© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 13: Short-Run Decision Making: Relevant Costing Cornerstones of Managerial Accounting, 4e

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Short-Run Decision Making ► Short-run decision making consists of choosing among alternatives with an immediate or limited end in view. ► Short-term decisions sometimes are referred to as tactical decisions because they involve choosing between alternatives with an immediate or limited time frame in mind. ► Accepting a special order for less than the normal selling price to utilize idle capacity and to increase this year’s profits is an example. Thus, some decisions tend to be short run in nature. ► However, it should be emphasized that short-run decisions often have long-run consequences. 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Decision-Making Model ► A decision model, a specific set of procedures that produces a decision, can be used to structure the decision maker’s thinking and to organize the information to make a good decision. ► The following is an outline of one decision-making model: ► Step 1. Recognize and define the problem. ► Step 2. Identify alternatives as possible solutions to the problem. Eliminate alternatives that clearly are not feasible. ► Step 3. Identify the costs and benefits associated with each feasible alternative. Classify costs and benefits as relevant or irrelevant, and eliminate irrelevant ones from consideration. ► Step 4. Estimate the relevant costs and benefits for each feasible alternative. ► Step 5. Assess qualitative factors. ► Step 6. Make the decision by selecting the alternative with the greatest overall net benefit. 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Relevant Costs Defined ► The decision-making approach just described emphasized the importance of identifying and using relevant costs. ► Relevant costs possess two characteristics: 1. they are future costs AND 2. they differ across alternatives. ► All pending decisions relate to the future. ► Accordingly, only future costs can be relevant to decisions. 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Opportunity Costs ► Opportunity cost is the benefit sacrificed or foregone when one alternative is chosen over another. ► An opportunity cost is relevant because it is both a future cost and one that differs across alternatives. ► While an opportunity cost is never an accounting cost, because accountants do not record the cost of what might happen in the future (i.e., they do not appear in financial statements), it is an important consideration in relevant decision making. 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sunk Costs ► A sunk cost is a cost that cannot be affected by any future action. ► It is important to note the psychology behind managers’ treatment of sunk costs. ► Although managers should ignore sunk costs for relevant decisions, it unfortunately is human nature to allow sunk costs to affect these decisions. ► For example, depreciation, a sunk cost, is sometimes allocated to future periods though the original cost is unavoidable. In choosing between the two alternatives, the original cost of an asset and its associated depreciation are not relevant factors. 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost Behavior and Relevant Costs ► Most short-run decisions require extensive consideration of cost behavior. ► It is easy to fall into the trap of believing that variable costs are relevant and fixed costs are not. ► But this assumption is not true. ► The key point is that changes in supply and demand for resources must be considered when assessing relevance. ► If changes in demand and supply for resources across alternatives bring about changes in spending, then the changes in resource spending are the relevant costs that should be used in assessing the relative desirability of the two alternatives. 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Some Common Relevant Cost Applications ► Relevant costing is of value in solving many different types of problems. Traditionally, these applications include decisions: ► to make or buy a component. ► to keep or drop a segment or product line. ► to accept a special order at less than the usual price. ► to further process joint products or sell them at the split- off point. ► Though by no means an exhaustive list, many of the same decision-making principles apply to a variety of problems. 2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Make-or-Buy Decisions ► Managers often face the decision of whether to make a particular product (or provide a service) or to purchase it from an outside supplier. ► Make-or-buy decisions are those decisions involving a choice between internal and external production. ► One type of relevant cost that is becoming increasingly large due to globalization and the green environmental movement concerns the disposal costs associated with electronic waste (or e-waste). 2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Special Order Decisions ► From time to time, a company may consider offering a product or service at a price different from the usual price. ► Firms often have the opportunity to consider special orders from potential customers in markets not ordinarily served. ► Special-order decisions focus on whether a specially priced order should be accepted or rejected. ► These orders often can be attractive, especially when the firm is operating below its maximum productive capacity. 2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Keep-or-Drop Decisions ► Often, a manager needs to determine whether a segment, such as a product line, should be kept or dropped. ► Segmented reports prepared on a variable-costing basis provide valuable information for these keep-or-drop decisions. ► Both the segment’s contribution margin and its segment margin are useful in evaluating the performance of segments. ► However, while segmented reports provide useful information for keep-or-drop decisions, relevant costing describes how the information should be used to arrive at a decision. 2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Keep-or-Drop with Complementary Effects ► Sometimes dropping one line would lower sales of another line, as many customers buy both lines at the same time. ► This information can affect the keep-or-drop decision. 2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Further Processing of Joint Products ► Joint products have common processes and costs of production up to a split-off point. At that point, they become distinguishable as separately identifiable products. The point of separation is called the split-off point. ► Sometimes it is more profitable to process a joint product further, beyond the split-off point, prior to selling it (sell or- process-further decision). 2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Product Mix Decisions ► Most of the time, organizations have wide flexibility in choosing their product mix. ► Product mix refers to the relative amount of each product manufactured (or service provided) by a company. ► Decisions about product mix can have a significant impact on an organization’s profitability. ► Every firm faces limited resources and limited demand for each product. These limitations are called constraints. ► A manager must choose the optimal mix given the constraints found within the firm. 3

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Multiple Constrained Resources ► The presence of only one constrained resource might not be realistic. ► Organizations often face multiple constraints, including: ► limitations of raw materials ► limitations of skilled labor ► limited demand for each product ► The solution of the product mix problem in the presence of multiple constraints is considerably more complicated and requires the use of a specialized mathematical technique known as linear programming, which is reserved for advanced cost management courses. 3

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost-Based Pricing ► Demand is one side of the pricing equation; supply is the other side. ► Since revenue must cover all costs for the firm to make a profit, many companies start with cost to determine price. ► That is, they calculate product cost and add the desired profit. ► The mechanics of this approach are straightforward. Usually, there is a cost base and a markup. ► The markup is a percentage applied to the base cost. ► It includes desired profit and any costs not included in the base cost. ► Companies that bid for jobs routinely base bid price on cost. 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Target-Costing and Pricing ► Many American and European firms set the price of a new product as the sum of the costs and the desired profit. The rationale is that the company must earn sufficient revenues to cover all costs and yield a profit. ► Target costing is a method of determining the cost of a product or service based on the price (target price) that customers are willing to pay. ► The marketing department determines what characteristics and price for a product are most acceptable to consumers. 4