1. Financial and Managerial Accounting
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Wild, Shaw, and Chiappetta
Fifth Edition
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. 1

2. Relevant Costing for Managerial Decisions
Chapter 23
Relevant Costing for Managerial Decisions
This chapter explains several tools and procedures useful for making and evaluating short-term managerial decisions. It also describes how to assess the consequences of such decisions.

3. Conceptual Learning Objectives
C1: Describe the importance of relevant costs for short-term decisions.
Conceptual Learning Objectives:
C1: Describe the importance of relevant costs for short-term decisions.
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4. Analytical Learning Objectives
A1: Evaluate short-term managerial decisions using relevant costs.
A2: Determine product selling price based on total costs.
Analytical Learning Objectives:
A1: Evaluate short-term managerial decisions using relevant costs.
A2: Determine product selling price based on total costs.
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5. Procedural Learning Objectives
P1: Identify relevant costs and apply them to managerial decisions.
Procedural Learning Objectives:
P1: Identify relevant costs and apply them to managerial decisions.
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6. Decision Making Decision making involves five steps:
Define the decision task.
Identify alternative courses of action.
Collect relevant information and evaluate each alternative.
Select the preferred course of action.
Analyze and assess decisions made.
This chapter deals with using accounting information to make managerial decisions.
Managerial decision-making involves five steps. These five steps represent an orderly, structured decision-making process that will lead to better decisions. First, we need to clearly define the task and the goal. Next, we need to identify alternative courses of action. In the third step, we will gather information so that we can evaluate each alternative. Some of the information might not be relevant, so we need to discard that information and concentrate on using only relevant information to select the best alternative. Using the relevant information collected, we can select the preferred course of action. Our last step is to review the outcome in an effort to become even better decision makers in the future.
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7. Relevant Costs Are applicable to a particular decision.
Should have a bearing on which alternative a manager selects.
Are avoidable.
Are future costs that differ between alternatives. 1 2
Relevant costs are future costs that differ between alternatives. A relevant cost is a cost that will be incurred if an alternative is selected but avoided if the alternative is rejected. For example, if you are deciding between walking to class and driving to class, the cost of gasoline would be a relevant cost.
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8. Identifying Relevant CostsP1
Historical costs are generally not relevant to decisions. Instead the relevant costs are the additional costs, called incremental, or avoidable, costs. -These are costs incurred if a company decides on a specific course of action. 1 2
Sunk costs
Out-of-pocket costs
Opportunity costs
Although historical costs are useful for many tasks such as product pricing, we sometimes find that an analysis of relevant costs, or avoidable costs is especially useful. Three types of costs are pertinent to our discussion of relevant costs: Sunk costs, out-of-pocket costs, and opportunity costs.
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9. Classification by Relevance: Sunk Costs
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 an automobile 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.
Sunk costs cannot be changed by any decision we make as they have been incurred in the past and cannot possibly differ between any alternative that we might currently choose. Dwelling on sunk costs can frequently be the cause of decision errors. Sunk costs should not be considered in the decision process. For example, if you bought an automobile two years ago for $10,000, that amount is a sunk cost. Whether you drive the car, park it, trade it, or sell it, the $10,000 cost will not change.
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10. Classification by Relevance: Out-of-Pocket Costs
Future outlays of cash associated with a particular decision.
Out-of-Pocket-Costs ARE relative for current and future decision making.
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 a vacation.
Sometimes we hear the term out-of-pocket cost, meaning a future outlay of cash associated with a particular decision alternative. Out-of-pocket costs are relevant costs as they are future costs that differ between alternatives.
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11. Classification by Relevance: Opportunity Costs
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.
Opportunity costs are the potential benefits that are given up when one alternative is selected over another. Opportunity costs are not actual dollar outlays; however, they may impact our decisions. For example, some of you may have made the decision to attend college rather than go straight into the workforce. The opportunity cost of attending college is the lost salary that you could have earned had you worked.
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12. Accepting Additional Business
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.
Management needs to know whether accepting the offer will increase net income
Thanks for the offer! Let me talk to our management team and I’ll let you know tomorrow.
Managers experience many different scenarios that require analyzing alternative actions and making a decision. On occasion, we may have the opportunity to accept additional business. We should make the decision to accept or reject the additional business using incremental revenues and incremental costs. Some of our costs may not change if we accept additional business. Those costs are not relevant as they do not differ between the alternatives: accept or reject the additional business.
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13. Accepting Additional Business (Exhibit 23.2)
FasTrac currently sells 100,000 units of its product. The company has revenue and costs as shown below:
Let’s examine a business offer that a company named FasTrac has just received. They currently make 100,000 units of a single product that normally sells for $10 per unit. Total cost to make one unit is $9, resulting in a $1 profit per unit. The company operates at 80% of full capacity.
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14. Accepting Additional Business
FasTrac is approached by an overseas company that offers to purchase 10,000 units at $8.50 per unit.
If FasTrac accepts the offer, total factory overhead will increase by $5,000; total selling expenses will increase by $2,000; and total administrative expenses will increase by $1,000.
Should FasTrac accept the offer?
A foreign distributor offers to purchase 10,000 units at $8.50 each. FasTrac will have some additional costs if the order is accepted: Total factory overhead will increase by $5,000; total selling expenses will increase by $2,000; and total administrative expenses will increase by $1,000.
We will assume that FasTrac has idle capacity to make the ten thousand units and that this is a one-time order which will not affect the company’s regular business.
Should FasTrac accept this special order from the foreign distributor?
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15. Accepting Additional Business
Per Unit
Total
Sales (10,000 additional units)
$8.50
$85,000
Total costs and expenses
(9.00)
(90,000)
Operating Loss
$(0.50)
$(5,000)
Sorry, we are going to reject the offer because the selling price is less than the per unit cost to make it.
First let’s look at an incorrect approach to the decision that does not consider incremental revenues and incremental costs. If we compare the foreign distributor’s offer with FasTrac’s unit cost of $9, we see that the offer of $8.50 is $.50 less than the unit cost. Because management is relying incorrectly, on per unit historical costs, it would lead the company to reject the offer. If instead, the company focuses on the incremental costs brought on by the added volume that this new order would bring, a different decision will be made. Let’s take a look.
This analysis leads to the incorrect decision.
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16. Accepting Additional Business (Exhibit 23.4)
To determine whether to accept or reject this one time special order, FasTrac needs to know whether accepting the offer will increase net income. Management needs to focus on the additional costs or incremental costs that would be incurred if they accept the offer. This slide shows that if management accepts the additional business, its sales revenue will increase by $85,000 (10,000 units times $8.50 per unit). Now, let’s take a closer look at the incremental expenses that would be incurred if they make these additional 10,000 units.
If they accept the offer, revenues will increase by 10,000 new units × $8.50 selling price = $85,000
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17. Accepting Additional Business (Exhibit 23.4)
Direct material is a variable cost that will increase in direct proportion to the increase in sales.
Direct material costs will increase by 10,000 new units × $3.50 = $35,000
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18. Accepting Additional Business (Exhibit 23.4)
Direct labor is also a variable cost that will increase in direct proportion to the increase in sales. Overhead, selling expenses, and administrative expenses are largely fixed costs that increase but not in direct proportion to sales as did the variable costs of direct labor and direct materials.
Overhead, selling expenses, and administrative expenses are largely fixed costs that increase but not in direct proportion to sales.
Direct labor costs will increase by 22,000 new units × $2.20 = $22,000
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19. Accepting Additional Business (Exhibit 23.4)
By comparing incremental revenue of $85,000 with the total incremental costs of $65,000, we see that the sale of the additional 10,000 units by the business will increase FasTrac’s income by an additional $20,000. FasTrac should accept the offer of the foreign distributor.
Even though the $8.50 selling price is less than the normal $10 selling price, FasTrac should accept the offer because net income will increase by $20,000.
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20. Make or Buy Decisions A1
Incremental costs also are important in the decision to make a component or purchase it from a supplier.
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.
The Make or Buy decision involves the question of whether it is more economical to produce a component internally or purchase it from an outside supplier. We will again concentrate on incremental cost for this decision.
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21. Make or Buy Decisions P1
FasTrac currently makes part #417, assigning overhead at 100 percent of direct labor cost, with the following unit cost:
FasTrac is now making part number 417 which is a component part in its final product. The unit cost of the part includes direct material, direct labor, and factory overhead as shown on your screen.
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22. Make or Buy Decisions (Exhibit 23.5)P1
FasTrac can buy part #417 from a supplier for $1.20/per unit. How much overhead do we have to eliminate before we should buy this part?
An outside supplier offers to make part number 417, and sell it to FasTrac for $1.20 per unit. We know that $1.20 is less that FasTrac’s $1.45 unit cost. Should FasTrac stop making the part and buy it from the outside supplier for $1.20 per unit?
We know that FasTrac will avoid the direct material cost and the direct labor cost if they buy the part instead of making it. But that total is only $.95. FasTrac cannot afford to pay $1.20 per unit if they will only avoid $.95 per unit. They must also be able to avoid some of the factory overhead.
How much overhead does FasTrac need to eliminate in order to justify buying the part?
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23. We must be able to eliminate a minimum of $.25 per unit of overhead.
Make or Buy Decisions P1
FasTrac can buy part #417 from a supplier for $1.20/unit. How much overhead do we have to eliminate before we should buy this part?
We must be able to eliminate a minimum of $.25 per unit of overhead.
($ $0.95)
FasTrac must be able to eliminate (avoid) a minimum of $.25 unit in factory overhead costs to justify buying the part. If the avoidable amount of factory overhead per unit is greater than $.25, then the incremental cost of making the part is greater than the $1.20 outside price and FasTrac should buy the part instead of making it. On the other hand, if the avoidable amount of factory overhead per unit is less than $.25, then the incremental cost of making the part is less than the $1.20 outside price and FasTrac should continue making the part.
To make the correct make or buy decision, we must always determine the relevant (avoidable) costs of making the part and then compare these avoidable costs to the outside purchase cost. In almost all make or buy decisions, a significant amount of the factory overhead will be unavoidable and, therefore, irrelevant to the decision as it will be the same for either alternative.
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24. Scrap or Rework A1
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 products in process.
Often in production processes, we have product that does not pass inspection. We can either sell it as is, or rework it to improve the quality. Once reworked, the product will likely be sold for a higher price. The decision to rework or sell as is, should be based on incremental revenues and incremental costs. The costs of manufacturing the product up to the inspection point are sunk and, therefore, irrelevant.
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25. Should FasTrac scrap or rework?
FasTrac has 10,000 defective units that cost $1.00 each to make. The units can be scrapped now for $.40 each or reworked at an additional cost of $.80 per unit.
If reworked, the units can be sold for the normal selling price of $1.50 each. Reworking the defective units will prevent the production of 10,000 new units that would also sell for $1.50.
Should FasTrac scrap or rework?
FasTrac has 10,000 defective units that can be sold as is for $.40 per unit, or reworked and sold for $ The cost of reworking the defective units is $.80 each. The $1per unit original cost to make the defective units is a sunk cost and irrelevant to the decision.
FasTrac does not have the capacity to rework the defective units and continue with its normal production. Reworking the defective units will prevent the production of 10,000 new units that would also sell for $1.50.
What should FasTrac do?
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26. Scrap or Rework (Exhibit 23.6)
Sale of the 10,0000 defective units as is for $.40 will generate $4,000. Reworking and selling each unit for $1.50 will generate $15,000.
Revenue from sale of the defective units =
10,000 units × $0.40 per unit
Revenue from the sale of the reworked units=
10,000 units × $1.50 per unit
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27. Scrap or Rework (Exhibit 23.6)
Costs to rework the units =
10,000 units × $0.80 per unit
The total cost to rework the 10,000 defective units at $.80 each will be $8,000. We must also include the opportunity cost of 10,000 units of regular production that would be prevented by the rework. The regular units sell for $1.50 each and cost $1 per unit to make. We give up the opportunity to earn this $5,000 if we rework the defective units.
Opportunity cost of not making 10,000 units =
10,000 units × ($ $1.00) per unit
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28. Scrap or Rework Defects (Exhibit 23.6)
The correct decision: FasTrac should scrap the units now.
FasTrac should sell the defective units as is for $4,000, because the net return is $2,000 higher than reworking the defective units. Note that if FasTrac does not include the opportunity cost of the displaced regular production, they will make an incorrect decision to rework the defective product. Failing to include the opportunity cost would result in an incorrect $7,000 net return for the rework alternative.
Note: If FasTrac fails to include the opportunity cost of $5,000, the rework option would show a return of $7,000, mistakenly making the rework option appear more favorable.
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29. Sell or Process A1
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.
Many products can be sold in an unfinished state, or processed further into a finished product that will sell for a higher price. The decision to sell or process should be based on incremental revenues and incremental costs. The costs of manufacturing the product up to the sell or process decision point are sunk costs and therefore irrelevant.
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30. Sell or Process A1
FasTrac has 40,000 units of partially finished product Q. Processing costs to date are $30,000. The 40,000 unfinished units can be sold as is for $50,000 or they can be processed further to produce finished products X, Y, and Z. The additional processing will cost $80,000 and result in the following revenues:
FasTrac has 40,000 partially completed units of product Q that can be sold for a total of $50,000. FasTrac also has the option of further processing the 40,000 units of product Q to obtain products X, Y, and Z. The additional processing will cost $80,000. The $30,000 of cost to date incurred in making product Q, is a sunk cost and irrelevant to the decision.
What should FasTrac do? First, we need some additional information that is on the next slide before we can make a decision.
Continue
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31. Sell or Process (Exhibit 23.7)
The total revenue from selling products X, Y, and Z is $220,000. Since FasTrac would receive $50,000 for Product Q, the incremental revenue from processing is $220,000 minus $50,000, or $170,000. The incremental cost of processing is $80,000.
Now what should FaxTrac do?
Remember: The company would receive $50,000 for Product Q. The incremental revenue from additional processing is $220,000- $50,000 = $170,000. The incremental cost of processing is $80,000
Should FasTrac sell product Q or continue processing into products X, Y, and Z?
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32. Sell or Process (Exhibit 23.7)
Remember: The company would receive $50,000 for Product Q.
Incremental revenue (220,000-50,000) =$170,000
Incremental cost = 80,000
Incremental revenue > Incremental cost
Decision…FasTrac should continue processing!
FasTrac should process because the incremental revenue of $170,000 is greater that the incremental cost of $80,000. Processing product Q into products X, Y, and Z results in a $90,000 advantage. Note that we did not use the $30,000 cost to make product Q. It was incurred before the sell or process decision so it is a sunk cost and irrelevant to the decision.
Note that the earlier $30,000 cost for producing Q is sunk and therefore irrelevant to the decision.
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33. Sales Mix Selection A1
When a company sells a variety of products, some are likely to be more profitable than others. They are wise to concentrate sales efforts on more profitable products. How do they identify the best sales mix?
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
The demand for each product.
All businesses face constraints that affect production and sales decisions. When a company sells a mix of products, some are likely to be more profitable than others. Management must make decisions to best utilize constrained resources. They are wise to concentrate efforts on more profitable products. Usually fixed costs are not affected by this particular decision, so management can focus on maximizing the contribution margin given the constraints and the demand for products.
Let’s look at an example.
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34. Consider the following data for two products made and sold by FasTrac.
Sales Mix Selection Demand Is Unlimited and Products Use SAME Inputs. P1
Consider the following data for two products made and sold by FasTrac.
FasTrac produces Product A and Product B. Product A has a contribution margin of $1.50 per unit and Product B has a contribution margin of $2 per unit. If each product requires the same time to make, and the demand is unlimited for each product, FasTrac should produce only Product B because it has the highest contribution per unit.
If each product requires the same time to make, and the demand is unlimited, FasTrac should produce only Product B because it has the highest contribution margin.
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35. Sales Mix Selection Demand Is Unlimited and Products Use Different Inputs. (Exhibit 23.9)
Consider the following data for two products made and sold by FasTrac. The company is operating at full capacity and the products produced require a different amount of machine hours.
In the time that it takes to produce one unit of Product B, we can produce two units of Product A.
An important consideration is the time required to produce each product. It takes one hour to produce one unit of Product A, and it takes two hours to produce one unit of Product B. In other words, in the same time that it takes to produce one unit of Product B, we can produce two units of Product A.
If we divide the contribution per unit by the hours required to produce each unit, we find that we generate more contribution per hour if we make product A, even though its unit contribution is less.
Product B has a greater contribution margin than Product A, but it requires more machine hours per unit to produce.
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36. Sales Mix Selection Demand Is Unlimited and Products Use Different Inputs. (Exhibit 23.9)
When a company faces unlimited demand and limited capacity, only the most profitable product per input, should be manufactured.
If demand for Products A and B is unlimited, we should produce as many units of Product A as possible, even if that means producing no Product B. By producing Product A we make $1.50 per machine hour worked, which is higher than the $1 per machine hour that Product B generates.
The key to understanding the utilization of constrained resources, in this case our limited number of machine hours, is to determine the contribution margin per unit of the constrained resource used by each product. A company will want to produce the product that has the highest contribution margin per limited resource.
With unlimited demand for A and B, produce as many units of A as possible since A provides more dollars per hour worked.
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37. Sales Mix Selection Demand Is Limited (Exhibit 23.9)P1
Using the same information for FasTrac below but adding the additional fact that the market for Product A is limited to 80,000 units.
Let’s examine one additional scenario that FasTrac could face regarding the mix of products they should produce. In the previous slide, we determined that FasTrac should manufacture only product A because it had the highest contribution per machine hour. However, what if demand for Product A is limited to 80,000 units? Then the company should produce Product A first, until they satisfy the sales demand. After satisfying the sales demand for A, they should then use any remaining machine time to produce Product B.
If demand for A is limited, produce to meet that demand, then use the remaining facilities to produce B.
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38. Segment Elimination (Information from Exhibit 23.10)
A segment is a candidate for elimination if its revenues are less than its avoidable expenses.
FasTrac is considering eliminating its Treadmill Division because total expenses of $48,300 are greater than its sales of $47,800.
Managers should consider eliminating poorly performing segments. A segment may be a division, territory, store, or product line. You have no doubt seen a segment eliminated. It might have been a large segment such as an automobile or it may have been a much smaller segment such as a store or restaurant closing.
How should we make segment elimination decisions? Let’s look at an example from FasTrak whose Treadmill Division’s total expenses are greater than its total costs.
Continue
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39. Do not eliminate the Treadmill Division!
Segment Elimination P1
FasTrac should eliminate the Treadmill Division if its revenues are less than it avoidable expenses. Avoidable expenses are amounts the company would not incur if it eliminated the segment..
The Treadmill Division sales revenue is greater than its avoidable expenses by $6,000.
In deciding to eliminate the Treadmill Division, FasTrac needs to look at the segment’s avoidable expenses and unavoidable expenses. Avoidable expenses are amounts the company would not incur if it eliminated the segment. Unavoidable expenses, are amounts that would continue even if the segment is eliminated. The Treadmill Division sales revenue is greater than its avoidable expenses by $6,000. If FasTrac eliminates the Treadmill Division, the company’s income will be $6,000 less. We would have made an incorrect decision using total costs. We must compare avoidable expenses to sales revenue to make the correct decision.
Do not eliminate the Treadmill Division!
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40. Qualitative Decisions Factors
Qualitative factors are involved in most all
managerial decisions. For example:
Quality.
Delivery schedule.
Supplier reputation.
Employee morale.
Effects on the company’s image.
We have seen how to analyze quantitative factors in business decisions, but qualitative factors are also important considerations in many decisions. For example in the make or buy decision, we must consider the supplier’s reputation for quality work as well as the supplier’s ability to deliver the goods when we need them. When making a segment elimination decision, employee morale will be affected. Negative publicity resulting from a segment elimination could also cause adverse reactions from customers or potential customers.
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41. Setting Product PricesA2
Relevant costs are useful to management to
assist in determining prices for special short-
term decisions.
However, long-run pricing decisions also need to cover both variable and fixed costs, and yield a profit.
There are several methods to help management in setting prices
There are several methods to help management in setting normal selling price. All methods must insure that all costs plus a profit are built in. The “cost plus” method, where management adds a mark-up to the costs to reach a target price is most common.
Let’s take a look at one common method called the “total cost method.”
The “cost plus” method, where management adds a mark-up to the costs to reach a target price is most common.
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42. Four Steps Using the Total Cost Method
Determine the total costs (production and nonproduction).
Determine the total cost per unit.
Determine the markup per unit.
Determine the selling price per unit: Total cost per unit + Markup per unit
The total cost method is a common way to determine the normal selling price of a product. It involves four basic steps. In the first step, you calculate total costs by combining all the production costs (like direct materials, direct labor, and overhead.) To that you add any nonproduction costs (like selling and administrative costs.) The second step is to calculate the total cost per unit, by taking the total costs and dividing by the number of units. The next step is to determine the markup per unit. This can be found by taking the total cost per unit and multiplying by a markup percentage. At this point, the final step of setting the selling price can be computed, by taking the total cost per unit and adding in the markup per unit.
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43. End of Chapter 23
Now that we have mastered some of the basic concepts and principles of relevant costing for managerial decisions, we are ready to put this knowledge to work.
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