1. Relevant Costs and Benefits
Decision making:
Relevant Costs and Benefits

2. Cost Concepts for Decision Making
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Cost Concepts for Decision Making
A relevant cost/benefit is a cost/benefit that differs between alternatives. 1 2
A relevant cost is a cost that differs between alternatives.

3. Identifying Relevant Costs
3-3
Identifying Relevant Costs
An avoidable cost 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. They include:
Sunk costs.
Future costs that do not differ between the 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.

4. Relevant Cost Analysis: A Two-Step Process
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Relevant Cost Analysis: A Two-Step Process
Eliminate costs and benefits that do not differ between alternatives.
Use the remaining costs and benefits that differ between alternatives in making the decision. The costs that remain are the differential, or avoidable, costs.
Step 1
Step 2
Relevant cost analysis is a two-step process.
The first step is to eliminate costs and benefits that do not differ between alternatives. These irrelevant costs consist of sunk costs and future costs that do not differ between alternatives.
The second step is to use the remaining costs and benefits that differ between alternatives in making the decision. The costs that remain are the differential, or avoidable, costs.

5. Let’s take a look at a decision faced by many businesses.
Make versus Buy
Let’s take a look at a decision faced by many businesses.
We need a particular component for our manufacturing process. Do you think we should make or buy this particular item? W

6. Make or Buy
Han Products manufactures 30,000 units of part S-6 each year for use on its production line. At this level of activity, the cost per unit for part S-6 is as follows:
Direct materials $3.60
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead  
Total cost per part $25.00

7. Make or Buy (continued)
An outside supplier has offered to sell 30,000 units of part S-6 each year to Han Products for $21 per part. If Han Products accepts this offer, the facilities now being used to manufacture part S-6 could be rented to another company at an annual rental of $80,000. However, Han Products has determined that two-thirds of the fixed manufacturing overhead being applied to part S-6 would continue even if part S-6 were purchased from the outside supplier.
Prepare computations showing how much profits will increase or decrease if the outside supplier’s offer is accepted.

8. Analysis of Special Pricing Decisions
Let’s take a look at another decision faced by many businesses:
Another firm has offered to pay us $10 for a product that normally sells for $25. Do you think we should accept this special order? W

9. Accept/Reject Special Orders
Polaski Company manufactures and sells a single product called a Ret. Operating at capacity, the company can produce and sell 30,000 Rets per year. Costs associated with this level of production and sales are given below:
The Rets normally sell for $50 each. Fixed manufacturing overhead is constant at $270,000 per year within the range of 25,000 through 30,000 Rets per year.
Unit
Total
Direct materials
$15
$450,000
Direct labor 8
240,000
Variable manufacturing overhead 3
90,000
Fixed manufacturing overhead 9
270,000
Variable selling expense 4
120,000
Fixed selling expense 6
180,000
Total cost
$45
$1,350,000

10. Accept/Reject Special Orders (continued)
Assume that due to a recession, Polaski Company expects to sell only 25,000 Rets through regular channels next year. A large retail chain has offered to purchase 5,000 Rets if Polaski is willing to accept a 16% discount off the regular price. There would be no sales commissions on this order; thus, variable selling expenses would be slashed by 75%.
However, Polaski Company would have to purchase a special machine to engrave the retail chain’s name on the 5,000 units. This machine would cost $10,000. Polaski Company has no assurance that the retail chain will purchase additional units in the future. Determine the impact on profits next year if this special order is accepted.

11. Accept/Reject Special Orders (continued)
Refer to the original data. Assume again that Polaski Company expects to sell only 25,000 Rets through regular channels next year. The U.S. Army would like to make a one-time-only purchase of 5,000 Rets. The Army would pay a fixed fee of $1.80 per Ret, and it would reimburse Polaski Company for all costs of production (variable and fixed) associated with the units. Because the army would pick up the Rets with its own trucks, there would be no variable selling expenses associated with this order.
If Polaski Company accepts the order, by how much will profits increase or decrease for the year?

12. Accept/Reject Special Orders (continued)
Assume the same situation as that described in the previous slide, except that the company expects to sell 30,000 Rets through the regular channels next year. Thus, accepting the U.S. Army’s order would require giving up regular sales of 5,000 Rets.
If the Army’s order is accepted, by how much will profits increase or decrease from what they would be if the 5,000 Rets were sold through regular channels?

13. Utilizing a Constrained Resource
Let’s take a look at another decision faced by many businesses:
One of our machines is a constraint in the operation. What products should we produce on this machine? W

14. Scarce Resource Constraint
A company has two products: a plain cellular phone and a fancier cellular phone with many special features:
Plain Fancy
Phone Phone
Selling price $ $ 120
Variable costs
Contribution margin $ $ 36
Contribution-margin ratio % %

15. Scarce Resource Constraint
Which product is more profitable?
On which should the firm spend its resources?
It depends.
If sales are restricted by demand for only a limited number of phones, fancy phones are more profitable.

16. Scarce Resource Constraint
Suppose annual demand for phones of both types is more than the company can produce in the next year.
Only 10,000 hours of capacity are available
If in one hour plant workers can make either three plain phones or one fancy phone, which phone is more profitable?

17. Scarce Resource Constraint
Plain Fancy
Phone Phone
1. Units per hour
2. Contribution margin per unit $ $ 36
Contribution margin per hour
Total contribution for
10,000 hours

18. Scarce Resource Constraint
Additional Question:
At what price for the fancy phone would the company be indifferent between producing and selling the plain phone or the fancy phone?

19. Constrained Resources
Westford Company produces three products, A110, B382, and C657. Unit data for the three products follows:
Product
A110
B382
C657
Selling Price
$84
$56
$70
Variable Costs
Direct materials 24 15 9
Labor and other costs 28 27 40
Quantity of Bistide per unit
8 lb.
5 lb.
3 lb.

20. Constrained Resources (continued)
All three products use the same direct material, Bistide. The demand for the products far exceeds the direct materials available to produce the products. Bistide costs $3 per pound and a maximum of 5,000 pounds is available each month. Westford must produce a minimum of 200 units of each product.
How many units of product A110, B832, and C657 should Westford produce?
What is the maximum amount Westford would be willing to pay for another 1,000 pounds of Bistide?

21. Add or Drop a Product Line
Let’s take a look at another decision faced by many businesses:
Does adding or dropping a product line increase our operating income? W

22. Add or Drop a Product Line
Discount Drug Company has three major product lines. What can be done to improve the company’s overall performance?
Product Line
Total
Drug
Cosmetics
Housewares
Sales
250,000
125,000
75,000
50,000
Less:
30,000
Variable Expenses
105,000
50,000
25,000
Contribution Margin
145,000
75,000
50,000
20,000
Less: Fixed Expenses
Salaries
50,000
29,500
12,500
8,000
Advertising
15,000
1,000
7,500
6,500
Utilities
2,000
500
500
1,000
Depreciation –
fixtures
5,000
1,000
2,000
2,000
Rent
20,000
10,000
6,000
4,000
Insurance
3,000
2,000
500
500
Administrative
30,000
15,000
9,000
6,000
Total
125,000
59,000
38,000
28,000
Net Op Income (Loss)
20,000
16,000
12,000
(8,000)

23. Add or Drop a Product Line
Which fixed expenses in Housewares will Discount Drug be able to avoid?
Total
Unavoidable
Avoidable
Salaries
8,000
8,000
Advertising
6,500
6,500
Utilities
1,000
1,000
Depreciation - fixtures
2,000
2,000
Rent
4,000
4,000
Insurance
500
500
General Administrative
6,000
6,000
Total Fixed Expenses
28,000
13,000
15,000

24. Add or Drop a Product Line
Contribution margin lost if housewares $ line is discontinued
Less fixed costs that can be avoided if the housewares line is discontinued $
Inc/(Dec) in overall company net operating inc. $
DECISION RULE:
The Housewares Line should be dropped only if the fixed cost savings exceed the lost contribution margin.

25. Analysis of Equipment Replacement Decisions
Let’s take a look at another decision faced by many businesses:
Should we replace a machine with a newer and more efficient one? W

26. Equipment Replacement Decision
A manager at White Co. wants to replace an old machine with a new, more efficient machine:

27. Should the manager purchase the new machine?
Equipment Replacement Decision
White’s sales are $200,000 per year
Fixed expenses, other than depreciation, are $70,000 per year
Should the manager purchase the new machine?

28. Another Equipment Replacement Decision
Toledo Company is considering replacing a metal-cutting machine with a newer model. The new machine is more efficient than the old machine, but it has a shorter life. Revenues from aircraft parts ($1.1 million per year) will be unaffected by the replacement decision. Here’s the data on the existing (old) machine and the replacement (new) machine:

29. Equipment Replacement Decision (cont.)
Old Machine
New Machine
Original Cost
$1,000,000
$600,000
Useful Life
5 years
2 years
Current age
3 years
0 years
Remaining useful life
Accumulated Depreciation
Not acquired yet
Book Value
$400,000
Current disposal value (in cash)
$40,000
Terminal disposal value (in cash 2 years from now) $0
Annual operating costs (maintenance, energy, repairs, coolants, and so on)
$800,000
$460,000

30. Equipment Replacement Decision (cont.)
Toledo Corporation uses straight-line depreciation. To focus on relevance, we ignore time value of money and income taxes.
Should Toledo replace its old machine?

31. Sell or Process Further
Let’s take a look at another decision faced by many businesses:
We have a joint process in our manufacturing operation. How should we decide whether to sell a joint product as is, or process it further? W

32. Joint Products Joint Costs Separable Split-Off Product Point Costs
Separate
Processing
Final
Sale
Oil
Common
Production
Process
Joint
Input
Final
Sale
Gasoline
Separate
Processing
Final
Sale
Chemicals
Separable
Product
Costs
Split-Off
Point

33. Sell-or-Process Further Decisions
In Sell-or-Process Further decisions, joint costs are irrelevant since they are “sunk” costs at the decision point
Decision should be based on whether the incremental revenue due to further processing is greater/less than the separable costs for the same

34. Sell or Process Further
Wexpro, Inc., produces several products from processing 1 ton of clypton, a rare mineral. Material and processing costs total $60,000 per ton, one-fourth of which is allocated to product X15. Seven thousand units of product X15 are produced from each ton of clypton. The units can either be sold at the split-off point for $9 each, or processed further at a total cost of $9,500 and then sold for $12 each.
Should product X15 be processed further or sold at the split-off point?

35. Joint Products - Practice
The wood spirits company produces two products, turpentine and methanol, by a joint process.
Joint costs are $120,000 per batch of output. Each batch totals 10,000 gallons, 25% methanol and 75% turpentine.
At split-off, methanol sells for $21/gallon and turpentine sells for $14/ gallon.

36. Joint Products - Practice (continued)
The company has discovered an new process by which the methanol can be made into a pleasant-tasting beverage.
The selling price for this beverage would be $40 per gallon. The additional processing would cost $12 per gallon s and the company would have to pay excise taxes of 20% on the selling price.
Should the company undertake further processing?