Financial and Managerial Accounting Wild, Shaw, and Chiappetta Fifth Edition Wild, Shaw, and Chiappetta Fifth Edition McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 23 Relevant Costing for Managerial Decisions

Conceptual Learning Objectives C1: Describe the importance of relevant costs for short-term decisions. 23-3

A1: Evaluate short-term managerial decisions using relevant costs. A2: Determine product selling price based on total costs. Analytical Learning Objectives 23-4

P1: Identify relevant costs and apply them to managerial decisions. Procedural Learning Objectives 23-5

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. Decision Making C1 23-6

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. 1 2 Relevant Costs C1 23-7

Identifying Relevant Costs Historical costs are generally not relevant to decisions. Instead the relevant costs are the additional costs, called incremental, or avoidable, costs. -These are costs incurred if a company decides on a specific course of action. P Sunk costs Out-of-pocket costs Opportunity 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. 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. Classification by Relevance: Sunk Costs 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. C1 23-9

Future outlays of cash associated with a particular decision. Out-of-Pocket-Costs ARE relative for current and future decision making. 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. Classification by Relevance: Out-of-Pocket Costs C

The potential benefit that is given up when one alternative is selected over another. Classification by Relevance: Opportunity Costs C 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.

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. Management needs to know whether accepting the offer will increase net income Accepting Additional Business A Thanks for the offer! Let me talk to our management team and I’ll let you know tomorrow.

FasTrac currently sells 100,000 units of its product. The company has revenue and costs as shown below: Accepting Additional Business (Exhibit 23.2) A

Accepting Additional Business FasTrac is approached by an overseas company that offers to purchase 10,000 units at $8.50 per unit. If FasTrac 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 FasTrac accept the offer? A

This analysis leads to the incorrect decision. Accepting Additional Business A Per UnitTotal Sales (10,000 additional units) $8.50$85,000 Total costs and expenses (9.00)(90,000) Operating Loss$(0.50)$(5,000) Sorry, we are going to reject the offer because the selling price is less than the per unit cost to make it.

If they accept the offer, revenues will increase by 10,000 new units × $8.50 selling price = $85,000 P1 Accepting Additional Business (Exhibit 23.4) 23-16

Direct material costs will increase by 10,000 new units × $3.50 = $35,000 P1 Accepting Additional Business (Exhibit 23.4) 23-17

Direct labor costs will increase by 22,000 new units × $2.20 = $22,000 P1 Accepting Additional Business (Exhibit 23.4) Overhead, selling expenses, and administrative expenses are largely fixed costs that increase but not in direct proportion to sales.

Even though the $8.50 selling price is less than the normal $10 selling price, FasTrac should accept the offer because net income will increase by $20,000. P1 Accepting Additional Business (Exhibit 23.4) 23-19

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. Make or Buy Decisions A

FasTrac currently makes part #417, assigning overhead at 100 percent of direct labor cost, with the following unit cost: Make or Buy Decisions P

FasTrac 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? Make or Buy Decisions (Exhibit 23.5) P

We must be able to eliminate a minimum of $.25 per unit of overhead. Make or Buy Decisions FasTrac can buy part #417 from a supplier for $1.20/unit. How much overhead do we have to eliminate before we should buy this part? P ($ $0.95)

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. Scrap or Rework A

FasTrac 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 FasTrac scrap or rework? Scrap or Rework P

Revenue from the sale of the reworked units= 10,000 units × $1.50 per unit Revenue from sale of the defective units = 10,000 units × $0.40 per unit Scrap or Rework (Exhibit 23.6) P

Costs to rework the units = 10,000 units × $0.80 per unit Opportunity cost of not making 10,000 units = 10,000 units × ($ $1.00) per unit Scrap or Rework (Exhibit 23.6) P

The correct decision: FasTrac should scrap the units now. Note: If FasTrac 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. Scrap or Rework Defects (Exhibit 23.6) P

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. Sell or Process A

FasTrac 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 Sell or Process A

Sell or Process (Exhibit 23.7) P Should FasTrac sell product Q or continue processing into products X, Y, and Z? 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

Note that the earlier $30,000 cost for producing Q is sunk and therefore irrelevant to the decision. Sell or Process (Exhibit 23.7) Incremental revenue (220,000-50,000) =$170,000 Incremental cost = 80,000 Incremental revenue > Incremental cost Decision…FasTrac should continue processing ! P Remember: The company would receive $50,000 for Product Q.

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? Sales Mix Selection A 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.

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

Consider the following data for two products made and sold by FasTrac. The company is operating at full capacity and the products produced require a different amount of machine hours. P1 Sales Mix Selection Demand Is Unlimited and Products Use Different Inputs. (Exhibit 23.9) 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.

With unlimited demand for A and B, produce as many units of A as possible since A provides more dollars per hour worked. P Sales Mix Selection Demand Is Unlimited and Products Use Different Inputs. (Exhibit 23.9) When a company faces unlimited demand and limited capacity, only the most profitable product per input, should be manufactured.

If demand for A is limited, produce to meet that demand, then use the remaining facilities to produce B. Using the same information for FasTrac below but adding the additional fact that the market for Product A is limited to 80,000 units. P Sales Mix Selection Demand Is Limited (Exhibit 23.9)

FasTrac is considering eliminating its Treadmill Division because total expenses of $48,300 are greater than its sales of $47,800. A segment is a candidate for elimination if its revenues are less than its avoidable expenses. Continue Segment Elimination (Information from Exhibit 23.10) A

P1 Segment Elimination Do not eliminate the Treadmill Division! FasTrac 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 Treadmill Division sales revenue is greater than its avoidable expenses by $6,000.

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

Setting Product Prices A2 Relevant costs are useful to management to assist in determining prices for special short- term 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.

Four Steps Using the Total Cost Method 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 A

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