Module 16

Relevant Costs and Benefits

for Decision Making

Relevant and Irrelevant Costs

Primary focus is profit maximization Additional factors that should be

considered Effects on long-run profit Nonquantitative factors

Such as legal, ethical, social

Future costs that differ among

competing decision alternatives

RelevantRelevant IrrelevantIrrelevant

Future costs that DO NOT differ among

competing decision alternatives

Sunk Costs Result from past decisions that

cannot be changed Sunk costs are NEVER relevant Sunk costs in decisions to replace a

machine Book value of old machine

Can cause ethical dilemmas Managers often avoid disposing of old

assets Disposing may create a loss on the income

statement, making the manager’s performance look bad and decrease their bonuses!

Disposal and Salvage Values

Disposal value Amount of cash an old asset can be sold

for at the time the new asset is purchased

Relevant cash inflow Obtained only if the replacement alternative

is accepted

Salvage value Amount of cash an asset will bring at

the end of its useful life if held to that time

Opportunity Costs

Any benefit forgone as a result of rejecting one alternative in favor of another

Make or Buy Do we make a product, part, or

service or do we purchase it from the outside?

Compare the total cost of purchasing with the internal costs that may be saved (avoided) by purchasing.

Be careful on the long-term effects of such a decision on quality and stability

Special Sales Orders Do we accept a low priced sales

order? Compare the additional revenues with

the differential costs. Be careful on sales to direct

competitors, especially retailers, as an price differences may have to be defended in court. Only cost differences allowed.

Budget Alternatives Which alternative is best? Dropping

products, changing prices, advertising increases…

Select the alternative with the highest positive impact on profits?

Sell or Process Further Do we sell products as is or process

them further? Compare the increase in revenues

with the increase in costs. Joint products are a special case of

this.

Use of Limited Resources Which products or services do we

produce with our limited resources? Select the products first with the

highest contribution margin per unit of limited resource, subject to sales and other constraints.

Equipment Replacement How do we decide to replace a

working piece of equipment? Compare the impact on profits over

the life of the new equipment with the net cost of the new equipment.

Be sure to net out the disposal value of the old equipment from the cost of the new equipment.

Note that taxes saved from disposal losses can be relevant in real situations.