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
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
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 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.
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.
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.