Relevant Costs for Decision Making

Chapter 13

 

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 in Chapter 13 as follows:

          Adding and Dropping Product Lines and Other Segments

          Make or Buy Decisions

          Special Orders

          Utilization of a Scarce Resources

          Sell or Process further Decisions

 

Adding and Dropping Product Lines and Other Segments

In Exhibit 13-2, Page 609, it appears that Discount Drug Company will improve its overall profits if it drops the House-wares Product Line.  However, 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 Discount Drug Company is better off dropping the House-wares Product Line.  In analyzing the House-wares fixed costs, we find that $13,000 of the total fixed costs of $28,000 are not avoidable, that is, they will continue even if the House-wares line is dropped.   Only $15,000 of the fixed costs are avoidable.  When we compare the avoidable fixed costs of $15,000 with the loss contribution margin of $20,000, we see that total net profits will decrease by $5,000 if the House-wares Product Line is dropped.

 

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. The authors warn the reader to beware of allocated common costs.  Common fixed costs are fixed costs that support the operation of more than one segment, but are not traceable in whole or in part to any one segment.  Thus they continue even when the product line is dropped.  Allocated common fixed costs can make a segment look unprofitable even though dropping the segment might result in a decrease in overall company net operating income

 

Make or Buy Decisions

A make or buy decision relates to whether an item should be made internally or purchased from an external supplier.   Beginning on Page 613 the authors describe how Mountain Goat Cycles Company is producing 8,000 gear shifters annually at an internal “cost” of $21 per unit.  An outside supplier has offered to sell 8,000 shifters per year to Mountain Goat Cycles at a unit price of $19.  Should Mountain Goat Cycles continue to make the shifter or should they purchase it?   Analyzing the “costs” of the internally produced shifter reveals that the depreciation and allocated general overhead costs (totalling $7 per unit) will continue even if the shifter is purchased externally.  Thus the relevant costs are $14 to make versus $19 to buy or a difference in favor of the cycle firm continuing to make the shifter of ($5 * 8,000) or $40,000.

 

Special Orders

Special 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.   Beginning on Page 616 the authors describe an example of a special order in which the Seattle Police Department offers to buy bicycles from Mountain Goat Cycles on a special order price of $179 per unit.  The bikes have a unit product “cost” of $182.  Should the special order be accepted?  Since this order would have no effect on other sales and since the company has idle capacity, then only incremental costs and benefits are relevant.  See the analysis on Page 617 showing why the special order should be accepted.

 

Utilization of a Constrained Resources

Whenever 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 those orders that provide the highest unit contribution margin in relation to the constrained resource.  See the example on Pages 618-9.  Since the capacity of an entire factory or an entire service organization may be determined by a single constraint, it is extremely important to effectively manage the constraint.  Methods to increase the capacity of the constraint or bottleneck are described on Page 605.

 

Sell or Process Further Decisions

In 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.  See example on Page 623-4.