Jordan Managment Accounting 71

8/8/2019 Jordan Managment Accounting 71

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Relevant Costs for Decision

Making


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Learning Objective 1

Identify relevant andIdentify relevant andirrelevant costs andirrelevant costs andbenefits in a decision.benefits in a decision.


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Cost Concepts for Decision

MakingA relevant cost is a cost that differs

between alternatives.


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Identifying Relevant CostsAnAn avoidable costavoidable cost can be eliminated, incan be eliminated, inwhole or in part, by choosing onewhole or in part, by choosing one

alternative over another. Avoidable costsalternative over another. Avoidable costs

are relevant costs. Unavoidable costs areare relevant costs. Unavoidable costs areirrelevant costs.irrelevant costs.

Two broad categories of costs are neverTwo broad categories of costs are neverrelevant in any decision. They include:relevant in any decision. They include:

Sunk costs.Sunk costs.

Future costs thatFuture costs that do not differdo not differbetween thebetween the

alternatives.alternatives.


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Relevant Cost Analysis: A Two-

Step ProcessEliminate costs and benefits that do not differbetween alternatives.

Use the remaining costs and benefits thatdiffer between alternatives in making thedecision. The costs that remain are thedifferential, or avoidable, costs.

Step 1

Step 2


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Different Costs for Different

Purposes

Costs that are

relevantin onedecision situation

may not be relevantin another context.


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Identifying Relevant Costs

Annual ost

of Fixed Items

ost per

Mile

1 Annual straight-line depreciation on car 800$ 0 80$

2 ost of gasoline 0 050

3 Annual cost of auto insurance and license 1,380 0 138

4 Maintenance and repairs 0 065

5 Par ing fees at school 360 0 0366 Total average cost 0 569$

Automobile osts (based on 10,000 miles driven peryear)

Cynthia, a Boston student, is considering visiting her friend in New York.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 friendsShe 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 expensiveapartment. She is trying to decide which alternative is less expensiveand has gathered the following information:and has gathered the following information:

$45 per month$45 per month 8 months8 months 1. per gallon 32 MPG

$18,000 cost$18,000 cost $4,000 salvage value$4,000 salvage value 5 years5 years


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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 ????

1 Per day cost of parking car in New York 25$

Some Additional Information

Annual Cost

of Fixed Items

Cost per

Mile

1 Annual straight-line depreciation on car 2,800$ 0.280$

2 Cost of gasoline 0.050

Annua l cost of a uto insura nce and lice nse 1, 80 0.1 8

4 Maintenance and repairs 0.065

5 Parking fees at school 60 0.0 66 Total average cost 0.569$

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


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Which costs and benefits are relevant in CynthiasWhich costs and benefits are relevant in Cynthiasdecision?decision?

The cost of

thecaris a sunk costandis not

relevant to thecurrent decision.

However, the cost ofgasoline is clearly relevantifshe decides to drive. Ifshe takes the train,the cost would now be incurred, so it varies

depending on the decision.

The annual cost ofinsurance is not

relevant. It will remainthe same ifshe drives

or takes the train.


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Which costs and benefits are relevant in Cynthiasdecision?

The cost ofmaintenance and

repairs is relevant. Inthe long-run thesecosts depend upon

miles driven.

The monthly

school parkingfee is not

relevant becauseit must be paidifCynthia drives ortakes the train.

At this point, we can see that some of the averagecost of . per mile are relevant and others are

not.


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Thed

ecli

nei

n resalevalue due to additionalmiles is a relevant

cost.

The round

-tri

p trai

nfare is clearly relevant.Ifshe drives the cost

can be avoided.

Relaxing on the train isrelevant even though itis difficult to assign adollar value to the

benefit.

The kennel cost is notrelevant because

Cynthia will incur thecost ifshe drives or

takes the train.


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The cost ofparking isrelevant because it canbe avoidedifshe takes

the train.

The benefits ofhaving a carin New York andthe problems offinding a parking space are

both relevant but are difficult to assign adollar amount.


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From a financial standpoint, Cynthia would be betteroff taking the train to visit herfriend. Some of the

non-financial factormay influence herfinal decision.

asoline (4 @ . per mile 3.

aintenance (4 @ . per mile .

eduction in resale (4 @ . per mile .

arking in ew ork ( days @ perday .

otal 4.

elevant Financial Cost ofDriving

ound-trip ticket 4.

elevant Financial Cost of aking the rain


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Relevant Costs, an Alternative

What if the decision was not just whetherto take the train to NYC once, but to usepublic transportation exclusively as a life

style decision. What irrelevant costswould become relevant?


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Total and Differential Cost Approaches

The management of a company is considering a new labor savingmachine that rents for $3,000 per year. Data about the companys

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

Curren

Situ tion

Situ tion

ith Ne

Machine

Differential

Costs and

BenefitsSales (5,000 units @ $40 perunit) 200,000$ 200,000$ -

Lessvariableexpenses:

Direct materials (5,000 units @ $14 perunit) 70,000 70,000 -

Direct labor(5,000 units @ $8 and $5 perunit) 40,000 25,000 15,000

Variableoverhead (5,000 units @ $2perunit) 10,000 10,000 -

Total variableexpenses 120,000 105,000 -

Contribution margin 80,000 95,000 15,000Less fixed expense:

Other 62,000 62,000 -

Rent onne 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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Current

Situation

Situation

Wit New

Machine

Differential

Costs and

Bene fits

Sales ( , units @ $40 per unit) 00,000$ 200,000$ -

Less variable expenses:

Directmaterials ( ,000 units @ $14 per unit) 0,000 70,000 -Direct labor( ,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

As you can see, the only costs that differ between the alternatives arethe direct labor costs savings and the increase in fixed rental costs.

We can efficiently analyze the decision bylooking at the different costs and revenues

and arrive at the same solution.

ecrease in direct labor costs (5,000 units $3 er unit 15,000$

ncrease in fixed rental ex enses (3,000)

et annual cost saving from renting the ne machine 12,000$

Net Advantage to Renting the New Machine


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Using the differential approach is desirable fortwo reasons

1. Only rarely will enough information beavailable to prepare detailedincomestatements for both alternatives.

2. Mingling irrelevant costs with relevant costsmay cause confusion anddistract attentionaway from the information that is reallycritical.


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Prepare an analysisPrepare an analysis

showing whether ashowing whether aproduct line or otherproduct line or other

business segment shouldbusiness segment should

be dropped or retained.be dropped or retained.


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Adding/Dropping Segments

One of the most importantdecisions managers make is

whether to add ordrop a businesssegment, such as a product or a

store.

Lets see how relevant costsLets see how relevant costsshould be usedin this type ofshould be usedin this type of

dec

ision.

dec

ision.


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Due to the declining popularity ofDue to the declining popularity of

digital watches,L

ovell Companysdigital watches,L

ovell Companysdigital watch line has not reporteddigital watch line has not reporteda profit for several years. Lovella profit for several years. Lovell

is considering dropping thisis considering dropping this

product line.product line.


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A Contribution Margin Approach

DECISION RULE

Lovell should drop the digital watch segment

only if its profit would increase. This wouldonly happen if the fixed cost savingsexceed the lost contribution margin.

Lets look at this solution.


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Adding/Dropping SegmentsSegment Income Statement

Digital Watches

Sales 500,000$

Less: variable expenses

Variable manufacturing costs 120,000$

Variable shipping costs 5,000Commissions 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 30,000 400,000Net operating loss (100,000)$


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Segment Income StatementDigital Watches

Sales 500,000$


Variable manufacuring costs 120,000$

Variable shipping costs 5,000

Commissions 75,000 200,000





Depreciation of equipment 50,000Advertising - direct 100,000




Investigation has revealed thatInvestigation has revealed that total fixed generaltotal fixed generalfactory overheadfactory overhead andand generalgeneral

administrative expensesadministrative expenses would not be affected ifwould not be affected ifthe digital watch line is dropped. The fixedthe digital watch line is dropped. The fixed

general factory overhead and generalgeneral factory overhead and generaladministrative expenses assigned to this productadministrative expenses assigned to this product

would be reallocated to other product lines.would be reallocated to other product lines.


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Adding/Dropping SegmentsSegment Income Statement

Digital Watches

Sales 500,000$


Variable manufacturing costs 120,000$

Variable shipping costs 5,000

Commissions 75,000 200,000





Depreciation of equipment 50,000Advertising - direct 100,000



The equipment used to manufactureThe equipment used to manufacture

digital watches has no resaledigital watches has no resalevalue or alternative use.value or alternative use.

Should Lovell retain or dropthe digital watch segment?


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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)$


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Comparative Income Approach

The Lovell solution can also be obtained bypreparing comparative income statementsshowing results with and without the digital

watch segment.

Lets look at this second approach.Lets look at this second approach.


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Solution

Keep

DigitalWatches

Drop

DigitalWatches 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


Depreciation 50,000

Advertising - direct 100,000Rent - factory space 70,000

General admin. expenses 30,000

Total fixed expenses 400,000Net operating loss (100,000)$

If the digital watchline is dropped, thecompany gives up

its contributionmargin.


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Solution

Keep

DigitalWatches

Drop


Sales 500,000$ -$ (500,000)$



Shipping 5,000 - 5,000





General factory overhead 60,000 60,000 -


Depreciation 50,000




On the other hand, the generalfactory overhead would be thesame. So this cost really isnt

relevant.


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Solution

Keep

DigitalWatches

Drop


Sales 500,000$ -$ (500,000)$



Shipping 5,000 - 5,000






Salary of line manager 90,000 - 90,000

Depreciation 50,000




But we wouldnt need amanager for the product line

anymore.


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Solution

Keep

DigitalWatches

Drop


Sales 500,000$ -$ (500,000)$



Shipping 5,000 - 5,000







Depreciation 50,000 50,000 -




If the digital watch line is dropped, the net book valueof the equipment would be written off. The depreciation

that would have been taken will flow through the

income statement as a loss instead.


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Solution

Keep

DigitalWatches

Drop


Sales 500,000$ -$ (500,000)$



Shipping 5,000 - 5,000







Depreciation 50,000 50,000 -

Advertising - direct 100,000 - 100,000Rent - factory space 70,000 - 70,000

General admin. expenses 30,000 30,000 -

Total fixed expenses 400,000 140,000 260,000Net operating loss (100,000)$ (140,000)$ (40,000)$


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Beware of Allocated Fixed Costs

Why should we keep theWhy should we keep thedigital watch segmentdigital watch segmentwhen its showing awhen its showing a

$100,000$100,000 lossloss??


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The answer lies in theThe answer lies in theway we allocateway we allocate

common fixed costscommon fixed costs toto

our products.our products.


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Our allocations canOur allocations canmake a segment lookmake a segment lookless profitableless profitable than itthan it

really is.really is.


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Prepare a make or buyPrepare a make or buyanalysis.analysis.


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The Make or Buy Decision

When a company is involved in more thanWhen a company is involved in more thanone activity in the entire value chain, it isone activity in the entire value chain, it is

vertically integrated. A decision to carry outvertically integrated. A decision to carry outone of the activities in the value chainone of the activities in the value chaininternally, rather than to buy externally frominternally, rather than to buy externally from

a supplier is called a make or buya supplier is called a make or buydecision.decision.


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Vertical Integration- Advantages

Smootherflow ofparts andmaterials

Betterqualitycontrol

Realize profits


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Vertical Integration-

DisadvantageCompanies may failto take advantage of

suppliers who cancreate economies ofscale advantage by

pooling demandfromnumerouscompanies.


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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 1Depreciation of special equip. 3

Supervisor's salary 2

General factory overhead 10Unit product cost 30$


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

The special equipment used to manufacturepart 4A has no resale value.

The total amount of general factory overhead,

which is allocated on the basis of direct laborhours, 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 the20,000 parts at a cost of $25 per part.

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


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CostPer Unit Cost of 20,000 Units

Make Buy

Outside purchase price $ 25 $ 500,000

Direct materials 9$ 180,000Direct labor 5 100,000Variable 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$

TheMakeorBuyDecision

20,00020,000 $9 per unit = $180,000$9 per unit = $180,000


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Make Buy






ThespecialequipmenthasnoresaleThespecialequipmenthasnoresalevalueandisasunkcost.valueandisasunkcost.


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Make Buy






Not avoidable; irrelevant. If the product isdropped, it will be reallocated to other products.


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Should we make or buy part 4A?Should we make or buy part 4A?

CostPerUnit Cost of20,000Units

Make Buy


Directm

aterials 9$ 180,000Direct labor 5 100,000Variable overhead 1 20,000Depreciation ofequip. 3 -Supervisor'ssalary 2 40,000General factory overhead 10 -Total cost 30$ 340,000$ 500,000$


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Opportunity Cost

How would this concept potentially relate toHow would this concept potentially relate tothe Essex Company?the Essex Company?

AnAn opportunity costopportunity cost is the benefit that isis the benefit that isforegone as a result of pursuing someforegone as a result of pursuing some

course of action.course of action.

Opportunity costs are not actual dollar outlaysOpportunity costs are not actual dollar outlaysand are not recorded in the formal accountsand are not recorded in the formal accounts

of an organization.of an organization.

How would this concept potentially relate toHow would this concept potentially relate tothe Essex Company?the Essex Company?

Documents

Jordan Managment Accounting 71