11A-1

Differential Analysis: The Key to

Decision Making
CHAPTER 13

Managerial Accounting
17th edition

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11-2

Learning Objective 1

Identify
relevant and irrelevant
costs and benefits
in a decision.

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11-3

Decision Making – Six Key Concepts –

Concepts 1 and 2
Key Concept #1
Every decision involves choosing from among at least two
alternatives. Therefore, the first step in decision-making is
to define the alternatives being considered.

Key Concept #2
Once you have defined the alternatives, you need to
identify the criteria for choosing among them.
 Relevant costs and relevant benefits should be
considered when making decisions.
 Irrelevant costs and irrelevant benefits should be
ignored when making decisions.

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11-4

Decision Making – Six Key Concepts –

Concept 3
Key Concept #3
The key to effective decision making is differential analysis—
focusing on the future costs and benefits that differ between
the alternatives. Everything else is irrelevant and should be
ignored.
 A future cost that differs between any two alternatives is
known as a differential cost.
 Future revenue that differs between any two alternatives is
known as differential revenue.
 An incremental cost is an increase in cost between two
alternatives.
 An avoidable cost is a cost that can be eliminated by
choosing one alternative over another.

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11-5

Decision Making – Six Key Concepts –

Concepts 4 and 5
Key Concept #4
Sunk costs are always irrelevant when choosing among
alternatives.
 A sunk cost is a cost that has already been incurred
and cannot be changed regardless of what a manager
decides to do.

Key Concept #5
Future costs and benefits that do not differ between
alternatives are irrelevant to the decision-making
process.

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11-6

Decision Making – Six Key Concepts –

Concept 6
Key Concept #6
Opportunity costs also need to be considered when
making decisions.
 An opportunity cost is the potential benefit that is given
up when one alternative is selected over another.

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11-7

Identifying Relevant Costs – An Example

Cynthia, a Boston student, is considering visiting her friend in New York.
She can drive or take the train. By car, it is 230 miles to her friend’s
apartment. She is trying to decide which alternative is less expensive
and has gathered the following information.

Automobile Costs (based on 10,000 miles driven per year)

Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

$45 per month × 8 months $2.70 per gallon ÷ 27 MPG

$24,000 cost – $10,000 salvage value ÷ 5 years

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11-8

Identifying Relevant Costs – Additional

Information
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

Additional Information
7 Reduction in resale value of car per mile of wear $ 0.026
8 Round-tip train fare $ 104
9 Benefits of relaxing on train trip ????
10 Cost of putting dog in kennel while gone $ 40
11 Benefit of having car in New York ????
12 Hassle of parking car in New York ????
13 Per day cost of parking car in New York $ 25

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11-9

Identifying Relevant Costs – Part 1

Which costs and benefits are relevant
in Cynthia’s decision?

The cost of the The annual cost of

car is a sunk cost insurance is not
and is not relevant. It will remain
relevant to the the same if she drives
current decision. or takes the train.

However, the cost of gasoline is clearly relevant if

she decides to drive. If she takes the train, she
would avoid the cost of the gasoline, so the cost
differs between the alternatives.

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11-10

Identifying Relevant Costs – Part 2

Which costs and benefits are relevant
in Cynthia’s decision?

The cost of The monthly school

maintenance and parking fee is not
repairs is relevant. In relevant because it
the long-run, these must be paid if Cynthia
costs depend upon drives or takes the
miles driven. train.

At this point, we can see that some of the average cost of

$0.619 per mile are relevant and others are not.

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11-11

Identifying Relevant Costs – Part 3

Which costs and benefits are relevant
in Cynthia’s decision?

The decline in The round-trip train fare

resale value due to is clearly relevant. If she
additional miles is a drives the cost can be
relevant cost. avoided.

Relaxing on the train is The kennel cost is

relevant even though it not relevant because
is difficult to assign a Cynthia will incur the
dollar value to the cost if she drives or
benefit. takes the train.

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11

11-12

Identifying Relevant Costs – Part 4

Which costs and benefits are relevant
in Cynthia’s decision?

The cost of parking in

New York is relevant
because it can be
avoided if she takes
the train.

The benefits of having a car in New York and

the problems of finding a parking space are
both relevant but are difficult to assign a
dollar amount.

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11-13

Identifying Relevant Costs – Part 5

From a financial standpoint, Cynthia would be better
off taking the train to visit her friend.
Some of the non-financial factors may influence her
final decision.

Relevant Financial Cost of Driving

Gasoline (460 @ $0.100 per mile) $ 46.00
Maintenance (460 @ $0.065 per mile) 29.90
Reduction in resale (460 @ $0.026 per mile) 11.96
Parking in New York (2 days @ $25 per day) 50.00
Total $ 137.86

Relevant Financial Cost of Taking the Train

Round-trip ticket $ 104.00

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13

11-14

Total and Differential Cost Approaches – Total

Cost Approach
The management of a company is considering a new labor
saving machine that rents for $3,000 per year. Data about the
company’s annual sales and costs with and without the new
machine are:
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000

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11-15

Total and Differential Cost Approaches –

Differential Cost Approach
As you can see, the only costs that differ between the
alternatives are the direct labor costs savings and the increase
in fixed rental costs.
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
We can efficiently analyze the decision by
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
looking at the different costs and revenues
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
and arrive at the same solution.
Less fixed expense:
Other 62,000 62,000 -
Rent on newFinanical
machine Advantage of Renting the - New Machine3,000 (3,000)
Total fixed Decrease
expensesin direct labor costs (5,000 units @ $362,000
per unit) $ 65,000
15,000 (3,000)
Increase
Net operating incomein fixed rental expenses $ 18,000 $ (3,000)
30,000 12,000
Financial advantage of renting the new machine $ 12,000

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15

11-16

Total and Differential Cost Approaches

Using the differential approach is desirable for

two reasons:
1. Only rarely will enough information be available to
prepare detailed income statements for both
alternatives.
2. Mingling irrelevant costs with relevant costs may
cause confusion and distract attention away from
the information that is really critical.

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11-17

Learning Objective 2

Prepare an analysis
showing whether a
product line or
other business segment
should be
added or dropped.

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17

11-18

Adding/Dropping Segments – Part 1

One of the most important

decisions managers make
is whether to add or drop a To assess this
business segment. impact, it is
Ultimately, a decision to necessary to
drop an old segment or carefully analyze
add a new one is going to the costs.
hinge primarily on its
financial impact.

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11-19

Adding/Dropping Segments – Part 2

Due to the declining popularity of

digital watches, Lovell Company’s
digital watch line has not reported a profit for
several years.
Lovell is considering whether to keep this
product line or drop it.

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19

11-20

A Contribution Margin Approach

DECISION RULE
Lovell should drop the digital watch segment only if its
profit would increase.
Lovell will compare the
contribution margin that would be lost
if the digital watch line was discontinued to the fixed
expenses that would be avoided
if the line was discontinued.

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11-21

Adding/Dropping Segments – Example –

Part 1
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)

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21

11-22

Adding/Dropping Segments – Example –

Part 2
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
An investigation has revealed
General factory overhead $ 60,000
that the
fixed general
Salary of line manager factory overhead
90,000 and
fixed general administrative expenses
Depreciation of equipment 50,000 will not be
Advertising - direct 100,000
affected by dropping the digital watch line.
Rent - factory space 70,000
The fixed
General general
admin. factory overhead
expenses 30,000and general
400,000
Net operating loss
administrative expenses assigned to this$product (100,000)
would be reallocated to other product lines.

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11-23

Adding/Dropping Segments – Example –

Part 3
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
The equipment used to manufacture
Variable shipping costs 5,000
digital watches has no resale
Commissions 75,000 200,000
value or alternative use.
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - directShould Lovell 100,000
retain or drop the
Rent - factory space digital watch segment?
70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)

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11-24

Contribution Margin Approach Solution

Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped $ (300,000)

Less fixed costs that can be avoided

Salary of the line manager $ 90,000
Advertising - direct 100,000
Rent - factory space 70,000 260,000
Financial disadvantage of dropping
the digital wataches product line $ (40,000)

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11-25

Comparative Income Approach – Part 1

The Lovell solution can also be obtained by

preparing comparative income statements
showing results with and without the digital watch
segment.

Let’s look at this second approach.

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25

11-26

Comparative Income Approach – Part 2

If the digital watch line

is dropped, the
company loses
$300,000 in
contribution margin.

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11-27

Comparative Income Approach – Part 3

Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000
Depreciation 50,000
Advertising - direct 100,000
Rent - factory space On the other hand,
70,000
General admin. expenses the general factory overhead
30,000
Total fixed expenses 400,000
Net operating loss would be the same under both
$ (100,000)
alternatives, so it is irrelevant.

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11-28

Comparative Income Approach – Part 4

Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses The salary of the product line 30,000
Total fixed expenses 400,000
Net operating loss manager would disappear, so it is $ (100,000)

relevant to the decision.

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11-29

Comparative Income Approach – Part 5

Keep Drop
Digital Digital

Sales
The depreciation is a sunk cost. Difference
$ (500,000)
Watches
$ 500,000 $
Watches
-
Also, remember that the equipment has no resale
Less variable expenses: -
Manufacturing expenses 120,000 120,000 -
value or alternative use, so
Shipping
the equipment and
5,000
the
5,000 -
depreciation expense associated with it are
Commissions 75,000 75,000 -
Total variable expenses 200,000 200,000 -
irrelevant to the
Contribution margin decision.
300,000 (300,000) -
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)

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11-30

Comparative Income Approach – Part 6

Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
The complete comparative
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
income statements reveal
Commissions 75,000 that - 75,000
Lovell would earn $40,000 of
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
additional profit by retaining the
Less fixed expenses:
digital watch line.
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000 - 100,000
Rent - factory space 70,000 - 70,000
General admin. expenses 30,000 30,000 -
Total fixed expenses 400,000 140,000 260,000
Net operating loss $ (100,000) $ (140,000) $ (40,000)

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11-31

Beware of Allocated Fixed Costs – Part 1

Be aware that allocated fixed costs can

distort the keep/drop decision.

Lovell’s managers may ask: “Why

should we keep the digital watch
segment
when it’s showing a $100,000 loss?”

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31

11-32

Beware of Allocated Fixed Costs – Part 2

The answer lies in the way we allocate

common fixed costs to our products.

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11-33

Beware of Allocated Fixed Costs – Part 3

Including unavoidable common fixed costs

makes the product line
appear to be unprofitable,
when in fact dropping the product line
would decrease the company’s
overall net operating income.

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33

11-34

Learning Objective 3

Prepare a
make or buy analysis.

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11-35

The Make or Buy Decision

When a company is involved in more than one

activity in the entire value chain,
it is vertically integrated.
A decision to carry out one of the activities in the
value chain internally, rather than to buy
externally from a supplier is called a
“make or buy” decision.

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35

11-36

Vertical Integration – Advantages

Smoother flow of
parts and materials

Better quality
control

Realize profits

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11-37

Vertical Integration – Disadvantages

Companies may fail to take advantage of suppliers
who can create economies of scale advantage by
pooling demand from numerous companies.

While the economics of scale factor can be

appealing, a company must be careful to retain
control over activities that are essential to
maintaining its competitive position.

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37

11-38

The Make or Buy Decision – An Example

Essex Company manufactures part 4A that is used in
one of its products. The unit product cost of this part
is:

Direct materials $ 9
Direct labor 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary 2
General factory overhead 10
Unit product cost $ 30

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11-39

The Make or Buy Decision – Part 1

The special equipment used to manufacture part 4A has
no resale value.
The total amount of general factory overhead, which is
allocated on the basis of direct labor hours, would be
unaffected by this decision.
The $30 unit product cost is based on 20,000 parts
produced each year.
An outside supplier has offered to provide the 20,000 parts
at a cost of $25 per part.
Should the company stop making part 4A
and buy it from an outside supplier?

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39

11-40

The Make or Buy Decision – Part 2

Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
Allocated gen. fact. overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The avoidable costs associated with making part 4A include

direct materials, direct labor, variable overhead, and
the supervisor’s salary.

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11-41

The Make or Buy Decision – Part 3

Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
Allocated gen. fact. overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The cost incurred to buy the equipment is a

sunk cost; the depreciation simply spreads this
sunk cost over the equipment’s useful life.
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11-42

The Make or Buy Decision – Part 4

Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
Allocated gen. fact. overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The allocated general factory overhead represents

allocated costs common to all items produced in the factory
and would continue unchanged.
Thus, it is irrelevant to the decision.

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11-43

The Make or Buy Decision – Part 5

Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
Allocated gen. fact. overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

Financial advantage of making part 4A $160,000

Should we make or buy part 4A? Given that the total

avoidable costs are less than the cost of buying the
part, Essex should continue to make the part.

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11-44

Opportunity Cost

Opportunity costs are not actual cash outlays and are

not recorded in the formal accounts of an
organization. An opportunity cost is the benefit that
is foregone as a result of pursuing some course of
action.
If the space to make Part 4A had an alternative use,
the opportunity cost would have been equal to the
segment margin that could have been derived from
the best alternative use of the space.

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11-45

Learning Objective 4

Prepare an analysis
showing whether
a special order
should be accepted.

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11-46

Special Orders
A special order is a one-time order that is not
considered part of the company’s normal ongoing
business.

When analyzing a special order, only the

incremental costs and benefits
are relevant.

Since the existing fixed manufacturing overhead

costs would not be affected by the order, they are
not relevant.
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11-47

Special Orders – Example

 Jet Inc. makes a single product whose normal
selling price is $20 per unit.
 A foreign distributor offers to purchase 3,000 units
for $10 per unit.
 This is a one-time order that would not affect the
company’s regular business.
 Annual capacity is 10,000 units, but Jet Inc. is
currently producing and selling only 5,000 units.

Should Jet accept the offer?

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47

11-48

Special Orders – Part 1

Jet Inc.
Contribution Inc. Stmt, before considering special order
Revenue (5,000 × $20) $ 100,000
Variable costs:
Direct materials $ 20,000
Direct labor 5,000 $8
Manufacturing overhead 10,000 variable cost
Marketing costs 5,000
Total variable costs 40,000
Contribution margin 60,000
Fixed costs:
Manufacturing overhead $ 28,000
Marketing costs 20,000
Total fixed costs 48,000
Net operating income $ 12,000

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11-49

Special Orders – Part 2

If Jet accepts the special order, the incremental revenue
will exceed the incremental costs. In other words, net
operating income will increase by $6,000. This suggests
that Jet should accept the order.

Incremental revenue (3,000 × $10) $ 30,000

Incremental cost (3,000 × $8 variable cost) 24,000
Financial advantage of accepting the order $ 6,000

Note: This answer assumes that the fixed costs are

unavoidable and that variable marketing costs must be
incurred on the special order.

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49

11-50

Concept Check 1
Northern Optical ordinarily sells the X-lens for $50.
The variable production cost is $10, the fixed
production cost is $18 per unit, and the variable selling
cost is $1. A customer has requested a special order
for 10,000 units of the X-lens to be imprinted with the
customer’s logo. This special order would not involve
any selling costs, but Northern Optical would have to
purchase an imprinting machine for $50,000.

(see the next slide)

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11-51

Concept Check 1a
What is the rock bottom minimum price below which
Northern Optical should not go in its negotiations with
the customer? In other words, below what price would
Northern Optical actually be losing money on the
sale? There is ample idle capacity to fulfill the order
and the imprinting machine has no further use after
this order.
A. $50
B. $10
C. $15
D. $29

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Learning Objective 5

Determine the most

profitable use of a
constrained resource.

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Volume Trade-Off Decisions

Companies are forced to make volume trade-off
decisions when they do not have enough capacity to
produce all of the products and sales volumes
demanded by their customers.
• In these situations, companies must trade off, or
sacrifice production of some products in favor of
others in an effort to maximize profits.

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Key Terms and Concepts

When a limited resource of

some type restricts the
company’s ability to satisfy
demand, the company is
said to have a constraint.
The machine or
process that is
limiting overall output
is called the
bottleneck – it is the
constraint.

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Utilization of a Constrained Resource

Fixed costs are usually unaffected in these situations,

so the product mix that maximizes the company’s
total contribution margin should ordinarily be
selected.
A company should not necessarily promote those
products that have the highest unit contribution
margins.
Rather, total contribution margin will be maximized by
promoting those products or accepting those orders
that provide the highest contribution margin in relation
to the constraining resource.

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Utilization of a Constrained Resource –

An Example – Part 1
Ensign Company produces two products
and selected data are shown below:
Product
1 2
Selling price per unit $ 60 $ 50
Less variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.

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Utilization of a Constrained Resource –

An Example – Part 2

1. Machine A1 is the constrained resource and is

being used at 100% of its capacity.
2. There is excess capacity on all other machines.
3. Machine A1 has a capacity of 2,400 minutes per
week.

Should Ensign focus its efforts on

Product 1 or Product 2?

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Concept Check 2
Refer to the information on the previous slide.
How many units of each product can be
processed through Machine A1 in one
minute?
Product 1 Product 2
A. 1 unit 0.5 unit
B. 1 unit 2.0 units
C. 2 units 1.0 unit
D. 2 units 0.5 unit

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Concept Check 2b
What generates more profit for the company,
using one minute of machine A1 to process
Product 1 or using one minute of machine A1
to process Product 2?
A. Product 1
B. Product 2
C. They both would generate the same
profit.
D. Cannot be determined.

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Utilization of a Constrained Resource –

Part 1
The key is the contribution margin per unit of
the constrained resource.
Product
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.
Contribution margin per minute $ 24 $ 30

Ensign should emphasize Product 2 because it

generates a contribution margin of $30 per minute of
the constrained resource relative to $24 per minute for
Product 1.

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Utilization of a Constrained Resource –

Part 2
The key is the contribution margin per unit of
the constrained resource.
Product
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.
Contribution margin per minute $ 24 $ 30

Ensign can maximize its contribution margin by first

producing Product 2 to meet customer demand and
then using any remaining capacity
to produce Product 1.
The calculations would be performed as follows.

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Utilization of a Constrained Resource –

Part 3
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

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Utilization of a Constrained Resource –

Part 4
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.

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Utilization of a Constrained Resource –

Part 5
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.
Time required per unit ÷ 1.00 min.
Production of Product 1 1,300 units

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Utilization of a Constrained Resource –

Part 6
According to the plan, we will produce 2,200
units of Product 2
and 1,300 of Product 1.
Our contribution margin looks like this.

Product 1 Product 2
Production and sales (units) 1,300 2,200
Contribution margin per unit $ 24 $ 15
Total contribution margin $ 31,200 $ 33,000

The total contribution margin for Ensign

is $64,200.

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Learning Objective 6

Determine the
value of obtaining more
of the constrained resource.

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Value of a Constrained Resource –

Example

Increasing the capacity

of a constrained
resource should lead to
increased production
and sales.

How much should

Ensign be willing to pay
for an additional minute
of Machine A1 time?

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Value of a Constrained Resource –

Solution
The additional machine time would be used to make
more units of Product 1, which had a contribution
margin per minute of $24.

Ensign should be willing to pay up to $24 per minute.

This amount equals the contribution margin per
minute of machine time that would be earned
producing more units of Product 1.

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Concept Check 3
Colonial Heritage makes reproduction colonial furniture
from select hardwoods.
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only be able to

supply 2,000 board feet this month. Is this enough
hardwood to satisfy demand?
A. Yes
B. No

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Concept Check 3b
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only be

able to supply 2,000 board feet this month. What
plan would maximize profits?
A. 500 chairs and 100 tables
B. 600 chairs and 80 tables
C. 500 chairs and 80 tables
D. 600 chairs and 100 tables

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Concept Check 4
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100
Colonial Heritage’s supplier of hardwood will only be able to
supply 2,000 board feet this month. Assume the company
follows the plan we have proposed. Up to how much should
Colonial Heritage be willing to pay above the usual price to
obtain more hardwood?
A. $40 per board foot
B. $25 per board foot
C. $20 per board foot
D. Zero

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Managing Constraints
It is often possible for a manager to increase the
capacity of a bottleneck, which is called relaxing (or
elevating) the constraint, in numerous ways such as:
1. Working overtime on the bottleneck.
2. Subcontracting some of the processing that would be done
at the bottleneck.
3. Investing in additional machines at the bottleneck.
4. Shifting workers from non-bottleneck processes to the
bottleneck.
5. Focusing business process improvement efforts on the
bottleneck.
6. Reducing defective units processed through the bottleneck.

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Learning Objective 7

Prepare an analysis showing

whether joint products should
be sold at the split-off point
or processed further.

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Joint Product Costs

In some industries, two or more products, known as

joint products are produced from a single raw
material input.
The point in the manufacturing process where joint
products can be recognized as a separate product is
called the split-off point.
A decision as to whether a joint product should be
sold at the split-off point or processed further is
known as a sell or process further decision.

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Joint Products
For example, in
the petroleum
Oil
refining industry,
a large number of
products are
Common
Joint extracted from
Production Gasoline
Input crude oil,
Process
including
gasoline, jet fuel,
Chemicals home heating oil,
lubricants,
asphalt, and
Split-Off various organic
Point chemicals.

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Joint Products – Additional Processing

Joint costs
are incurred
up to the
Oil
Separate Final
split-off point Processing Sale

Common
Joint Production Final
Gasoline
Input Process
Sale

Separate Final
Chemicals
Processing
Sale

Split-Off Separate
Point Product
Costs
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The Pitfalls of Allocation

Joint costs are traditionally allocated among
different products at the split-off point. A typical
approach is to allocate joint costs according to the
relative sales value of the end products.

Although allocation is needed for some purposes

such as balance sheet inventory valuation,
allocations of this kind are very dangerous for
decision making.

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Sell or Process Further

Joint costs are irrelevant in decisions regarding what
to do with a product from the split-off point forward.
Therefore, these costs should not be allocated to end
products for decision-making purposes.

With respect to sell or process further decisions,

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 incurred after the split-
off point.

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Sell or Process Further – An Example

Sawmill, Inc. cuts logs from which unfinished
lumber and sawdust are the immediate joint
products.
Unfinished lumber is sold “as is” or processed
further into finished lumber.
Sawdust can also be sold “as is” to gardening
wholesalers or processed further into “presto-
logs.”

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Sell or Process Further – Additional Data

Data about Sawmill’s joint products includes:

Per Log
Lumber Sawdust
Sales value at the split-off point $ 140 $ 40

Sales value after further processing 270 50

Allocated joint product costs 176 24
Cost of further processing 50 20

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Sell or Process Further – Part 1

Analysis of Sell or Process Further
Per Log
Lumber Sawdust
Final sales value after further
processing $ 270 $ 50
Sales value at the split-off point 140 40
Incremental revenue from further
processing 130 10
Cost of further processing
Financial advantage (disadvantage)
of further processing

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Sell or Process Further – Part 2

Analysis of Sell or Process Further
Per Log
Lumber Sawdust
Final sales value after further
processing $ 270 $ 50
Sales value at the split-off point 140 40
Incremental revenue from further
processing 130 10
Cost of further processing 50 20
Financial advantage (disadvantage)
of further processing $ 80 $ (10)

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Sell or Process Further – Part 3

Analysis of Sell or Process Further
Per Log
Lumber Sawdust
Final sales value after further
processing $ 270 $ 50
Sales value at the split-off point 140 40
Incremental revenue from further
processing 130 10
Cost of further processing 50 20
Financial advantage (disadvantage)
of further processing $ 80 $ (10)

The lumber should be processed

further and the sawdust should be
sold at the split-off point.
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Activity-Based Costing and Relevant Costs

ABC can be used to help identify potentially
relevant costs for decision-making purposes.

However, managers should exercise

caution against reading more into this
“traceability” than really exists.

People have a tendency to assume that if a cost is

traceable to a segment, then the cost is automatically
avoidable, which is untrue. Before making a decision,
managers must decide which of the potentially
relevant costs are actually avoidable.

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End of Chapter 13

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