Relevant costs for decision making Developing Next Generation Leaders through Applied Know-How Introduction to Business Relevant costs for decision making Metka Tekavčič, PhD Developing Next Generation Leaders through Applied Know-How project number: 2015-1-MK01-KA202-002851

COST CONCEPTS FOR DECISION MAKING Every decision involves a choice from among at least two alternatives. The costs and benefits of the alternatives should be compared when making the decision. Only those costs and benefits that differ between alternatives are relevant in a decision. When making a decision, eliminate all irrelevant costs. Make the decision based on the remaining, relevant costs. Examples of decisions: Adding and dropping product lines Make or buy decision Developing Next Generation Leaders through Applied Know-How project number: 2015-1-MK01-KA202-002851

COST CONCEPTS FOR DECISION MAKING DIFFERENTIAL COST: difference in costs between any two alternatives DIFFERENTIAL REVENUE: difference in revenues between any two alternatives OPPORTUNITY COST: potential benefit that is given up when one alternative is selected over another 3. SUNK COST - never relevant in decisions! A sunk cost is a cost that has already been incurred. It cannot be avoided regardless what a manager decides to do. It cannot be changed by any decision made now or in the future. Developing Next Generation Leaders through Applied Know-How project number: 2015-1-MK01-KA202-002851

Continue / abandon product B? (Ex. 1) Company Y produces products A and B using the same plant. Product A is sold in the market at a price of €500, which is €100 above its cost per unit. Company Y produces 10,000 units of product A and has therefore €1,000,000 of profit related to product A. Product B’s cost per unit is €200, while the price at which product B is sold in the market is €150. The company produces 4,000 units of B and has a loss of €200,000 from producing B. Costs per unit for both products were calculated considering the fact that production of product A uses 70% of the plant’s available capacities and production of B uses the remaining 30% of these capacities. Company’s total fixed costs are €900,000. Due to limited demand for product A, the company cannot increase the production of A or produce any other product, except B. Considering the fact that company Y has a loss from production of product B, would you recommend the company should stop producing product B? Please, give your answer by calculating the necessary information. Developing Next Generation Leaders through Applied Know-How project number: 2015-1-MK01-KA202-002851

SOLUTION Data: Product A: P = €500, Cost per unit = €400; Q = 10,000 Profit per unit =€100; Total profit = €1 mill. Product B: P = €150, Cost per unit = €200; Q = 4,000 Profit per unit = -€50; Total profit = - €200,000 Costs per unit for both products were calculated by considering the fact that production of product A uses 70% of the plant’s available capacities and production of B uses the remaining 30% of these capacities. FC = €900,000  FC (A) = 0.7 * €900,000 = €630,000 FC (B) = 0.3 * €900,000 = €270,000 Developing Next Generation Leaders through Applied Know-How project number: 2015-1-MK01-KA202-002851

SOLUTION 5 different ways of calculation : No 1: P(B) > VCunit(B) (in the short run!) VCunit (B) = Cost per unit (B) – FCunit (B) = €200 – (€270,000/4,000) = €200 – €67.50 = €132.50 €150 > €132.50  Price covers €132.50 VC per unit and €17.50 FC per unit No 2: TR(B) > VC(B) TR (B) = €150 * 4,000 = €600,000 VC (B) = €132.50 * 4,000 = €530,000 €600,000 > €530,000  TR cover €530,000 VC and €70,000 FC In the short-run, the company will produce B despite the loss when revenues cover at least variable cost. Developing Next Generation Leaders through Applied Know-How project number: 2015-1-MK01-KA202-002851

SOLUTION No 3: Profit (A+B) > Profit (A) Profit (A+B) = €1 mill – €200,000 = €800,000 Profit (A) = €1 mill – €270,000 = €730,000 No 4: FC(B) > Loss(B) FC (B) = €270,000 Loss (B) = €200,000 In the short-run, the company will produce B despite the loss when the loss is smaller than fixed cost. No 5: Decrease in TR (B) > Decrease in VC (B) Decrease in TR (B) = €150 * 4,000 = €600,000 Decrease in VC (B) = €530,000 Developing Next Generation Leaders through Applied Know-How project number: 2015-1-MK01-KA202-002851