Relevant Costs for

Decision Making
MANAGEMENT ACCOUNTING 1
Learning Objective 1
Identify relevant and
irrelevant costs and
benefits in a decision.

MANAGEMENT ACCOUNTING 1 2
Cost Concepts for Decision
Making
A relevant cost is a cost that
differs between alternatives.

MANAGEMENT ACCOUNTING 1 3
Identifying Relevant Costs
An avoidable cost is a cost that 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. They include:

Sunk
Sunk costs.
costs.

Future
Future costs
costs that
that do not differ between the
alternatives.

MANAGEMENT ACCOUNTING 1 4
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
differ between alternatives in making the
decision. The costs that remain are the
differential, or avoidable, costs.

MANAGEMENT ACCOUNTING 1 5
Different Costs for Different Purposes
Costs that are
relevant in one
decision situation
may not be relevant
in another context.
Thus, in each
decision situation,
the manager must
examine the data at
hand and isolate the
relevant costs.
MANAGEMENT ACCOUNTING 1 6
Identifying Relevant Costs
Cynthia, a Boston student, is considering visiting her friend in New York.
She
She can
can drive or
or take
take the
the train.
train. By
By car,
car, itit is
is 230
230 miles
miles to
to her
her friend’s
friend’s
apartment. She is trying to decide which alternative is less expensive
and has gathered the following information:
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

$45
$45 per
per month
month ×× 88 months
months $2.70
$2.70 per
per gallon
gallon ÷÷ 27
27 MPG
MPG

$24,000
$24,000 cost
cost –– $10,000
$10,000 salvage
salvage value
value ÷÷ 55 years
years
MANAGEMENT ACCOUNTING 1 7
Identifying Relevant Costs
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

Some Additional Information

7 Reduction in resale value of car per mile of wear $ 0.026
8 Round-tip train fare $ 104
9 Benefits of relaxing on train trip ????
10 Cost of putting dog in kennel while gone $ 40
11 Benefit of having car in New York ????
12 Hassle of parking car in New York ????
13 Per day cost of parking car in New York $ 25

MANAGEMENT ACCOUNTING 1 8
Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?

The cost of the The annual cost of

car is a sunk cost insurance is not
and is not relevant. It will remain
relevant to the the same if she drives
current decision. or takes the train.

However, the cost of gasoline is clearly

relevant if she decides to drive. If she takes the
train, the cost would not be incurred, so it
varies depending on the decision.
MANAGEMENT ACCOUNTING 1 9
Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?

The cost of The monthly school

maintenance and parking fee is not
repairs is relevant. In relevant because it
the long-run these must be paid if Cynthia
costs depend upon drives or takes the
miles driven. train.

At this point, we can see that some of the average cost

of $0.619 per mile are relevant and others are not.

MANAGEMENT ACCOUNTING 1 10
Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?

The decline in resale The round-trip train

value due to additional fare is clearly relevant.
miles is a relevant If she drives the cost
cost. can be avoided.

Relaxing on the train is The kennel cost is not

relevant even though it relevant because
is difficult to assign a Cynthia will incur the
dollar value to the cost if she drives or
benefit. takes the train.

MANAGEMENT ACCOUNTING 1 11
Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?

The cost of parking

parking inin
New York is relevant
relevant
because
because it it can
can be
be
avoided
avoided if
if she
she takes
takes
the train.

The benefits of having a car in New York and

the problems of finding a parking space are
both relevant but are difficult to assign a
dollar amount.

MANAGEMENT ACCOUNTING 1 12
Identifying Relevant Costs
From a financial standpoint, Cynthia would be better
off taking the train to visit her friend. Some of the
non-financial factor may influence her final decision.
Relevant Financial Cost of Driving
Gasoline (460 @ $0.100 per mile) $ 46.00
Maintenance (460 @ $0.065 per mile) 29.90
Reduction in resale (460 @ $0.026 per mile) 11.96
Parking in New York (2 days @ $25 per day) 50.00
Total $ 137.86

Relevant Financial Cost of Taking the Train

Round-trip ticket $ 104.00

MANAGEMENT ACCOUNTING 1 13
 Total and Differential Cost
Approaches
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:
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000

MANAGEMENT ACCOUNTING 1 14
 Total and Differential Cost
Approaches
As you can see, the only costs that differ between the
alternatives are the direct labor costs savings and the
increase in fixed rental costs.
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
We
Direct materials canunits
(5,000 efficiently analyze the
@ $14 per unit) decision 70,000
70,000 by -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
looking at the different
Variable overhead (5,000 units @ $2 per unit)
costs and
10,000
revenues
10,000 -
Total variable expenses and arrive at the same 120,000 .
solution 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:Net Advantage to Renting the New Machine
Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Other 62,000 62,000 -
Increase in fixed rental expenses (3,000)
Rent on newNet machine
annual cost saving from renting the new machine
- $
3,000
12,000
(3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000

MANAGEMENT ACCOUNTING 1 15
Total and Differential Cost
Approaches
Using the differential approach is desirable for
two reasons:
1. Only rarely will enough information be
available to prepare detailed income
statements for both alternatives.
2. Mingling irrelevant costs with relevant costs
may cause confusion and distract attention
away from the information that is really
critical.

MANAGEMENT ACCOUNTING 1 16
Learning Objective 2
Prepare an analysis
showing whether a product
line or other business
segment should be
dropped or retained.

MANAGEMENT ACCOUNTING 1 17
Adding/Dropping Segments
One of the most
important decisions
managers make is
whether to add or
drop a business
segment. Ultimately,
a decision to drop an
old segment or add a
new one is going to
hinge primarily on the
To assess this impact,
impact the decision
will have on net
it is necessary to
operating income. carefully analyze the
costs.
MANAGEMENT ACCOUNTING 1 18
Adding/Dropping Segments
Due to the declining popularity of
digital watches, Lovell Company’s
digital watch line has not
reported a profit for several
years. Lovell is considering
discontinuing this product line.

MANAGEMENT ACCOUNTING 1 19
A Contribution Margin Approach
DECISION RULE
Lovell should drop the digital watch
segment only if its profit would
increase.
Lovell will compare the contribution
margin that would be lost to the
costs that would be avoided if the
line was to be dropped.
Let’s look at this solution.

MANAGEMENT ACCOUNTING 1 20
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
MANAGEMENT ACCOUNTING 1 21
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
An
Less: investigation
Anvariable expenses
investigation has
has revealed
revealed that
that the
the fixed
fixed
Variable
general manufacturing costs $ 120,000 general
general factory
factory overhead
overhead andand fixed
fixed general
Variable shipping costs 5,000
administrative
administrative expenses will
expenses will notnot be
be affected
affected by
by
Commissions 75,000 200,000
dropping
dropping
Contribution the
the digital
margin digital watch
watch line.
line. The
The fixed
fixed
$ 300,000
general
general
Less: fixed factory
factory overhead
expenses overhead and and general
general
administrative
administrative
General expenses
expenses assigned
factory overhead 60,000 to
assigned
$ to this
this
product
Salary
product would
of line be
be reallocated
manager
would reallocated to other
other product
90,000
to product
Depreciation of equipment lines.
lines. 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
MANAGEMENT ACCOUNTING 1 22
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
The
The equipment
equipment
Variable used to
to manufacture
usedcosts
manufacturing manufacture
$ 120,000
digital
Variable watches
shipping
digital has
costs
watches has no
no resale
resale5,000
Commissions 75,000 200,000
value or
Contribution margin
alternative use.
value or alternative use. $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Should
Should Lovell
Depreciation of equipment Lovell retain
retain or
50,000 or drop
drop
Advertising - direct the digital watch
100,000segment?
the digital watch segment?
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
MANAGEMENT ACCOUNTING 1 23
A Contribution Margin Approach
Contribution Margin
Solution
Contribution margin lost if digital
  watches are dropped $ (300,000)
Less fixed costs that can be avoided
Salary of the line manager $ 90,000
Advertising - direct 100,000
Rent - factory space 70,000 260,000
Net disadvantage $ (40,000)
RRe
ettaai
inn

MANAGEMENT ACCOUNTING 1 24
Comparative Income Approach
The Lovell solution can also be
obtained by preparing comparative
income statements showing results
with and without the digital watch
segment.

Let’s look at this second approach.

MANAGEMENT ACCOUNTING 1 25
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000
Salary of line manager 90,000
Depreciation 50,000 If
If the
the digital
digital
Advertising - direct 100,000
Rent - factory space 70,000
watch
watch line
line isis
General admin. expenses 30,000 dropped,
dropped, the the
Total fixed expenses 400,000 company
company loses
loses
Net operating loss $ (100,000)
$300,000
$300,000 in
in
contribution
contribution
MANAGEMENT ACCOUNTING 1 26
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000
Depreciation 50,000
Advertising - direct
On
On the
100,000the other
other hand,
hand, the the
Rent - factory space general
general
70,000 factory
factory overhead
overhead
General admin. expenses would
would be
be the
30,000 the same
same underunder both
both
Total fixed expenses alternatives,
alternatives,
400,000 so
so it
it isis irrelevant.
irrelevant.
Net operating loss $ (100,000)

MANAGEMENT ACCOUNTING 1 27
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
The salary
Manufacturing expensesThe salary
of the product
of the product
120,000 - 120,000
Shipping line
line manager
manager
5,000 would
would - 5,000
Commissions disappear,
disappear,75,000 so it is-
so it is 75,000
Total variable expenses 200,000 - 200,000
Contribution margin relevant to
to the
relevant 300,000 the decision.
decision.- (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)

MANAGEMENT ACCOUNTING 1 28
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
The depreciation
depreciation is
Theexpenses:
Less variable is aa sunk
sunk cost.
cost.- Also,
Also,
Manufacturing expenses 120,000 - 120,000
remember
remember that
that the
the equipment
equipment has
has no
no resale
resale
Shipping 5,000 - 5,000
value
value or
Commissions or alternative
alternative use, use, so
so the
75,000 the equipment
equipment
- 75,000
and
and
Total the
variable depreciation
depreciation expense
theexpenses expense
200,000 associated
associated
- with
with
200,000
Contribution margin 300,000 - (300,000)
it
it are
are
Less fixed expenses:
irrelevant
irrelevant to
to the
the decision.
decision.
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)

MANAGEMENT ACCOUNTING 1 29
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping The
The complete 5,000 comparative
complete comparative
- 5,000
Commissions income
income statements
statements
75,000 reveal
reveal- that
that 75,000
Total variable expenses Lovell
Lovell would
would
200,000earn
earn $40,000
$40,000
- of
of 200,000
Contribution margin additional profit
profit by
additional 300,000 by retaining
-
retaining the
the(300,000)
Less fixed expenses: digital
digital watch
watch line.
line.
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000 - 100,000
Rent - factory space 70,000 - 70,000
General admin. expenses 30,000 30,000 -
Total fixed expenses 400,000 140,000 260,000
Net operating loss $ (100,000) $ (140,000) $ (40,000)

MANAGEMENT ACCOUNTING 1 30
Beware of Allocated Fixed Costs
Why should we keep the
digital watch segment
when it’s showing a
$100,000 loss?

MANAGEMENT ACCOUNTING 1 31
Beware of Allocated Fixed
Costs

The answer lies in the

way we allocate
common fixed costs
to our products.

MANAGEMENT ACCOUNTING 1 32
Beware of Allocated Fixed
Costs
Including unavoidable Our allocations can
common fixed costs make a segment
makes the product look less profitable
line appear to be than it really is.
unprofitable.

MANAGEMENT ACCOUNTING 1 33
Learning Objective 3

Prepare a make or buy

analysis.

MANAGEMENT ACCOUNTING 1 34
The Make or Buy Decision
When a company is involved in more than
one activity in the entire value chain, it is
vertically integrated. A decision to carry
out one of the activities in the value chain
internally, rather than to buy externally
from a supplier is called a “make or buy”
decision.

MANAGEMENT ACCOUNTING 1 35
Vertical Integration-
Advantages
Smoother flow of
parts and materials

Better quality
control

Realize profits

MANAGEMENT ACCOUNTING 1 36
Vertical Integration-
Disadvantage
Companies may fail to
take advantage of
suppliers who can
create economies of
scale advantage by
pooling demand from
numerous companies.

While the economics of scale factor can be

appealing, a company must be careful to retain
control over activities that are essential to
maintaining its competitive position.
MANAGEMENT ACCOUNTING 1 37
The Make or Buy Decision:
An Example
Essex Company manufactures part 4A that is used
in one of its products.
The unit product cost of this part is:

Direct materials $ 9
Direct labor 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary 2
General factory overhead 10
Unit product cost $ 30

MANAGEMENT ACCOUNTING 1 38
The Make or Buy Decision
The
The special
special equipment
equipment used to manufacture part 4A has no
resale value.
The
The total
total amount
amount of general factory overhead, which is
allocated on the basis of direct labor hours,
hours, would
would be
be
unaffected by
by this decision.
The
The $30
$30 unit
unit product
product cost is based on 20,000 parts produced
produced
each year.
An outside supplier has
has offered
offered to provide
provide the
the 20,000
20,000 parts
parts at
at
a cost of $25 per part.

Should we accept the supplier’s offer?

MANAGEMENT ACCOUNTING 1 39
The Make or Buy Decision
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The avoidable costs

The costs associated
associated with making
making part
part 4A
4A include
include
direct
direct materials,
materials, direct
direct labor,
labor, variable overhead,
overhead, and
and the
the
supervisor’s
supervisor’s salary.
salary.
MANAGEMENT ACCOUNTING 1 40
The Make or Buy Decision
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The
The depreciation
depreciation of of the
the special
special equipment
equipment
represents
represents aa sunk
sunk cost.
cost. The The equipment
equipment has
has no
no
resale
resale value,
value, thus
thus its its cost
cost and and associated
associated
depreciation
depreciation are
are irrelevant
irrelevant to to the
the decision.
decision.
MANAGEMENT ACCOUNTING 1 41
The Make or Buy Decision
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

Not
Not avoidable;
avoidable; irrelevant.
irrelevant. IfIf the
the product
product is
is
dropped,
dropped, itit will
will be
be reallocated
reallocated toto other
other products.
products.

MANAGEMENT ACCOUNTING 1 42
The Make or Buy Decision
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

Should we make or buy part 4A? Given that the total

avoidable costs are less than the cost of buying the part,
Essex should continue to make the part.
MANAGEMENT ACCOUNTING 1 43
Opportunity Cost
An opportunity cost is the benefit that is
foregone as a result of pursuing some
course of action.
Opportunity costs are not actual cash
outlays and are not recorded in the
formal accounts of an organization.

How would this concept potentially

relate to the Essex Company?

MANAGEMENT ACCOUNTING 1 44
Learning Objective 4

Prepare an analysis
showing whether a special
order should be accepted.

MANAGEMENT ACCOUNTING 1 45
Key Terms and Concepts
A special order is a one-time
order that is not considered
part of the company’s normal
ongoing business.

When analyzing a special

order, only the incremental
costs and benefits are
relevant.
Since the existing fixed
manufacturing overhead costs
would not be affected by the
order, they are not relevant.
MANAGEMENT ACCOUNTING 1 46
Special Orders
Jet, Inc. makes a single product whose normal
selling price is $20 per unit.
A foreign distributor offers to purchase 3,000
units for $10 per unit.
This is a one-time order that would not affect
the company’s regular business.
Annual capacity is 10,000 units, but Jet, Inc. is
currently producing and selling only 5,000
units.

Should Jet accept the offer?

MANAGEMENT ACCOUNTING 1 47
Special Orders
Jet, Inc.
Contribution Income Statement
Revenue (5,000 × $20) $ 100,000
Variable costs:
Direct materials $ 20,000
Direct labor 5,000
Manufacturing overhead 10,000 $8 variable cost
Marketing costs 5,000
Total variable costs 40,000
Contribution margin 60,000
Fixed costs:
Manufacturing overhead $ 28,000
Marketing costs 20,000
Total fixed costs 48,000
Net operating income $ 12,000
MANAGEMENT ACCOUNTING 1 48
Special Orders
If Jet accepts the special order, the incremental revenue will
exceed the incremental costs. In other words, net operating
income will increase by $6,000. This suggests that Jet should
accept the order.

Increase in revenue (3,000 × $10) $ 30,000

Increase in costs (3,000 × $8 variable cost) 24,000
Increase in net income $ 6,000

Note: This answer assumes that the fixed costs are

unavoidable and that variable marketing costs must be
incurred on the special order.

MANAGEMENT ACCOUNTING 1 49
Quick Check 
Northern Optical ordinarily sells the X-
lens for $50. The variable production cost is
$10, the fixed production cost is $18 per
unit, and the variable selling cost is $1. A
customer has requested a special order for
10,000 units of the X-lens to be imprinted
with the customer’s logo. This special order
would not involve any selling costs, but
Northern Optical would have to purchase an
imprinting machine for $50,000.
(see the next page)

MANAGEMENT ACCOUNTING 1 50
Quick Check 
What is the rock bottom minimum price
below which Northern Optical should not go
in its negotiations with the customer? In
other words, below what price would
Northern Optical actually be losing money
on the sale? There is ample idle capacity to
fulfill the order and the imprinting machine
has no further use after this order.
a. $50
b. $10
c. $15
d. $29

MANAGEMENT ACCOUNTING 1 51
Quick Check 
What is the rock bottom minimum price
below which Northern Optical should not go
in its negotiations with the customer? In
other words, below what price would
Northern Optical actually be losing money
on the sale? There is ample idle capacity to
fulfill the order and the imprinting machine
has no further use
Variable after this cost
production order. $100,000
a. $50 Additional fixed cost + 50,000
b. $10 Total relevant cost $150,000
c. $15 Number of units 10,000
d. $29 Average cost per unit = $15
MANAGEMENT ACCOUNTING 1 52
Learning Objective 5
Determine the most
profitable use of a
constrained resource and
the value of obtaining
more of the constrained
resource.

MANAGEMENT ACCOUNTING 1 53
Key Terms and Concepts
When a limited resource of
some type restricts the
company’s ability to satisfy
demand, the company is
said to have a constraint.

The machine or
process that is
limiting overall output
is called the
bottleneck – it is the
constraint.

MANAGEMENT ACCOUNTING 1 54
Utilization of a Constrained Resource
Fixed costs are usually unaffected in these
situations, so the product mix that maximizes
the company’s total contribution margin
should ordinarily be selected.
A company should not necessarily promote
those products that have the highest unit
contribution margins.
Rather, total contribution margin will be
maximized by promoting those products or
accepting those orders that provide the
highest contribution margin in relation to the
constraining resource.

MANAGEMENT ACCOUNTING 1 55
Utilization of a Constrained
Resource: An Example
Ensign Company produces two products and selected
data are shown below:
Product
1 2
Selling price per unit $ 60 $ 50
Less variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.

MANAGEMENT ACCOUNTING 1 56
Utilization of a Constrained
Resource: An Example
Machine A1 is the constrained resource
and is being used at 100% of its capacity.
There is excess capacity on all other
machines.
Machine A1 has a capacity of 2,400
minutes per week.

Should Ensign focus its efforts on

Product 1 or Product 2?

MANAGEMENT ACCOUNTING 1 57
Quick Check 

How many units of each product can

can be
be processed
processed through
through
Machine A1 in one minute?

Product
Product 11 Product 2
a.
a. 11 unit
unit 0.5
0.5 unit
unit
b.
b. 11 unit
unit 2.0
2.0 units
units
c.
c. 22 units
units 1.0
1.0 unit
unit
d.
d. 22 units
units 0.5
0.5 unit
unit

MANAGEMENT ACCOUNTING 1 58
Quick Check 
How many units of each product can be
processed through Machine A1 in one
minute?

Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2.0 units
c. 2 units 1.0 unit
d. 2 units 0.5 unit
Just checking to make sure you are with us.

MANAGEMENT ACCOUNTING 1 59
Quick Check 
What generates more profit for the
company, using one minute of machine A1
to process Product 1 or using one minute of
machine A1 to process Product 2?
a. Product 1
b. Product 2
c. They both would generate the same
profit.
d. Cannot be determined.

MANAGEMENT ACCOUNTING 1 60
Quick Check 
With one minute of machine A1, we could make 1
What
unit ofgenerates
Product 1,more
with aprofit for the company,
contribution margin of
using one
$24, orminute
2 units of
of machine
Product 2,A1 to process
each with a
Product 1contribution
or using one minute
margin of machine A1
of $15.
to process Product 2?
a. Product 1 2 × $15 = $30 > $24
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.

MANAGEMENT ACCOUNTING 1 61
Utilization of a Constrained Resource

The key is the contribution margin per unit of the constrained

resource.
P roduct
1 2
Contri buti on m a rgi n pe r uni t $ 24 $ 15
Ti m e re quire d to produce one unit ÷ 1. 00 m i n. ÷ 0. 50 m i n.
Contri buti on m a rgi n pe r m i nute $ 24 $ 30

Ensign
Ensign should
should emphasize
emphasize Product 2 because it
generates a contribution margin of $30 per minute
of
of the
the constrained
constrained resource
resource relative
relative to
to $24
$24 per
per
minute
minute for
for Product
Product 1.
1.

MANAGEMENT ACCOUNTING 1 62
Utilization of a Constrained Resource

The key is the contribution margin per unit of the constrained

resource. P roduct
1 2
Contri buti on m a rgi n pe r uni t $ 24 $ 15
Ti m e re quire d to produce one unit ÷ 1. 00 m i n. ÷ 0. 50 m i n.
Contri buti on m a rgi n pe r m i nute $ 24 $ 30

Ensign
Ensign can
can maximize
maximize its
its contribution
contribution margin
margin
by
by first
first producing
producing Product
Product 2 2 to
to meet
meet customer
customer
demand
demand and
and then
then using
using any
any remaining
remaining
capacity
capacity to
to produce
produce Product
Product 1.
1. The
The
calculations
calculations would
would bebe performed
performed asas follows.
follows.

MANAGEMENT ACCOUNTING 1 63
Utilization of a Constrained Resource

Let’s see how this plan would work.

Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

MANAGEMENT ACCOUNTING 1 64
Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.

MANAGEMENT ACCOUNTING 1 65
Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.
Time required per unit ÷ 1.00 min.
Production of Product 1 1,300 units

MANAGEMENT ACCOUNTING 1 66
Utilization of a Constrained Resource
According to the plan, we will produce
2,200 units of Product 2 and 1,300 of
Product 1. Our contribution margin
looks like this.
Product 1 Product 2
Production and sales (units) 1,300 2,200
Contribution margin per unit $ 24 $ 15
Total contribution margin $ 31,200 $ 33,000

The total contribution margin for Ensign is $64,200.

MANAGEMENT ACCOUNTING 1 67
Quick Check 
Colonial Heritage makes reproduction
colonial furniture from select hardwoods.
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will

only be able to supply 2,000 board feet this
month. Is this enough hardwood to satisfy
demand?
a. Yes
b. No

MANAGEMENT ACCOUNTING 1 68
Quick Check 
Colonial Heritage makes reproduction
colonial furniture from select
hardwoods. Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will

only be able to supply 2,000 board feet
this month. Is this enough hardwood to
(2  600) + (10  100 ) = 2,200 > 2,000
satisfy demand?
a. Yes
MANAGEMENT ACCOUNTING 1 69
Quick Check 
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood

will only be able to supply 2,000
board feet this month. What plan
would maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
MANAGEMENT ACCOUNTING 1 70
Quick Check  Selling price
Chairs Tables
$ 80 $ 400
Variable cost 30 200
Chairs Tables
Contribution margin $ 50 $ 200
Selling price per unit $80 $400
Variable cost Board feet $30
per unit $200 2 10
Board feet perCM per board foot
unit 2 $10 25 $ 20
Monthly demand 600 100
Production of chairs 600
The company’s Board
supplier of hardwood
feet required 1,200 will
only be able to Board
supplyfeet 2,000
remainingboard
800feet
this month. What plan
Board would
feet per table maximize
10
profits? Production of tables 80
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
MANAGEMENT ACCOUNTING 1 71
Quick Check 
As before, Colonial Heritage’s supplier of
hardwood will only be able to supply 2,000
board feet this month. Assume the company
follows the plan we have proposed. Up to
how much should Colonial Heritage be willing
to pay above the usual price to obtain more
hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero

MANAGEMENT ACCOUNTING 1 72
Quick Check 
As before, Colonial Heritage’s supplier
of
Thehardwood
additionalwill only
wood be able
would to supply
be used to make
2,000 board
tables. In feet this each
this use, month. Assume
board foot ofthe
company follows the plan we have
additional wood will allow the company to earn
proposed. Up to how much should
an additional
Colonial $20 ofbe
Heritage contribution
willing to margin and
pay above
profit. more hardwood?
the usual price to obtain
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero

MANAGEMENT ACCOUNTING 1 73
Managing Constraints
It is often possible for a manager to increase the capacity of a
bottleneck, which is called relaxing (or elevating) the constraint,
in numerous ways such as:
1. Working overtime on the bottleneck.
2. Subcontracting some of the processing that would be done
at the bottleneck.
3. Investing in additional machines at the bottleneck.
4. Shifting workers from non-bottleneck processes to the
bottleneck.
5. Focusing business process improvement efforts on the
bottleneck.
6. Reducing defective units processed through the bottleneck.

These methods and ideas are all consistent with the Theory
of Constraints, which was introduced in Chapter 1.
MANAGEMENT ACCOUNTING 1 74
Learning Objective 6
Prepare an analysis
showing whether joint
products should be sold at
the split-off point or
processed further.

MANAGEMENT ACCOUNTING 1 75
Joint Costs
In some industries, a number of end
products are produced from a single
raw material input.
Two or more products produced from
a common input are called joint
products.
The point in the manufacturing
process where each joint product can
be recognized as a separate product
is called the split-off point.
MANAGEMENT ACCOUNTING 1 76
Joint Products For example,
in the petroleum
Oil
refining industry,
a large number
Common of products are
Joint
Input
Production Gasoline extracted from
Process crude oil,
including
gasoline, jet fuel,
Chemicals
home heating oil,
lubricants,
asphalt, and
Split-Off
various organic
Point chemicals.
MANAGEMENT ACCOUNTING 1 77
Joint Products
Joint costs
are incurred
up to the Oil
Separate Final
split-off point Processing Sale

Common
Joint Final
Production Gasoline
Input Sale
Process

Separate Final
Chemicals
Processing
Sale

Split-Off Separate
Point Product
Costs
MANAGEMENT ACCOUNTING 1 78
The Pitfalls of Allocation
Joint costs are traditionally
allocated among different
products at the split-off point.
A typical approach is to allocate
joint costs according to the
relative sales value of the end
products.
Although allocation is needed for
some purposes such as balance
sheet inventory valuation,
allocations of this kind are very
dangerous for decision making.
MANAGEMENT ACCOUNTING 1 79
Sell or Process Further
Joint costs are irrelevant in decisions regarding
what to do with a product from the split-off
point forward. Therefore, these costs should
not be allocated to end products for decision-
making purposes.
With respect to sell or process further
decisions, it is profitable to continue processing
a joint product after the split-off point so long
as the incremental revenue from such
processing exceeds the incremental processing
costs incurred after the split-off point.

MANAGEMENT ACCOUNTING 1 80
Sell or Process Further: An Example
Sawmill, Inc. cuts logs from which
unfinished lumber and sawdust are the
immediate joint products.
Unfinished lumber is sold “as is” or
processed further into finished lumber.
Sawdust can also be sold “as is” to
gardening wholesalers or processed
further into “presto-logs.”

MANAGEMENT ACCOUNTING 1 81
Sell or Process Further
Data about Sawmill’s joint products includes:

Per Log
Lumber Sawdust
Sales value at the split-off point $ 140 $ 40

Sales value after further processing 270 50

Allocated joint product costs 176 24
Cost of further processing 50 20

MANAGEMENT ACCOUNTING 1 82
Sell or Process Further
Analysis of Sell or Process Further
Per Log
Lumber Sawdust

Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing
Profit (loss) from further processing

MANAGEMENT ACCOUNTING 1 83
Sell or Process Further
Analysis of Sell or Process Further
Per Log
Lumber Sawdust

Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing 50 20
Profit (loss) from further processing $ 80 $ (10)

MANAGEMENT ACCOUNTING 1 84
Sell or Process Further
Analysis of Sell or Process Further
Per Log
Lumber Sawdust

Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing 50 20
Profit (loss) from further processing $ 80 $ (10)

The lumber should be

processed further and the
sawdust should be sold at the
split-off point.
MANAGEMENT ACCOUNTING 1 85
Activity-Based Costing and Relevant Costs
ABC can be used to help identify potentially relevant
costs for decision-making purposes.

However, managers should

exercise caution against reading
more into this “traceability” than
really exists.

People have a tendency to assume that if a cost is traceable to a

segment, then the cost is automatically avoidable, which is untrue.
Before making a decision, managers must decide which of the
potentially relevant costs are actually avoidable.

MANAGEMENT ACCOUNTING 1 86
REFERENCE:
Garrison, R. H., Noreen, E. W. & Brewer, P. C., 13th edition (2010). Managerial
Accounting, McGraw-Hill/Irwin

MANAGEMENT ACCOUNTING 1 87