Relevant Costs for Decision-Making

Cost Classifications for Decision MakingEvery decision involves a choice between at least two alternatives. Only those costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits can and should be ignored as irrelevant.

11-*Cost Concepts for Decision Making A relevant cost is a cost that differs between alternatives.12

11-* Two broad categories of costs are never relevant in any decision and include: Sunk costs.Future costs that do not differ between the alternatives.Identifying Relevant Costs

Sunk CostsSunk costs have already been incurred and cannot be changed now or in the future. These costs should be ignored when making decisions.Example: Suppose you purchased some shoes, but dont wear them because they are not comfortable. You need the room in your closet, but you keep the shoes because you paid good money for them. Thats a sunk cost causing a bad decision. The money is gone either way, so you might as well make some room in the closet!

11-*Costs that are relevant in one decision situation may not be relevant in another context. Different Costs for Different Purposes

Quick Check Which of the following statements is false? (Check all that apply)a. Under some circumstances, a sunk cost may be a relevant costb. Future costs that do not differ between alternatives are irrelevantc. The same cost may be relevant or irrelevant depending on the decision contextd. Only variable costs are relevant costs; fixed costs cannot be relevant costs

Quick Check Which of the following statements is false? (Check all that apply)a. Under some circumstances, a sunk cost may be a relevant costb. Future costs that do not differ between alternatives are irrelevantc. The same cost may be relevant or irrelevant depending on the decision contextd. Only variable costs are relevant costs; fixed costs cannot be relevant costs

11-*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:Identifying Relevant Costs

Entries

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

Annual Cost of Fixed ItemsCost per Mile

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

2Cost of gasoline0.050

3Annual cost of auto insurance and license1,3800.138

4Maintenance and repairs0.065

5Parking fees at school3600.036

6Total average cost$0.569

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11-*Which costs and benefits are relevant in Cynthias decision?The cost of the car is a sunk cost and is not relevant to the current decision.However, the cost of gasoline is clearly relevant if she decides to drive. If she chooses to drive, the gasoline cost would be incurred, so it varies, depending on the decision.The annual cost of insurance is not relevant. It will remain the same if she drives or takes the train.Identifying Relevant Costs

11-*Which costs and benefits are relevant in Cynthias decision?The cost of maintenance and repairs is relevant. In the long-run, these costs depend upon miles driven. The monthly school 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, while others are not.Identifying Relevant Costs

11-*Identifying Relevant Costs

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Some Additional Information

7Reduction in resale value of car per mile of wear$0.026

8Round-tip train fare104$104

9Benefits of relaxing on train trip????

10Cost of putting dog in kennel while gone$40

11Benefit of having car in New York????

12Hassle of parking car in New York????

13Per day cost of parking car in New York$25

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

Annual Cost of Fixed ItemsCost per Mile

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

2Cost of gasoline0.050

3Annual cost of auto insurance and license1,3800.138

4Maintenance and repairs0.065

5Parking fees at school3600.036

6Total average cost$0.569

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11-*Which costs and benefits are relevant in Cynthias decision?The decline in resale value due to additional miles is a relevant cost. The round-trip train fare is clearly relevant. If she drives, the cost can be avoided. Relaxing on the train is relevant even though it is difficult to assign a dollar value to the benefit. The kennel cost is not relevant because Cynthia will incur the cost if she drives or takes the train.Identifying Relevant Costs

11-*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.Identifying Relevant Costs

11-*From a financial standpoint, Cynthia would be better off taking the train to visit her friend. Some non-financial factors may influence her final decision.Identifying Relevant Costs

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Relevant Financial Cost of Driving

Gasoline (460 @ $0.050 per mile)$23.00

Maintenance (460 @ $0.065 per mile)10429.90

Reduction in resale (460 @ $0.026 per mile)11.96

Parking in New York (2 days @ $25 per day)50.00

Total$114.86

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Relevant Financial Cost of Taking the Train

Round-trip ticket$104.00

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11-*A business example:Total and Differential Cost ApproachesThe management of a company is considering a new laborsaving machine that rents for $3,000 per year. Data about the companys annual sales and costs with and without the new machine are shown on the next slide.

11-*Total Cost Approach

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Current SituationSituation With New Machine

Sales (5,000 units @ $40 per unit)$200,000$200,000

Less variable expenses:

Direct materials (5,000 units @ $14 per unit)70,00070,000

Direct labor (5,000 units @ $8 and $5 per unit)40,00025,000

Variable overhead (5,000 units @ $2 per unit)10,00010,000

Total variable expenses120,000105,000

Contribution margin80,00095,000

Less fixed expense:

Other62,00062,000

Rent on new machine0.03,000

Total fixed expenses62,00065,000

Net operating income$18,000$30,000

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11-*Total Cost ApproachIf we compare total results, net income increases with the new machine.

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Current SituationSituation With New Machine

Sales (5,000 units @ $40 per unit)$200,000$200,000

Less variable expenses:

Direct materials (5,000 units @ $14 per unit)70,00070,000

Direct labor (5,000 units @ $8 and $5 per unit)40,00025,000

Variable overhead (5,000 units @ $2 per unit)10,00010,000

Total variable expenses120,000105,000

Contribution margin80,00095,000

Less fixed expense:

Other62,00062,000

Rent on new machine0.03,000

Total fixed expenses62,00065,000

Net operating income$18,000$30,000

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11-*As you can see, the only costs that differ between the alternatives are the direct labor costs savings and the increase in fixed rental costs.Differential Cost Approach

11-*Using the differential approach focuses on what really mattersMingling irrelevant costs with relevant costs may cause confusionOften we dont have all the info anywayGetting good at identifying relevant info takes practiceTotal and Differential Cost Approaches

11-*Keep or drop a segmentMake or buy a componentAccept or reject a special orderAssign use of constrained resource

Typical decisions where focus is on relevant costs

Relevant Costs: Drop or Keep a Segment?

11-*Lovell Companys digital watch line has not reported a profit for several years. Lovell is considering dropping this product line.Adding/Dropping Segments

11-*DECISION RULELovell should drop the digital watch segment only if its profit would increase. This would only happen if the fixed cost savings exceed the lost contribution margin. Lets look at this solution.A Contribution Margin Approach

11-*Adding/Dropping Segments

Sheet1

Segment Income Statement

Digital Watches

Sales$500,000

Less: variable expenses

Variable manufacturing costs$120,000

Variable shipping costs5,000

Commissions75,000200,000

Contribution margin$300,000

Less: fixed expenses

General factory overhead$60,000

Salary of line manager90,000

Depreciation of equipment50,000

Advertising - direct80,000

Rent - factory space70,000

General admin. expenses30,000380,000

Net operating loss$(80,000)

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11-*Costs that will change

Sheet1

Segment Income Statement

Digital Watches

Sales$500,000

Less: variable expenses

Variable manufacturing costs$120,000

Variable shipping costs5,000

Commissions75,000200,000

Contribution margin$300,000

Less: fixed expenses

General factory overhead$60,000

Salary of line manager90,000

Depreciation of equipment50,000

Advertising - direct80,000

Rent - factory space70,000

General admin. expenses30,000380,000

Net operating loss$(80,000)

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11-*A Contribution Margin Approach

Sheet1

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 - direct80,000

Rent - factory space70,000240,000

Net disadvantage$(60,000)

Less: fixed expenses

General factory overhead$60,000

Salary of line manager90,000

Depreciation of equipment50,000

Advertising - direct100,000

Rent - factory space70,000

General admin. expenses30,000400,000

Net loss$(460,000)

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11-*Segment Margin Approach*Costs that would go away if the segment is dropped.Segment Margin is KEY to making drop or keep decisions!

Sheet1

Revenue

Less traceable costs*

Segment margin

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11-*Segment Margin

Sheet1

Segment Income Statement

Digital Watches

Sales$500,000

Less: variable expenses

Variable manufacturing costs$120,000

Variable shipping costs5,000

Commissions75,000200,000

Contribution margin$300,000

Less: traceable fixed expenses

Salary of line manager$90,000

Advertising - direct80,000

Rent - factory space70,000$240,000

Segment margin$60,000

Less: common fixed expenses

Depreciation of equipment$50,000

General factory overhead60,000

General admin. expenses30,000140,000

Net operating loss$(80,000)

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11-*Segment MarginSunk cost

Sheet1

Segment Income Statement

Digital Watches

Sales$500,000

Less: variable expenses

Variable manufacturing costs$120,000

Variable shipping costs5,000

Commissions75,000200,000

Contribution margin$300,000

Less: traceable fixed expenses

Salary of line manager$90,000

Advertising - direct80,000

Rent - factory space70,000$240,000

Segment margin$60,000

Less: common fixed expenses

Depreciation of equipment$50,000

General factory overhead60,000

General admin. expenses30,000140,000

Net operating loss$(80,000)

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11-*The Lovell solution can also be obtained by preparing comparative income statements showing results with and without the digital watch segment. This is a proof of the results, but not the best way to reach the decision.Comparative Income Approach

11-*Comparative Income ApproachIf the digital watch line is dropped, the company gives up its contribution margin.

Sheet1

Comparative Income Approach

Solution

Keep Digital WatchesDrop Digital WatchesDifference

Sales$500,0000.0$(500,000)

Less variable expenses:0.0

Manufacturing expenses120,0000.0120,000

Shipping5,0000.05,000

Commissions75,0000.075,000

Total variable expenses200,0000.0200,000

Contribution margin300,0000.0(300,000)

Less fixed expenses:

General factory overhead60,000

Salary of line manager90,000

Depreciation50,000

Advertising - direct80,000

Rent - factory space70,000

General admin. expenses30,000

Total fixed expenses380,000

Net operating loss$(80,000)

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11-*Comparative Income ApproachOn the other hand, the general factory overhead would be the same. So this cost really isnt relevant.

Sheet1

Comparative Income Approach

Solution

Keep Digital WatchesDrop Digital WatchesDifference

Sales$500,0000.0$(500,000)

Less variable expenses:0.0

Manufacturing expenses120,0000.0120,000

Shipping5,0000.05,000

Commissions75,0000.075,000

Total variable expenses200,0000.0200,000

Contribution margin300,0000.0(300,000)

Less fixed expenses:

General factory overhead60,00060,0000.0

Salary of line manager90,000

Depreciation50,000

Advertising - direct80,000

Rent - factory space70,000

General admin. expenses30,000

Total fixed expenses380,000

Net operating loss$(80,000)

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11-*Comparative Income ApproachBut we wouldnt need a manager for the product line anymore.

Sheet1

Comparative Income Approach

Solution

Keep Digital WatchesDrop Digital WatchesDifference

Sales$500,0000.0$(500,000)

Less variable expenses:0.0

Manufacturing expenses120,0000.0120,000

Shipping5,0000.05,000

Commissions75,0000.075,000

Total variable expenses200,0000.0200,000

Contribution margin300,0000.0(300,000)

Less fixed expenses:

General factory overhead60,00060,0000.0

Salary of line manager90,0000.090,000

Depreciation50,000

Advertising - direct80,000

Rent - factory space70,000

General admin. expenses30,000

Total fixed expenses380,000

Net operating loss$(80,000)

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11-*Comparative Income ApproachIf the digital watch line is dropped, the net book value of the equipment would be written off. The depreciation that would have been taken will flow through the income statement as a loss instead.

Sheet1

Comparative Income Approach

Solution

Keep Digital WatchesDrop Digital WatchesDifference

Sales$500,0000.0$(500,000)

Less variable expenses:0.0

Manufacturing expenses120,0000.0120,000

Shipping5,0000.05,000

Commissions75,0000.075,000

Total variable expenses200,0000.0200,000

Contribution margin300,0000.0(300,000)

Less fixed expenses:

General factory overhead60,00060,0000.0

Salary of line manager90,0000.090,000

Depreciation50,00050,0000.0

Advertising - direct80,000

Rent - factory space70,000

General admin. expenses30,000

Total fixed expenses380,000

Net operating loss$(80,000)

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11-*Comparative Income Approach

Sheet1

Comparative Income Approach

Solution

Keep Digital WatchesDrop Digital WatchesDifference

Sales$500,0000.0$(500,000)

Less variable expenses:0.0

Manufacturing expenses120,0000.0120,000

Shipping5,0000.05,000

Commissions75,0000.075,000

Total variable expenses200,0000.0200,000

Contribution margin300,0000.0(300,000)

Less fixed expenses:

General factory overhead60,00060,0000.0

Salary of line manager90,0000.090,000

Depreciation50,00050,0000.0

Advertising - direct80,0000.080,000

Rent - factory space70,0000.070,000

General admin. expenses30,00030,0000.0

Total fixed expenses380,000140,000240,000

Net operating loss$(80,000)$(140,000)$(60,000)

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Relevant Costs: Make or Buy a Component?

11-*Essex Company manufactures part 4A that is used in one of its products.The unit product cost of this part is:The Make or Buy Decision: An Example

Sheet1

Direct materials$9

Direct labor5

Variable overhead1

Depreciation of special equip.3

Supervisor's salary2

General factory overhead10

Unit product cost$30

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11-*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 we accept the suppliers offer?The Make or Buy Decision

11-*20,000 $9 per unit = $180,000The Make or Buy Decision

Sheet1

Cost Per UnitCost of 20,000 Units

MakeBuy

Outside purchase price$25$500,000

Direct materials$9180,000

Direct labor5100,000

Variable overhead120,000

Depreciation of equip.30.0

Supervisor's salary240,000

General factory overhead100.0

Total cost$30$340,000$500,000

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11-*The special equipment has no resale value and is a sunk cost.The Make or Buy Decision

Sheet1

Cost Per UnitCost of 20,000 Units

MakeBuy

Outside purchase price$25$500,000

Direct materials$9180,000

Direct labor5100,000

Variable overhead120,000

Depreciation of equip.30.0

Supervisor's salary240,000

General factory overhead100.0

Total cost$30$340,000$500,000

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11-*Not avoidable; irrelevant. If the product is dropped, it will be reallocated to other products.The Make or Buy Decision

Sheet1

Cost Per UnitCost of 20,000 Units

MakeBuy

Outside purchase price$25$500,000

Direct materials$9180,000

Direct labor5100,000

Variable overhead120,000

Depreciation of equip.30.0

Supervisor's salary240,000

General factory overhead100.0

Total cost$30$340,000$500,000

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11-*Should we make or buy part 4A?The Make or Buy Decision

Sheet1

Cost Per UnitCost of 20,000 Units

MakeBuy

Outside purchase price$25$500,000

Direct materials$9180,000

Direct labor5100,000

Variable overhead120,000

Depreciation of equip.30.0

Supervisor's salary240,000

General factory overhead100.0

Total cost$30$340,000$500,000

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11-*An opportunity cost is the benefit that is foregone as a result of pursuing some course of action.Opportunity costs are not actual dollar outlays and are not recorded in the formal accounts of an organization.

How would this concept potentially relate to the Essex Company?Opportunity Cost

11-*What if we could rent out the space for $200,000?The Make or Buy Decision

Sheet1

Cost Per UnitCost of 20,000 Units

MakeBuy

Outside purchase price$25$500,000

Direct materials$9180,000

Direct labor5100,000

Variable overhead120,000

Depreciation of equip.30.0

Supervisor's salary240,000

General factory overhead100.0

Total cost$30$340,000$500,000

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11-*What if we could rent out the space for $200,000?The Make or Buy Decision

Sheet1

Cost Per UnitCost of 20,000 Units

MakeBuy

Outside purchase price$25$500,000

Direct materials$9180,000

Direct labor5100,000

Variable overhead120,000

Depreciation of equip.30.0

Supervisor's salary240,000

General factory overhead100.0

Total cost$30$340,000$500,000

Rent space200,000(200,000)

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Relevant Costs: Accept the Special Order?

11-*A special order is a one-time order that is not considered part of the companys normal ongoing business.When analyzing a special order, only the incremental costs and benefits are relevant.Key Terms and Concepts

11-*Jet, Inc. makes a single product whose normal selling price is $20 per unit.A foreign distributor offers to purchase 3,000 units for $10 per unit. Variable cost per unit is $8.This is a one-time order that would not affect the companys regular business.Annual capacity is 10,000 units, but Jet, Inc. is currently producing and selling only 5,000 units.Should Jet accept the offer?Special Orders

11-*If Jet accepts the offer, net operating income will increase by $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.Special Orders

Sheet1

Increase in revenue (3,000 $10)$30,000

Increase in costs (3,000 $8 variable cost)24,000

Increase in net income$6,000

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11-* 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. Whats the incremental cost per unit? Quick Check

11-* In other words, what is the minimum price below which Northern Optical should not go in its negotiations with the customer? (Below what price would Northern Optical actually be losing money on the sale?) There is ample idle capacity to fulfill the order and the imprinting machine has no further use after this order.a. $50b. $10c. $15d. $29Quick Check

11-* What is the 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 and the imprinting machine has no further use after this order.a. $50b. $10c. $15d. $29Variable production cost $100,000Additional fixed cost 50,000Total relevant cost$150,000Number of units 10,000Average cost per unit $15Quick Check

Relevant Costs: Best Use of Limited Resource?

11-*When a limited resource of some type restricts the companys ability to satisfy demand, the company is said to have a constraint.The machine or process that is limiting overall output is called the bottleneck it is the constraint.Utilization of a Constrained Resource Key Terms and Concepts

11-* Ensign Company produces two products and selected data are shown below:Utilization of a Constrained ResourceAn Example

Sheet1

Product

12

Selling price per unit$60$50

Less variable expenses per unit3635

Contribution margin per unit$24$15

Current demand per week (units)2,0002,200

Contribution margin ratio40%30%

Processing time required

on machine A1 per unit1.00min.0.50min.

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11-*Machine A1 is the constrained resource and is being used at 100% of its capacity. There is excess capacity on all other machines. Machine A1 has a capacity of 2,400 minutes per week.

Should Ensign focus its efforts on Product 1 or 2?Utilization of a Constrained ResourceAn Example

11-* How many units of each product can be processed through Machine A1 in one minute?

Product 1 Product 2a. 1 unit 0.5 unitb. 1 unit 2.0 unitsc. 2 units 1.0 unitd. 2 units 0.5 unitQuick Check

11-* How many units of each product can be processed through Machine A1 in one minute?

Product 1 Product 2a. 1 unit 0.5 unitb. 1 unit 2.0 unitsc. 2 units 1.0 unitd. 2 units 0.5 unitThe first step is to identify the unit measure of the constrained resource.Quick Check

11-* What generates more profit for the company, using one minute of machine A1 to process Product 1 or using one minute of machine A1 to process Product 2?a. Product 1b. Product 2c. They both would generate the same profit.d. Cannot be determined.Quick Check

11-* Ensign Company produces two products and selected data are shown below:Utilization of a Constrained ResourceAn Example

Sheet1

Product

12

Selling price per unit$60$50

Less variable expenses per unit3635

Contribution margin per unit$24$15

Current demand per week (units)2,0002,200

Contribution margin ratio40%30%

Processing time required

on machine A1 per unit1.00min.0.50min.

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11-*Quick Check What generates more profit for the company, using one minute of machine A1 to process Product 1 or using one minute of machine A1 to process Product 2?a. Product 1b. Product 2c. They both would generate the same profit.d. Cannot be determined.With one minute of machine A1, we could make 1 unit of Product 1, with a contribution margin of $24, or 2 units of Product 2, each with a contribution margin of $15. 2 $15 = $30 > $24

11-*The key is the contribution margin per unit of the constrained resource.Product 2 should be emphasized. Provides more valuable use of the constrained resource machine A1, yielding a contribution margin of $30 per minute as opposed to $24 for Product 1.Utilization of a Constrained ResourceAn Example

Sheet1

Product

12

Contribution margin per unit$24$15

Time required to produce one unit1.00min.0.50min.

Contribution margin per minute$24$30

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11-*If there are no other considerations, the best plan would be to produce to meet current demand for Product 2 and then use remaining capacity to make Product 1.Utilization of a Constrained ResourceAn ExampleThe key is the contribution margin per unit of the constrained resource.

Sheet1

Product

12

Contribution margin per unit$24$15

Time required to produce one unit1.00min.0.50min.

Contribution margin per minute$24$30

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11-* Colonial Heritage makes reproduction colonial furniture from select hardwoods.

The companys supplier of hardwood will only be able to supply 2,000 board feet this month. Is this enough hardwood to satisfy demand?a. Yesb. NoQuick Check

Chairs

Tables

Selling price per unit

$80

$400

Variable cost per unit

$30

$200

Board feet per unit

2

10

Monthly demand

600

100

11-* Colonial Heritage makes reproduction colonial furniture from select hardwoods.

The companys supplier of hardwood will only be able to supply 2,000 board feet this month. Is this enough hardwood to satisfy demand?a. Yesb. No(2 600) + (10 100 ) = 2,200 > 2,000Quick Check

Chairs

Tables

Selling price per unit

$80

$400

Variable cost per unit

$30

$200

Board feet per unit

2

10

Monthly demand

600

100

11-*

The companys supplier of hardwood will only be able to supply 2,000 board feet this month. What plan would maximize profits?a. 500 chairs and 100 tablesb. 600 chairs and 80 tablesc. 500 chairs and 80 tablesd. 600 chairs and 100 tablesQuick Check

Chairs

Tables

Selling price per unit

$80

$400

Variable cost per unit

$30

$200

Board feet per unit

2

10

Monthly demand

600

100

11-*

The companys supplier of hardwood will only be able to supply 2,000 board feet this month. What plan would maximize profits?a. 500 chairs and 100 tablesb. 600 chairs and 80 tablesc. 500 chairs and 80 tablesd. 600 chairs and 100 tablesQuick Check

Chairs

Tables

Selling price per unit

$80

$400

Variable cost per unit

$30

$200

Board feet per unit

2

10

Monthly demand

600

100

Sheet1

ChairsTables

Selling price$80$400

Variable cost30200

Contribution margin$50$200

Board feet210

CM per board foot$25$20

Production of chairs600

Board feet required1,200

Board feet remaining800

Board feet per table10

Production of tables80

11-* As before, Colonial Heritages supplier of hardwood will only be able to supply 2,000 board feet this month. Assume the company follows the plan we have proposed. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood?a. $40 per board footb. $25 per board footc. $20 per board footd. ZeroQuick Check

11-* As before, Colonial Heritages supplier of hardwood will only be able to supply 2,000 board feet this month. Assume the company follows the plan we have proposed. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood?a. $40 per board footb. $25 per board footc. $20 per board footd. ZeroThe additional wood would be used to make tables. In this use, each board foot of additional wood will allow the company to earn an additional $20 of contribution margin and profit.Quick Check

*It is important to realize that every decision involves a choice between at least two alternatives. The goal of making decisions is to identify those costs that are either relevant or irrelevant to the decision. Costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits are irrelevant and can and should be ignored. To make decisions, it is essential to have a grasp on three concepts: differential costs, opportunity costs, and sunk costs. *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.

Two broad categories of costs are never relevant in any decision: A sunk cost is a cost that has already been incurred and cannot be avoided regardless of what a manager decides to do. A future cost that does not differ between alternatives is never a relevant cost. A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Since sunk costs cannot be changed and therefore cannot be differential costs, they should be ignored in decision making. While students usually accept the idea that sunk costs should be ignored on an abstract level, like most people, they often have difficulty putting this idea into practice.

*Costs that are relevant in one decision situation may not be relevant in another context. Thus, in each decision situation, the manager must examine the data at hand and isolate the relevant costs.

*Can you calculate the contribution margin ratio for Coffee Klatch? The calculation may take a minute or so to complete.*Can you calculate the contribution margin ratio for Coffee Klatch? The calculation may take a minute or so to complete.*Part IAssume the following information with respect to Cynthia, a Boston student, who is considering visiting her friend in New York. Cynthia is trying to decide whether it would be less expensive to drive or take the train to New York. She has assembled the following information with respect to her automobile.

Part IIThe straight-line depreciation is calculated as cost minus salvage value divided by useful life.

Part IIIGasoline per mile is calculated by taking the price per gallon of gasoline and dividing it by the number of miles per gallon of the car.

Part IVThe parking fee at school is $45 a month. Cynthia attends school only eight months out of the year. *Part IWhich costs are relevant to her decision?

The cost of the car is irrelevant to the decision because it is a sunk cost.

The annual cost of auto insurance is irrelevant because it does not differ between alternatives.

Part IIThe cost of the gasoline is relevant because it is avoidable if she takes the train.

*Part I.The cost of maintenance and repairs is relevant because in the long-run these costs depend upon miles driven.The parking fee is irrelevant because it is not a differential cost.

Part II.At this point, we can see that some of the average cost of $0.569 per mile are relevant, while others are not.

*She has also gathered this additional information to aid in her decision. *Part I.The decline in resale value is relevant due to the additional miles driven.

The round trip train fare is relevant because it is avoidable if she drives her car.

Relaxing on the train is relevant, but difficult to quantify.

Part II.The kennel cost is irrelevant because it is not a differential cost.

*The cost of parking is relevant because it is avoidable if she takes the train.

The benefits of having a car in New York and the problem of finding a parking space are both relevant, but difficult to quantify. *From a financial standpoint, Cynthia would be better off taking the train. But, as with any decision we may face, it may be the non-financial or non-quantitative factors that have the greatest impact on our decision.*Assume the following information for a company considering a new labor-saving machine that rents for $3,000 per year. The total approach requires constructing two contribution format income statements one for each alternative.

The difference between the two income statements of $12,000 equals the differential benefits shown at the bottom of the right-hand column.

*Assume the following information for a company considering a new labor-saving machine that rents for $3,000 per year. The total approach requires constructing two contribution format income statements one for each alternative.

The difference between the two income statements of $12,000 equals the differential benefits shown at the bottom of the right-hand column.

*Assume the following information for a company considering a new labor-saving machine that rents for $3,000 per year. The total approach requires constructing two contribution format income statements one for each alternative.

The difference between the two income statements of $12,000 equals the differential benefits shown at the bottom of the right-hand column.

*The most efficient means of analyzing this decision is to use the differential approach to isolate the relevant costs and benefits as shown. *Using the differential approach is desirable for two reasons:

Only rarely will enough information be available to prepare detailed income statements for both alternatives. Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical. *Using the differential approach is desirable for two reasons:

Only rarely will enough information be available to prepare detailed income statements for both alternatives. Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical. **Assume that Lovell Companys digital watch line has not reported a profit for several years; accordingly, Lovell is considering discontinuing this product line. *To determine how dropping this line will affect the overall profits of the company, Lovell will compare the contribution margin that would be lost to the costs that would be avoided if the line was to be dropped.Lovell should drop the digital watch segment only if its profit would increase. This would only happen if the fixed cost savings exceed the lost contribution margin.

*Assume the sales and cost information for the digital watch line is as shown on this slide.*Assume the sales and cost information for the digital watch line is as shown on this slide.*A contribution margin approach reveals that the $300,000 of lost contribution margin exceeds the $240,000 of avoidable costs by $60,000. Therefore, Lovell should retain the digital watch segment. *The segment margin is the difference between the revenue generated by a segment and its own traceable costs. It provides a different perspective of the Digital Watches product line.

*The segment margin for Digital Watches is $10,000, instead of the $80,000 loss shown earlier; thus, suggesting the product line should be retained.

*The segment margin for Digital Watches is $10,000, instead of the $80,000 loss shown earlier; thus, suggesting the product line should be retained.

*Comparative income statements can also be prepared to help make the decision.

*These income statements show that if the digital watch line is dropped, the company loses $300,000 in contribution margin.

*The $60,000 of general factory overhead would be the same under both alternatives, so it is irrelevant. *The $90,000 salary of the product line manager would be eliminated, so it is relevant to the decision.

*The $50,000 of depreciation is a sunk cost. Also, remember that the equipment has no resale value or alternative use, so the equipment and the depreciation expense associated with it are irrelevant to the decision.

*The comparative income statements reveal that Lovell would earn $60,000 of additional profit by retaining the digital watch line.

**Assume that Essex Company manufactures part 4A with a unit product cost as shown. *Also, assume the information as shown on this slide with respect to part 4A. Given these additional assumptions, should Essex make or buy part 4A? *The avoidable costs associated with making part 4A include $180,000 of direct materials, $100,000 of direct labor, $20,000 of variable overhead, and the supervisors $40,000 salary. *The depreciation of special equipment represents a sunk cost. Furthermore, the equipment has no resale value, thus, the special equipment and its associated depreciation expense are irrelevant to the decision. *The general factory overhead represents future costs that will be incurred regardless of whether Essex makes or buys part 4A; hence, it is also irrelevant to the decision.*The total avoidable costs of $340,000 are less than the $500,000 cost of buying the part, thereby suggesting that Essex should continue to make the part. *An opportunity cost is the benefit that is foregone as a result of pursuing a course of action. These costs do not represent actual cash outlays and they are not recorded in the formal accounts of an organization.

In the Essex example that we just completed, if Essex had an alternative use for the capacity that it used to make part 4A, there would have been an opportunity cost to factor into the analysis.The opportunity cost would have been equal to the segment margin that could have been derived from the best alternative use of the space. *The total avoidable costs of $340,000 are less than the $500,000 cost of buying the part, thereby suggesting that Essex should continue to make the part. *The total avoidable costs of $340,000 are less than the $500,000 cost of buying the part, thereby suggesting that Essex should continue to make the part. **A special order is a one-time order that is not considered part of the companys normal ongoing business. When analyzing a special order, only the incremental costs and benefits are relevant. Since the existing fixed manufacturing overhead costs would not be affected by the order, they are not relevant. *Given the information shown on this slide, should Jet accept the special order opportunity?*If Jet accepts the special order, the incremental revenue of $30,000 will exceed the incremental costs of $24,000 by $6,000. This suggests that Jet should accept the order. Notice that this answer assumes that the fixed costs are unavoidable and that variable marketing costs must be incurred on the special order. *Take a minute and read the information provided about Northern Optical.*What is the minimum price below which Northern Optical should discontinue its negotiations with the customer?*The answer is $15. Take a minute and review the solution to this problem before proceeding to the next slide.**When a limited resource of some type restricts the companys ability to satisfy demand, the company is said to have a constraint. The machine or process that is limiting overall output is called the bottleneck it is the constraint. *Assume that Ensign Company produces two products and selected data are as shown on this slide. *In addition, assume that: Machine A1 is the constraint; There is excess capacity on all other machines; andMachine A1 has a capacity of 2,400 minutes per week.

Should Ensign focus its efforts on Product 1 or 2?

*How many units of each product can be processed through Machine A1 in one minute?*The answer is one unit of Product 1 and two units of Product 2.

*What generates more profit for the company, using one minute of machine A1 to process Product 1 or using one minute of machine A1 to process Product 2?

*Assume that Ensign Company produces two products and selected data are as shown on this slide. *The answer is using one minute of time to process Product 2. With one minute of machine A1, we can make 1 unit of Product 1, with a contribution margin of $24 dollars, or 2 units of Product 2, each with a contribution margin of $15. *As suggested by the answer to the Quick Check question, Ensign should emphasize product 2 because it generates a contribution margin of $30 per minute of the constrained resource relative to $24 per minute for product 1. *Ensign can maximize its contribution margin by first producing product 2 to meet customer demand and then using any remaining capacity to produce product 1. The calculations would be performed as shown on the following slide. *Review the information provided about Colonial Heritage. Is this enough hardwood to satisfy demand?

*The answer is no. Colonial Heritage needs 2,200 board feet to satisfy its demand. *The companys supplier of hardwood will only be able to supply 2,000 board feet this month. What plan would maximize profits?

*Production of 600 chairs and 80 tables would maximize the companys contribution margin. *Read this information about Colonial Heritage. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood?

*The additional wood would be used to make tables. In this use, each board foot of additional wood will allow the company to earn an additional $20 dollars of contribution margin and profit.