Chapter 13:

Short-Run Decision
Making: Relevant Costing
1 Short-Run Decision Making
► Short-run decision making consists of choosing among
alternatives with an immediate or limited end in view.
► Short-term decisions sometimes are referred to as tactical
decisions because they involve choosing between alternatives
with an immediate or limited time frame in mind.
► Accepting a special order for less than the normal selling price
to utilize idle capacity and to increase this year’s profits is an
example. Thus, some decisions tend to be short run in nature.
► However, it should be emphasized that short-run decisions
often have long-run consequences.
1 The Decision-Making Model
► A decision model, a specific set of procedures that produces a decision,
can be used to structure the decision maker’s thinking and to organize
the information to make a good decision.
► The following is an outline of one decision-making model:
► Step 1. Recognize and define the problem.
► Step 2. Identify alternatives as possible solutions to the problem. Eliminate
alternatives that clearly are not feasible.
► Step 3. Identify the costs and benefits associated with each feasible alternative.
Classify costs and benefits as relevant or irrelevant, and eliminate irrelevant ones
from consideration.
► Step 4. Estimate the relevant costs and benefits for each feasible alternative.
► Step 5. Assess qualitative factors.
► Step 6. Make the decision by selecting the alternative with the greatest overall net
benefit.
1 Relevant Costs Defined
► The decision-making approach just described emphasized the
importance of identifying and using relevant costs.
► Relevant costs possess two characteristics:
1. they are future costs AND
2. they differ across alternatives.
► All pending decisions relate to the future.
► Accordingly, only future costs can be relevant to decisions.
1 Opportunity Costs
► Opportunity cost is the benefit sacrificed or foregone when
one alternative is chosen over another.
► An opportunity cost is relevant because it is both a future cost
and one that differs across alternatives.
► While an opportunity cost is never an accounting cost,
because accountants do not record the cost of what might
happen in the future (i.e., they do not appear in financial
statements), it is an important consideration in relevant
decision making.
1 Sunk Costs
► A sunk cost is a cost that cannot be affected by any future
action.
► It is important to note the psychology behind managers’
treatment of sunk costs.
► Although managers should ignore sunk costs for relevant
decisions, it unfortunately is human nature to allow sunk
costs to affect these decisions.
► For example, depreciation, a sunk cost, is sometimes allocated to
future periods though the original cost is unavoidable. In choosing
between the two alternatives, the original cost of an asset and its
associated depreciation are not relevant factors.
 Cost Behavior and Relevant
1
Costs
► Most short-run decisions require extensive consideration of
cost behavior.
► It is easy to fall into the trap of believing that variable costs
are relevant and fixed costs are not.
► But this assumption is not true.
► The key point is that changes in supply and demand for
resources must be considered when assessing relevance.
► If changes in demand and supply for resources across
alternatives bring about changes in spending, then the
changes in resource spending are the relevant costs that
should be used in assessing the relative desirability of the two
alternatives.
2 Some Common
Relevant Cost Applications
►Relevant costing is of value in solving many different
types of problems. Traditionally, these applications
include decisions:
►to make or buy a component.
► to keep or drop a segment or product line.
►to accept a special order at less than the usual price.
► to further process joint products or sell them at the split-off
point.
► Though by no means an exhaustive list, many of the same
decision-making principles apply to a variety of problems.
2 Make-or-Buy Decisions
► Managers often face the decision of whether to make a particular
product (or provide a service) or to purchase it from an outside
supplier.
► Make-or-buy decisions are those decisions involving a choice
between internal and external production.
► One type of relevant cost that is becoming increasingly large due to
globalization and the green environmental movement concerns the
disposal costs associated with electronic waste (or e-waste).
2 Special Order Decisions
► From time to time, a company may consider offering a product or
service at a price different from the usual price.
► Firms often have the opportunity to consider special orders from
potential customers in markets not ordinarily served.
► Special-order decisions focus on whether a specially priced order
should be accepted or rejected.
► These orders often can be attractive, especially when the firm is
operating below its maximum productive capacity.
2 Keep-or-Drop Decisions
► Often, a manager needs to determine whether a segment,
such as a product line, should be kept or dropped.
► Segmented reports prepared on a variable-costing basis
provide valuable information for these keep-or-drop decisions.
► Both the segment’s contribution margin and its segment
margin are useful in evaluating the performance of segments.
► However, while segmented reports provide useful
information for keep-or-drop decisions, relevant costing
describes how the information should be used to arrive at a
decision.
2 Keep-or-Drop with
Complementary Effects
►Sometimes dropping one line would lower sales of
another line, as many customers buy both lines at
the same time.
►This information can affect the keep-or-drop
decision.
2 Further Processing of
Joint Products
► Joint products have common processes and costs of
production up to a split-off point. At that point, they become
distinguishable as separately identifiable products. The point
of separation is called the split-off point.
► Sometimes it is more profitable to process a joint product
further, beyond the split-off point, prior to selling it (sell or-
process-further decision).
3 Product Mix Decisions

► Most of the time, organizations have wide flexibility in

choosing their product mix.
► Product mix refers to the relative amount of each product
manufactured (or service provided) by a company.
► Decisions about product mix can have a significant impact on
an organization’s profitability.
► Every firm faces limited resources and limited demand for
each product. These limitations are called constraints.
► A manager must choose the optimal mix given the constraints
found within the firm.
 Multiple Constrained
3
Resources
► The presence of only one constrained resource might not be
realistic.
► Organizations often face multiple constraints, including:
► limitations of raw materials
► limitations of skilled labor
► limited demand for each product
► The solution of the product mix problem in the presence of
multiple constraints is considerably more complicated and
requires the use of a specialized mathematical technique
known as linear programming, which is reserved for advanced
cost management courses.
4 Cost-Based Pricing

► Demand is one side of the pricing equation; supply is the other side.
► Since revenue must cover all costs for the firm to make a profit,
many companies start with cost to determine price.
► That is, they calculate product cost and add the desired profit.
► The mechanics of this approach are straightforward. Usually, there
is a cost base and a markup.
► The markup is a percentage applied to the base cost.
► It includes desired profit and any costs not included in the base
cost.
► Companies that bid for jobs routinely base bid price on cost.
4 Target-Costing and Pricing

► Many American and European firms set the price of a new

product as the sum of the costs and the desired profit. The
rationale is that the company must earn sufficient revenues
to cover all costs and yield a profit.
► Target costing is a method of determining the cost of a
product or service based on the price (target price) that
customers are willing to pay.
► The marketing department determines what characteristics
and price for a product are most acceptable to consumers.