin per unit of the
constrained resource (a)÷ (b).................... $24 per minute $30 per minute
UTILIZATION OF CONSTRAINED RESOURCES (cont’d)
• Product Y should be emphasized since it has the larger contribution margin per unit of the constrained resource. A minute of processing time on Machine N34 can be used to make 1 unit of Product X, with a contribution margin of $24, or 2 units of Product Y, with a combined contribution margin of $30.
• In the absence of other considerations (such as satisfying an important customer), the best plan would be to produce to meet current demand for Product Y and then use any remaining capacity to make Product X.
ALLOTING THE CONSTRAINED RESOURCE
Total time available on Machine N34 (a)............................... 2,400 minutesPlanned production and sales of Product Y........................... 2,200 unitsTime required to process one unit........................................ × 0.5 minuteTotal time required to make Product Y (b)............................ 1,100 minutesTime available to process Product X (a) – (b)........................ 1,300 minutesTime required to process one unit........................................ ÷ 1 minute
per unitPlanned production and sales of Product X........................... 1,300 units
RESULTS OF FOLLOWING THE ABOVE PLAN
X Y TotalPlanned production and sales (units).................... 1,300 2,200Contribution margin per unit................................. × $24 × $15 Total contribution margin...................................... $31,200 $33,000 $64,200
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UTILIZATION OF CONSTRAINED RESOURCES (cont’d)
MANAGING CONSTRAINTS
Processing more units through the bottleneck that customers want is a key to increased profits:
• Produce only what can be sold.
• Pay workers overtime to keep the bottleneck running after normal working hours.
• Shift workers from non-bottleneck areas to the bottleneck.
• Hire more workers or acquire more machines for the bottleneck.
• Subcontract some of the production that would use the bottleneck.
• Focus business process improvement efforts on the bottleneck.
• Reduce defects.
The potential payoff to effectively managing the constraint can be enormous.
EXAMPLE: Suppose the available time on Machine N34 can be increased by paying the machine’s operator to work overtime. Would this be worthwhile?
ANSWER: Since the additional time would be used to make more of Product X, each minute of overtime is worth $24 to the company and hence each hour is worth $1,440 (60 minutes × $24 per minute)!
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