10-1

BU8101 Accounting: A User Perspective

Lecture 10
Relevant Costs, Incremental Analysis

Recommended Reading:
WHB 16th edition
Chapter 21
Other Reference:
Financial and Managerial Accounting: Information for Decisions
John J Wild, Barbara Chiapetta
Chapter 23

Lecture Date: 25 March 2013

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Lecture Outline
 Relevant Costs
 Definition
 Relevant cost and decision-making
 Total vs. incremental approach

 Incremental Analysis
 Types of Business Decisions
1. Special Order Decisions
2. Production Constraint (Product Mix) Decisions
3. Make or Buy Decisions
4. Sell, Scrap or Rebuild Decisions
5. Joint Product Decisions
 Non-Financial Considerations
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Relevant Costs for Decision Making

A relevant cost is a cost that differs between

alternatives.

A relevant cost is likely to have a bearing on

the future.
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Cost Concepts for Decision Making

Relevant Irrelevant

Differential Cost (aka Relevant Cost) Allocated Cost -- a common cost that
-- will differ according to alternative has been arbitrarily assigned to a
activities being considered. product or activity.
Likely a future cost.

Opportunity Cost -- benefits foregone Sunk Cost -- has already been incurred
by choosing one alternative over and will not change.
another.

Let’s take a closer look at

Opportunity Cost &
Sunk Cost
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Opportunity Cost (Benefits Forgone )

The benefit that could have been attained by

pursuing an alternative course of action.

Example: If you are not attending college, you

could be earning $20,000 per year. Your
opportunity cost of attending college for one
year includes the $20,000 salary foregone.

Opportunity costs are not recorded in the

accounting records, but are relevant to decisions
because they are a real sacrifice.
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Sunk Cost
Costs that have already been incurred.
They do not affect any future cost and cannot be
changed by current or future action.

Sunk costs are irrelevant to decisions.

Example: You bought a car that cost $10,000 two years

ago. The $10,000 cost is sunk because whether you
drive it, park it, trade it, or sell it, you cannot change the
$10,000 cost.
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Sunk Cost

OLD CAR Trade ? NEW CAR

Cost = $10,000 Cost = $25,000

two years ago today

The dealer will trade for $20,000 plus your car.

What amount is relevant to your decision,
the $10,000 sunk cost of your car or the
$20,000 out-of-pocket cash differential?

What’s the trade-in value for the old car?

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Relevant Cost and Decision Making

Decision making involves 5 steps:

 Define the problem.
 Identify the alternatives.
 Collect information on alternatives.
 Eliminate irrelevant information.
 Make a decision with the remaining relevant
information.
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Relevant Cost Example

1. Going to Florida for spring break.
2. Alternatives: Will you drive or fly to Florida for spring break?
3. You have gathered the following information to help you with
the decision.
Motel cost is $80 per night.
Meal cost is $20 per day.
Your car insurance is $100 per month.
Kennel cost for your dog is $5 per day.
Round-trip cost of gasoline for your car is $200.
Round-trip airfare and rental car for a week is $500.
Driving requires two days, with an overnight stay, cutting your
time in Florida by two days.
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Relevant Cost Example

Florida Spring Break

Drive/Fly Analysis
8 days @ $80
Cost Drive Fly
Motel $ 640 $ 640 8 days @ $20
Eating out costs 160 160
Kennel cost 40 40 8 days @ $5
Car insurance 100 100
Gasoline 200 -
Airfare/rental car - 500
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Relevant Cost Example

Florida Spring Break

Drive/Fly Analysis
Cost Drive Fly
Motel $ 640 $ 640 4. Irrelevant information
Costs do not differ,
Eating out costs 160 160 so they are
Kennel cost 40 40 irrelevant to decision
Car insurance 100 100
Gasoline 200 - Also, car insurance
Airfare/rental car - 500 is irrelevant to
the decision as it
is a past/sunk cost.
 10-12

Relevant Cost Example

Are the extra two
days in Florida
Florida Spring Break worth the $300
Drive/Fly Analysis extra cost to fly?

Cost Drive Fly

Motel $ 640 $ 640
Eating out costs 160 160 5. Relevant Information
Kennel cost 40 40 Transportation
Car insurance 100 100 costs differ between
Gasoline 200 - the two alternatives,
so they are relevant
Airfare/rental car - 500 to the decision
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Total and Incremental Cost Approach

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:

TOTAL APPROACH Situation

Current With New
Situation Machine Variance
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
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Total and Incremental Cost Approach

INCREMENTAL APPROACH

The only costs that differ between the two alternatives are the direct
labor cost savings and the increase in machine rental costs.

We can efficiently analyze the decision by

looking at the differential costs and benefits
and arrive at the same solution.

Net Advantage to Renting the New Machine

Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Increase in machine rental expenses (3,000)
Net annual cost savings from renting the new machine $ 12,000
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(1) Special Order Decisions

The decision to accept additional business should
be based on
incremental costs and incremental revenues.

Incremental amounts are those that occur only if

the company decides to accept the new business.
‘differ between alternatives’

Special consideration:
Does the company have excess capacity?
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Special Order Decisions

Victory Co. currently sells 100,000 units of a product. The company
has revenues and costs as shown below:

Per Unit Total

Sales $ 10.00 $ 1,000,000
Direct materials 3.50 350,000
Direct labor 2.20 220,000
Factory overhead 1.10 110,000
Selling expenses 1.40 140,000
Administrative expenses 0.80 80,000
Total expenses $ 9.00 $ 900,000
Operating income $ 1.00 $ 100,000
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Special Order Decisions

Victory Co. is approached by an overseas company that offers to

purchase 10,000 units at $8.50 per unit.
If Victory Co. accepts the offer, total factory overhead will
increase by $5,000; total selling expenses will increase by
$2,000; and total administrative expenses will increase by
$1,000.
Victory Co. has a production capacity of 120,000 units.

Should Victory accept the offer?

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Special Order Decisions

First, let’s look at incorrect reasoning
that leads to an incorrect decision.

Our cost is $9.00

per unit. I can’t sell
for $8.50 per unit.
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Special Order Decisions

Current Additional
Has excess capacity
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Direct materials $ 350,000 $ 35,000 $ 385,000
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

10,000 new units × $8.50 selling price = $85,000

10,000 new units × $3.50 = $35,000

10,000 new units × $2.20 = $22,000

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Even though the $8.50 selling price is less than the
normal $10 selling price, Victory Co. should accept the
offer because net income will increase by $20,000.

Current Additional
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Direct materials $ 350,000 $ 35,000 $ 385,000
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

DECISION RULE
Accept the special order when there’s incremental benefits for
the company.
 10-21

Special Order Decisions

We can also look at this decision
using the contribution margin method
10,000
Per Unit units
Special order revenue $ 8.50
Direct materials 3.50
Direct labor 2.20
Contribution margin $ 2.80 $ 28,000
Increase in fixed costs:
Factory overhead $ 5,000
Selling expenses 2,000
Administrative expenses 1,000
Special order profit $ 20,000
 10-22

Special Order Decisions

Victory Co. has a production capacity of 100,000 units.
Should Victory accept the offer?
Per Unit Total
No excess capacity
10,000 units
Special order revenue $ 8.50
Direct materials 3.50
Direct labor 2.20
Contribution margin $ 2.80 $ 28,000
Increase in fixed costs:
Factory overhead $ 5,000
Selling expenses 2,000
Administrative expenses 1,000
8,000

Loss of CM on regular sales 43,000

10,000 units x CM $4.30 ($10 - $3.50 - $2.20)
Special order loss $ (23,000)
 10-23

(2) Production Constraint Decisions

Managers often face the problem of deciding how scarce
resources are going to be utilized.
Usually, fixed costs are not affected by this particular
decision, so management can focus
on maximizing total contribution margin.

Let’s look at the Kaiser Company example.

How to maximize contribution margin when one

factor limits production capacity?
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Production Constraint Decisions

Kaiser Company produces two products and selected data
is shown below:
Products
A B
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 (per unit)
required on Machine X 1.00 min. 0.50 min.
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Production Constraint Decisions

Machine X is the scarce resource because there is

excess capacity on other machines. Machine X is
being used at 100% of its capacity.
Machine X capacity is 2,400 minutes per week.
Should Kaiser focus its efforts on Product A or B?
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Let’s calculate the contribution margin per unit of the scarce

resource, machine X.
Products
A B
Contribution margin per unit $ 24 $
15
Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.
Contribution margin per minute $ 24 $ 30

Product B should be emphasized. It makes more valuable use

of the scarce resource (Machine X), yielding a higher
contribution margin of $30 per minute as opposed to $24 for
Product A.

If there are no other considerations, the best plan would be

to produce to meet current demand for Product B and then
use any capacity that remains to make Product A.
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Production Constraint Decisions

Let’s see how this plan would work.
Allotting Scarce Resource (Machine X)

Weekly demand for Product B 2,200 units

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

Total machine time available 2,400 min.

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

Current demand for A is 2,000 units

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Production Constraint Decisions

According to the plan, we will produce 2,200 units of Product
B and 1,300 units of Product A.
Product A Product B
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 Kaiser is $64,200.

Any other combination would result in a lesser CM.

DECISION RULE
Priority is given to the product with the highest
contribution margin per unit of scarce resource
 10-29

(3) Make or Buy Decisions

Should I
continue to make
the part, or should
I buy it?
I suppose I
should compare What will I
the outside purchase do with my
price with the additional idle facilities if
costs to manufacture I buy the part?
the part.
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Make or Buy Decisions

Outsourcing - Definition Outsourcing
 The decision to buy or subcontract a component product or service
rather than produce it in-house.
 May lead to reduced control over delivery time or product quality.
 Outsourcing is a regular feature of companies with limited resources.
Why Outsource?
 Cost savings.
 Focus on core business.
 Knowledge: access to intellectual property, wider experience.
 Access to talent.
Factors to Consider:
 Reliability of supplier – delivery, quality, price etc.
 Flexibility to adapt to changing conditions.
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Make or Buy Decisions

Incremental costs are also important in the decision
to make a product or buy it from a supplier.
The cost to produce an item must include
(1) direct materials (usually avoidable VC)
(2) direct labor (avoidable VC)
(3) incremental overhead (unavoidable v. avoidable F.C.)

We should NOT use the predetermined overhead rate

to determine product cost.
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Make or Buy Decisions

Excel makes computer chips used in
one of its products. Unit costs, based on production of
20,000 chips per year, are:

Unit Costs
Direct Materials $ 9.00
Direct Labor 5.00
Variable Overhead 1.00
Fixed Overhead 13.00
Total $ 28.00
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Make or Buy Decisions

An outside supplier has offered to provide the
20,000 chips at a cost of $25 per chip. Fixed
overhead costs will not be avoided if the chips
are purchased.
Irrelevant cost: same under both alternatives

Excel has no alternative use for the facilities.

Should Excel accept the offer?
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Make or Buy Decisions

Make Buy
Direct Material $ 9.00 $ -
Direct Labor 5.00 -
Variable Overhead 1.00 - 0
Purchase costs - 25.00
Total $ 15.00 $ 25.00

Incremental costs = $10

Excel should not pay $25 per unit to an outside supplier to
avoid the $15 per unit differential cost of making the part.
Unavoidable fixed costs are irrelevant.
DECISION RULE
Outsource if there is incremental benefits
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Avoidable Fixed Cost
Fixed Overhead $13, out of which $3 is avoidable.
Make Buy
Direct Material $ 9.00 $ -
Direct Labor 5.00 -
Variable Overhead 1.00 - 0
Purchase costs - 25.00
Avoidable Fixed Overhead - (3.00)
Total $ 15.00 $ 22.00

Incremental costs = $7
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Avoidable Fixed Cost
Fixed Overhead $13, out of which $3 is avoidable.
Make Buy
Direct Material $ 9.00 $ -
Direct Labor 5.00 -
Variable Overhead 1.00 - 0
Purchase costs - 25.00
Avoidable Fixed Overhead 3.00 -
Total $ 18.00 $ 25.00

Incremental costs = $7

QUESTION
What is the maximum price that the company can pay
the external supplier for the outsourced part?
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(4) Sell, Scrap, or Rebuild Decisions

Costs incurred in manufacturing units of product
that do not meet quality standards are sunk costs
and cannot be recovered.

As long as rebuild costs are recovered

through sale of the product, and
rebuilding does not interfere with normal
production, we should rebuild.
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Sell, Scrap, or Rebuild Decisions

Servo has 10,000 defective units that cost $1.00 each to

make. The units can be scrapped now for $.40 each or
rebuilt at an additional cost of $.80 per unit.
If rebuilt, the units can be sold for the normal selling price
of $1.50 each. Rebuilding the 10,000 defective units will
prevent the production of 10,000 new units that would
also sell for $1.50.
Should Servo scrap or rebuild?
 10-39

Sell, Scrap, or Rebuild Decisions

Scrap
Now Rebuild
Sale of defects $ 4,000 $ 15,000
Less rebuild costs -
Less opportunity cost -
Net return $ 4,000

10,000 units × $0.40 per unit

10,000 units × $1.50 per unit

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Sell, Scrap, or Rebuild Decisions

10,000 units × $0.80 per unit
Scrap
Now Rebuild
Sale of defects $ 4,000 $ 15,000
Less rebuild costs - (8,000)
Less opportunity cost - (5,000)
Net return $ 4,000 2,000

Benefits foregone: CM for 10,000 new products

10,000 units × (Selling Price $1.50 – Cost $1.00)

Servo should scrap the units now.

DECISION RULE
Choose the option with the highest incremental
benefits
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(5) Joint Product Decisions

Two or more products produced from a
common input are called joint products

Product 1
Joint costs are
the costs of
Joint Costs Product 2 processing prior to
the split-off point

Product 3
The split-off point is the point in a process where
joint products can be recognized as separate products
 10-42
For example, in the petroleum refining industry, a large number of
products are extracted from crude oil, including gasoline, jet fuel, home heating
oil, lubricants, asphalt, and various organic chemicals.
Joint costs
are incurred
up to the Oil
Further Final
split-off point
Processing Sale

Common Final
Joint
Production Gasoline
Input Sale
Process

Further
Chemicals Final
Processing
Sale

Split-Off
Point
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Joint Product Decisions

Businesses are often faced with the decision to sell
partially completed products at the split-off point or to
process them to completion.

DECISION RULE
Process further if
incremental revenues > incremental costs
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Joint Product Decisions

Ames Co. produces two products, A and B, from this process.

Should the products be

Additional Final
sold at split-off or
process further?
A Processing Sale
Cost $120,000
Revenue $40,000
Joint Common $70,000
Cost Production
$100,000 Process

Revenue Additional Final

$50,000 Processing Sale
Cost $65,000
Split-Off
Point B $20,000
 10-45

Joint Product Decisions

Incremental Incremental
Product Revenue Cost Difference
A $ 50,000 $ 40,000 $ 10,000
B 15,000 20,000 (5,000)
Product A incremental revenue = $120,000 - $70,000 = $50,000
Incremental revenue $50,000 > Incremental cost $40,000

Product B incremental revenue = $65,000 - $50,000 = $15,000

Incremental revenue $15,000 < Incremental cost $20,000

Process product A, but sell product B at the split-off point.

Joint costs are not relevant in decisions regarding what to do with a

product after the split-off point.
Joint costs are really common costs incurred to simultaneously produce a
variety of end products.
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Non-financial Considerations

Legal Reputation
issues

Environmental
impacts
It would be irresponsible
for me to base my
Ethical decision entirely on revenue
implications and cost figures.
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Non-Financial Considerations

 Impact on  High CM but  Product  Cannibalize  Market

regular low demand quality / other Demand
customers availability products
 Complementary
 Undercutting Products  Supplier
by special- relationship
order
customers

(1) (2) (3) (4) (5)

Special Production Make Sell, Scrap Joint
order constraint or buy or Rebuild product
decisions decisions decisions decisions decisions
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Review Questions
1. Which of the following is true?
a. Fixed costs are always irrelevant.
b. Variable costs are always relevant.
c. Joint costs are always irrelevant.
d. All of the above.

2. In the sell-or-process further decision,

a. Joint costs are always relevant.
b. Total costs of joint processing and further processing are
relevant.
c. All costs incurred prior to the split-off point are relevant.
d. The most profitable outcome can be to further process some
separately identifiable products beyond the split-off point, but
sell others at the split-off point.
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Check List
Do you have a good understanding of:
 Types of relevant cost
 Five types of decisions and the decision rules
 Non-financial factors to consider when making
decisions

END