Relevant Costs for Decision Making May 27, 2009 – Part 2 Relevant Costs for Decision Making Chapter 11: Relevant Costs for Decision Making. Making decisions is one of the basic functions of a manager. To be successful in decision making, managers must be able to tell the difference between relevant and irrelevant data and must be able to correctly use the relevant data in analyzing alternatives. The purpose of this chapter is to develop these skills by illustrating their use in a wide range of decision-making situations.

Today’s Agenda Relevant Costs vs. Irrelevant Costs Differential Approach vs. Total Cost Approach Product Transfer Decision Example Constrained Resources

Relevant Costs Costs that are relevant to decision making are those costs which differ between two or more alternatives Differential costing Costs that are irrelevant to decision making are those that cannot be altered Sunk costs Future costs that cannot be changed By definition, these costs will not be different from each other in differing scenarios These costs are unavoidable Costs that are relevant to one decision may not be relevant to a different decision One can use a total cost approach as opposed to a differential cost approach

Total Cost versus Differential Cost Approach Total Cost Approach Factor in ALL costs More time consuming Provides a complete picture and budget basis Differential Cost Approach Only factor in relevant costs; ie, those that differ between scenarios Quicker Does not provide the full cost picture Either approach should lead to the same business decision conclusion

Total and Differential Cost Approaches Using the differential approach is desirable for two reasons: Only rarely will enough information be available to prepare detailed income statements for both alternatives. Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical. Using the differential approach is desirable for two reasons: Only rarely will enough information be available to prepare detailed income statements for both alternatives. Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical.

Production Transfer Decision James Company manufactures Switches It manufactures and sells its products in North America Its best customer has received a price quote from James Co’s competitor for $7,000 per unit The customer expects to grow significantly and says that costs are its #1 issue What would happen to the company if it matched the competitor’s quote? What should James Co do?

Production Transfer Decision James Co options: Keep prices the same and hope the customer stays Suggest the extra cost is provided in value added service Argue that James Co knows the customer better & can better serve it Argue that James Co quality and timeliness of delivery is superior Match the price, lose money and try to cut costs over time Manufacture in a lower cost location Investigate whether James Co can manufacture the product profitably elsewhere

Production Transfer Decision You are the head of managerial accounting and you learn the following about producing in China: Component parts can be sourced for 70% of current costs Because they are made in China and would not require shipping Labour costs are 20% of what they are in North America Shipping completed product back to North America would cost $250 per unit AND it would add two weeks to the delivery schedule Power is approximately the same cost in both locations If the company transferred, the customer would conduct a detailed one-time facility inspection at a cost to James Co of $2 million There are other “one-time” costs Building up extra inventory for the transfer period to ensure continuity of supply Parallel production until China facility is in steady-state It would take a full 12 months to sub-lease the North American facility What information is missing to make a decision whether to transfer production?

Product Transfer Decision

Product Transfer Decision Do you have a conclusion? Is there anything analysis still missing?

Product Transfer Decision There has been no consideration for additional inventory required due to increase in delivery time Two weeks additional inventory costs However, there is less inventory ($ value) because it now costs less Also, still need to consider “on-time” costs How can these one-time costs be addressed?

Tutorial Assignment Review Build versus Buy Decisions Study Review Problems Complete Alternative Question