1. Relevant costs for decision making
Developing Next Generation Leaders through Applied Know-How
Introduction to Business
Relevant costs for decision making
Metka Tekavčič, PhD
Developing Next Generation Leaders through Applied Know-How project number: MK01-KA

2. COST CONCEPTS FOR DECISION MAKING
Every decision involves a choice from among at least two alternatives.
The costs and benefits of the alternatives should be compared when making the decision.
Only those costs and benefits that differ between alternatives are relevant in a decision.
When making a decision, eliminate all irrelevant costs.
Make the decision based on the remaining, relevant costs.
Examples of decisions: Adding and dropping product lines
Make or buy decision
Developing Next Generation Leaders through Applied Know-How project number: MK01-KA

3. COST CONCEPTS FOR DECISION MAKING
DIFFERENTIAL COST: difference in costs between any two alternatives
DIFFERENTIAL REVENUE: difference in revenues
between any two alternatives
OPPORTUNITY COST: potential benefit that is given up
when one alternative is selected over another
3. SUNK COST - never relevant in decisions!
A sunk cost is a cost that has already been incurred.
It cannot be avoided regardless what a manager decides to do.
It cannot be changed by any decision made now or in the future.
Developing Next Generation Leaders through Applied Know-How project number: MK01-KA

4. Continue / abandon product B? (Ex. 1)
Company Y produces products A and B using the same plant. Product A is sold in the market at a price of €500, which is €100 above its cost per unit. Company Y produces 10,000 units of product A and has therefore €1,000,000 of profit related to product A. Product B’s cost per unit is €200, while the price at which product B is sold in the market is €150. The company produces 4,000 units of B and has a loss of €200,000 from producing B. Costs per unit for both products were calculated considering the fact that production of product A uses 70% of the plant’s available capacities and production of B uses the remaining 30% of these capacities. Company’s total fixed costs are €900,000. Due to limited demand for product A, the company cannot increase the production of A or produce any other product, except B. Considering the fact that company Y has a loss from production of product B, would you recommend the company should stop producing product B? Please, give your answer by calculating the necessary information.
Developing Next Generation Leaders through Applied Know-How project number: MK01-KA

5. SOLUTION
Data: Product A: P = €500, Cost per unit = €400; Q = 10,000 Profit per unit =€100; Total profit = €1 mill. Product B: P = €150, Cost per unit = €200; Q = 4,000 Profit per unit = -€50; Total profit = - €200,000 Costs per unit for both products were calculated by considering the fact that production of product A uses 70% of the plant’s available capacities and production of B uses the remaining 30% of these capacities. FC = €900,000  FC (A) = 0.7 * €900,000 = €630,000 FC (B) = 0.3 * €900,000 = €270,000
Developing Next Generation Leaders through Applied Know-How project number: MK01-KA

6. SOLUTION
5 different ways of calculation : No 1: P(B) > VCunit(B) (in the short run!) VCunit (B) = Cost per unit (B) – FCunit (B) = €200 – (€270,000/4,000) = €200 – €67.50 = € €150 > €  Price covers € VC per unit and €17.50 FC per unit No 2: TR(B) > VC(B) TR (B) = €150 * 4,000 = €600,000 VC (B) = € * 4,000 = €530,000 €600,000 > €530,000  TR cover €530,000 VC and €70,000 FC In the short-run, the company will produce B despite the loss when revenues cover at least variable cost.
Developing Next Generation Leaders through Applied Know-How project number: MK01-KA

7. SOLUTION No 3: Profit (A+B) > Profit (A)
Profit (A+B) = €1 mill – €200,000 = €800,000
Profit (A) = €1 mill – €270,000 = €730,000
No 4: FC(B) > Loss(B)
FC (B) = €270,000
Loss (B) = €200,000
In the short-run, the company will produce B despite the loss when the loss is smaller than fixed cost.
No 5: Decrease in TR (B) > Decrease in VC (B)
Decrease in TR (B) = €150 * 4,000 = €600,000
Decrease in VC (B) = €530,000
Developing Next Generation Leaders through Applied Know-How project number: MK01-KA