Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 29 Relevant Costing for Managerial Decisions

29-2 Learning Objective 1 Compute contribution margin and describe what it reveals about a company’s cost structure. Mixed costs contain a fixed portion that is incurred even when the facility is unused, and a variable portion that increases with usage. LO1

29-3 Compute contribution margin. Contribution Margin Ratio = Contribution margin per unit Sales price per unit Contribution margin is the amount by which revenue exceeds the variable costs of producing the revenue. LO1

29-4 Learning Objective 2 Compute break-even point for a single-product company. Let’s compute the break-even point in units. Break-even point in units = Fixed costs Contribution margin per unit The break-even formula may also be expressed in sales dollars. Break-even point in dollars = Fixed costs Contribution margin ratio Unit contribution margin Unit sales price The break-even point is the level of sales where a company’s income is exactly equal to zero. At breakeven, total costs equal total revenues. LO2

29-5 Learning Objective 3 Prepare a contribution margin income statement. Here is an example of an contribution margin income statement for Matrix, Inc. It differs from a conventional income statement in two ways. First, it separately classifies costs and expenses as variable or fixed. Second, it reports contribution margin (Sales – Variable costs). LO3

29-6 Computing Income from Sales and Costs Income (pretax) = Sales – Variable costs – Fixed costs Learning Objective 4 Describe several applications of cost-volume-profit analysis. Computing Sales for a Target Income Unit sales = Fixed costs + Target income Contribution margin per unit Dollar sales = Fixed costs + Target income Contribution margin ratio LO4

29-7 Margin of safety Expected sales - Break-even sales percentage Expected sales = Computing the Margin of Safety Margin of safety is the amount by which sales can drop before the company incurs a loss. Margin of safety is the amount by which sales can drop before the company incurs a loss. Margin of safety may be expressed as a percentage of expected sales. Margin of safety may be expressed as a percentage of expected sales. Margin of safety is the amount by which sales can drop before the company incurs a loss. Margin of safety is the amount by which sales can drop before the company incurs a loss. Margin of safety may be expressed as a percentage of expected sales. Margin of safety may be expressed as a percentage of expected sales. LO4

29-8 Decision making involves five steps:  Define the decision task.  Identify alternative actions.  Collect relevant information on alternatives.  Select the course of action.  Analyze and assess decisions made. Learning Objective 5 Explain the steps in the managerial decision process. LO5

29-9 Costs that are applicable to a particular decision. Costs that should have a bearing on which alternative a manager selects. Costs that are avoidable. Future costs that differ between alternatives. Relevant Costs Relevant Costs: Sunk Costs All costs incurred in the past that cannot be changed by any decision made now or in the future. All costs incurred in the past that cannot be changed by any decision made now or in the future. Sunk costs should not be considered in decisions. Example: You bought a car that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost. Learning Objective 6 Describe the importance of relevant costs for short-term decisions. LO6

29-10 Future outlays of cash associated with a particular decision. Example: Considering the decision to take a vacation or stay at home, you will have travel costs (out-of-pocket costs) only if you choose the vacation. Relevant Costs: Out-of-Pocket Costs Relevant Costs: Opportunity Costs The potential benefit that is given up when one alternative is selected over another. The potential benefit that is given up when one alternative is selected over another. Example: If you were not attending college, you could be earning $20,000 per year. Your opportunity cost of attending college for one year is $20,000. LO6

29-11 Learning Objective 7 Evaluate short-term managerial decisions using relevant costs. The decision to accept additional business should be based on incremental costs and incremental revenues. The decision to accept additional business should be based on incremental costs and incremental revenues. Incremental amounts are those that occur if the company decides to accept the new business. Incremental amounts are those that occur if the company decides to accept the new business. LO7

29-12 Make or Buy Incremental costs also are important in the decision to make a product or purchase it from a supplier. Incremental costs also are important in the decision to make a product or purchase it from a supplier. The cost to produce an item must include (1) direct materials, (2) direct labor, and (3) incremental overhead. The cost to produce an item must include (1) direct materials, (2) direct labor, and (3) incremental overhead. We should not use the predetermined overhead rate to determine product cost. We should not use the predetermined overhead rate to determine product cost. LO7

29-13 Costs incurred in manufacturing units of product that do not meet quality standards are sunk costs and cannot be recovered. As long as rework costs are recovered through sale of the product, and rework does not interfere with normal production, we should rework rather than scrap. Scrap or Rework LO7

29-14 Sell or Process Businesses are often faced with the decision to sell partially completed products or to process them to completion., As a general rule, we process further only if incremental revenues exceed incremental costs. Sales Mix Selection When a company sells a variety of products, some are likely to be more profitable than others. To make an informed decision, management must consider... The contribution margin of each product, The facilities required to produce each product and any constraints on the facilities, and The demand for each product. LO7

29-15 A segment is a candidate for elimination if its revenues are less than its avoidable expenses. Segment Elimination Qualitative Decision Factors Qualitative factors are involved in most all managerial Qualitative factors are involved in most all managerial decisions. For example: decisions. For example: Quality. Quality. Delivery schedule. Delivery schedule. Supplier reputation. Supplier reputation. Employee morale. Employee morale. Customer opinions. Customer opinions. Qualitative factors are involved in most all managerial Qualitative factors are involved in most all managerial decisions. For example: decisions. For example: Quality. Quality. Delivery schedule. Delivery schedule. Supplier reputation. Supplier reputation. Employee morale. Employee morale. Customer opinions. Customer opinions. LO7

29-16 End of Chapter 29