Relevant Costs for Decision Making

Chapter 13

© 2010 The McGraw-Hill Companies, Inc.

 Learning Objective 1

Identify relevant and

irrelevant costs and
benefits in a decision.

McGraw-Hill/Irwin Slide 2
 Cost Concepts for Decision Making

A relevant cost is a cost that differs

between alternatives.

McGraw-Hill/Irwin Slide 3
 Identifying Relevant Costs

An avoidable cost is a cost that can be eliminated,

in whole or in part, by choosing one alternative
over another. Avoidable costs are relevant costs.
Unavoidable costs are irrelevant costs.

Two broad categories of costs are never relevant

in any decision. They include:
 Sunk costs.
 Future costs that do not differ between the
alternatives.

McGraw-Hill/Irwin Slide 4
 Relevant Cost Analysis: A Two-Step Process

Step 1 Eliminate costs and benefits that do not differ

between alternatives.
Step 2 Use the remaining costs and benefits that
differ between alternatives in making the
decision. The costs that remain are the
differential, or avoidable, costs.

McGraw-Hill/Irwin Slide 5
 Different Costs for Different Purposes
Costs that are
relevant in one
decision situation
may not be relevant
in another context.
Thus, in each
decision situation,
the manager must
examine the data at
hand and isolate the
relevant costs.
McGraw-Hill/Irwin Slide 6
 Identifying Relevant Costs
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

McGraw-Hill/Irwin Slide 7
 Identifying Relevant Costs
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

Some 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

McGraw-Hill/Irwin Slide 8
 Identifying Relevant Costs
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, the cost would
not be incurred, so it varies depending on the decision.

McGraw-Hill/Irwin Slide 9
 Identifying Relevant Costs
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.

McGraw-Hill/Irwin Slide 10
 Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?

The decline in resale The round-trip train

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

Relaxing on the train is The kennel cost is not

relevant even though it relevant because
is difficult to assign a Cynthia will incur the
dollar value to the cost if she drives or
benefit. takes the train.

McGraw-Hill/Irwin Slide 11
 Identifying Relevant Costs
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.

McGraw-Hill/Irwin Slide 12
 Identifying Relevant Costs

From a financial standpoint, Cynthia would be better

off taking the train to visit her friend. Some of the
non-financial factor 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

McGraw-Hill/Irwin Slide 13
 Total and Differential Cost Approaches
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

McGraw-Hill/Irwin Slide 14
 Total and Differential Cost Approaches
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:
We
Direct materials canunits
(5,000 efficiently analyze the
@ $14 per unit) decision 70,000
70,000 by -
Direct labor looking
(5,000 units at
@ $8 anddifferent
the $5 per unit) costs 40,000
and revenues 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses and arrive at the same 120,000 .
solution 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:Net Advantage to Renting the New Machine
Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Other 62,000 62,000 -
Increase in fixed rental expenses (3,000)
Rent on newNet machine
annual cost saving from renting the new machine
- $
3,000
12,000
(3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000

McGraw-Hill/Irwin Slide 15
 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.

McGraw-Hill/Irwin Slide 16
 Learning Objective 2
Prepare an analysis
showing whether a
product line or other
business segment should
be dropped or retained.

McGraw-Hill/Irwin Slide 17
 Adding/Dropping Segments
One of the most
important decisions
managers make is
whether to add or drop
a business segment.
Ultimately, a decision
to drop an old segment
or add a new one is
going to hinge primarily To assess this impact,
on the impact the it is necessary to
decision will have on carefully analyze
net operating income. the costs.
McGraw-Hill/Irwin Slide 18
 Adding/Dropping Segments

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
discontinuing this product line.

McGraw-Hill/Irwin Slide 19
 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 to the costs
that would be avoided if the line was
to be dropped.
Let’s look at this solution.

McGraw-Hill/Irwin Slide 20
 Adding/Dropping Segments
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)
McGraw-Hill/Irwin Slide 21
 Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
An
Less: investigation
variable expenses has revealed that the fixed
Variable manufacturing costs $ 120,000
general factory
Variable shipping costs
overhead and fixed general
5,000
administrative
Commissions expenses will not75,000
be affected200,000
by
dropping the
Contribution digital watch line. The fixed general
margin $ 300,000
Less: fixed expenses
factory overhead and general administrative
General factory overhead $ 60,000
expenses
Salary of line assigned
manager to this product
90,000 would be
reallocated
Depreciation to other product
of equipment lines.
50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)

McGraw-Hill/Irwin Slide 22
 Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
The equipment
Variable used costs
manufacturing to manufacture
$ 120,000
digital
Variable watches
shipping has no resale5,000
costs
Commissions
value or alternative use. 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Should Lovell
Depreciation of equipment retain or drop
50,000
Advertising - direct the digital watch
100,000segment?
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)

McGraw-Hill/Irwin Slide 23
 A Contribution Margin Approach
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
Net disadvantage $ (40,000)

McGraw-Hill/Irwin Slide 24
 Comparative Income Approach

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.

McGraw-Hill/Irwin Slide 25
 Comparative Income Approach
Solution
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
Salary of line manager 90,000
Depreciation 50,000 If the digital watch
Advertising - direct 100,000
Rent - factory space 70,000
line is dropped, the
General admin. expenses 30,000 company loses
Total fixed expenses 400,000 $300,000 in
Net operating loss $ (100,000)
contribution margin.

McGraw-Hill/Irwin Slide 26
 Comparative Income Approach
Solution
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 On 100,000
the other hand, the general
Rent - factory space factory overhead would be the
70,000
General admin. expenses 30,000
same under both alternatives,
Total fixed expenses 400,000
Net operating loss so it is irrelevant.
$ (100,000)

McGraw-Hill/Irwin Slide 27
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses
The salary of the
120,000
product -
line 120,000
Shipping manager would 5,000disappear, - so 5,000
Commissions it is relevant to the decision.
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 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)

McGraw-Hill/Irwin Slide 28
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
The
Less depreciation
variable expenses: is a sunk cost. Also, remember - that
Manufacturing
the equipment expenses
has no resale120,000 -
value or alternative 120,000
use,
Shipping 5,000 - 5,000
so
Commissionsthe equipment and the depreciation
75,000 expense
- 75,000
associated
Total variable with it are irrelevant
expenses 200,000 to the decision.
- 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 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)

McGraw-Hill/Irwin Slide 29
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping The complete 5,000 comparative- 5,000
Commissions income statements
75,000 reveal- that 75,000
Total variable expenses 200,000 - 200,000
Contribution margin
Lovell would
300,000
earn $40,000
-
of (300,000)
Less fixed expenses: additional profit by retaining the
General factory overhead 60,000
digital 60,000
watch line. -
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)

McGraw-Hill/Irwin Slide 30
 Beware of Allocated Fixed Costs

Why should we keep the

digital watch segment
when it’s showing a
$100,000 loss?

McGraw-Hill/Irwin Slide 31
 Beware of Allocated Fixed Costs

The answer lies in the

way we allocate
common fixed costs
to our products.

McGraw-Hill/Irwin Slide 32
 Beware of Allocated Fixed Costs

Including unavoidable Our allocations can

common fixed costs make a segment
makes the product line look less profitable
appear to be unprofitable. than it really is.

McGraw-Hill/Irwin Slide 33
 Learning Objective 3

Prepare a make or buy

analysis.

McGraw-Hill/Irwin Slide 34
 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.

McGraw-Hill/Irwin Slide 35
 Vertical Integration- Advantages

Smoother flow of
parts and materials

Better quality
control

Realize profits

McGraw-Hill/Irwin Slide 36
 Vertical Integration- Disadvantage
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.
McGraw-Hill/Irwin Slide 37
 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

McGraw-Hill/Irwin Slide 38
 The Make or Buy Decision
 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 we accept the supplier’s offer?

McGraw-Hill/Irwin Slide 39
 The Make or Buy Decision
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
General factory 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.

McGraw-Hill/Irwin Slide 40
 The Make or Buy Decision
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
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The depreciation of the special equipment represents a sunk

cost. The equipment has no resale value, thus its cost and
associated depreciation are irrelevant to the decision.

McGraw-Hill/Irwin Slide 41
 The Make or Buy Decision
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
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

Not avoidable; irrelevant. If the product is

dropped, it will be reallocated to other products.

McGraw-Hill/Irwin Slide 42
 The Make or Buy Decision
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
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

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.
McGraw-Hill/Irwin Slide 43
 Opportunity Cost
An opportunity cost is the benefit that is
foregone as a result of pursuing some course
of action.
Opportunity costs are not actual cash outlays
and are not recorded in the formal accounts of
an organization.

How would this concept potentially relate to the

Essex Company?

McGraw-Hill/Irwin Slide 44
 Learning Objective 4

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

McGraw-Hill/Irwin Slide 45
 Key Terms and Concepts
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.

McGraw-Hill/Irwin Slide 46
 Special Orders
 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?

McGraw-Hill/Irwin Slide 47
 Special Orders
Jet, Inc.
Contribution Income Statement
Revenue (5,000 × $20) $ 100,000
Variable costs:
Direct materials $ 20,000
Direct labor 5,000
Manufacturing overhead 10,000 $8 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

McGraw-Hill/Irwin Slide 48
 Special Orders
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.

Increase in revenue (3,000 × $10) $ 30,000

Increase in costs (3,000 × $8 variable cost) 24,000
Increase in net income $ 6,000

Note: This answer assumes that the fixed costs are

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

McGraw-Hill/Irwin Slide 49
 Quick Check 
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 page)

McGraw-Hill/Irwin Slide 50
 Quick Check 
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

McGraw-Hill/Irwin Slide 51
 Quick Check 
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 Variable production cost $100,000
b. $10 Additional fixed cost + 50,000
c. $15 Total relevant cost $150,000
d. $29 Number of units 10,000
Average cost per unit= $15
McGraw-Hill/Irwin Slide 52
 Learning Objective 5
Determine the most
profitable use of a
constrained resource and
the value of obtaining
more of the constrained
resource.

McGraw-Hill/Irwin Slide 53
 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.

McGraw-Hill/Irwin Slide 54
 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.

McGraw-Hill/Irwin Slide 55
 Utilization of a Constrained Resource: An
Example
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.

McGraw-Hill/Irwin Slide 56
 Utilization of a Constrained Resource: An
Example

 Machine A1 is the constrained resource

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

Should Ensign focus its efforts on

Product 1 or Product 2?

McGraw-Hill/Irwin Slide 57
 Quick Check 
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

McGraw-Hill/Irwin Slide 58
 Quick Check 
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

Just checking to make sure you are with us.

McGraw-Hill/Irwin Slide 59
 Quick Check 

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.

McGraw-Hill/Irwin Slide 60
 Quick Check 
With one minute of machine A1, we could make 1
unit of Product 1, with a contribution margin
What generates more profit for the company, using of
one$24, or of
minute 2 units of A1
machine Product 2, each
to process with1 a
Product or
contribution
using one minute margin
of machine A1 toof $15. Product 2?
process
a. Product 1 2 × $15 = $30 > $24
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.

McGraw-Hill/Irwin Slide 61
 Utilization of a Constrained Resource
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.

McGraw-Hill/Irwin Slide 62
 Utilization of a Constrained Resource
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.

McGraw-Hill/Irwin Slide 63
 Utilization of a Constrained Resource
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.

McGraw-Hill/Irwin Slide 64
 Utilization of a Constrained Resource
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.

McGraw-Hill/Irwin Slide 65
 Utilization of a Constrained Resource
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

McGraw-Hill/Irwin Slide 66
 Utilization of a Constrained Resource

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.

McGraw-Hill/Irwin Slide 67
 Quick Check 
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

McGraw-Hill/Irwin Slide 68
 Quick Check 
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 (2  600) + (10  100 ) = 2,200 > 2,000

McGraw-Hill/Irwin Slide 69
 Quick Check 
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
McGraw-Hill/Irwin Slide 70
 Chairs Tables
Quick Check  Selling price $ 80 $ 400
Variable cost 30 200
Chairs Tables
Contribution margin $ 50 $ 200
Selling price per unit $80 $400
Variable cost Board feet $30
per unit $200 2 10
Board feet perCM per board foot
unit 2 $10 25 $ 20
Monthly demand 600 100
Production of chairs 600
The company’s supplier
Board feetofrequired
hardwood will only
1,200
be able to supplyBoard
2,000feet
board feet this800
remaining month.
What plan wouldBoard
maximize
feet per profits?
table 10
a. 500 chairs and Production
100 tables of tables 80
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
McGraw-Hill/Irwin Slide 71
 Quick Check 
As before, 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

McGraw-Hill/Irwin Slide 72
 Quick Check 
As before, Colonial Heritage’s supplier of hardwood
The additional
will only wood
be able to would
supply 2,000 be used
board feetto make
this
tables.
month. In this
Assume use, each
the company board
follows foot
the planofwe
have proposed.
additional woodUp to how
will allowmuch
the should
companyColonial
to earn
Heritage
an be willing
additional $20toofpay above the usual
contribution priceand
margin to
obtain more hardwood?
profit.
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero

McGraw-Hill/Irwin Slide 73
 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.

These methods and ideas are all consistent with the Theory
of Constraints, which was introduced in Chapter 1.

McGraw-Hill/Irwin Slide 74
 Learning Objective 6

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

McGraw-Hill/Irwin Slide 75
 Joint Costs

 In some industries, a number of end

products are produced from a single raw
material input.
 Two or more products produced from a
common input are called joint products.
 The point in the manufacturing process
where each joint product can be
recognized as a separate product is
called the split-off point.

McGraw-Hill/Irwin Slide 76
 Joint Products
For example,
Oil in the petroleum
refining industry,
a large number
Common of products are
Joint
Input
Production Gasoline extracted from
Process crude oil,
including
gasoline, jet fuel,
Chemicals
home heating oil,
lubricants,
asphalt, and
Split-Off
various organic
Point chemicals.

McGraw-Hill/Irwin Slide 77
 Joint Products
Joint costs
are incurred
up to the Oil
Separate Final
split-off point Processing Sale

Common
Joint Final
Production Gasoline
Input Sale
Process

Separate Final
Chemicals
Processing
Sale

Split-Off Separate
Point Product
Costs
McGraw-Hill/Irwin Slide 78
 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.
McGraw-Hill/Irwin Slide 79
 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.

McGraw-Hill/Irwin Slide 80
 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.”

McGraw-Hill/Irwin Slide 81
 Sell or Process Further
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

McGraw-Hill/Irwin Slide 82
 Sell or Process Further

Analysis of Sell or Process Further

Per Log
Lumber Sawdust

Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing
Profit (loss) from further processing

McGraw-Hill/Irwin Slide 83
 Sell or Process Further

Analysis of Sell or Process Further

Per Log
Lumber Sawdust

Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing 50 20
Profit (loss) from further processing $ 80 $ (10)

McGraw-Hill/Irwin Slide 84
 Sell or Process Further

Analysis of Sell or Process Further

Per Log
Lumber Sawdust

Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing 50 20
Profit (loss) from further processing $ 80 $ (10)

The lumber should be processed

further and the sawdust should be
sold at the split-off point.

McGraw-Hill/Irwin Slide 85
 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.

McGraw-Hill/Irwin Slide 86
 End of Chapter 13

McGraw-Hill/Irwin Slide 87