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CHAPTER 23
RELEVANT COSTING FOR MANAGERIAL DECISIONS
Related Assignment Materials
Student Learning Objectives
Questions
Quick
Studies*
Exercises*
Problems*
Beyond the
Numbers
Conceptual objectives:
C1. Describe the importance of
relevant costs for short-term
decisions.
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Analytical objectives:
A1. Evaluate short-term managerial
decisions using relevant costs.
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A2. Determine product selling
price based on total costs.
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Procedural objectives:
P1. Identify relevant costs and
apply them to managerial
decisions.
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* See additional information on next page that pertains to these quick studies, exercises and problems.
Additional Information on Related Assignment Material
Connect (Available on the instructor’s course-specific website) repeats all numerical Quick Studies, all
Exercises and Problems Set A. Connect provides new numbers each time the Quick Study, Exercise or
Problem is worked. It allows instructors to monitor, promote, and assess student learning. It can be used
in practice, homework, or exam mode.
Synopsis of Chapter Revision
Charlies Brownies—New opener
Expanded discussion and exhibits for short-term decisions, including additional
business, make or buy, scrap or rework, sell or process further, sales mix, and segment
elimination
Added a Need-to-Know illustration for each short-term decision
New Global View on segment elimination
Added 3 Quick Studies
Chapter Outline
Decisions and Information
Emphasis is on use of quantitative measures to make important short-term
decisions. Costs and other factors relevant to decision must be identified.
I. Decisions and Information
A. Decision Making
1. Five steps involved in managerial decision making.
a. Define the decision task
b. Identify alternative courses of action.
c. Collect relevant information and evaluate each alternative.
d. Select the preferred course of action.
e. Analyze and assess the decision.
2. Both managerial and financial accounting information play
important role in making decisions
a. Accounting system provides primarily financial
information such as performance reports and budget
analyses.
b. Non-financial information is also relevant, such as
environmental effects, political sensitivities, and social
responsibility.
B. Relevant Costs and Benefits
1. Most financial measures from cost accounting systems are
based on historical amounts; however, relevant costs, or
avoidable costs, are especially useful. Three types of costs:
a. Sunk cost arises from a past decision; cannot be avoided or
changed, and not relevant to future decisions.
b. Out-of-pocket cost requires future outlay of cash and
results from result of management’s decisions; is relevant.
c. Opportunity cost is a potential benefit lost by taking
specific action when two or more alternative choices are
available; consideration is important.
2. Relevant costs in making decisions are the incremental, also
called differential costs, which are the additional costs
incurred if a company pursues a certain course of action.
3. Relevant benefits are additional or incremental revenue
generated by selecting a particular course of action over
another; relevant to decision-making.
Notes
Chapter Outline
II. Managerial Decision Scenariosconsider each decision task
discussed below independent from the others.
A. Additional Business
1. Effect on net income must be considered when deciding
whether to accept or reject an order; reject if loss results.
2. Historical costs are not relevant to this decision.
3. Incremental or additional costs (also called differential costs)
are additional costs incurred if company pursues certain
course of action; relevant to this decision.
4. Minimum acceptable price per unit can be determined by
dividing incremental cost by the number of units in the order.
5. Incremental costs of additional volume are relevant.
6. If additional volume approaches or exceeds existing available
capacity of factory, incremental costs required to expand
capacity may quickly exceed incremental revenue.
7. Accepting order may cause existing sales to decline; the
contribution margin lost from the decline in sales is an
opportunity cost and is relevant (if future cash flows over
several time periods are affected, net present value should be
computed).
8. Note – Allocated overhead costs, which are historical costs,
should not automatically be considered; only incremental costs
to be incurred are relevant.
9. Key point: management must not blindly use historical costs,
especially allocated to overhead costs. Instead the accounting
system needs to provide incremental cost information if the
additional business is accepted.
B. Make or Buy
1. When determining whether to make or buy a component of a
product, only incremental costs are relevant.
2. Only incremental (additional) overhead costs are relevant; an
incremental overhead rate should be determined.
3. If the incremental costs of making the component exceed the
purchase price paid to buy the component, decision rule would
be to buy; however, several other factors should be
considered.
a. Product quality.
b. Timeliness of delivery (especially in JIT settings).
c. Reactions of customers and suppliers.
d. Other intangibles (employee morale and workload).
e. Must also consider if making the part will require
incremental fixed costs to expand plant capacity.
4. Make or buy decision for component parts can also be used for
decisions about the outsourcing of services.
Notes
Chapter Outline
C. Scrap or Rework
1. Costs already incurred in manufacturing units of product not
meeting quality are sunk costs and are irrelevant in any
decision on whether to sell to substandard units as scrap or
rework to meet quality standards.
2. Incremental revenues, incremental costs of reworking defects,
and opportunity costs (the contribution margin lost if sales of
other units are given up) are all relevant.
D. Sell or Process Further
1. Partially completed products can be sold as is or they can be
processed further and then sold as other products.
2. Compute incremental revenue from further processing
(amount of revenue after further processing less revenue from
selling the products as partially completed)
3. Compute incremental cost from further processing.
4. Process further and sell if incremental revenue from further
processing exceeds related incremental costs.
E. Sales Mix Selection
1. When more that one product is sold, some are likely to be
more profitable than others; management should concentrate
sales efforts on more profitable products.
2. If production facilities or other factors are limited, an increase
in production and sale of one product usually requires
reduction in production and sale of others.
3. The most profitable combination, or sales mix, of products
should be determined. To identify the best sales mix,
management focuses on the contribution margin per unit of
scarce resource. The scarce resource could be the machines
used to make the products.
4. Determine the contribution margin of each product, the
facilities required to produce these products and any
constraints on facilities and markets for the products.
5. If demand is unlimited and the products use the same inputs
then the product with the highest contribution margin should
be produced.
6. If demand is unlimited but the products use different inputs
then determine contribution margin per unit of the constraint
(the factor that limits capacity, such as machine time
required); produce the product with the highest contribution
margin per unit of the constraint.
7. If demand is limited then the company should first produce the
most profitable product, up to the point of the total demand.
The remaining capacity should be used to produce the next
most profitable product.
Notes
Chapter Outline
F. Segment Elimination
1. If segment, division, or store is performing poorly,
management must consider eliminating it.
2. It is not sufficient to base the decision on net income (loss) or
its contribution to overhead.
3. Need to consider avoidable and unavoidable expenses:
a. Avoidable (or escapable) expenses are costs or expenses
that would not be incurred if the segment is eliminated.
b. Unavoidable (or inescapable) expenses are costs or
expenses that would continue even if the segment is
eliminated.
4. Decision rule – Segment is candidate for elimination if its
revenues are less than its avoidable expenses.
5. Should also assess impact of elimination on other segments.
a. An unprofitable segment might contribute to another
segment’s revenue and expenses
b. A profitable segment might be eliminated if its space,
assets and staff can be more profitably used by another
segment or new segment.
G. Keep or Replace Equipment
1. Must decide whether the reduction in variable manufacturing
costs over its life is greater than the net purchase price of the
new equipment.
a. Net purchase price is the cost of the new equipment less
any trade in allowance given or cash receipt for the old
equipment.
b. Book value of the old equipment is not used. It is a sunk
cost.
III. Decision AnalysisSetting Product Price
A. Relevant costs are useful to management in determining prices for
special short-term decisions.
B. Longer run pricing decisions need to cover both variable and fixed
costs and yield a profit.
C. Methods to help in setting prices include cost-plus methods, where
management sets price equal to product’s total costs plus desired
profit.
D. Four-step process includes:
1. Determine total costs
2. Determine total cost per unit
3. Determine dollar markup per unit
4. Determine selling price per unit
Notes
Chapter 23: Alternate Demonstration Problem
Modern Company manufactures wood desks. They have the opportunity to
buy handles for the desks at $8 per unit. This purchase would affect costs
as follows:
Make Buy
Unit selling price: $340 $340
Volume (monthly) 500 500
Unit variable cost $ 95 $ 88
Price to purchase $ 0 $ 8
Fixed costs $5,500 $4,700
Decide whether the part should be made or purchased.
Solution: Chapter 23 Alternate Demonstration Problem
Buy Make
Revenue $170,000 $170,000
Less:
Variable costs 48,000 47,500
Contribution Margin $ 122,000 $ 122,500
Less:
Fixed Costs 4,700 5,500
Operating Profit $ 117,300 $ 117,000
Operating Profit is $300 higher if Modern purchases the handles instead of
making them.
