Topic 4:

Relevant information for

decision making
 12-2

The concept of Relevance

• Relevant information has two
characteristics:
▫ It occurs in the future
▫ It differs among the alternative courses of
action.
• Relevant costs are expected future costs.
• Relevant revenues are expected future
Revenues.
• Past costs (historical costs) are never
relevant and are also called sunk costs.

11-2
 12-3

Relevant Costs and Benefits

A relevant cost is a cost that

differs between alternatives.

A relevant benefit is a benefit

that differs between alternatives.

2
1
 12-4

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 costs (incurred in the past).
A future cost that does not differ between
the alternatives.
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Relevant Cost Illustration

 12-6

Terminology
• Incremental cost—the additional
total cost incurred for an activity.
• Differential cost—the difference in
total cost between two alternatives.
• Incremental revenue—the additional
total revenue from an activity.
• Differential revenue—the difference
in total revenue between two
alternatives.
• Note that incremental cost and
differential cost are sometimes used
interchangeably in practice.
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 12-7

Some Types of Decisions that need to be

made:
• One-time-only special orders
• Short-run pricing decisions
• Insourcing vs. outsourcing (Make-or-Buy)
• Product-mix with capacity constraints
▫ Bottlenecks, Theory of Constraints, and
Throughput-Margin Analysis
• Customer profitability and Relevant Costs
• Branch/segment: adding or discontinuing
• Equipment replacement

11-7
 12-8

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.
 12-9

One-Time-Only Special
Orders
• Accepting or rejecting special orders
when there is idle production capacity
and the special orders have no long-run
implications.
• Decision rule: Does the special order
generate additional operating income?
▫ Yes—accept
▫ No—reject
• Compares relevant revenues and relevant
costs to determine profitability.

11-9
 12-10

One-Time-Only Special
Orders
Sunbelt Company produces 100,000 Smoothie blenders per
month, which is 80% of plant capacity.
Variable manufacturing costs are $8 per unit. Fixed
manufacturing costs are $400,000, or $4 per unit.
The Smoothie blenders are normally sold directly to retailers at
$20 each. Sunbelt has an offer from Kensington Co. (a foreign
wholesaler) to purchase an additional 2,000 blenders at $11 per
unit. Acceptance of the offer would not affect normal sales of
the product, and the additional units can be manufactured
without increasing plant capacity.
What should management do?

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 12-11

One-Time-Only Special Orders

Net Income
Reject Order Accept Order Increase
(Decrease)
Revenues $0 $22,000 $22,000
Costs 0 16,000 (16,000)
Net income $0 $6,000 $6,000

▫ Fixed costs do not change since within existing capacity –

thus fixed costs are not relevant
▫ Variable manufacturing costs and expected revenues
change – thus both are relevant to the decision
LO 2
 12-12

Short-run pricing decision

•A special order decision is, in many
respects, a short-run pricing decision.
•Decision rule: Any price above incremental
costs will improve operating income.
•However, consideration must be given to
capacity constraints, current market
conditions, customer demand, competition,
etc.

11-
 12-13

Short-run pricing decision

Cobb Company incurs costs of $28 per unit ($18 variable and $10
fixed) to make a product that normally sells for $42. A foreign
wholesaler offers to buy 5,000 units at $25 each. The special order
results in additional shipping costs of $1 per unit. Compute the
increase or decrease in net income Cobb realizes by accepting the
special order, assuming Cobb has excess operating capacity.
Should Cobb Company accept the special order?
Net Income
Reject Order Accept Order Increase
(Decrease)
Revenues …0……. ……125.000….. ………..
Costs …0……. ……95.000….. ………..
Net income 30.000

LO 2
 12-14

The Make or Buy Decision

• A decision concerning whether an item

should be produced internally or
purchased from an outside supplier is
called a “make or buy” decision.
• This is often referred to as an
outsourcing decision.
 12-15

Insourcing v outsourcing
Make-or-Buy decision
• Outsourcing is purchasing goods and
services from outside vendors.
• Insourcing means you’ll produce the
good (or provide the service) within
the organization.
• Decisions about whether to insource
or outsource are called Make-or-Buy
decisions.
• Opportunity Costs are the
contribution to operating income
forgone by not using a limited
resource in its next-best alternative
11-
 12-16

Insourcing v outsourcing
Make-or-Buy decision
• Decision rule: Select the option that will
provide the firm with the lowest cost, and
therefore the highest profit.
• Same as special order: choose the
alternative that maximizes operating
income.

11-
 12-17

Insourcing v outsourcing
Make-or-Buy decision

LO 3
 12-18

Product-Mix Decisions with

Capacity constraints
•Product-mix decisions are decisions
managers make about which products to
sell and in what quantities.
•Decision rule (with a constraint):
Choose the product that produces the
highest contribution margin per unit of
the constraining resource (not the
highest contribution margin per unit of
the product).

11-
 12-19

Product mix decision with

capacity constraint,
example
Product A Product B
Selling Price $10.00 $30.00
Variable Cost per unit $ 6.00 $15.00
Contribution Margin/unit $ 4.00 $15.00
Contribution Margin percentage 40% 50%
Machine Hours Required per unit 0.5 3.0
Contribution Margin/machine $ 8.00 $ 5.00
hour

CONCLUSION: Produce product A to maximize profitability.

 12-20

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.
 12-21

Bottlenecks - Theory of constraints

Throughput-margin analysis

A bottleneck is a phenomenon where the performance

or capacity of an entire system is limited by a single or
limited number of components or resources.
Such limiting components of a system are sometimes
referred to as bottleneck points.

11-
 12-22

Bottlenecks - Theory of constraints

Throughput-margin analysis
The Theory of Constraints (TOC) describes methods to
maximize operating income when faced with some
bottleneck and some non-bottleneck operations. The
TOC defines these three measures:
Throughput margin
Investments
Operating costs
The objective of the TOC is to increase throughput
margin while decreasing investments and operating costs.
The TOC focuses on managing bottleneck operations.

11-
 12-23

Customer profitability and relevant

costs
• When the cost object is a customer,
managers must decide about adding or
dropping the customer.
• Decision rule: Does adding or dropping a
customer add operating income to the
firm?
▫ Yes—add or don’t drop
▫ No—drop or don’t add
• Decision is based on incremental income
of the customer, not how much revenue a
customer generates.
11-
 12-24

Customer Profitability Analysis, example

 12-25

Customer Profitability Analysis,

Extended
 12-26

Adding or Discontinuing
Branches or Segments

• Decision rule: Does adding or

discontinuing a branch or segment add
operating income to the firm?
▫ Yes—add or don’t discontinue
▫ No—discontinue or don’t add
• Decision is based on incremental
income of the branch or segment, not
how much revenue the branch or
segment generates.
11-
 12-27

Equipment-Replacement
Decisions
• Sometimes difficult due to amount of
information at hand that is irrelevant:
▫ Cost, accumulated depreciation, and book
value of existing equipment
▫ Any potential gain or loss on the
transaction—a financial accounting
phenomenon only.
• Decision rule: Select the alternative that
will generate the highest operating
income.

11-
 12-28

Equipment-Replacement Decisions

Illustration: Jeffcoat Company has a factory machine that originally

cost $110,000. It has a balance in Accumulated Depreciation of
$70,000, so the machine’s book value is $40,000. It has a remaining
useful life of four years. The company is considering replacing this
machine with a new machine. A new machine is available that costs
$120,000. It is expected to have zero salvage value at the end of its
four-year useful life. If the new machine is acquired, variable
manufacturing costs are expected to decrease from $160,000 to
$125,000 annually, and the old unit could be sold for $5,000.
Prepare the incremental analysis for the four-year period.

LO 5
 12-29

Equipment-Replacement Decisions

Prepare the incremental analysis for the four-year period.

Net Income
Retain Replace
Increase
Equipment Equipment
(Decrease)
Variable manufacturing costs $640,000a $500,000b $140,000
New machine cost 120,000 (120,000)
Sale of old machine (5,000) 5,000
Total $640,000 $615,000 $ 25,000

a
$160,000 × 4 years = $640,000
b
$125,000 × 4 years = $500,000
Retain or Replace?
begin underline end underline

LO 5
 12-30

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
 12-31

Sell or Process Further

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.
 12-32

Sell or Process Further

Illustration: Woodmasters Inc. makes tables. The cost to manufacture an
unfinished table is $35. The selling price per unfinished unit is $50.
Woodmasters has unused capacity that can be used to finish the tables and
sell them at $60 per unit. For a finished table, direct materials will
increase $2 and direct labor costs will increase $4. Variable manufacturing
overhead costs will increase by $2.40 (60% of direct labor). No increase is
anticipated in fixed manufacturing overhead.

Direct materials $15

Direct labor 10
Variable manufacturing overhead 6
Fixed manufacturing overhead 4
Manufacturing cost per unit $35

LO 4
 12-33

Sell Process Net Income

Unfinished Further Increase
(Decrease)
Sales price per unit $50.00 $60.00 $10.00
Cost per unit
Direct materials 15.00 17.00 (2.00)
Direct labor 10.00 14.00 (4.00)
Variable manufacturing overhead 6.00 8.40 (2.40)
Fixed manufacturing overhead 4.00 4.00 0.00
Total 35.00 43.40 (8.40)
Net income per unit $15.00 $ 16.60 $1.60

Should Woodmasters sell or process further?

begin underline End underline

LO 4
 12-34

End of topic 4