Relevant cost for decision making

1. Accounting for decision making
ACC 557: MANAGEMENT ACCOUNTING
Lecture 3
Relevant cost for decision making
(Break-even analysis)
by
Kwame Oduro Amoako (Ph.D.)

2. Learning Objectives
• Distinguish between relevant and irrelevant costs
and revenues in (alternative-choice) decisions.
• Prepare analyses showing
– whether to add or drop a segment
– whether to make or buy a component
– whether to accept or reject a special order
– the most profitable use of a scarce resource
– whether to sell or further process a product

3. Cost Concepts for Decision Making
A relevant cost is a cost that differs
between alternatives.

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.
Future costs that do not differ between the
alternatives.

5. Decision Making – Six Key Concepts
Sunk costs are always irrelevant when choosing among
alternatives.
• A sunk cost is a cost that has already been incurred and
cannot be changed regardless of what a manager decides
to do.
Future costs and revenues that do not differ between
alternatives are irrelevant to the decision-making process.

6. Decision Making – Future cost and
revenues
The key to effective decision making is differential analysis – focusing on
the future costs and revenues that differ between the alternatives.
Everything else is irrelevant and should be ignored.
• A future cost that differs between any two alternatives is known as a
differential cost.
• A future revenue that differs between any two alternatives is known as a
differential revenue.
• An incremental cost is an increase in cost between two alternatives.
• An avoidable cost is a cost that can be eliminated by choosing one
alternative over another.
• Opportunity costs also need to be considered when making decisions.
An opportunity cost is the potential benefit that is given up when one
alternative is selected over another.

7. Relevant Cost Analysis: A Two-Step
Process
Eliminate costs and benefits that do not differ
between alternatives.
Use the remaining costs and benefits that
differ between alternatives in making the
decision. The costs that remain are the
differential, or avoidable costs.
Step 1
Step 2

8. Types of Alternative-Choice Decisions
• Adding or dropping a product or other segments.
• Making or buying a component (outsourcing).
• Accepting or rejecting a special order.
• Rationing of a scarce resource.
• Sale versus further processing.
• Note: These decisions normally have a relatively
short time horizon.
– Time value of money and taxes are ignored.

9. General Steps in the Analysis
• Define the problem/opportunity
• Determine possible alternative actions/solutions
– the obviously unattractive ones are eliminated
• For each alternative, measure the differential
(incremental) revenues, costs, or profit
• Evaluate the alternatives
• Reach a decision
Note: Qualitative information is sometimes more
important than differential revenues and expenses.

10. 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
impact the decision will
have on net operating
income.
To assess this impact,
it is necessary to
carefully analyze
the costs.

11. Adding or Dropping a Segment
• An add or drop decision should be based only on
the differential (incremental) revenues and costs.
Revenue and cost items unaffected by the decision
should be disregarded.
• Differential revenues and costs are segment
contribution margin and some traceable fixed costs.
Note: Qualitative considerations are important.

12. • Rolex Company is considering dropping its digital
watch segment.
• The CM of the segment is GH¢300,000.
• Dropping the segment will yield the following fixed
cost savings:
Salary of the division manager GH¢90,000
Direct advertising GH¢100,000
Rent for factory space GH¢70,000
Adding or Dropping a Segment: Example

13. Segment Income Statement
Digital Watches
Sales GH¢500,000
Less: variable expenses
Variable manufacturing costs GH¢120,000
Variable shipping costs 5,000
Commissions 75,000 GH¢200,000
Contribution margin GH¢300,000
Less: fixed expenses
General factory overhead GH¢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 (GH¢100,000)
Adding/Dropping Segments

14. Adding/Dropping Segments
Due to the declining popularity of digital
watches, Rolex Company’s digital watch line
has not reported a profit for several years.
Rolex is considering discontinuing this
product line.
Should Rolex dispose of its digital watch
segment?

15. A Contribution Margin Approach
DECISION RULE
Rolex should drop the digital watch segment
only if its profit would increase.
Rolex 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.

16. • This same answer can be reached by preparing
income statements with and without the segment.
Rolex should not drop its digital watch segment
because its fixed cost savings does not exceed lost
contribution margin.
Adding or Dropping a Segment
Fixed costs reduction GH¢260000
Contribution margin lost if digital
watch segment is dropped (GH¢300,000)
Net disadvantage (GH¢40,000)

17. Beware of Allocated Fixed Costs
Why should we keep the
digital watch segment
when it’s showing a
GH¢100,000 loss?

18. Beware of Allocated Fixed Costs
The answer lies in the
way we allocate
common fixed costs
to our products.

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

20. Illustration 2
A company has three products: Product A, Product B and Product C.
Income statements of the three product lines for the latest month are given
below. Should product B be dropped since it is incurring a net loss of
GH¢3,000.
Product Line A B C
Sales GH¢467,000 GH¢314,000 GH¢598,000
Variable Costs 241,000 169,000 321,000
Contribution
Margin
226,000 145,000 277,000
Direct Fixed
Costs
91,000 86,000 112,000
Allocated Fixed
Costs
93,000 62,000 120,000
Net Income 42,000 − 3,000 45,000

21. Solution
Contribution margin lost
GH¢
145,000
Direct Fixed Costs avoided (86,000)
Decrease in Net Income of the Company 59,000

22. Making or Buying a Component
• Should we outsource a component that we are
currently making? Should we make a component
that we are currently outsourcing?
– Dependability, quality consideration, and focus
are important qualitative considerations.
• A make or buy decision should be based only on
the differential (incremental) costs. Cost items
unaffected by the decision should be disregarded.
• The cost of the buy alternative is usually easy to
estimate. The more difficult problem is to find the
differential costs of the make alternative.

23. Illustration 1:
The estimated costs of producing 6,000 units of a
component are:
Per Unit Total
Direct Material GH¢10 GH¢60,000
Direct Labor 8 48,000
Applied Variable Factory
Overhead
9 54,000
Applied Fixed Factory
Overhead
12 72,000
GH¢1.5 per direct labor
dollar
GH¢39 GH¢234,000

24. • The same component can be purchased from
market at a price of GH¢ 29 per unit. If the
component is purchased from market, 25% of the
fixed factory overhead will be saved.
• Should the component be purchased from the
market?

25. Solution
Per unit Total
Make
(GH¢)
Buy (GH¢) Make (GH¢) Buy (GH¢)
Purchase Price 29 GH¢174,000
Direct Material 10 60,000
Direct Labor 8 48,000
Variable
Overhead
9 54,000
Relevant Fixed
Overhead
3 18,000
Total Relevant
Costs
30 29 180,000 174,000
Difference in
Favor of
Buying
1 6,000

26. Making or Buying: Illustration 2
• Kantanka Motors incurs the following cost for part No. 300:
Total (10,000) Per unit
Direct materials GH¢80,000 GH¢8
Direct labor 10,000 1
Variable overhead (OH) 40,000 4
Fixed OH (traceable) 20,000 2
Fixed OH (Common) 30,000 3
• Another company offers to sell Kantanka Motors the same
part for GH¢16 per unit. There are no alternative uses of the
capacity that becomes available.
• Should Kantanka Motors continue to make or buy the part?

27. Making or Buying: Solution
• Items of differential costs are as follows:
If part No. 300
is manufactured
Direct material GH¢8
Direct labor 1
Variable OH 4
Fixed OH (part 300) 2
Total GH¢15
• Based on financial consideration alone, Kantanka
Motors should continue to make the part.
• What if the released facility can be used for ...?

28. The Make or Buy Decision: An Example 3
• Aspect A Company manufactures part 4A that is used
in one of its products.
• The unit product cost of this part is:
Direct materials GH¢9
Direct labor 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary(traceable) 2
General factory overhead 10
Unit product cost GH¢30

29. The Make or Buy Decision
• The special equipment used to manufacture part 4A
has no resale value.
• The total amount of general factory overhead, which
is allocated on the basis of direct labor hours, would
be unaffected by this decision.
• Supervisors salary is also traceable to the parts
produced
• The GH¢30 unit product cost is based on 20,000 parts
produced each year.
• An outside supplier has offered to provide the 20,000
parts at a cost of GH¢25 per part.
Should we accept the supplier’s offer?

30. The Make or Buy Decision
The avoidable costs associated with making part 4A include direct
materials, direct labor, variable overhead, and the supervisor’s salary.
Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price GH¢25 GH¢500,000
Direct materials (20,000 GH¢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 GH¢30 GH¢340,000 GH¢500,000

31. The Make or Buy Decision
Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price GH¢25 GH¢500,000
Direct materials (20,000 GH¢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 GH¢30 GH¢340,000 GH¢500,000
Not avoidable; irrelevant. If the product is
dropped, it will be reallocated to other products.

32. The Make or Buy Decision
Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price GH¢25 GH¢500,000
Direct materials (20,000 GH¢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 GH¢30 GH¢340,000 GH¢500,000
Should we make or buy part 4A? Given that the total
relevant/avoidable costs of making are less than the cost of
buying the part, Aspect A should continue to make the part.

33. Special order
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.
Revenue and cost items unaffected by
the decision should be disregarded.

34. Accept or reject a special order-With
excess capacity
• When the company is operating at less than its
maximum capacity and the company has enough
capacity to produce and fill the special order, the
order should be accepted if the additional sales
exceed the additional variable costs.

35. The special order will not affect normal unit sales and will not increase
fixed overhead and selling expenses. variable selling expenses on the
special order are reduced to one-half the normal amount.
Should the company accept the special order?
A company receives a special order for 200 units that require stamping the
buyer’s name on each unit, yielding an additional fixed cost of GH¢400 to
its normal costs. Without the order, the company is operating at 75% of
capacity and produces 7,500 units of product at the costs below. The
company's normal selling price is GH¢22 per unit. The sales price for the
special order is GH¢18 per unit. The following is cost estimates of the
company.
Description Costs (7,500 units) Variable costs
Per unit
Fixed costs
Direct materials GH¢37,500 GH¢5.00
Direct labour GH¢60,000 GH¢8.00
Overhead (30%
variable)
GH¢20,000 GH¢0.80 GH¢14,000
Selling expenses
(60% variable)
GH¢25,000 GH¢2.00 GH¢10,000

36. Solution

37. Special Orders Example 2
• Accra Brewery Limited operates with a monthly
capacity of one million barrels of a beer product
(Club beer) that has gained significant market share.
Current production and sales are 600,000 barrels a
month. The selling price is GH¢90 per barrel. The
costs are as follows:
VC /barrel FC /barrel
Direct material (barley, etc.) GH¢ 7
Direct labor 22
Overhead 6 GH¢13
Marketing costs* 5 16
Distribution costs 9 8
* Variable marketing cost is sales commission.

38. Special Orders Example
• A Togolese brewery wants to buy 250,000 barrels
of Club beer for each of the next four months until
its current brewery is renovated. It is willing to pay
GH¢45 per barrel. If ABL accepts this order, an
additional GH¢300,000 in manufacturing costs will
be incurred each month.
• No additional costs will be incurred for marketing
& distribution.
• Should ABL accept the special order?

39. Special Orders Example
• Items of differential monthly revenues and costs are:
Total revenue GH¢11,250,000
Variable costs GH¢8,750,000
Additional costs 300,000 9,050,000
Differential profit GH¢2,200,000
• Based on profit alone, Accra should accept the offer.

40. Special order-without excess capacity
• When the company has no excess capacity, the
cost to be considered must include the lost
contribution margin from sacrificing regular sales
to be able to fill up the special order.

41. Illustration
• In a month, ABC Company normally produces and sells 9000
units of its product for GH¢20.
• Variable manufacturing cost per unit is GH¢10.
• Total fixed manufacturing costs (up to the maximum capacity
of 10,000 units) are GH¢38,000.
• Variable operating cost is GH¢1 per unit and fixed operating
costs total GH¢10,000.
• A customer placed a special order for 1,500 units for GH¢15
each.
• The customer is willing to shoulder the delivery costs; hence
the business will not incur additional variable operating costs.
• Should the company accept or reject the special order?

42. Solution

43. Solution
w/o Special
Order
w/ Special
Order
Sales GH¢180,000 GH¢192,500
Less: Variable
costs
Var. manufacturing 90,000 100,000
Var. operating 9,000 8,500
Contribution
margin
GH¢81,000 GH¢84,000
Less: Fixed costs
Fixed
manufacturing
38,000 38,000
Fixed operating 10,000 10,000
Operating Income GH¢33,000 GH¢36,000
• The GH¢192,500 sales
revenue includes regular
sales of 8,500 units (sold
at GH¢20 each) and 1,500
specially ordered units
(sold at GH¢15).
• As mentioned in the
problem, the company will
incur the variable
operating cost only for
regular sales.
• Fixed costs remain the
same.

44. Solution
• Since the company has excess capacity of 1,000 units only, it is not enough
to fill up the special order of 1,500 units.
• Hence, a portion of the regular sales (500 units) must be sacrificed to fill up
the entire special order. The lost contribution margin should be considered.
• Contribution margin is equal to sales (at GH¢20) minus variable costs
(GH¢10 variable manufacturing plus GH¢1 variable operating).
• Lost contribution margin = (GH¢20 - GH¢11) x 500 units = GH¢4,500
• The lost contribution margin is allocated over the items sold through the
special order.
• Lost contribution margin per unit = GH¢4,500 / 1,500 units = GH¢3
• This cost is an additional consideration in the decision. Should the company
accept the offer? The answer is still yes since the selling price (GH¢15) is
higher than the cost (GH¢13, i.e. variable manufacturing cost per unit of
GH¢10 plus lost CM per unit of GH¢3). This will result in additional income
of GH¢3,000 (1,500 x GH¢2).

45. Rationing A Scarce Resource
• Usually, fixed costs are not affected by this
decision.
• Therefore, producing products with highest
CM per unit of scarce resource maximizes
total contribution margin and overall profit.

46. Rationing A Scarce Resource Example
• Active Company produces two products and
selected data is shown below.
A B
CM/unit GH¢ 10 GH¢ 12
Std. machine hrs/unit 1 hr. 2 hrs.
• If only10,000 machine hours are available,
which product should Active focus its efforts
on?

47. Rationing A Scarce Resource Example
A B
CM/unit GH¢ 10 GH¢ 12
Std. requirement/unit 1 hr. 2 hrs.
CM/hour GH¢10 GH¢ 6
• Active should focus its attention on product A, if
only 10,000 machine hours are available:
Total CM = 10,000 * GH¢10, if only A is produced
Total CM = 10,000 * GH¢6, if only B is produced

48. 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

49. Sale Versus Further Processing
• Should we sell our product at some point before
the final step in its production?
• Costs incurred prior to the point of decision are
not relevant in deciding whether to sell or further
process a product (joint or otherwise).
• As a general rule, a product should be further
processed if the incremental revenues from
processing it exceed the incremental processing
costs.

50. Sensitivity analysis
• All decisions involve making assumptions and
estimates about the future. It is important to make
note of the assumptions and estimates.
• After completing the analysis, it is often useful to
redo the analysis under different assumptions and
estimates to determine the sensitivity of the
conclusions.
• With computer, the sensitivity (what if) analysis
can be performed quickly.