Relevant Costing
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This document discusses relevant costing and how it is used to make business decisions. It defines relevant costs as those associated with the decision being considered and important to the decision maker. Sunk costs are irrelevant while opportunity costs are relevant. When making outsourcing decisions, both quantitative factors like production costs and qualitative factors like quality control must be considered. Special order pricing must cover variable and incremental costs plus profit. Segment margin income statements are used for product line decisions to determine if a product should be retained by assessing its avoidable fixed costs, unavoidable fixed costs, and allocation of common expenses.
Relevant Costing
- 1. Chapter 12 Relevant Costing Cost Accounting Traditions and Innovations Barfield, Raiborn, Kinney
- 2. Learning Objectives (1 of 2) • List the relevant decision-making factors • Explain how opportunity costs affect decision making • Define sunk costs and clarify why they are not relevant in making decisions • Describe the relevant financial considerations in outsourcing • Explain how management can make the best use of scarce resources
- 3. Learning Objectives (2 of 2) • Describe how sales mix pertains to relevant costing problems • Demonstrate how special prices are set and when special prices are used • Describe how segment margin is used to determine whether to retain a product line • (Appendix) Formulate a linear programming problem
- 4. Relevant Costing A process of making human approximations of the costs of alternative decision results
- 5. Relevant Costing and Business Decisions • Replacing an asset • Outsourcing a product or part • Allocating scarce resources • Accepting special orders • Determining the sales/production mix
- 6. Relevance Focusing managerial attention on a decision’s relevant (or pertinent) facts 1 Associated with the decision under consideration 2 Important to the decision maker 3 Connected to or bearing on some future endeavor
- 7. Relevant Costing • Incremental Revenue - the amount of revenue that differs across decision choices • Incremental Cost or Differential Cost - the amount of cost that varies across decision choices • Incremental Benefit - the difference between incremental revenue and incremental cost
- 8. Relevant Costing • Most variable costs are relevant • Most fixed costs are not relevant • Opportunity Costs - benefits foregone because one course of action is chosen over another • Sunk Cost - costs incurred in the past SUNK COSTS ARE IRRELEVANT
- 10. Outsourcing Make-or-Buy Decisions Quantitative Factors – Incremental production costs per unit – Cost to purchase outside – Number of available suppliers – Production capacity available – Opportunity costs of production facilities • Space available for storage • Inventory carrying costs • Increase in throughput from buying components
- 11. Outsourcing Make-or-Buy Decisions Qualitative Factors – Reliable supply sources – Ability to control quality of items purchased outside – Nature/importance of the work to be subcontracted – Impact on customers and markets – Future bargaining position with suppliers – Perceptions about future price changes – Perceptions about current product prices
- 12. Outsourcing Risk Pyramid Strategic Direction, Unique Core Competencies Tax, Audit, Legal Information Technology Help Desk, Call Centers Data Centers, Logistics Facility, Network, Supply-Chain Management, Temporary Staffing, Payroll, Security Services, Food Services The Yankee Group, 1995 Never Outsource Outsource under Tight Control Outsource under Service Levels Low Risk Outsourcing
- 14. Scarce Resources • Choose product or service with highest contribution margin per unit of scarce resource • Use linear programming when there are several limiting factors • Consider qualitative factors – company reputation – impact on customer base – market saturation or company stagnation
- 15. Sales Mix Decision • Sales Mix - relative quantities of the products that make up the total sales of a company – Product selling prices – Salesforce compensation – Advertising expenditures
- 16. Impact of Change in Sales Price Quantitative Factors • New contribution margin per unit of each product • Changes in product demand and production volume • Best use of scarce resources Qualitative Factors • Customer goodwill • Customer loyalty • Response of competitors • Production of new products
- 17. Impact of Change in Compensation • Commission based on – fixed percentage of gross sales dollars • sell highest priced product – product contribution margin • sell most profitable product
- 18. Impact of Change in Advertising • Increase in advertising costs may cause – Change in sales mix – Change in sales volume
- 19. Special Order Decisions • “Low-ball bid” to introduce product or service to particular market • Private-label order • Unusual quantity, delivery, packaging, or customization of product • One-time job • Selling price adequate to cover – Variable costs – Incremental costs – Profit
- 20. Special Order Decisions Qualitative Factors • Impact on future prices and sales • Sufficient contribution margin to justify the additional burden on workers and management • Impact on scarce resources and throughput • Workforce employed during slow times • Robinson-Patman Act
- 21. Product Line Decisions Costs by • Product Line – Revenue – Variable costs – Avoidable direct fixed costs – Unavoidable direct fixed costs • Common Costs
- 22. Segment Margin Income Statement Sales <Variable Expenses> Contribution Margin <Avoidable Fixed Expenses> Segment Margin <Unavoidable Fixed Expenses> Product Line Result <Allocated Common Expenses> Net Income (Loss)
- 23. Product Line Decisions • Costs that appear to be avoidable may not be • Deprecation on equipment is irrelevant • Proceeds from sale of equipment are relevant • Eliminating a product may affect customers
- 24. Linear Programming • Typically one objective - maximize profit or minimize some measure of performance • Multiple limiting factors – Resource constraints – Demand or marketing constraints – Technical product constraints – Nonnegativity constraints – Integer constraints • Optimal solution - provides best answer to allocation problem
- 25. Questions • What are some relevant financial considerations when making an outsourcing decision? • How are prices set for special orders? • What types of decisions require segment margin income statements?