Relevant Costs and Benefits for Decision Making Module 16 Relevant Costs and Benefits for Decision Making

Relevant and Irrelevant Costs Future costs that differ among competing decision alternatives Future costs that DO NOT differ among competing decision alternatives Primary focus is profit maximization Additional factors that should be considered Effects on long-run profit Nonquantitative factors Such as legal, ethical, social

Sunk Costs Result from past decisions that cannot be changed Sunk costs are NEVER relevant Sunk costs in decisions to replace a machine Book value of old machine Can cause ethical dilemmas Managers often avoid disposing of old assets Disposing may create a loss on the income statement, making the manager’s performance look bad and decrease their bonuses!

Disposal and Salvage Values Disposal value Amount of cash an old asset can be sold for at the time the new asset is purchased Relevant cash inflow Obtained only if the replacement alternative is accepted Salvage value Amount of cash an asset will bring at the end of its useful life if held to that time

Opportunity Costs Any benefit forgone as a result of rejecting one alternative in favor of another

Make or Buy Do we make a product, part, or service or do we purchase it from the outside? Compare the total cost of purchasing with the internal costs that may be saved (avoided) by purchasing. Be careful on the long-term effects of such a decision on quality and stability

Special Sales Orders Do we accept a low priced sales order? Compare the additional revenues with the differential costs. Be careful on sales to direct competitors, especially retailers, as an price differences may have to be defended in court. Only cost differences allowed.

Budget Alternatives Which alternative is best? Dropping products, changing prices, advertising increases… Select the alternative with the highest positive impact on profits?

Sell or Process Further Do we sell products as is or process them further? Compare the increase in revenues with the increase in costs. Joint products are a special case of this.

Use of Limited Resources Which products or services do we produce with our limited resources? Select the products first with the highest contribution margin per unit of limited resource, subject to sales and other constraints.

Equipment Replacement How do we decide to replace a working piece of equipment? Compare the impact on profits over the life of the new equipment with the net cost of the new equipment. Be sure to net out the disposal value of the old equipment from the cost of the new equipment. Note that taxes saved from disposal losses can be relevant in real situations.