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Chapter 23 Relevant Costing for Managerial Decisions

Conceptual Learning Objectives C 1: Describe the importance of relevant costs for short-term decisions. 23 -3

Analytical Learning Objectives A 1: Evaluate short-term managerial decisions using relevant costs. A 2: Determine product selling price based on total costs. 23 -4

Procedural Learning Objectives P 1: Identify relevant costs and apply them to managerial decisions. 23 -5

C 1 Decision Making Decision making involves five steps: Define the decision task. Identify alternative courses of action. Collect relevant information and evaluate each alternative. Select the preferred course of action. Analyze and assess decisions made. 23 -6

C 1 Relevant Costs l l l 1 l Are applicable to a particular decision. Should have a bearing on which alternative a manager selects. Are avoidable. Are future costs that differ between alternatives. 2 23 -7

P 1 Identifying Relevant Costs 1 Historical costs are generally not relevant to decisions. 2 Instead the relevant costs are the additional costs, Sunk costs called incremental, or avoidable, costs. Out-of-pocket costs -These are costs incurred Opportunity costs if a company decides on a specific course of action. 23 -8

C 1 Classification by Relevance: Sunk Costs All costs incurred in the past that cannot be changed by any decision made now or in the future. Sunk costs should not be considered in decisions. Example: You bought an automobile 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. 23 -9

C 1 Classification by Relevance: Out-of-Pocket Costs Future outlays of cash associated with a particular decision. Out-of-Pocket-Costs ARE relative for current and future decision making. Example: Considering the decision to take a vacation or stay at home, you will have travel costs (out-of-pocket costs) only if you choose a vacation. 23 -10

C 1 Classification by Relevance: Opportunity Costs The potential benefit that is given up when one alternative is selected over another. Example: If you were not attending college, you could be earning \$20, 000 per year. Your opportunity cost of attending college for one year is \$20, 000. 23 -11

A 1 Accepting Additional Business The decision to accept additional business should be based on incremental costs and incremental revenues. Incremental amounts are those that occur if the company decides to accept the new business. Thanks for the offer! Let me talk to our management team and I’ll let you know tomorrow. Management needs to know whether accepting the offer will increase net income 23 -12

A 1 Accepting Additional Business (Exhibit 23. 2) Fas. Trac currently sells 100, 000 units of its product. The company has revenue and costs as shown below: 23 -13

A 1 Accepting Additional Business Fas. Trac is approached by an overseas company that offers to purchase 10, 000 units at \$8. 50 per unit. If Fas. Trac 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. Should Fas. Trac accept the offer? 23 -14

A 1 Accepting Additional Business Per Unit Total Sales (10, 000 additional units) \$8. 50 \$85, 000 Total costs and expenses (9. 00) (90, 000) \$(0. 50) \$(5, 000) Operating Loss Sorry, we are going to reject the offer because the selling price is less than the per unit cost to make it. This analysis leads to the incorrect decision. 23 -15

P 1 Accepting Additional Business (Exhibit 23. 4) If they accept the offer, revenues will increase by 10, 000 new units × \$8. 50 selling price = \$85, 000 23 -16

P 1 Accepting Additional Business (Exhibit 23. 4) Direct material costs will increase by 10, 000 new units × \$3. 50 = \$35, 000 23 -17

P 1 Accepting Additional Business (Exhibit 23. 4) Direct labor costs will increase by 22, 000 new units × \$2. 20 = Overhead, selling expenses, and administrative expenses are largely fixed costs that increase but not in direct proportion to sales. 23 -18

P 1 Accepting Additional Business (Exhibit 23. 4) Even though the \$8. 50 selling price is less than the normal \$10 selling price, Fas. Trac should accept the offer because net income will increase by \$20, 000. 23 -19

A 1 Make or Buy Decisions l l l Incremental costs also are important in the decision to make a component or purchase it from a supplier. The cost to produce an item must include (1) direct materials, (2) direct labor, and (3) incremental overhead. We should not use the predetermined overhead rate to determine product cost. 23 -20

P 1 Make or Buy Decisions Fas. Trac currently makes part #417, assigning overhead at 100 percent of direct labor cost, with the following unit cost: 23 -21

P 1 Make or Buy Decisions (Exhibit 23. 5) Fas. Trac can buy part #417 from a supplier for \$1. 20/per unit. How much overhead do we have to eliminate before we should buy this part? 23 -22

P 1 Make or Buy Decisions Fas. Trac can buy part #417 from a supplier for \$1. 20/unit. How much overhead do we have to eliminate before we should buy this part? We must be able to eliminate a minimum of \$. 25 per unit of overhead. (\$1. 20 \$0. 95) 23 -23

A 1 Scrap or Rework Costs incurred in manufacturing units of product that do not meet quality standards are sunk costs and cannot be recovered. As long as rework costs are recovered through sale of the product, and rework does not interfere with normal production, we should rework rather than scrap products in process. 23 -24

P 1 Scrap or Rework Fas. Trac has 10, 000 defective units that cost \$1. 00 each to make. The units can be scrapped now for \$. 40 each or reworked at an additional cost of \$. 80 per unit. If reworked, the units can be sold for the normal selling price of \$1. 50 each. Reworking the defective units will prevent the production of 10, 000 new units that would also sell for \$1. 50. Should Fas. Trac scrap or rework? 23 -25

P 1 Scrap or Rework (Exhibit 23. 6) Revenue from sale of the defective units = 10, 000 units × \$0. 40 per unit Revenue from the sale of the reworked units= 10, 000 units × \$1. 50 per unit 23 -26

P 1 Scrap or Rework (Exhibit 23. 6) Costs to rework the units = 10, 000 units × \$0. 80 per unit Opportunity cost of not making 10, 000 units = 10, 000 units × (\$1. 50 - \$1. 00) per unit 23 -27

P 1 Scrap or Rework Defects (Exhibit 23. 6) The correct decision: Fas. Trac should scrap the units now. Note: If Fas. Trac fails to include the opportunity cost of \$5, 000, the rework option would show a return of \$7, 000, mistakenly making the rework option appear more favorable. 23 -28

A 1 Sell or Process l l Businesses are often faced with the decision to sell partially completed products or to process them to completion. As a general rule, we process further only if incremental revenues exceed incremental costs. 23 -29

A 1 Sell or Process Fas. Trac has 40, 000 units of partially finished product Q. Processing costs to date are \$30, 000. The 40, 000 unfinished units can be sold as is for \$50, 000 or they can be processed further to produce finished products X, Y, and Z. The additional processing will cost \$80, 000 and result in the following revenues: Continue 23 -30

P 1 Sell or Process (Exhibit 23. 7) Remember: The company would receive \$50, 000 for Product Q. The incremental revenue from additional processing is \$220, 000\$50, 000 = \$170, 000. The incremental cost of processing is \$80, 000 Should Fas. Trac sell product Q or continue processing into products X, Y, and Z? 23 -31

P 1 Sell or Process (Exhibit 23. 7) Remember: The company would receive \$50, 000 for Product Q. Incremental revenue (220, 000 -50, 000) =\$170, 000 Incremental cost = 80, 000 Incremental revenue > Incremental cost Decision…Fas. Trac should continue processing! Note that the earlier \$30, 000 cost for producing Q is sunk and therefore irrelevant to the decision. 23 -32

A 1 Sales Mix Selection When a company sells a variety of products, some are likely to be more profitable than others. They are wise to concentrate sales efforts on more profitable products. How do they identify the best sales mix? To make an informed decision, management must consider. . . • • The contribution margin of each product The facilities required to produce each product and any constraints on the facilities • The demand for each product. 23 -33

Sales Mix Selection P 1 Demand Is Unlimited and Products Use SAME Inputs. Consider the following data for two products made and sold by Fas. Trac. If each product requires the same time to make, and the demand is unlimited, Fas. Trac should produce only Product B because it has the highest contribution margin. 23 -34

Sales Mix Selection P 1 Demand Is Unlimited and Products Use Different Inputs. (Exhibit 23. 9) Consider the following data for two products made and sold by Fas. Trac. The company is operating at full capacity and the products produced require a different amount of machine hours. In the time that it takes to produce one unit of Product B, we can produce two units of Product A. Product B has a greater contribution margin than Product A, but it requires more machine hours per unit to produce. 23 -35

Sales Mix Selection P 1 Demand Is Unlimited and Products Use Different Inputs. (Exhibit 23. 9) When a company faces unlimited demand limited capacity, only the most profitable product per input, should be manufactured. With unlimited demand for A and B, produce as many units of A as possible since A provides more dollars per hour worked. 23 -36

P 1 Sales Mix Selection Demand Is Limited (Exhibit 23. 9) Using the same information for Fas. Trac below but adding the additional fact that the market for Product A is limited to 80, 000 units. If demand for A is limited, produce to meet that demand, then use the remaining facilities to produce B. 23 -37

A 1 Segment Elimination (Information from Exhibit 23. 10) A segment is a candidate for elimination if its revenues are less than its avoidable expenses. Fas. Trac is considering eliminating its Treadmill Division because total expenses of \$48, 300 are greater than its sales of \$47, 800. Continue 23 -38

P 1 Segment Elimination Fas. Trac should eliminate the Treadmill Division if its revenues are less than it avoidable expenses. Avoidable expenses are amounts the company would not incur if it eliminated the segment. . The Do not eliminate the Treadmill Division! Treadmill Division sales revenue is greater than its avoidable expenses by \$6, 000. 23 -39

A 1 Qualitative Decisions Factors Qualitative factors are involved in most all managerial decisions. For example: l Quality. l Delivery schedule. l Supplier reputation. l Employee morale. l Effects on the company’s image. 23 -40

A 2 Setting Product Prices Relevant costs are useful to management to assist in determining prices for special shortterm decisions. However, long-run pricing decisions also need to cover both variable and fixed costs, and yield a profit. There are several methods to help management in setting prices The “cost plus” method, where management adds a mark-up to the costs to reach a target price is most common. 23 -41

A 2 Four Steps Using the Total Cost Method: 1. Determine the total costs (production and nonproduction). 2. Determine the total cost per unit. 3. Determine the markup per unit. 4. Determine the selling price per unit: Total cost per unit + Markup per unit 23 -42

End of Chapter 23 23 -43