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Relevant Costs for Decision
Making
Learning Objectives
1. Identify relevant and irrelevant costs and benefits in
a decision situation.
2. Prepare an analysis showing whether a product line or other organizational
segment should be dropped or retained.
3. Prepare a make or buy analysis.
4. Prepare an analysis showing whether a special order should be accepted.
5. Determine the most profitable use of a constrained resource and the
value of obtaining more of the constrained resource.
6. Prepare an analysis showing whether joint products should be sold
at the split-off point or processed further.
Lecture Notes
A. Cost Concepts for Decision-Making. Every
decision involves a choice from among at least two
alternatives. The costs and benefits of the alternatives
should be compared when making the decision.
1. Identifying relevant costs. A relevant
cost or benefit is a cost or benefit that differs between
alternatives. Differential costs are relevant costs. Any
cost or benefit that does not differ between alternatives
is irrelevant and can be ignored in a decision. This is a
tremendously powerful concept that allows us to ignore
mounds of data when making decisions since most things
are not affected by any given decision.
a. All sunk costs (i.e., costs already
irrevocably incurred) are irrelevant since they will
be the same for any alternative. All future costs that
do not differ between alternatives are irrelevant.
b. Any cost that is avoidable is potentially
relevant. An avoidable cost is a cost that can be
eliminated (in whole or in part) as a result of
choosing one alternative over another.
c.When making a decision, eliminate all irrelevant
costs. Make the decision based on the remaining,
relevant costs.
NOTE: A more
algebraic approach can also be considered.. Suppose there are two alternatives: A and B.
Alternative A is preferred to Alternative B if total
profits under Alternative A exceed total profits under
Alternative B. The profits under Alternative A can be
written as "RevA- CostA" and the profits under
Alternative B can be written as "RevB- CostB". The profit
under Alternative A exceeds the profit under Alternative
B if and only if RevA- CostA > RevB- CostB. Or, the
profit under Alternative A exceeds the profit under
Alternative B if and only if RevA- RevB > CostA-
CostB. Thus, Alternative A is preferred if and only if
the differential revenue exceeds the differential cost.
The only costs (and benefits) that matter are those that
differ between the alternatives.
2. Different costs for different purposes.
Costs that are relevant in one decision situation are not
necessarily relevant in another. In each situation the
manager must examine the data and isolate the relevant
costs.
NOTE: Don't develop incorrect
rules of thumbs for identifying relevant costs. One such
popular thumb-rule is that variable costs are relevant
and fixed costs are irrelevant. This thumb-rule is wrong.The
fixed costs that differ between alternatives and that are
therefore relevant.
3. Human frailties. Many (most?) people have a
great deal of difficulty ignoring irrelevant costs when
making decisions. People are especially reluctant to
discard sunk costs in decision-making when the sunk costs
are a consequence of a past decision that in retrospect
was unwise. People have a tendency to become committed to
courses of action that have not worked out. Taking a loss
on an asset is an admission of failure.
B. Adding or Dropping a Segment. Decisions
relating to dropping old products (or segments) and adding
new products (or segments) are among the most difficult that
a manager makes. Two basic approaches can be used to analyze
data in this type of decision.
1. Compare contribution margins and fixed
costs. A segment should be added only if the increase
in total contribution margin is greater than the increase
in fixed cost. A segment should be dropped only if the
decrease in total contribution margin is less than the
decrease in fixed cost.
2. Compare net incomes. A second approach is to
calculate the total net income under each alternative.
The alternative with the highest net income is preferred.
This approach requires more information than the first
approach since costs and revenues that don't differ
between the alternatives must be included in the analysis
when the net incomes are compared.
3. Beware of allocated common costs. Allocated
common costs can make a segment look unprofitable even
though dropping the segment might result in a decrease in
overall company net operating income. Allocated costs
that would not be affected by a decision are irrelevant
and should be ignored in a decision relating to adding or
dropping a segment.
C. The Make or Buy Decision. A make or buy
decision is concerned with whether an item should be made
internally or purchased from an external supplier.
1. Advantages of making an item
internally.
a. Producing a part internally reduces
dependence on suppliers and may ensure a smoother flow
of parts and material for production.
b. Quality control may be easier when parts are
produced internally.
c. Profits can be realized on the parts and
materials.
2. Advantages of buying an item from an external
supplier.
a. By pooling the requirements of a number of
users, a supplier can realize economies of scale and
may be able to move more quickly up the learning
curve.
b. A specialized supplier may be able to respond
more quickly and at less cost to changing future
needs.
c. Changing technology may make producing one's own
parts riskier than purchasing from the outside.
3. Opportunity Cost. Opportunity costs should
be considered in decisions. There is no opportunity cost
involved in using a resource that has excess capacity.
However, if the resource is a constraint (i.e., there is
no excess capacity) then there is an opportunity cost.
The opportunity costs may be far more important than the
costs typically recorded in accounting systems.
D. Special Order. 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, the order should be
accepted. If there is no idle capacity, opportunity costs
should be included as part of the incremental costs.
E. Utilization of a Constrained Resource. A
constraint is whatever prevents an individual or
organization from getting more of what it wants. There is
always a constraint as long as desires are unsatisfied. The
chapter focuses on one particular kind of constraint-a
production constraint. A production constraint can be a raw
material, a part, a machine, or a workstation. If the
constraint is a machine or workstation, it is called a
bottleneck.
1. Contribution Margin Per Unit of the
Constrained Resource. Whenever demand exceeds productive
capacity, there is a production constraint. 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. The problem is how to
most effectively use the constrained resource.
a. Whether this order or that order is
filled, the fixed costs will usually be the same.
Therefore, maximizing the total contribution margin
will also maximize profit.
b. The total contribution margin is maximized by
emphasizing those products or accepting those orders
with the highest contribution margin per unit of the
constrained resource.
c. In general, the correct way to rank the
profitability of products or orders (or anything else
for that matter) is in terms of their contribution
margins per unit of the constrained resource.
2. Managing constraints. Ordinarily, there is
only one constraint in any system. The capacity of an
entire factory or of an entire service organization is
determined by the capacity at the constraint, which could
be a single machine or work center. In addition to making
sure that the best product mix is chosen by ranking
products based on the contribution margin per unit of the
constrained resource, managers should seek ways to
increase the effective capacity of the constraint.
NOTE: A chain is a good metaphor to use
when thinking about how to manage a constraint. A production
process can be thought of as a chain, with each link in
the chain representing a step in the process. A chain is
only as strong as its weakest link. Likewise, the
capacity of a production process is determined by its
weakest link, which is the constraint. The only way to
increase the strength of a chain is to strengthen the
weakest link. The only way to increase the output of the
entire process is to increase the output of the
constraint. Strengthening the stronger links has no
effect on the strength of the entire chain. The moral is
to identify the constraint and concentrate management
attention on effectively increasing its
capacity.
a. Increasing the capacity of the constraint
or bottleneck is called "relaxing the constraint" or
"elevating the constraint." Conceptually, there are
two ways one can go about increasing the effective
capacity of the bottleneck: increase the rate of
output at the bottleneck or increase the time
available at the bottleneck. Some specific examples of
ways to elevate the constraint follow:
- Pay workers overtime to keep the
bottleneck running after normal working hours. As
discussed below, the potential payoff from taking
such an action is often well worth the additional
expense. In contrast, paying workers overtime to
keep non-bottleneck processes running after normal
working hours is a total waste of money.
- Shift workers from non-bottleneck areas to the
bottleneck.
- Hire more workers or acquire more machines
specifically to augment the bottleneck.
- Subcontract some of the production that would
use the bottleneck. If an unimportant part requires
a lot of time on the bottleneck and can be
purchased cheaply from an external supplier, this
is a great way to increase profits. The bottleneck
can be shifted to more profitable uses.
- Streamline the production process at the
bottleneck to eliminate wasted time. Improvement
programs such as TQM and Business Process
Re-engineering should be focused on the
bottlenecks. A decrease in processing time at the
bottleneck can have an immediate and dramatic
effect on profits because of the increased rate of
output that is possible. A decrease in processing
time at a non-bottleneck is likely to have no
immediate impact on profits; it just creates more
excess capacity.
- Reduce defects. A part that is processed on
the bottleneck and later rejected because it is
defective uses valuable bottleneck processing
time.
b. The benefits from effectively managing
constraints (i.e., bottlenecks) can be enormous.
Managers should be given information that conveys to
them this potential. Decide how additional processing
capacity at the bottleneck would be used if it were
available. In other words, what product or order would
be produced that otherwise could not be produced? This
is the marginal job. The contribution margin per unit
of the constrained resource for this marginal job is
the value of elevating the constraint by one unit. (It
is also the opportunity cost of using the constrained
resource.) Quite often these calculations reveal that
the value of additional time is so valuable that some
decisions can be made very easily-such as adding a
shift on the bottleneck.
F. Joint Product Costs and the Contribution
Approach. In some manufacturing processes, several end
products are produced from a single input. Such end 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.
1. The pitfalls of allocation. Joint
product costs are really common costs that are incurred
to simultaneously produce a variety of end products.
Unfortunately, these common costs are routinely allocated
to the joint products. Allocated joint product costs are
often misinterpreted as costs that could be avoided by
producing less of one of the joint products. However,
joint product costs can only be avoided by producing less
of all of the joint products simultaneously. If any of
the joint products is made, then all of the joint product
costs up to the split-off point will have to be incurred.
2. Sell or process further decisions. A
decision often must be made about selling a joint product
as is or processing it further.
a. 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.
b. In such decisions, the joint product costs
incurred before the split-off point are not relevant.
They would be relevant in a decision to shut down the
joint process altogether, but they are irrelevant in
any decision about what to do with the joint products
once they have reached the split-off point.
G. Activity-Based Costing and Relevant Costs. Activity-based costing is a resource consumption model, not
a spending model. Activity-based costing gives an idea of
the magnitude of resources involved in carrying out
activities, but it should be used with a great deal of
caution in making particular decisions. The costs assigned
to products and other cost objects are only potentially
relevant costs. Whether they are relevant or not in any
particular situation should be carefully considered.
For example, in most activity-based costing systems the
fixed depreciation costs of a sophisticated milling machine
would be allocated to products based upon their usage of
that resource. Suppose you are trying to decide whether to
drop a product that uses the milling machine. The fact that
the product uses the milling machine is relevant only if the
milling machine is a bottleneck (and opportunity costs are
involved in its use) or somehow future cash flows associated
with the machine will be affected by how much it is used. If
the machine is not a bottleneck and using some of its excess
capacity has no effect on future spending, then there really
is no cost associated with using the machine. In this case,
the costs assigned by the activity-based costing system to
the product would not be relevant.
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