Relevant Costing

1.Garrison
 Relevant costs
• Every decision involves choosing from among at least two
alternatives. In making a decision, the costs and benefits
of one alternative must be compared to the costs and
benefits of other alternatives.
• Costs that differ between alternatives are called relevant
costs. Distinguishing between relevant and irrelevant
costs and benefits is critical for two reasons. First,
irrelevant data can be ignored—saving decision makers
tremendous amounts of time and effort. Second, bad
decisions can easily result from erroneously including
irrelevant costs and benefits when analyzing alternatives.
• Only those costs and benefits that differ in
total between alternatives are relevant in a
decision. If the total amount of a cost will be
the same regardless of the alternative
selected, then the decision has no effect on
the cost, so the cost can be ignored.
• An avoidable cost is a cost that can be
eliminated in whole or in part by choosing one
alternative over another.
• Two broad categories of costs are never relevant in
decisions. These irrelevant costs are:
1. Sunk costs.
2. Future costs that do not differ between the alternatives.
• As we learned in an earlier chapter, a sunk cost is a cost
that has already been incurred and cannot be avoided
regardless of what a manager decides to do. For
example, suppose a used car dealer purchased a five-
year-old Toyota Camry for $12,000. The amount paid for
the Camry is a sunk cost because it has already been
incurred and the transaction cannot be undone. Sunk
costs are always the same no matter what alternatives
• In managerial accounting, the terms avoidable cost,
differential cost, incremental cost, and relevant cost
are often used interchangeably. To identify the costs
that are avoidable in a particular decision situation and
are therefore relevant, these steps should be followed:
• 1. Eliminate costs and benefits that do not differ
between alternatives. These irrelevant costs consist of
• (a) sunk costs and (b) future costs that do not differ
between alternatives.
• 2. Use the remaining costs and benefits that do differ
between alternatives in making the decision. The costs
that remain are the differential, or avoidable, costs.
• Isolating relevant costs is desirable for at least
two reasons. First, only rarely will enough
information be available to prepare a detailed
income statement for both alternatives.
Assume, for example, that you are called on to
make a decision relating to a portion of a
single business process in a multi
departmental, multiproduct company. Under
these circumstances, it would be virtually
impossible to prepare an income statement of
any type.
• You would have to rely on your ability to recognize
which costs are relevant and which are not in
order to assemble the data necessary to make a
decision.
• Second, mingling irrelevant costs with relevant
costs may cause confusion and distract attention
from the information that is really critical.
Furthermore, the danger always exists that an
irrelevant piece of data may be used improperly,
resulting in an incorrect decision. The best
approach is to ignore irrelevant data and base the
decision entirely on relevant data.
• Decisions relating to whether product lines or
other segments of a company should be
dropped and new ones added are among the
most difficult that a manager has to make.
• In such decisions, many qualitative and
quantitative factors must be considered.
Ultimately, however, any final decision to drop
a business segment or to add a new one is
going to hinge primarily on the impact the
decision will have on net operating income
 Managing Constraint
• Effectively managing an organization’s constraints is
a key to increased profits.
• Effective management of a bottleneck constraint
involves selecting the most profitable product mix
and finding ways to increase the capacity of the
bottleneck operation. As discussed above, if the
constraint is a bottleneck in the production process,
the most profitable product mix consists of the
products with the highest contribution margin per
unit of the constrained resource.
• In addition, increasing the capacity of the
bottleneck operation should lead to increased
production and sales. Such efforts will often
pay off in an almost immediate increase in
profits.
Value Chain/ Make or Buy Decision
• Providing a product or service to a customer involves many
steps.
• For example, consider all of the steps that are necessary to
develop and sell a product such as tax preparation software
in retail stores. First the software must be developed, which
involves highly skilled software engineers and a great deal of
project management effort. Then the product must be put
into a form that can be delivered to customers. This involves
burning the application onto a blank CD or DVD, applying a
label, and packaging the result in an attractive box. Then the
product must be distributed to retail stores.
• Then the product must be sold. And finally,
help lines and other forms of after-sale service
may have to be provided. And we should not
forget that the blank CD or DVD, the label, and
the box must of course be made by someone
before any of this can happen. All of these
activities, from development, to production,
to after-sales service are called a value chain.
• Separate companies may carry out each of the
activities in the value chain or a single
company may carry out several. When a
company is involved in more than one activity
in the entire value chain, it is vertically
integrated. Vertical integration is very
common.
• Some companies control all of the activities in
the value chain from producing basic raw
materials right up to the final distribution of
finished goods and provision of after-sales
service.
• Other companies are content to integrate on a
smaller scale by purchasing many of the parts
and materials that go into their finished
products.
• 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.
• Quite often these decisions involve whether to
buy a particular part or to make it internally.
Make or buy decisions also involve decisions
concerning whether to outsource
development tasks, after-sales service, or
other activities.
• Vertical integration provides certain
advantages. An integrated company is less
dependent on its suppliers and may be able to
ensure a smoother flow of parts and materials
for production than a nonintegrated company.
• For example, a strike against a major parts
supplier can interrupt the operations of a
nonintegrated company for many months,
whereas an integrated company that is
producing its own parts would be able to
continue operations.
• Also, some companies feel that they can
control quality better by producing their own
parts and materials, rather than by relying on
the quality control standards of outside
suppliers. In addition, an integrated company
realizes profits from the parts and materials
that it is “making” rather than “buying,” as
well as profits from its regular operations.
 Constraint
• Managers routinely face the problem of deciding
how constrained resources are going to be used. A
department store, for example, has a limited
amount of floor space and therefore cannot stock
every product that may be available.
• A manufacturer has a limited number of machine-
hours and a limited number of direct labor-hours at
its disposal. When a limited resource of some type
restricts the company’s ability to satisfy demand,
the company has a constraint.
• Because the company cannot fully satisfy
demand, managers must decide which
products or services should be cut back. In
other words, managers must decide which
products or services make the best use of the
constrained resource. Fixed costs are usually
unaffected by such choices, so the course of
action that will maximize the company’s total
contribution margin should ordinarily be
selected.
• . The machine or process that is limiting
overall output is called the bottleneck— it is
the constraint.
 Managing Constraint
• Effectively managing an organization’s constraints is a key to
increased profits. Effective management of a bottleneck
constraint involves selecting the most profitable product mix
and finding ways to increase the capacity of the bottleneck
operation.
• As discussed above, if the constraint is a bottleneck in the
production process, the most profitable product mix consists
of the products with the highest contribution margin per unit
of the constrained resource. In addition, as discussed below,
increasing the capacity of the bottleneck operation should
lead to increased production and sales. Such efforts will often
pay off in an almost immediate increase in profits.
• It is often possible for a manager to increase the
capacity of the bottleneck, which is called
relaxing (or elevating) the constraint.
• For example, the stitching machine operator
could be asked to work overtime. This would
result in more available stitching time and
hence the production of more finished goods
that can be sold. The benefits from relaxing the
constraint are often enormous and can be easily
quantified. The manager should first ask, “What
would I do with additional capacity at the
bottleneck if it were available?”
• In our example, if unfilled orders exist for both
the touring and mountain panniers, the
additional capacity would be used to process
more touring panniers because they earn a
contribution margin of $12 per minute, or
$720 per hour. Given that the overtime pay for
the operator is likely to be much less than
$720 per hour, running the stitching machine
on overtime would be an excellent way to
increase the company’s profits while at the
same time satisfying more customers
• The capacity of a bottleneck can be effectively increased in
a number of ways, including:
• Working overtime on the bottleneck.
• Subcontracting some of the processing that would be done
at the bottleneck.
• Investing in additional machines at the bottleneck
• Shifting workers from processes that are not bottlenecks to
the process that is the bottleneck.
• Focusing business process improvement efforts such as Six
Sigma on the bottleneck.
• Reducing defective units. Each defective unit that is
processed through the bottleneck and subsequently
scrapped takes the place of a good unit that could have
been sold.
 Joint Product cost
• At Santa Maria Wool Cooperative, coarse wool, fine
wool, and superfine wool are produced from one
input—raw wool.
• Two or more products that are produced from a
common input are known as joint products. The split-
off point is the point in the manufacturing process at
which the joint products can be recognized as
separate products. This does not occur at Santa Maria
Cooperative until the raw wool has gone through the
separating process. The term joint cost is used to
describe the costs incurred up to the split-off point.
 Activity costing and relevant cost
• Activity-based costing can be used to help identify
potentially relevant costs for decision-making
purposes.
• Activity-based costing improves the traceability of
costs by focusing on the activities caused by a product
or other segment. 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 an avoidable cost.
• That is not true. the costs provided by a well-
designed activity-based costing system are
only potentially relevant. Before making a
decision, managers must still decide which of
the potentially relevant costs are actually
avoidable. Only those costs that are avoidable
are relevant and the others should be ignored.
 1 Identifying Relevant Costs [
• a. Sales revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . b. Direct
materials. . . . . . . . . . . . . . . . . . . . . . . . . . c. Direct
labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . d. Variable
manufacturing overhead . . . . . . . . . . . e. Depreciation—
Model B100 machine . . . . . . . . . f. Book value—Model
B100 machine . . . . . . . . . . g. Disposal value—Model
B100 machine. . . . . . . . h. Market value—Model B300
machine (cost) . . . i. Fixed manufacturing overhead
(general) . . . . . . j. Variable selling expense. . . . . . . . . . . . .
. . . . . . k. Fixed selling expense . . . . . . . . . . . . . . . . . . . . .
l.General administrative overhead . .
• Required:
• Copy the information above onto your answer
sheet and place an X in the appropriate
column to indicate whether each item is
relevant or not relevant in the following
situations.
 Case-1
1. The company chronically has no idle capacity and the old
Model B100 machine is the company’s constraint.
Management is considering purchasing a Model B300
machine to use in addition to the company’s present
Model B100 machine. The old Model B100 machine will
continue to be used to capacity as before, with the new
Model B300 machine being used to expand production.
This will increase the company’s production and sales.
The increase in volume will be large enough to require
increases in fixed selling expenses and in general
administrative overhead, but not in the fixed
manufacturing overhead
 Case-2
2. The old Model B100 machine is not the
company’s constraint, but management is
considering replacing it with a new Model
B300 machine because of the potential
savings in direct materials with the new
machine. The Model B100 machine would be
sold. This change will have no effect on
production or sales, other than some savings
in direct materials costs due to less waste.
 Identification of Relevant Costs
• The costs associated with the acquisition and
annual operation of a delivery truck are given
below:
• Insurance . . . . . . . . . . . .$1,600
• Licenses. . . . . . . . . . . . . . . . . . . . . . . . . . $250 Taxes
(vehicle) . . . . . . . . . . . . . . . . . . . . . $150 Garage rent
for parking (per truck). . . . .$1,200 Depreciation
($9,000 5 years) . . . . . $1,800* Gasoline, oil, tires,
and repairs. . . . . . . . . $0.07 per mile *Based on
obsolescence rather than on wear and tear
• Required:
• 1. Assume that Hollings Company has purchased
one truck that has been driven 50,000 miles during
the fi rst year. Compute the average cost per mile of
owning and operating the truck.
• 2. At the beginning of the second year, Hollings
Company is unsure whether to use the truck or
leave it parked in the garage and have all hauling
done commercially. (The state requires the
payment of vehicle taxes even if the vehicle isn’t
used.) What costs from the previous list are
relevant to this decision? Explain
• 3. Assume that the company decides to use the truck
during the second year. Near year-end an order is
received from a customer over 1,000 miles away.
What costs from the above list are relevant in a
decision between using the truck to make the delivery
and having the delivery done commercially? Explain.
• 4. Occasionally, the company could use two trucks at
the same time. For this reason, some thought is being
given to purchasing a second truck. The total miles
driven would be the same as if only one truck were
owned. What costs from the above list are relevant to
a decision over whether to purchase the second
truck? Explain.
 Problem Related
• 1. Dropping or Retaining a Segment.
• 2. Make or Buy a Component.
• 3. Sell or Process Further.