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Chapter 13

Relevant Costs for


Decision Making
5/10/04

Cost Concepts for Decision


Making
A relevant cost is a cost that
differs between alternatives.
1

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Identifying Relevant Costs


Costs that can be eliminated (in whole or in
part) by choosing one alternative over
another are avoidable costs. Avoidable costs
are relevant costs.
Unavoidable costs are never relevant and
include:
Sunk costs.
Future costs that do not differ between the
alternatives.

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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 friends
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)

1
2
3
4
5
6

Annual straight-line depreciation on car


Cost of gasoline
Annual cost of auto insurance and license
Maintenance and repairs
Parking fees at school
Total average cost

$45 per month


month 8 months
months

Annual Cost
of Fixed Items
$
2,800
1,380
360

Cost per
Mile
$
0.280
0.050
0.138
0.065
0.036
$
0.569

$1.60 per gallon 32


32 MPG
MPG
$18,000 cost $4,000
$4,000 salvage
salvage value
value 5 years

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Identifying Relevant Costs


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

1
2
3
4
5
6

Annual straight-line depreciation on car


Cost of gasoline
Annual cost of auto insurance and license
Maintenance and repairs
Parking fees at school
Total average cost

7
8
9
10
11
12
13

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Annual Cost
of Fixed Items
$
2,800
1,380
360

Cost per
Mile
$
0.280
0.050
0.138
0.065
0.036
$
0.569

Some Additional Information


Reduction in resale value of car per mile of wear
Round-tip train fare
Benefits of relaxing on train trip
Cost of putting dog in kennel while gone
Benefit of having car in New York
Hassle of parking car in New York
Per day cost of parking car in New York

$ 0.026
$
104
????
$
40
????
????
$
25

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Identifying Relevant Costs


Which costs and benefits are relevant in Cynthias decision?

The cost of the car is


a sunk cost and is
not relevant to the
current decision.

The annual cost of


insurance is not
relevant. It will
remain the same if
she drives or takes
the train.

However, the cost of gasoline is clearly relevant if she


decides to drive. If she takes the drive the cost would
now be incurred, so it varies depending on the decision.
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Identifying Relevant Costs


Which costs and benefits are relevant in Cynthias decision?
The cost of maintenance
and repairs is relevant. In
the long-run these costs
depend upon miles driven.

The monthly school


parking fee is not
relevant because it
must be paid if
Cynthia drives or
takes the train.

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


$0.569 per mile are relevant and others are not.
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Identifying Relevant Costs


Which costs and benefits are relevant in Cynthias decision?
The decline in resale value
due to additional miles is a
relevant cost.

The round-trip train fare is


clearly relevant. If she
drives the cost can be
avoided.

Relaxing on the train is


relevant even though it is
difficult to assign a dollar
value to the benefit.

The kennel cost is not


relevant because Cynthia
will incur the cost if she
drives or takes the train.

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Identifying Relevant Costs


Which costs and benefits are relevant in Cynthias decision?
The cost of parking 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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Identifying Relevant Costs


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 @ $0.050 per mile)
Maintenance (460 @ $0.065 per mile)
Reduction in resale (460 @ $0.026 per mile)
Parking in New York (2 days @ $25 per day)
Total

$ 23.00
29.90
11.96
50.00
$ 114.86

Relevant Financial Cost of Taking the Train


Round-trip ticket
$ 104.00

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Note
Do not underestimate the importance and
power of the relevant cost idea.

Most costs (and benefits) do not differ


between alternatives. This allows you to focus
on the few things that matter.
This principle also helps avoid mistakes.
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Old Machine vs New Machine


Old Machine book value $140,000
Original Cost $210,000
Salvage value $90,000
Annual Variable cost $345,000
New Machine Cost $200,000
Annual Variable cost $300,000
Expected life for both is 4 years
Should new machine be purchased?
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Relevant Costs Old vs. New


Relevant costs/Benefits
Salvage Value Old mach
Variable cost old mach
Variable cost new mach
Annual savings x 4 year
Cost of new machine
Costs that do not differ
Cost of old machine
Book value old machine
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$90,000
$345,000
$300,000
45,000 180,000
200,000
210,000
140,000

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Should New Machine Be Purchased


Benefits

Costs

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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 companys
annual sales and costs with and without the new machine are:

Sales (5,000 units @ $40 per unit)


Less variable expenses:
Direct materials (5,000 units @ $14 per unit)
Direct labor (5,000 units @ $8 and $5 per unit)
Variable overhead (5,000 units @ $2 per unit)
Total variable expenses
Contribution margin
Less fixed expense:
Other
Rent on new machine
Total fixed expenses
Net operating income
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Current
Situation
$
200,000

Situation
With New
Machine
$
200,000

Differential
Costs and
Benefits
-

70,000
40,000
10,000
120,000
80,000

70,000
25,000
10,000
105,000
95,000

15,000
15,000

62,000
62,000
18,000

62,000
3,000
65,000
30,000

(3,000)
(3,000)
12,000

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Total and Differential Cost Approaches


As you see, the only costs that differ between the alternatives are the
direct labor costs savings and the increase in fixed rental costs.
Sales (5,000 units @ $40 per unit)
Less variable expenses:
Direct materials (5,000 units @ $14 per unit)
Direct labor (5,000 units @ $8 and $5 per unit)
Variable overhead (5,000 units @ $2 per unit)
Total variable expenses
Contribution margin
Less fixed expense:
Other
Rent on new machine
Total fixed expenses
Net operating income

Current
Situation
$
200,000

Situation
With New
Machine
$
200,000

Differential
Costs and
Benefits
-

70,000
40,000
10,000
120,000
80,000

70,000
25,000
10,000
105,000
95,000

15,000
15,000

62,000
3,000
65,000
30,000

(3,000)
(3,000)
12,000

We can efficiently analyze the decision by 62,000


looking at the different costs and revenues and
62,000
$
18,000
arrive at the same solution.

Net Advantage to Renting the New Machine


Decrease in direct labor costs (5,000 units @ $3 per unit)
Increase in fixed rental expenses
Net annual cost saving from renting the new machine

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$
$

15,000
(3,000)
12,000

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Adding/Dropping Segments
One of the most important decisions
managers make is whether to add or
drop a business segment such as a
product or a store.

Lets see how relevant costs


should be used in this decision.
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Adding/Dropping Segments
Due to the declining popularity of digital
watches, Lovell Companys digital
watch line has not reported a profit for
several years. An income statement for
last year is shown on the next screen.

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Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales
Less: variable expenses
Variable manufacturing costs
Variable shipping costs
Commissions
Contribution margin
Less: fixed expenses
General factory overhead
Salary of line manager
Depreciation of equipment
Advertising - direct
Rent - factory space
General admin. expenses
Net operating loss
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$ 500,000
$ 120,000
5,000
75,000

$ 60,000
90,000
50,000
100,000
70,000
30,000

200,000
$ 300,000

400,000
$ (100,000)

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Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales
$ 500,000
Less: variable expenses
Investigation
has
Investigation
has revealed
revealed
that
total fixed
fixed general
general
Variable manufacuring
coststhat
$ total
120,000
Variablefactory
shippingoverhead
costs
5,000
and
factory
overhead
and general
general
Commissions expenses would not
75,000
200,000
administrative
be
affected
ifif
administrative
expenses
would
not
be
affected
Contribution margin
$ 300,000
the
digital
watch
the
digital
watch line
line is
is dropped.
dropped. The
The fixed
fixed
Less:
fixed
expenses
general
factory
overhead
general
General
factory
overhead
$ and
60,000
general
factory
overhead
and
general
Salary of line manager
90,000
administrative
expenses
to
administrative
expenses assigned
assigned
to this
this product
product
Depreciation of equipment
50,000
would
to
product
would be
be -reallocated
reallocated
to other
other100,000
product lines.
lines.
Advertising
direct
Rent - factory space
70,000
General admin. expenses
30,000
400,000
Net operating loss
$ (100,000)
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Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales
$ 500,000
Less: variable expenses
Variable
manufacturing
costs
$ 120,000
The
equipment
used
manufacture
The
equipment
used to
to
manufacture
Variable shipping costs
5,000
digital
digital watches
watches has
has no
no resale
resale
Commissions
75,000
200,000
value
or
Contribution
margin
$ 300,000
value
or alternative
alternative use.
use.
Less: fixed expenses
General factory overhead
$ 60,000
Salary of line manager
90,000
Depreciation of equipment
50,000
Should
retain or drop
Should Lovell
Lovell
Advertising - direct
100,000 retain or drop
the
watch
Rent - factory space
the digital
digital70,000
watch segment?
segment?
General admin. expenses
30,000
400,000
Net operating loss
$ (100,000)
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A Contribution Margin Approach


DECISION
DECISION RULE
RULE
Lovell
Lovell should
should drop
drop the
the digital
digital watch
watch segment
segment only
only
ifif its
its profit
profit would
would increase.
increase. This
This would
would only
only
happen
happen ifif the
the fixed
fixed cost
cost savings
savings exceed
exceed the
the lost
lost
contribution
contribution margin.
margin.

Lets look at this solution.

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A Contribution Margin Approach


Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped
Less fixed costs that can be avoided
Salary of the line manager
$
90,000
Advertising - direct
100,000
Rent - factory space
70,000
Net disadvantage

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$ (300,000)

260,000
$ (40,000)

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Comparative Income
Approach
The Lovell solution can also be obtained
by preparing comparative income
statements showing results with and
without the digital watch segment.

Lets look at this second approach.

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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
IfIf the
the digital
digital watch
watch line
line
Advertising - direct
100,000
is
is dropped,
dropped, the
the
Rent - factory space
70,000
company
General admin. expenses
30,000
company gives
gives up
up its
its
Total fixed expenses
400,000
contribution
margin.
contribution
margin.
Net operating loss
$ (100,000)

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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
On
the
On100,000
the other
other hand,
hand, the
the general
general
Advertising - direct
Rent - factory space
70,000overhead
factory
factory
overhead would
would be
be the
the
General admin. expenses
30,000
same.
So this cost really isnt
same.
Total fixed expenses
400,000So this cost really isnt
Net operating loss
$ (100,000) relevant.
relevant.

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Comparative Income Approach


Solution
Keep
Drop
Digital
Digital
Watches
Watches
Difference
Sales
$ 500,000
$
$ (500,000)
Less variable expenses:
But
we
wouldnt
need
a
manager
need a manager
Manufacturing expensesBut we wouldnt
120,000
120,000
for
line
Shipping
5,000
5,000
for the
the product
product
line anymore.
anymore.
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
30,000
Total fixed expenses
400,000
Net operating loss
$ (100,000)

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Comparative Income Approach


Solution
Keep
Drop
Digital
Digital
Watches
Watches
Difference
Sales
$ 500,000
$
$ (500,000)
Less
variable
expenses:
IfIf the
digital
watch
the
digital
watch line
line is
is dropped,
dropped, the
the net
net book
book- value
value of
of the
the
Manufacturing
expenses
120,000
120,000
equipment
would
be
written
off.
The
depreciation
that
equipment
would
be
written
off.
The
depreciation
that
Shipping
5,000
5,000
would
would have
have been
been taken
taken will
will flow
flow through
through the
the
income75,000
Commissions
75,000
- income
Total variable expenses
200,000
statement
loss
statement as
as aa 200,000
loss instead.
instead. 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)

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Comparative Income Approach


Solution
Keep
Drop
Digital
Digital
Watches
Watches
Sales
$ 500,000
$
Less variable expenses:
Manufacturing expenses
120,000
Shipping
5,000
Commissions
75,000
Total variable expenses
200,000
Contribution margin
300,000
Less fixed expenses:
General factory overhead
60,000
60,000
Salary of line manager
90,000
Depreciation
50,000
50,000
Advertising - direct
100,000
Rent - factory space
70,000
General admin. expenses
30,000
30,000
Total fixed expenses
400,000
140,000
Net operating loss
$ (100,000)
$ (140,000)

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Difference
$ (500,000)
120,000
5,000
75,000
200,000
(300,000)
90,000
100,000
70,000
260,000
$ (40,000)

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Beware of Allocated Fixed


Costs
Why should we keep
the digital watch
segment when its
showing a loss?

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Beware of Allocated Fixed


Costs
The answer lies in the
way we allocate
common fixed costs to
our products, and sunk
costs like depreciation.

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Beware of Allocated Fixed


Costs
Our allocations can
make a segment look
less profitable than it
really is. So dont
allocate them
anymore!

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The Make or Buy Decision


A decision concerning whether an item should
be produced internally or purchased from an
outside supplier is called a make or buy
decision.
Lets look at the Essex Company example.

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The Make or Buy Decision


Essex manufactures part 4A that is used in
one of its products.
The unit product cost of this part is:
Direct materials
Direct labor
Variable overhead
Depreciation of special equip.
Supervisor's salary
General factory overhead
Unit product cost
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9
5
1
3
2
10
$ 30

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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 suppliers offer?

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The Make or Buy Decision


Cost
Per Unit

Outside purchase price

$ 25

Direct materials
Direct labor
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost

9
5
1
3
2
10
$ 30

Cost of 20,000 Units


Buy
Make
$ 500,000
180,000
100,000
20,000
40,000
$ 340,000

$ 500,000

The
The special
special equipment
equipment has
has no
no resale
resale
value
value and
and is
is aa sunk
sunk cost.
cost.
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The Make or Buy Decision


Cost
Per Unit

Outside purchase price

$ 25

Direct materials
Direct labor
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost

9
5
1
3
2
10
$ 30

Cost of 20,000 Units


Buy
Make
$ 500,000
180,000
100,000
20,000
40,000
$ 340,000

$ 500,000

Not
Not avoidable;
avoidable; irrelevant.
irrelevant. IfIf the
the product
product is
is dropped,
dropped, itit
will
will be
be reallocated
reallocated to
to other
other products.
products.
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The Make or Buy Decision


Cost
Per Unit

Outside purchase price

$ 25

Direct materials
Direct labor
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost

9
5
1
3
2
10
$ 30

Cost of 20,000 Units


Buy
Make
$ 500,000
180,000
100,000
20,000
40,000
$ 340,000

$ 500,000

Should we make or buy part 4A?


Answer: Make!

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The Make or Buy Decision


DECISION
DECISION RULE
RULE
In
In deciding
deciding whether
whether to
to accept
accept the
the outside
outside
suppliers
suppliers offer,
offer, Essex
Essex isolated
isolated the
the relevant
relevant
costs
eliminating
costs of
of making
making the
the part
part by
by eliminating:
eliminating:
eliminating

The
The sunk
sunk costs
costs (depreciation)
(depreciation)

The
The future
future costs
costs that
that will
will not
not differ
differ between
between

making
making or
or buying
buying the
the parts
parts (common
(common costs)
costs)

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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
companys 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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Special Orders

$8 variable cost

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Special Orders
If Jet accepts the offer, net operating income
will increase by $6,000.
Increase
Increase
Increase

in revenue (3,000 $10)


in costs (3,000 $8 variable cost)
in net income

$ 30,000
24,000
$ 6,000

Note: This answer assumes that fixed costs are


unaffected by the order and that variable marketing
costs must be incurred on the special order.
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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 customers 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)
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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.
a. $50
b. $10
c. $15
d. $29
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Quick Check
What is the rock bottom minimum price below
Variable production cost
$100,000
which Northern Optical should not go in its
Additional fixed cost
50,000
negotiations with the customer? In other words,
Total relevant cost
$150,000
below what price would Northern Optical
Number of units
10,000
actually be losing money on the sale? There is
Average cost per unit
$15
ample idle capacity to fulfill the order.
a. $50
b. $10
c. $15
d. $29
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End of Chapter 13

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