11th Edition Chapter 13
Relevant Costs for Decision Making Chapter Thirteen
Learning Objectives •
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1. Iden Identi tifi fica cati tio on of rele releva vant nt cost costs. s. 2. Dro Drop or retain tain a segm segme ent. nt. 3. Make or buy decision.
Cost Concepts for Decision Making
A relevant cost is a cost that differs between alternatives.
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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 and include: Sunk
costs. is a cost that has already been incurred and cannot be avoided regardless of what a manager decides to do. Future costs that do not differ between the alternatives.
Relevant Cost Analysis: A Two-Step Process Step 1 Eliminate costs and benefits that do not differ between alternatives. Step 2 Use the remaining costs and benefits that do differ between alternatives in making the decision. The costs that remain remain are the differential, or avoidable, costs.
Different Costs for Different Purposes
Costs that are relevant in one decision situation may not be relevant in another context.
Adding/Dropping Segments
One of the most important decisions managers make is whether to add or drop a business segment such as a product or a store.
Let’s see how relevant costs should be used in this type of decision.
The Make or Buy Decision
When a company is involved in more than one activity in in the entire value chain, it is vertically integrated. integr ated. integrate integra ted. d. A decision to carry carry out one of the activities in the value chain internally, rather than to buy the value externally from a supplier is called a “make “make or or buy” buy” decision.
The Make or Buy Decision: An Example •
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Essex Company manufactures part 4A that is used in one of its products. The unit product cost of this part is: Direct materials Direct labor Variable overhead Depreciation of special equip. Supervisor's salary General factory overhead Unit product cost
$
9 5 1 3 2 10 $ 30
The Make or Buy Decision
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The special equipment used to manufacture part 4A has no resale value. The total amount of general factory overhead, which is allocated on the basis of direct labor hours, would be unaffected by this decision. The $30 unit product cost is based on 20,000 parts produced each year. An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part.
Should we accept the supplier’s offer?
The Make or Buy Decision Cost Perr Unit Pe Unit
Out side pur chase pr ice
Cost of 20, Make
$ 25
Dir ect mat er ials $ 9 Dir ect labor 5 Var iable over head 1 Depr eciat ion of equip. 3 Super visor 's salar y 2 Gener al factor y over head 10 Total cost $ 30 20,000 × $9 per unit = $180,000
180,000 100,000 20,000 40,000 $ 340,000
The Make or Buy Decision Cost Perr Unit Pe Unit
Out side pur chase pr ice
Cost of 20, Make
$ 25
Dir ect mat er ials $ 9 180,000 Dir ect labor 5 100,000 Var iable over head 1 20,000 Depr eciat ion of equip. 3 Super visor 's salar y 2 40,000 Gener al facThe tThe or yspecial over heequipment ad 10no has special equipment has no resale resale Total cost $ 30 value cost. value and and is is aa sunk sunk cost. $ 340,000
The Make or Buy Decision Cost Perr Unit Pe Unit
Out side pur chase pr ice
Cost of 20, Make
$ 25
Dir ect mat er ials $ 9 180,000 Dir ect labor 5 100,000 Var iable over head 1 20,000 Depr eciat ion of equip. 3 Super visor 's salar y 2 40,000 GenNot eNot r al avoidable; fa ctor y oveirrelevant. r head 0 aavoidable; voidable; If is a voidable; irrelevant. If the the1product product is Total cost itit will 30 products. $ 340,000 dropped, dropped, will be be reallocated reallocated to to$other other products.
The Make or Buy Decision Cost Per Pe r Unit
Ou tsi d e p u rcha se pri ce
$ 25
Di re ct m a te ri a l s Di re ct l a bo r V a ri a b l e o ve r h e a d Depreciation of equip.(Not S up e rvi sor's sa l a ry Gene ral factory factory overhe overhe ad( Not) Total cost
$
9 5 1 3 2 10 $ 30
Cost of 20,000 Units Buy Make $ 500, 000 180,000 100,000 20,000 40,000 $ 340,000
$ 500,000
Should we make or buy part 4A?
Example 2 •
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Our Company manufactures a part for its production cycle. The costs per unit for 5,000 units of this part are as follows: Direct materials $3 Direct labor 5 Variable factory overhead 4 Fixed factory overhead 4 Total costs $16 The fixed factory overhead costs are unavoidable. Spalding Corporation has offered to sell 5,000 units of the same part to our Company for $15 a unit. Assuming no other use for the facilities, Should we make or buy this part ?
Example 3 •
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Crispy Company manufactures a part for its production cycle. The costs per unit for 5,000 units of this part are as follows: Direct materials $3 Direct labor 5 Variable factory overhead 4 Fixed factory overhead 2 Total costs $14
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The fixed factory overhead costs are unavoidable. Assume that Crispy Company has been offered 5,000 units of the part from another producer for $15 each. The facilities currently used to make the part could be rented out to another manufacturer for $20,000 a year. Crispy Company should MAKE OR BUY (calculate the advantage or disadvantage per unit).
End of Chapter 13
