College of San Mateo

Accounting 131

Rosemary Nurre


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Chapter 13

 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.