NATIONAL COLLEGE OF BUSINESS AND c.

When making a decision, eliminate all

ARTS irrelevant costs. Make the decision based on the
MBA remaining, relevant costs.
Managerial Accounting
NOTE: A more algebraic approach can also
RELEVANT COSTS FOR DECISION MAKING be considered.. Suppose there are two
 The Decision Making Process alternatives: A and B. Alternative A is
Reported by: preferred to Alternative B if total profits
Jerralyn Cortez – Alva under Alternative A exceed total profits
28 March 2015 under Alternative B. The profits under
Alternative A can be written as "RevA-
CostA" and the profits under Alternative B
Learning Objectives can be written as "RevB- CostB". The profit
under Alternative A exceeds the profit under
1. Identify relevant and irrelevant costs and Alternative B if and only if RevA- CostA >
benefits in a decision situation. RevB- CostB. Or, the profit under Alternative
2. Prepare an analysis showing whether a A exceeds the profit under Alternative B if
product line or other organizational segment and only if RevA- RevB > CostA- CostB.
should be dropped or retained. Thus, Alternative A is preferred if and only if
3. Prepare a make or buy analysis. the differential revenue exceeds the
4. Prepare an analysis showing whether a differential cost. The only costs (and
special order should be accepted. benefits) that matter are those that differ
5. Determine the most profitable use of a between the alternatives.
constrained resource and the value of obtaining
more of the constrained resource. 2. Different costs for different purposes.
6. Prepare an analysis showing whether joint Costs that are relevant in one decision situation
products should be sold at the split-off point or are not necessarily relevant in another. In each
processed further. situation the manager must examine the data
and isolate the relevant costs.
Lecture Notes
NOTE: Don't develop incorrect rules of
A. Cost Concepts for Decision-Making. Every thumbs for identifying relevant costs. One
decision involves a choice from among at least such popular thumb-rule is that variable
two alternatives. The costs and benefits of the costs are relevant and fixed costs are
alternatives should be compared when making irrelevant. This thumb-rule is wrong.The
the decision. fixed costs that differ between alternatives
and that are therefore relevant.
1. Identifying relevant costs. A relevant cost or
benefit is a cost or benefit that differs between 3. Human frailties. Many (most?) people have a
alternatives. Differential costs are relevant costs. great deal of difficulty ignoring irrelevant costs
Any cost or benefit that does not differ between when making decisions. People are especially
alternatives is irrelevant and can be ignored in a reluctant to discard sunk costs in decision-
decision. This is a tremendously powerful making when the sunk costs are a consequence
concept that allows us to ignore mounds of data of a past decision that in retrospect was unwise.
when making decisions since most things are People have a tendency to become committed
not affected by any given decision. to courses of action that have not worked out.
a. All sunk costs (i.e., costs already irrevocably Taking a loss on an asset is an admission of
incurred) are irrelevant since they will be the failure.
same for any alternative. All future costs that do
not differ between alternatives are irrelevant. B. Adding or Dropping a Segment. Decisions
relating to dropping old products (or segments)
b. Any cost that is avoidable is potentially and adding new products (or segments) are
relevant. An avoidable cost is a cost that can be among the most difficult that a manager makes.
eliminated (in whole or in part) as a result of Two basic approaches can be used to analyze
choosing one alternative over another. data in this type of decision.
1. Compare contribution margins and fixed c. Changing technology may make producing
costs. A segment should be added only if the one's own parts riskier than purchasing from the
increase in total contribution margin is greater outside.
than the increase in fixed cost. A segment
should be dropped only if the decrease in total 3. Opportunity Cost. Opportunity costs should
contribution margin is less than the decrease in be considered in decisions. There is no
fixed cost. opportunity cost involved in using a resource
that has excess capacity. However, if the
2. Compare net incomes. A second approach resource is a constraint (i.e., there is no excess
is to calculate the total net income under each capacity) then there is an opportunity cost. The
alternative. The alternative with the highest net opportunity costs may be far more important
income is preferred. This approach requires than the costs typically recorded in accounting
more information than the first approach since systems.
costs and revenues that don't differ between the
alternatives must be included in the analysis D. Special Order. Special orders are one-time
when the net incomes are compared. orders that do not affect a company's normal
sales. The profit from a special order equals the
3. Beware of allocated common costs. incremental revenue less the incremental costs.
Allocated common costs can make a segment As long as the incremental revenue exceeds the
look unprofitable even though dropping the incremental costs, the order should be accepted.
segment might result in a decrease in overall If there is no idle capacity, opportunity costs
company net operating income. Allocated costs should be included as part of the incremental
that would not be affected by a decision are costs.
irrelevant and should be ignored in a decision
relating to adding or dropping a segment. E. Utilization of a Constrained Resource. A
constraint is whatever prevents an individual or
C. The Make or Buy Decision. A make or buy organization from getting more of what it wants.
decision is concerned with whether an item There is always a constraint as long as desires
should be made internally or purchased from an are unsatisfied. The chapter focuses on one
external supplier. particular kind of constraint-a production
constraint. A production constraint can be a raw
1. Advantages of making an item internally. material, a part, a machine, or a workstation. If
a. Producing a part internally reduces the constraint is a machine or workstation, it is
dependence on suppliers and may ensure a called a bottleneck.
smoother flow of parts and material for
production. 1. Contribution Margin Per Unit of the
Constrained Resource. Whenever demand
b. Quality control may be easier when parts are exceeds productive capacity, there is a
produced internally. production constraint. This means that the
company is unable to fill all orders and some
choices have to be made concerning which
c. Profits can be realized on the parts and
orders are filled and which are not filled. The
materials.
problem is how to most effectively use the
constrained resource.
2. Advantages of buying an item from an a. Whether this order or that order is filled, the
external supplier. fixed costs will usually be the same. Therefore,
maximizing the total contribution margin will also
a. By pooling the requirements of a number of maximize profit.
users, a supplier can realize economies of scale
and may be able to move more quickly up the b. The total contribution margin is maximized by
learning curve. emphasizing those products or accepting those
orders with the highest contribution margin per
b. A specialized supplier may be able to respond unit of the constrained resource.
more quickly and at less cost to changing future
needs.
c. In general, the correct way to rank the  Shift workers from non-bottleneck areas to
profitability of products or orders (or anything the bottleneck.
else for that matter) is in terms of their  Hire more workers or acquire more
contribution margins per unit of the constrained machines specifically to augment the
resource. bottleneck.
 Subcontract some of the production that
2. Managing constraints. Ordinarily, there is would use the bottleneck. If an unimportant
only one constraint in any system. The capacity part requires a lot of time on the bottleneck
of an entire factory or of an entire service and can be purchased cheaply from an
organization is determined by the capacity at the external supplier, this is a great way to
constraint, which could be a single machine or increase profits. The bottleneck can be
work center. In addition to making sure that the shifted to more profitable uses.
best product mix is chosen by ranking products  Streamline the production process at the
based on the contribution margin per unit of the bottleneck to eliminate wasted time.
constrained resource, managers should seek Improvement programs such as TQM and
ways to increase the effective capacity of the Business Process Re-engineering should be
constraint. focused on the bottlenecks. A decrease in
processing time at the bottleneck can have
NOTE: A chain is a good metaphor to use an immediate and dramatic effect on profits
when thinking about how to manage a because of the increased rate of output that
constraint. A production process can be is possible. A decrease in processing time at
thought of as a chain, with each link in the a non-bottleneck is likely to have no
chain representing a step in the process. A immediate impact on profits; it just creates
chain is only as strong as its weakest link. more excess capacity.
Likewise, the capacity of a production  Reduce defects. A part that is processed on
process is determined by its weakest link, the bottleneck and later rejected because it
which is the constraint. The only way to is defective uses valuable bottleneck
increase the strength of a chain is to processing time.
strengthen the weakest link. The only way to
increase the output of the entire process is b. The benefits from effectively managing
to increase the output of the constraint. constraints (i.e., bottlenecks) can be enormous.
Strengthening the stronger links has no Managers should be given information that
effect on the strength of the entire chain. The conveys to them this potential. Decide how
moral is to identify the constraint and additional processing capacity at the bottleneck
concentrate management attention on would be used if it were available. In other
effectively increasing its capacity. words, what product or order would be produced
that otherwise could not be produced? This is
a. Increasing the capacity of the constraint or the marginal job. The contribution margin per
bottleneck is called "relaxing the constraint" or unit of the constrained resource for this marginal
"elevating the constraint." Conceptually, there job is the value of elevating the constraint by
are two ways one can go about increasing the one unit. (It is also the opportunity cost of using
effective capacity of the bottleneck: increase the the constrained resource.) Quite often these
rate of output at the bottleneck or increase the calculations reveal that the value of additional
time available at the bottleneck. Some specific time is so valuable that some decisions can be
examples of ways to elevate the constraint made very easily-such as adding a shift on the
follow: bottleneck.

 Pay workers overtime to keep the bottleneck F. Joint Product Costs and the Contribution
running after normal working hours. As Approach. In some manufacturing processes,
discussed below, the potential payoff from several end products are produced from a single
taking such an action is often well worth the input. Such end products are known as joint
additional expense. In contrast, paying products. The costs associated with making
workers overtime to keep non-bottleneck these products up to the point where they can
processes running after normal working be recognized as separate products (the split-off
hours is a total waste of money. point) are called joint product costs.
1. The pitfalls of allocation. Joint product costs flows associated with the machine will be
are really common costs that are incurred to affected by how much it is used. If the machine
simultaneously produce a variety of end is not a bottleneck and using some of its excess
products. Unfortunately, these common costs capacity has no effect on future spending, then
are routinely allocated to the joint products. there really is no cost associated with using the
Allocated joint product costs are often machine. In this case, the costs assigned by the
misinterpreted as costs that could be avoided by activity-based costing system to the product
producing less of one of the joint products. would not be relevant.
However, joint product costs can only be
avoided by producing less of all of the joint
products simultaneously. If any of the joint Relevant Costs for Decision Making
products is made, then all of the joint product
costs up to the split-off point will have to be Making correct decisions is one of the most
incurred. important tasks of a successful manager. Every
decision involves a choice between at least two
2. Sell or process further decisions. A alternatives. The decision process may be
decision often must be made about selling a complicated by volumes of data, irrelevant data,
joint product as is or processing it further. incomplete information, an unlimited array of
alternatives, etc. The role of the managerial
a. It is profitable to continue processing a joint accountant in this process is often that of a
product after the split-off point so long as the gatherer and summarizer of relevant information
incremental revenue from such processing rather than the ultimate decision maker.
exceeds the incremental processing costs.
The costs and benefits of the alternatives need
to be compared and contrasted before making a
b. In such decisions, the joint product costs
decision.
incurred before the split-off point are not
The decision should be based only on
relevant. They would be relevant in a decision to
RELEVANT information. Relevant information
shut down the joint process altogether, but they
includes the predicted future costs and revenues
are irrelevant in any decision about what to do
that differ among the alternatives. Any cost or
with the joint products once they have reached
benefit that does not differ between alternatives
the split-off point.
is irrelevant and can be ignored in a decision. All
future revenues and/or costs that do not differ
G. Activity-Based Costing and Relevant between the alternatives are irrelevant. Sunk
Costs. Activity-based costing is a resource costs (costs already irrevocably incurred) are
consumption model, not a spending model. always irrelevant since they will be the same for
Activity-based costing gives an idea of the any alternative.
magnitude of resources involved in carrying out To identify which costs are relevant in a
activities, but it should be used with a great deal particular situation, take this three step
of caution in making particular decisions. The approach:
costs assigned to products and other cost 1. Eliminate sunk costs
objects are only potentially relevant costs. 2. Eliminate costs and benefits that do not differ
Whether they are relevant or not in any between alternatives
particular situation should be carefully 3. Compare the remaining costs and benefits
considered. that do differ between alternatives to make the
proper decision
For example, in most activity-based costing
systems the fixed depreciation costs of a Five separate types of decisions are discussed
sophisticated milling machine would be allocated in Chapter 13 as follows:
to products based upon their usage of that Adding and Dropping Product Lines and
resource. Suppose you are trying to decide Other Segments
whether to drop a product that uses the milling Make or Buy Decisions
machine. The fact that the product uses the Special Orders
milling machine is relevant only if the milling Utilization of a Scarce Resources
machine is a bottleneck (and opportunity costs Sell or Process further Decisions
are involved in its use) or somehow future cash
 Adding and Dropping Product Lines and Other continuing to make the shifter of ($5 * 8,000) or
Segments $40,000.
In Exhibit 13-2, Page 609, it appears that
Discount Drug Company will improve its overall Special Orders
profits if it drops the House-wares Product Line. Special orders are one-time orders that do not
However, in order to make the correct decision affect a company’s normal sales. The profit from
regarding dropping a product line, we need to a special order equals the incremental revenue
compare lost contribution margin with avoidable less the incremental costs. As long as the
fixed costs. If the avoidable fixed costs are incremental revenue exceeds the incremental
greater than lost contribution margin then costs and present sales are unaffected, the
Discount Drug Company is better off dropping special order should be accepted. Beginning on
the House-wares Product Line. In analyzing the Page 616 the authors describe an example of a
House-wares fixed costs, we find that $13,000 of special order in which the Seattle Police
the total fixed costs of $28,000 are not Department offers to buy bicycles from Mountain
avoidable, that is, they will continue even if the Goat Cycles on a special order price of $179 per
House-wares line is dropped. Only $15,000 of unit. The bikes have a unit product “cost” of
the fixed costs are avoidable. When we compare $182. Should the special order be accepted?
the avoidable fixed costs of $15,000 with the Since this order would have no effect on other
loss contribution margin of $20,000, we see that sales and since the company has idle capacity,
total net profits will decrease by $5,000 if the then only incremental costs and benefits are
House-wares Product Line is dropped. relevant. See the analysis on Page 617 showing
why the special order should be accepted.
A segment should be added only if the increase
in total contribution margin is greater than the Utilization of a Constrained Resources
increase in fixed costs. A segment should be Whenever demand exceeds productive capacity,
dropped only if the decrease in total contribution a production constraint (bottleneck) exists. This
margin is less than the decrease in fixed costs. means that the company is unable to fill all
The authors warn the reader to beware of orders and some choices have to be made
allocated common costs. Common fixed costs concerning which orders are filled and which are
are fixed costs that support the operation of not filled. Total contribution margin will be
more than one segment, but are not traceable in maximized by promoting those products or
whole or in part to any one segment. Thus they accepting those orders that provide the highest
continue even when the product line is dropped. unit contribution margin in relation to the
Allocated common fixed costs can make a constrained resource. See the example on
segment look unprofitable even though dropping Pages 618-9. Since the capacity of an entire
the segment might result in a decrease in overall factory or an entire service organization may be
company net operating income determined by a single constraint, it is extremely
Make or Buy Decisions important to effectively manage the constraint.
A make or buy decision relates to whether an Methods to increase the capacity of the
item should be made internally or purchased constraint or bottleneck are described on Page
from an external supplier. Beginning on Page 605.
613 the authors describe how Mountain Goat
Cycles Company is producing 8,000 gear Sell or Process Further Decisions
shifters annually at an internal “cost” of $21 per In some manufacturing processes, several
unit. An outside supplier has offered to sell intermediate products are produced from a
8,000 shifters per year to Mountain Goat Cycles single input. Such products are known as joint
at a unit price of $19. Should Mountain Goat products. The costs associated with making
Cycles continue to make the shifter or should these products up to the point where they can
they purchase it? Analyzing the “costs” of the be recognized as separate products (the split-off
internally produced shifter reveals that the point) are called joint product costs.
depreciation and allocated general overhead
costs (totalling $7 per unit) will continue even if A decision often must be made about selling a
the shifter is purchased externally. Thus the joint product as is or processing it further. It is
relevant costs are $14 to make versus $19 to profitable to continue processing a joint product
buy or a difference in favor of the cycle firm 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.

Relevant costs are those costs that will make a

difference in a decision. Relevant costs are
future costs that will differ among alternatives.

We can demonstrate relevant costs with the

following situation. A company is deciding
whether or not to eliminate a product line. The
product line accounts for approximately 4% of
the company's activities. If the product line is
eliminated, the officers of the corporation will
continue to receive the same salaries and the
central office expenses will not change. The
product line managers and other employees
working directly on the product line will be
terminated. Hence, their salaries will be
eliminated.

The salaries of the product line managers and

other employees whose salaries will be
eliminated are relevant to the decision. If these
salaries are $700,000 with the product line and
$0 without the product line, the $700,000 of
savings is relevant. Those cost savings and
other possible cost savings will be considered
along with the loss of sales revenues.

On the other hand, the officers' salaries are not

relevant in the decision. In other words, it
doesn't matter if the officers' salaries are
$500,000 or $5,000,000. The officers' salaries
will be the same with or without the product line.
Similarly, the decision maker does not need to
know the amount of its central office expenses,
since they will be the same with or without the
product line. Expenses from previous years are
also irrelevant.

To recap, relevant costs are the future costs that

will differ among alternatives. You might use the
past costs to help you predict those future costs,
but the past costs are otherwise irrelevant to the
decision. Accountants refer to the past costs as
sunk costs.