Chapter 13 Relevant Costs for Decision Making Learning Objectives LO1 Identify relevant and irrelevant costs and benefits in a decision situation LO2 Prepare an analysis showing whether a product line or other organizational segment should be dropped or retained LO3 Prepare a make or buy analysis LO4 Prepare an analysis showing whether a special order should be accepted LO5 Determine the most profitable use of a constrained resource and the value of obtaining more of the constrained resource LO6 Prepare an analysis showing whether joint products should be sold at the split-off point or processed further New in this Edition • New In Business boxes have been added to the chapter Chapter Overview A Cost Concepts for Decision-Making (Exercises 13-1, 13-7, and 13-13.) Every decision involves choosing from among at least two alternatives The costs and benefits of the alternatives should be compared Identifying relevant costs Only those costs and benefits that differ between alternatives are relevant in a decision Any cost or benefit that does not differ between the alternatives is irrelevant and can be ignored This is a tremendously powerful concept that allows us to ignore mounds of data when making decisions since most things are not affected by any given decision a All sunk costs (i.e., costs already irrevocably incurred) are irrelevant since they will be the same for any alternative All future costs that not differ between alternatives are irrelevant b Any cost that is avoidable is potentially relevant An avoidable cost is a cost that can be eliminated (in whole or in part) as a result of choosing one alternative over another Different costs for different purposes Costs that are relevant in one decision are not necessarily relevant in another In each situation the manager must examine the data and isolate the relevant costs Human frailties Most of us have a great deal of difficulty ignoring irrelevant costs when making decisions We are especially reluctant to ignore sunk costs when the sunk costs are 857 a consequence of a past decision that in retrospect was unwise We have a tendency to become committed to courses of action that have not worked out B Adding or Dropping a Segment (Exercises 13-2, 13-8, and 13-14.) Decisions related to dropping old products (or segments) and adding new products (or segments) are among the most difficult that a manager makes Two basic approaches can be used to analyze data in this type of decision Compare contribution margins and fixed costs A segment should be added only if the increase in total contribution margin is greater than the increase in fixed cost A segment should be dropped only if the decrease in total contribution margin is less than the decrease in fixed cost Compare net operating incomes A second approach is to calculate the total net operating income under each alternative The alternative with the highest net operating income is preferred This approach requires more information than the first approach since costs and revenues that don’t differ between the alternatives must be included in the analysis in order to compute net operating incomes Beware of allocated common costs Allocated common costs can make a profitable segment look unprofitable Allocated common costs that would not be affected by a decision are irrelevant and should be ignored C The Make or Buy Decision (Exercises 13-3, 13-9, and 13-15.) A make or buy decision is concerned with whether an item should be made internally or purchased from an external supplier Advantages of making an item internally a Producing a part internally reduces dependence on suppliers and may ensure a smoother flow of parts and material for production b Quality control may be easier when parts are produced internally c Profits can be realized on the parts and materials Advantages of buying an item from an external supplier a By pooling the requirements of a number of users, a supplier can realize economies of scale and may be able to move more quickly up the learning curve b A specialized supplier may be able to respond more quickly and at less cost to changing future needs c Changing technology may make producing one’s own parts riskier than purchasing from the outside Opportunity Cost Opportunity costs should be considered in decisions The opportunity cost of using a resource that has excess capacity is zero However, using a resource that has no idle capacity (i.e., that is a constraint) does involve an opportunity cost The opportunity costs may be far larger than the costs typically recorded in accounting systems 858 D Special Order (Exercises 13-4 and 13-10.) Special orders are one-time orders that not affect a company’s normal sales As long as the incremental revenue from the order exceeds its incremental costs, the order should be accepted If the special order requires a constrained resource, opportunity costs should be included as part of the incremental costs E Utilization of a Constrained Resource (Exercises 13-5 and 13-11.) A constraint is whatever prevents an individual or organization from getting more of what it wants There is always a constraint as long as desires are unsatisfied The chapter focuses on one particular kind of constraint—a production constraint A production constraint can be a raw material, a part, a machine, or a workstation If the constraint is a machine or workstation, it is called a bottleneck Contribution Margin per Unit of the Constrained Resource Whenever demand exceeds productive capacity, a production constraint exists The company is unable to fill all orders and some choices have to be made concerning which orders are filled and which are not filled The problem is how to most effectively use the constrained resource a Regardless of which orders are filled, the fixed costs will usually be the same Therefore, maximizing the total contribution margin will also maximize profit b To maximize contribution margin, rank products on the basis of their contribution margins per unit of the constrained resource Starting at the top of the list, produce up to demand or to the point where the constrained resource is exhausted—whichever comes first (This idea is generalized in the new Profitability Appendix.) Managing constraints Ordinarily, a system has only one constraint The capacity of any complete process is determined by the capacity of the constraint, which could be a single machine or work center In addition to making sure that the best product mix is chosen by ranking products based on the contribution margin per unit of the constrained resource, managers should seek ways to increase the effective capacity of the constraint a Increasing the capacity of the constraint or bottleneck is called “relaxing the constraint” or “elevating the constraint.” Conceptually, the capacity of the bottleneck can be increased by increasing the rate of output at the bottleneck or increasing the time available at the bottleneck Some specific examples of ways to elevate the constraint follow: • Pay workers overtime to keep the bottleneck running after normal working hours As discussed below, the potential payoff from taking such an action is often well worth the additional expense In contrast, paying workers overtime to keep non-bottleneck processes running after normal working hours is a waste of money • Shift workers from non-bottleneck areas to the bottleneck • Hire more workers or acquire more machines specifically to augment the bottleneck • Subcontract some of the production that would use the bottleneck If an unimportant part requires a lot of time on the bottleneck and can be purchased cheaply from an external supplier, this is a great way to increase profits The bottleneck can be shifted to more profitable uses • Streamline the production process at the bottleneck to eliminate wasted time Improvement programs such as TQM and Business Process Reengineering should focus on bottlenecks A decrease in processing time at the bottleneck can have an immediate and dramatic effect on profits A decrease in processing time at a non- 859 • bottleneck is likely to have no immediate impact on profits; it just creates more excess capacity Reduce defects A part that is processed on the bottleneck and later rejected because it is defective uses valuable bottleneck processing time b The benefits from effectively managing constraints (i.e., bottlenecks) can be enormous Managers should be given information that signals this potential Decide how additional processing capacity at the bottleneck would be used if it were available In other words, what product or order would be produced that otherwise could not be produced? This is the marginal job The contribution margin per unit of the constrained resource for this marginal job is the value of elevating the constraint by one unit (It is also the opportunity cost of using the constrained resource.) Quite often these calculations reveal that the value of additional time is so valuable that some decisions can be made very easily—such as adding a shift on the bottleneck F Joint Costs and the Contribution Approach (Exercises 13-6 and 13-12.) In some manufacturing processes, several end products are produced from a single input Such end products are known as joint products The costs associated with making these products up to the point where they can be recognized as separate products (the split-off point) are called joint costs The pitfalls of allocation Joint costs are really common costs that are incurred to simultaneously produce a variety of end products Unfortunately, these common costs are routinely allocated to the joint products Allocated joint costs are often misinterpreted as costs that could be avoided by producing less of one of the joint products However, joint costs can only be avoided by producing less of all of the joint products simultaneously If any of the joint products is made, then all of the joint costs up to the split-off point will have to be incurred Sell or process further decisions A decision may need to be made concerning whether to sell a joint product as is or process it further for a higher price (This type of decision is not confined to joint products Any time a product could be sold as is or processed further for additional revenue, this kind of analysis is pertinent.) a 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 b In such decisions, the joint costs incurred before the split-off point are not relevant They would be relevant in a decision to shut down the joint process, but they are irrelevant in any decision about what to with the joint products once they have reached the split-off point G Activity-Based Costing and Relevant Costs Activity-based costing is a resource consumption model, not a spending model Activity-based costing gives an idea of the magnitude of resources involved in carrying out activities, but it should be used with a great deal of caution in making particular decisions The costs assigned to products and other cost objects are only potentially relevant costs Whether they are relevant or not in any particular situation should be carefully considered For example, in most activity-based costing systems the fixed depreciation costs of a sophisticated milling machine would be allocated to products based on their usage of that 860 resource Suppose you are trying to decide whether to drop a product that uses the milling machine The fact that the product uses the milling machine is relevant only if the milling machine is a bottleneck (and opportunity costs are involved in its use) or somehow future cash flows associated with the machine will be affected by how much it is used If the machine is not a bottleneck and using some of its excess capacity has no effect on future spending, then using the machine costs nothing In this case, the costs assigned by the activity-based costing system to the product would not be relevant Assignment Materials Assignment Exercise 13-1 Exercise 13-2 Exercise 13-3 Exercise 13-4 Exercise 13-5 Exercise 13-6 Exercise 13-7 Exercise 13-8 Exercise 13-9 Exercise 13-10 Exercise 13-11 Exercise 13-12 Exercise 13-13 Exercise 13-14 Exercise 13-15 Problem 13-16 Problem 13-17 Problem 13-18 Problem 13-19 Problem 13-20 Problem 13-21 Problem 13-22 Problem 13-23 Problem 13-24 Problem 13-25 Problem 13-26 Case 13-27 Case 13-28 Case 13-29 Case 13-30 Case 13-31 Case 13-32 Topic Identifying relevant costs Dropping or retaining a segment Make or buy a component Evaluating a special order Utilization of a constrained resource Sell or process further Identification of relevant costs Dropping or retaining a segment Make or buy a component Special order Utilization of a constrained resource Sell or process further Identification of relevant costs Dropping or retaining a segment Make or buy a component Dropping or retaining a flight Sell or process further Close or retain a store Make or buy analysis Relevant cost analysis in a variety of situations Shutting down or continuing to operate a plant Make or buy decision Accept or reject a special order Utilization of a constrained resource Sell or process further Dropping or retaining a product Ethics and the manager; shut down or continue operations Plant closing decision Decentralization and relevant costs Sell or process further decision Integrative case; relevant costs; pricing Make or buy; utilization of a constrained resource Level of Difficulty Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Medium Medium Medium Medium Medium Medium Difficult Difficult Difficult Medium Difficult Difficult Difficult Difficult Difficult Suggested Time 15 30 30 15 30 10 20 30 20 15 15 10 30 10 15 30 15 60 60 45 45 60 30 45 45 45 60 60 75 30 90 120 Essential Problems: Problem 13-16 or Problem 13-18, Problem 13-17, Problem 13-19 or Problem 13-22, Problem 13-23, Problem 13-24 Supplementary Problems: Problem 13-20, Problem 13-21, Problem 13-25, Problem 13-26, Case 13-27, Case 13-28, Case 13-29, Case 13-30, Case 13-31, Case 13-32 861 862 Chapter 13 Lecture Notes Helpful Hint: Before beginning the lecture, show students the 16th segment from the third tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library This segment introduces students to many of the concepts discussed in chapter 13 The lecture notes reinforce the concepts introduced in the video I Chapter theme: Making decisions is one of the basic functions of a manager To be successful in decision making, managers must be able to tell the difference between relevant and irrelevant data and must be able to correctly use the relevant data in analyzing alternatives The purpose of this chapter is to develop these skills by illustrating their use in a wide range of decision-making situations Cost concepts for decision making A Identifying relevant costs and benefits i A relevant cost is a cost that differs between alternatives 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 ii Two broad categories of costs are never relevant in any decision: 863 864 A sunk cost is a cost that has already been incurred and cannot be avoided regardless of what a manager decides to A future cost that does not differ between alternatives is never a relevant cost “In Business Insights” Most people find it very difficult to ignore sunk costs when making decisions For example: “It Isn’t Easy to Be Smart about Money” (page 603) • Dan Seligman commented “Higher primates not like to admit, even to themselves, that they have screwed up.” Humans have “the deepseated, egoistic human need – evidenced in numerous psychological experiments – to justify the sunk costs in one’s life.” • Paula Zakoria reports: “If you put your house on the market but refuse offers below the price you paid, you are guilty of ‘anchoring.’ The amount you paid is irrelevant; a house like a stock, is worth what the market will bear at the time of sale iii Relevant cost analysis: a two-step process: The first step is to eliminate costs and benefits that not differ between alternatives These irrelevant costs consist of sunk costs and future costs that not differ between alternatives “In Business Insights” Companies occasionally offer deep discount prices to make use of idle capacity The fixed costs associated 865 866 TM 13-1 AGENDA: RELEVANT COSTS FOR DECISION MAKING Identification of relevant costs Drop or retain a segment Make or buy decision Utilization of constrained resources Special order Joint products © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 13-2 RELEVANT COSTS Every decision involves choosing from among at least two alternatives A relevant cost or benefit is a cost or benefit that differs, in total, between the alternatives Any cost or benefit that does not differ between the alternatives is irrelevant and can be ignored Relevant costs and benefits are also known as differential costs and benefits Avoidable costs are those costs that can be eliminated in whole or in part by choosing one alternative over another Avoidable costs are relevant costs Two broad categories of costs are never relevant in decisions: Sunk costs Future costs that not differ between alternatives To make a decision: Eliminate costs and benefits that not differ, in total, between alternatives Base the decision on the remaining costs and benefits © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 13-3 DROP OR RETAIN A SEGMENT EXAMPLE: Due to the declining popularity of digital watches, Sweiz Company’s digital watch line has not reported a profit for several years An income statement for last year follows: 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 product line manager Depreciation of equipment** Product line advertising Rent—factory space*** General administrative expense* Net operating loss $ 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) * Allocated common costs that would be redistributed to other product lines if digital watches were dropped ** This equipment has no resale value and does not wear out through use *** The digital watches are manufactured in their own facility Should the company retain or drop the digital watch line? © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 13-4 DROP OR RETAIN A SEGMENT (cont’d) Approach #1: If by dropping digital watches the company is able to avoid more in fixed costs than it loses in contribution margin, then it will be better off if the product line is eliminated The solution would be: Contribution margin lost if digital watches are dropped Less fixed costs that can be avoided: Salary of the product line manager Product line advertising Rent—factory space Net disadvantage of dropping the line $(300,000) $ 90,000 100,000 70,000 260,000 $( 40,000) The digital watch line should not be dropped If it is dropped, the company will be $40,000 worse off each year Note the following points: • Depreciation on the old equipment is not relevant to the decision It relates to a sunk cost • General factory overhead and general administrative expense are allocated common costs that would not be avoided if the digital watch line were dropped These costs would be reallocated to other product lines © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 13-5 DROP OR RETAIN A SEGMENT (cont’d) Approach #2: The solution can also be obtained by preparing comparative income statements showing results with and without the digital watch line Sales Less variable expenses: Variable manufacturing expense Variable shipping costs Commissions Total variable expenses Contribution margin Less fixed expenses: General factory overhead Salary of product line manager Depreciation Product line advertising Rent—factory space General administrative expense Total fixed expenses Net operating loss Keep Digital Watches $ 500,000 Drop Digital Watches $ 120,000 5,000 75,000 200,000 300,000 60,000 90,000 50,000 100,000 70,000 30,000 400,000 $(100,000) 0 0 0 60,000 50,000 0 30,000 140,000 $(140,000) © The McGraw-Hill Companies, Inc., 2006 All rights reserved Difference: Increase or (Decrease) $(500,000) 120,000 5,000 75,000 200,000 (300,000) 90,000 100,000 70,000 260,000 $ (40,000) TM 13-6 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 EXAMPLE: Essex Company is presently making a part that is used in one of its products The unit product cost is: Direct materials Direct labor Variable manufacturing overhead Depreciation of special equipment* Supervisor’s salary General factory overhead** Total unit product cost $9 10 $30 * The special equipment has no resale value ** Common costs allocated on the basis of direct labor-hours The costs above are based on 20,000 parts produced each year An outside supplier has offered to provide the 20,000 parts for only $25 per part Should this offer be accepted? © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 13-7 MAKE OR BUY DECISION (cont’d) The solution to Essex Company’s make or buy decision follows: Outside purchase price Direct materials Direct labor Variable manufacturing overhead Depreciation of equipment (not relevant) Supervisor’s salary General factory overhead (not relevant) Total cost Total Differential Costs of 20,000 units Make Buy $180,000 100,000 20,000 $500,000 40,000 $340,000 $500,000 This solution assumes that none of the general factory overhead costs will be saved if the parts are purchased from the outside; these costs would be reallocated to other items made by the company © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 13-8 SPECIAL ORDERS A special order is a one-time order that does not affect the company’s normal sales EXAMPLE: Jamestown Candleworks has just received a request from the Williamsburg Foundation for 800 candles to be used in a special event for major donors The candles will be used as the only illumination in the reception room and will be given out as gifts to the donors as they leave The candles will be imprinted with the Williamsburg Foundation logo This sale will have no effect on the company’s normal sales to retail outlets The normal selling price of a candle of about the size and weight of the special candles is $3.95 and its unit product cost is $2.30, as shown below: Direct materials Direct labor Manufacturing overhead Unit product cost $1.35 0.15 0.80 $2.30 The variable portion of the manufacturing overhead is $0.05 per candle; the other $0.75 represents fixed manufacturing costs that would not be affected by this special order Jamestown Candleworks would have to order a special candle mold in which the Williamsburg Foundation logo is inscribed Such a mold would cost $800 In addition, the Williamsburg Foundation wants a special wick containing gold-like thread that would add $0.20 to the cost of each candle Because of the large size of the order and the charitable nature of the work, the Williamsburg Foundation has asked to pay only $2.95 each for this candle If accepted, what effect would this order have on the company’s net operating income? © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 13-9 SPECIAL ORDERS Only the incremental costs and benefits are relevant The existing fixed manufacturing overhead costs would not be affected by the order and are irrelevant Incremental revenue Incremental costs: Variable costs: Direct materials Direct labor Variable manufacturing overhead Special wick Total variable cost Fixed cost: Special mold Total incremental cost Incremental net operating income Per Unit Total for 800 Candles 1.35 0.15 0.05 0.20 $1.75 1,080 120 40 160 1,400 $2.95 © The McGraw-Hill Companies, Inc., 2006 All rights reserved $2,360 800 2,200 $ 160 TM 13-10 UTILIZATION OF CONSTRAINED RESOURCES • Anything that prevents an organization from getting more of what it wants (for example, profits) is a constraint • A particular machine may not have enough capacity to satisfy current demand • Supplies of a critical part may not be sufficient to satisfy current demand • When the constraint is a machine or a work center, it is called a bottleneck • When capacity is not sufficient to satisfy demand, something must be cut back Which products should be cut back and by how much? • Fixed costs are not usually affected by the decision of which products should be emphasized in the short run All of the machines and other fixed assets are in place—it is just a question of how they should be used • When fixed costs are unaffected by the choice of which product to emphasize, maximizing the total contribution margin will maximize total profits • The total contribution margin is maximized by emphasizing the products with the greatest contribution margin per unit of the constrained resource © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 13-11 UTILIZATION OF CONSTRAINED RESOURCES (cont’d) EXAMPLE: Ensign Company makes two products, X and Y The current constraint is Machine N34 Selected data on the products follow: Selling price per unit Less variable expenses per unit Contribution margin Contribution margin ratio Current demand per week (units) Processing time required on Machine N34 per unit X Y $60 36 $24 40% 2,000 $50 35 $15 30% 2,200 1.0 minute 0.5 minute Machine N34 is available for 2,400 minutes per week, which is not enough capacity to satisfy demand for both product X and product Y Should the company focus its efforts on product X or product Y? CM PER UNIT OF THE CONSTRAINED RESOURCE X Contribution margin per unit (a) $24 Constrained resource required to produce one unit (b) 1.0 minute Contribution margin per unit of the constrained resource (a)÷ (b) $24 per minute © The McGraw-Hill Companies, Inc., 2006 All rights reserved Y $15 0.5 minute $30 per minute TM 13-12 UTILIZATION OF CONSTRAINED RESOURCES (cont’d) • Product Y should be emphasized since it has the larger contribution margin per unit of the constrained resource A minute of processing time on Machine N34 can be used to make unit of Product X, with a contribution margin of $24, or units of Product Y, with a combined contribution margin of $30 • In the absence of other considerations (such as satisfying an important customer), the best plan would be to produce to meet current demand for Product Y and then use any remaining capacity to make Product X ALLOTING THE CONSTRAINED RESOURCE Total time available on Machine N34 (a) Planned production and sales of Product Y Time required to process one unit Total time required to make Product Y (b) Time available to process Product X (a) – (b) Time required to process one unit Planned production and sales of Product X 2,400 2,200 × 0.5 1,100 1,300 ÷1 minutes units minute minutes minutes minute per unit 1,300 units RESULTS OF FOLLOWING THE ABOVE PLAN Planned production and sales (units) Contribution margin per unit Total contribution margin X Y 1,300 2,200 × $15 × $24 $31,200 $33,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved Total $64,200 TM 13-13 UTILIZATION OF CONSTRAINED RESOURCES (cont’d) MANAGING CONSTRAINTS Processing more units through the bottleneck that customers want is a key to increased profits: • Produce only what can be sold • Pay workers overtime to keep the bottleneck running after normal working hours • Shift workers from non-bottleneck areas to the bottleneck • Hire more workers or acquire more machines for the bottleneck • Subcontract some of the production that would use the bottleneck • Focus business process improvement efforts on the bottleneck • Reduce defects The potential payoff to effectively managing the constraint can be enormous EXAMPLE: Suppose the available time on Machine N34 can be increased by paying the machine’s operator to work overtime Would this be worthwhile? ANSWER: Since the additional time would be used to make more of Product X, each minute of overtime is worth $24 to the company and hence each hour is worth $1,440 (60 minutes × $24 per minute)! © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 13-14 JOINT PRODUCT COSTS • Some companies manufacture a number of end products from a single raw material input Such products are known as joint products • The split-off point is the point in the manufacturing process at which the joint products can be recognized as separate products • The term joint cost is used to describe those costs that are incurred up to the split-off point • It is profitable to continue processing a joint product after the splitoff point if the incremental revenue from further processing exceeds the incremental processing costs • In practice, joint costs incurred up to the split-off point are almost always allocated to the joint products Extreme caution should be exercised in interpreting these allocated joint costs They are not relevant in decisions concerning whether joint products should be processed further since they are incurred whether or not there is further processing © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 13-15 JOINT PRODUCT COSTS (cont’d) EXAMPLE: NW Sawmill buys logs and then runs them through a saw that produces unfinished lumber and scrap (i.e., sawdust, chips, and bark) The unfinished lumber can be sold “as is” or processed further into finished lumber The scrap can also be sold “as is” to gardening supply wholesalers or processed further into prestologs Data concerning these joint products appear below: Sales value at the split-off point Sales value after further processing Allocated joint costs* Cost of further processing *Allocated on the basis of weight Per Log Lumber Scraps $140 $270 $176 $50 $5 $20 $24 $4 Analysis of Sell or Process Further Sales value after further processing Sales value at the split-off point Incremental revenue Cost of further processing Profit from further processing Per Log Lumber Scraps $270 140 130 50 $ 80 $20 15 $11 © The McGraw-Hill Companies, Inc., 2006 All rights reserved