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.

2
1

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Identifying Relevant Costs

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

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 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)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.050
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 $ 0.569

$45 per month

month 8 months
months $1.60 per gallon 32
32 MPG
MPG

$18,000 cost $4,000

$4,000 salvage
salvage value
value 5 years
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 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 0.050
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 $ 0.569

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 The McGraw-Hill Companies, Inc.

 Identifying Relevant Costs
Which costs and benefits are relevant in Cynthias decision?

The annual cost of

The cost of the car is insurance is not
a sunk cost and is relevant. It will
not relevant to the remain the same if
current decision. 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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Identifying Relevant Costs
Which costs and benefits are relevant in Cynthias decision?

The cost of maintenance The monthly school

and repairs is relevant. In
the long-run these costs
depend upon miles driven.
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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Identifying Relevant Costs
Which costs and benefits are relevant in Cynthias decision?

The decline in resale value The round-trip train fare is

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

Relaxing on the train is The kennel cost is not

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

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 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) $ 23.00
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 $ 114.86

Relevant Financial Cost of Taking the Train

Round-trip ticket $ 104.00

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 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.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 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?

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

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

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Should New Machine Be Purchased

Benefits

Costs

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 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:
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 The McGraw-Hill Companies, Inc.

 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.
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

We can efficiently analyze the decision by 62,000

Less fixed expense:
Other 62,000 -

looking at the different costs and revenues and

Rent on new machine
Total fixed expenses
-
62,000
3,000
65,000
(3,000)
(3,000)

arrive at the same solution.

Net operating income
$ 18,000 $ 30,000 12,000

Net Advantage to Renting the New Machine

Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Increase in fixed rental expenses (3,000)
Net annual cost saving from renting the new machine $ 12,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Adding/Dropping Segments

One
One of
of the
the most
most important
important decisions
decisions
managers
managers make
make is
is whether
whether to to add
add or
or
drop
drop aa business
business segment
segment such
such as
as aa
product
product or
or aa store.
store.

Lets
Lets see how relevant costs
should
should be used in this decision.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Adding/Dropping Segments

Due
Due toto the
the declining
declining popularity
popularity of
of digital
digital
watches,
watches, Lovell
Lovell Companys
Companys digital
digital
watch
watch line
line has
has not
not reported
reported aa profit
profit for
for
several
several years.
years. An
An income
income statement
statement for for
last
last year
year is
is shown
shown onon the
the next
next screen.
screen.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 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 The McGraw-Hill Companies, Inc.

 Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Investigation
Investigation has
has revealed
Variable manufacuring coststhat
revealed $ total
that total fixed
120,000 fixed general
general
Variablefactory
shippingoverhead
factory overhead
costs and
and general
general
5,000
Commissions expenses would not
administrative 75,000
be affected200,000
ifif
administrative
Contribution margin
expenses would not be affected
$ 300,000
the
the
Less: digital
digital
fixed watch
watch line
expenses line is
is dropped.
dropped. The The fixed
fixed
general
general
General factory
factory
factory overhead
overhead
overhead $ and
and general
general
60,000
administrative expenses
expenses assigned
Salary of line manager
administrative assigned to
to this
90,000
this product
product
Depreciation of equipment 50,000
would
would be be -reallocated
Advertising reallocated
direct
to
to other product
product lines.
other100,000 lines.
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
The
The equipment
Variable used
used to
manufacturing
equipment manufacture
costs
to $ 120,000
manufacture
Variable shipping costs 5,000
digital
digital watches
Commissions watches hashas no
no resale
resale
75,000 200,000
value
value
Contribution or
or alternative
marginalternative use.
use. $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct
Should
Should Lovell
Lovell retain or drop
100,000 retain or drop
Rent - factory space the
the digital watch
watch segment?
digital70,000 segment?
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 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 The McGraw-Hill Companies, Inc.

 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
look at
at this
this second
second approach.
approach.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 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
Rent - factory space 70,000
is
is dropped,
dropped, thethe
General admin. expenses 30,000 company
company givesgives upup its
its
Total fixed expenses 400,000 contribution
contribution margin.
margin.
Net operating loss $ (100,000)

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

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

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
But we wouldnt
Manufacturing expensesBut we wouldnt120,000
need a manager
need a manager - 120,000
Shipping for
for the
the product
product line
5,000line anymore.
anymore. - 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 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

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

 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 - 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 The McGraw-Hill Companies, Inc.

 Beware of Allocated Fixed
Costs

Why should we keep

the digital watch
segment when its
showing a loss?

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

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

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

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

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 The Make or Buy Decision

A
A decision
decision concerning
concerning whether
whether anan item
item should
should
be
be produced
produced internally
internally oror purchased
purchased from
from an
an
outside
outside supplier
supplier is
is called
called aa make
make oror buy
buy
decision.
decision.

Lets
Lets look
look at
at the
the Essex
Essex Company
Company example.
example.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 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 $ 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 The McGraw-Hill Companies, Inc.

 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
Should we
we accept
accept the
the suppliers
suppliers offer?
offer?

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

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

Direct materials $ 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
The special
special equipment
equipment hashas no
no resale
resale
value
value and
and is
is aa sunk
sunk cost.
cost.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

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

Direct materials $ 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
Not avoidable;
avoidable; irrelevant.
irrelevant. IfIf the
the product
product is
is dropped,
dropped, itit
will
will be
be reallocated
reallocated toto other
other products.
products.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

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

Direct materials $ 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?

Answer: Make! The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
 The Make or Buy Decision

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

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 Special Orders
Jet,
Jet, Inc.
Inc. makes
makes aa single
single product
product whose
whose normal
normal
selling
selling price
price is
is $20
$20 per
per unit.
unit.
A
A foreign
foreign distributor
distributor offers
offers to
to purchase
purchase 3,000
3,000 units
units
for
for $10
$10 perper unit.
unit.
This
This isis aa one-time
one-time order
order that
that would
would not
not affect
affect thethe
companys
companys regular
regular business.
business.
Annual
Annual capacity
capacity isis 10,000
10,000 units,
units, but
but Jet,
Jet, Inc.
Inc. is
is
currently
currently producing
producing and and selling
selling only
only 5,000
5,000 units.
units.

Should Jet accept the offer?

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 Special Orders

$8 variable cost

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

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

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 fixed costs are

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

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 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)

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.

 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
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 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
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.
 End of Chapter 13

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc.