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BU8101 Accounting: A User Perspective
Lecture 10 Relevant Costs, Incremental Analysis Recommended Reading:
WHB 16th edition Chapter 21 Other Reference:
Financial and Managerial Accounting: Information for Decisions John J Wild, Barbara Chiapetta Chapter 23 Lecture Date: 25 March 2013
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Lecture Outline Relevant Costs Definition Relevant cost and decision-making Total vs. incremental approach
Incremental Analysis Types of Business Decisions 1. Special Order Decisions 2. Production Constraint (Product Mix) Decisions 3. Make or Buy Decisions 4. Sell, Scrap or Rebuild Decisions 5. Joint Product Decisions Non-Financial Considerations
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Relevant Costs for Decision Making A relevant cost is a cost that differs between alternatives.
A relevant cost is likely to have a bearing on the future.
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Cost Concepts for Decision Making Relevant
Irrelevant
Differential Cost (aka Relevant Cost) -- will differ according to alternative activities being considered. Likely a future cost.
Allocated Cost -- a common cost that has been arbitrarily assigned to a product or activity.
Opportunity Cost -- benefits foregone by choosing one alternative over another.
Sunk Cost -- has already been incurred and will not change.
Let’s take a closer look at Opportunity Cost & Sunk Cost
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Opportunity Cost (Benefits Forgone ) The benefit that could have been attained by pursuing an alternative course of action. Example: If you are not attending college, you could be earning $20,000 per year. Your opportunity cost of attending college for one year includes the $20,000 salary foregone.
Opportunity costs are not recorded in the accounting records, but are relevant to decisions because they are a real sacrifice.
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Sunk Cost Costs that have already been incurred. They do not affect any future cost and cannot be changed by current or future action. Sunk costs are irrelevant to 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.
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Sunk Cost OLD CAR Cost = $10,000 two years ago
Trade ?
NEW CAR Cost = $25,000 today
The dealer will trade for $20,000 plus your car. What amount is relevant to your decision, the $10,000 sunk cost of your car or the $20,000 out-of-pocket cash differential? What’s the trade-in value for the old car?
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Relevant Cost and Decision Making Decision making involves 5 steps:
Define the problem. Identify the alternatives. Collect information on alternatives. Eliminate irrelevant information. Make a decision with the remaining relevant information.
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Relevant Cost Example 1. Going to Florida for spring break. 2. Alternatives: Will you drive or fly to Florida for spring break?
3. You have gathered the following information to help you with the decision. Motel cost is $80 per night. Meal cost is $20 per day. Your car insurance is $100 per month. Kennel cost for your dog is $5 per day. Round-trip cost of gasoline for your car is $200. Round-trip airfare and rental car for a week is $500. Driving requires two days, with an overnight stay, cutting your time in Florida by two days.
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Relevant Cost Example Florida Spring Break Drive/Fly Analysis Cost Motel Eating out costs Kennel cost Car insurance Gasoline Airfare/rental car
Drive $ 640 160 40 100 200 -
8 days @ $80 Fly $ 640 160 40 100 500
8 days @ $20
8 days @ $5
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Relevant Cost Example Florida Spring Break Drive/Fly Analysis Cost Motel Eating out costs Kennel cost Car insurance Gasoline Airfare/rental car
Drive $ 640 160 40 100 200 -
Fly $ 640 160 40 100 500
4. Irrelevant information Costs do not differ, so they are irrelevant to decision Also, car insurance is irrelevant to the decision as it is a past/sunk cost.
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Relevant Cost Example Are the extra two days in Florida worth the $300 extra cost to fly?
Florida Spring Break Drive/Fly Analysis Cost Motel Eating out costs Kennel cost Car insurance Gasoline Airfare/rental car
Drive $ 640 160 40 100 200 -
Fly $ 640 160 40 100 500
5. Relevant Information Transportation costs differ between the two alternatives, so they are relevant to the decision
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Total and Incremental Cost Approach The management of a company is considering a new labor-saving machine that rents for $3,000 per year. Data about the company’s annual sales and costs with and without the new machine are:
TOTAL APPROACH Sales (5,000 units @ $40 per unit) Less variable expenses: Direct materials (5,000 units @ $14 per unit) Direct labor (5,000 units @ $8 and $5 per unit) Variable overhead (5,000 units @ $2 per unit) Total variable expenses Contribution margin Less fixed expense: Other Rent on new machine Total fixed expenses Net operating income
Current Situation $ 200,000
Situation With New Machine $ 200,000
Variance -
70,000 40,000 10,000 120,000 80,000
70,000 25,000 10,000 105,000 95,000
15,000 15,000
62,000 62,000 18,000
62,000 3,000 65,000 30,000
(3,000) (3,000) 12,000
$
$
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Total and Incremental Cost Approach INCREMENTAL APPROACH The only costs that differ between the two alternatives are the direct labor cost savings and the increase in machine rental costs. We can efficiently analyze the decision by looking at the differential costs and benefits and arrive at the same solution.
Net Advantage to Renting the New Machine Decrease in direct labor costs (5,000 units @ $3 per unit) Increase in machine rental expenses Net annual cost savings from renting the new machine
$ $
15,000 (3,000) 12,000
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(1) Special Order Decisions The decision to accept additional business should be based on incremental costs and incremental revenues. Incremental amounts are those that occur only if the company decides to accept the new business. ‘differ between alternatives’
Special consideration: Does the company have excess capacity?
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Special Order Decisions Victory Co. currently sells 100,000 units of a product. The company has revenues and costs as shown below:
Sales Direct materials Direct labor Factory overhead Selling expenses Administrative expenses Total expenses Operating income
Per Unit $ 10.00 3.50 2.20 1.10 1.40 0.80 $ 9.00 $ 1.00
$
$ $
Total 1,000,000 350,000 220,000 110,000 140,000 80,000 900,000 100,000
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Special Order Decisions Victory Co. is approached by an overseas company that offers to purchase 10,000 units at $8.50 per unit. If Victory Co. 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. Victory Co. has a production capacity of 120,000 units.
Should Victory accept the offer?
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Special Order Decisions First, let’s look at incorrect reasoning that leads to an incorrect decision.
Our cost is $9.00 per unit. I can’t sell for $8.50 per unit.
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Special Order Decisions Has excess capacity
Sales Direct materials Direct labor Factory overhead Selling expenses Admin. expenses Total expenses Operating income
Current Business $ 1,000,000 $ 350,000 220,000 110,000 140,000 80,000 $ 900,000 $ 100,000
Additional Business $ 85,000 $ 35,000 22,000 5,000 2,000 1,000 $ 65,000 $ 20,000
10,000 new units × $8.50 selling price = $85,000 10,000 new units × $3.50 = $35,000 10,000 new units × $2.20 = $22,000
Combined $ 1,085,000 $ 385,000 242,000 115,000 142,000 81,000 $ 965,000 $ 120,000
Even though the $8.50 selling price is less than the normal $10 selling price, Victory Co. should accept the offer because net income will increase by $20,000.
Sales Direct materials Direct labor Factory overhead Selling expenses Admin. expenses Total expenses Operating income
Current Business $ 1,000,000 $ 350,000 220,000 110,000 140,000 80,000 $ 900,000 $ 100,000
Additional Business $ 85,000 $ 35,000 22,000 5,000 2,000 1,000 $ 65,000 $ 20,000
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Combined $ 1,085,000 $ 385,000 242,000 115,000 142,000 81,000 $ 965,000 $ 120,000
DECISION RULE
Accept the special order when there’s incremental benefits for the company.
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Special Order Decisions We can also look at this decision using the contribution margin method
Special order revenue Direct materials Direct labor Contribution margin Increase in fixed costs: Factory overhead Selling expenses Administrative expenses Special order profit
Per Unit $ 8.50 3.50 2.20 $ 2.80
10,000 units
$
28,000
$
5,000 2,000 1,000 20,000
$
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Special Order Decisions Victory Co. has a production capacity of 100,000 units. Should Victory accept the offer? Per Unit
No excess capacity Special order revenue Direct materials Direct labor Contribution margin
$
$
8.50 3.50 2.20 2.80
Increase in fixed costs: Factory overhead Selling expenses Administrative expenses Loss of CM on regular sales 10,000 units x CM $4.30 ($10 - $3.50 - $2.20) Special order loss
Total 10,000 units
$
28,000
$
5,000 2,000 1,000 8,000 43,000
$
(23,000)
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(2) Production Constraint Decisions Managers often face the problem of deciding how scarce resources are going to be utilized. Usually, fixed costs are not affected by this particular decision, so management can focus on maximizing total contribution margin. Let’s look at the Kaiser Company example. How to maximize contribution margin when one factor limits production capacity?
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Production Constraint Decisions Kaiser Company produces two products and selected data is shown below: Products B
A Selling price per unit Less: variable expenses per unit Contribution margin per unit Current demand per week (units) Contribution margin ratio Processing time (per unit) required on Machine X
$
60 36 $ 24 2,000 40% 1.00 min.
$
50 35 $ 15 2,200 30% 0.50 min.
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Production Constraint Decisions Machine X is the scarce resource because there is excess capacity on other machines. Machine X is being used at 100% of its capacity. Machine X capacity is 2,400 minutes per week. Should Kaiser focus its efforts on Product A or B?
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Let’s calculate the contribution margin per unit of the scarce resource, machine X. Products B
A Contribution margin per unit Time required to produce one unit Contribution margin per minute
$
24 ÷ 1.00 min. $ 24
$
15 ÷ 0.50 min. $ 30
Product B should be emphasized. It makes more valuable use of the scarce resource (Machine X), yielding a higher contribution margin of $30 per minute as opposed to $24 for Product A. If there are no other considerations, the best plan would be to produce to meet current demand for Product B and then use any capacity that remains to make Product A.
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Production Constraint Decisions Let’s see how this plan would work. Allotting Scarce Resource (Machine X) Weekly demand for Product B Time required per unit Total time required to make Product B Total machine time available Time used to make Product B Time available for Product A Time required per unit Production of Product A
×
2,200 units 0.50 min. 1,100 min.
÷
2,400 1,100 1,300 1.00 1,300
min. min. min. min. units
Current demand for A is 2,000 units
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Production Constraint Decisions According to the plan, we will produce 2,200 units of Product B and 1,300 units of Product A. Production and sales (units) Contribution margin per unit Total contribution margin
Product A 1,300 $ 24 $ 31,200
Product B 2,200 $ 15 $ 33,000
The total contribution margin for Kaiser is $64,200. Any other combination would result in a lesser CM. DECISION RULE Priority is given to the product with the highest contribution margin per unit of scarce resource
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(3) Make or Buy Decisions
I suppose I should compare the outside purchase price with the additional costs to manufacture the part.
Should I continue to make the part, or should I buy it?
What will I do with my idle facilities if I buy the part?
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Make or Buy Decisions Outsourcing - Definition
Outsourcing
The decision to buy or subcontract a component product or service rather than produce it in-house.
May lead to reduced control over delivery time or product quality.
Outsourcing is a regular feature of companies with limited resources.
Why Outsource?
Cost savings.
Focus on core business.
Knowledge: access to intellectual property, wider experience.
Access to talent.
Factors to Consider:
Reliability of supplier – delivery, quality, price etc.
Flexibility to adapt to changing conditions.
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Make or Buy Decisions Incremental costs are also important in the decision to make a product or buy it from a supplier. The cost to produce an item must include (1) direct materials (usually avoidable VC) (2) direct labor (avoidable VC) (3) incremental overhead (unavoidable v. avoidable F.C.)
We should NOT use the predetermined overhead rate to determine product cost.
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Make or Buy Decisions Excel makes computer chips used in one of its products. Unit costs, based on production of 20,000 chips per year, are:
Unit Costs Direct Materials Direct Labor Variable Overhead Fixed Overhead Total
$
9.00 5.00 1.00 13.00 $ 28.00
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Make or Buy Decisions An outside supplier has offered to provide the 20,000 chips at a cost of $25 per chip. Fixed overhead costs will not be avoided if the chips are purchased. Irrelevant cost: same under both alternatives
Excel has no alternative use for the facilities.
Should Excel accept the offer?
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Make or Buy Decisions Make Direct Material Direct Labor Variable Overhead Purchase costs
$
9.00 5.00 1.00 -
Total
$
15.00
Buy $
- 0 25.00
$ 25.00
Incremental costs = $10
Excel should not pay $25 per unit to an outside supplier to avoid the $15 per unit differential cost of making the part. Unavoidable fixed costs are irrelevant. DECISION RULE Outsource if there is incremental benefits
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Avoidable Fixed Cost
Fixed Overhead $13, out of which $3 is avoidable. Make
Buy
Direct Material Direct Labor Variable Overhead Purchase costs Avoidable Fixed Overhead
$
9.00 5.00 1.00 -
$
- 0 25.00 (3.00)
Total
$
15.00
$
22.00
Incremental costs = $7
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Avoidable Fixed Cost
Fixed Overhead $13, out of which $3 is avoidable. Make
Buy
Direct Material Direct Labor Variable Overhead Purchase costs Avoidable Fixed Overhead
$
9.00 5.00 1.00 3.00
$
- 0 25.00 -
Total
$
18.00
$
25.00
Incremental costs = $7
QUESTION What is the maximum price that the company can pay the external supplier for the outsourced part?
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(4) Sell, Scrap, or Rebuild Decisions Costs incurred in manufacturing units of product that do not meet quality standards are sunk costs and cannot be recovered.
As long as rebuild costs are recovered through sale of the product, and rebuilding does not interfere with normal production, we should rebuild.
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Sell, Scrap, or Rebuild Decisions Servo has 10,000 defective units that cost $1.00 each to make. The units can be scrapped now for $.40 each or rebuilt at an additional cost of $.80 per unit. If rebuilt, the units can be sold for the normal selling price of $1.50 each. Rebuilding the 10,000 defective units will prevent the production of 10,000 new units that would also sell for $1.50.
Should Servo scrap or rebuild?
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Sell, Scrap, or Rebuild Decisions
Scrap Now $ 4,000 $ 4,000
Sale of defects Less rebuild costs Less opportunity cost Net return
Rebuild $ 15,000
10,000 units × $0.40 per unit 10,000 units × $1.50 per unit
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Sell, Scrap, or Rebuild Decisions 10,000 units × $0.80 per unit
Sale of defects Less rebuild costs Less opportunity cost Net return
Scrap Now $ 4,000 $ 4,000
Rebuild $ 15,000 (8,000) (5,000) 2,000
Benefits foregone: CM for 10,000 new products 10,000 units × (Selling Price $1.50 – Cost $1.00) Servo should scrap the units now. DECISION RULE Choose the option with the highest incremental benefits
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(5) Joint Product Decisions Two or more products produced from a common input are called joint products
Product 1
Joint Costs
Product 2
Joint costs are the costs of processing prior to the split-off point
Product 3 The split-off point is the point in a process where joint products can be recognized as separate products
For example, in the petroleum refining industry, a large number of products are extracted from crude oil, including gasoline, jet fuel, home heating oil, lubricants, asphalt, and various organic chemicals.
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Joint costs are incurred up to the split-off point
Joint Input
Oil
Further Processing
Common Production Process
Gasoline
Chemicals
Split-Off Point
Final Sale
Final Sale Further Processing
Final Sale
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Joint Product Decisions Businesses are often faced with the decision to sell partially completed products at the split-off point or to process them to completion.
DECISION RULE Process further if incremental revenues > incremental costs
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Joint Product Decisions Ames Co. produces two products, A and B, from this process. Should the products be sold at split-off or process further? Joint Cost $100,000
Common Production Process
A Revenue $70,000
Revenue $50,000
Split-Off Point
B
Additional Processing Cost $40,000
Final Sale $120,000
Additional Processing Cost $20,000
Final Sale $65,000
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Joint Product Decisions Product A B
Incremental Revenue $
Incremental Cost
Difference
50,000
$ 40,000
$ 10,000
15,000
20,000
(5,000)
Product A incremental revenue = $120,000 - $70,000 = $50,000 Incremental revenue $50,000 > Incremental cost $40,000 Product B incremental revenue = $65,000 - $50,000 = $15,000 Incremental revenue $15,000 < Incremental cost $20,000
Process product A, but sell product B at the split-off point. Joint costs are not relevant in decisions regarding what to do with a product after the split-off point. Joint costs are really common costs incurred to simultaneously produce a variety of end products.
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Non-financial Considerations Reputation
Legal issues
Environmental impacts Ethical implications
It would be irresponsible for me to base my decision entirely on revenue and cost figures.
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Non-Financial Considerations
Impact on regular customers Undercutting by specialorder customers
(1) Special order decisions
High CM but low demand
Complementary Products
(2) Production constraint decisions
Product quality / availability
Supplier relationship
(3) Make or buy decisions
Cannibalize other products
(4) Sell, Scrap or Rebuild decisions
Market Demand
(5) Joint product decisions
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Review Questions 1. Which of the following is true? a. Fixed costs are always irrelevant. b. Variable costs are always relevant. c. Joint costs are always irrelevant. d. All of the above. 2. In the sell-or-process further decision, a. Joint costs are always relevant. b. Total costs of joint processing and further processing are relevant. c. All costs incurred prior to the split-off point are relevant. d. The most profitable outcome can be to further process some separately identifiable products beyond the split-off point, but sell others at the split-off point.
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Check List Do you have a good understanding of:
Types of relevant cost
Five types of decisions and the decision rules
Non-financial factors to consider when making decisions
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