1. Financial and Managerial Accounting
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John J. Wild
Third Edition
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Relevant Costing for Managerial Decisions
Chapter 23
Relevant Costing for Managerial Decisions
This chapter explains several tools and procedures for making and evaluating short-term managerial decisions. It also describes how to assess the consequences of such decisions.

3. Conceptual Learning Objectives
C1: Describe the importance of relevant costs for short-term decisions.
In this chapter, you will learn the following conceptual objectives:
C1: Describe the importance of relevant costs for short-term decisions.

4. Analytical Learning Objectives
A1: Evaluate short-term managerial decisions using relevant costs.
A2: Determine product selling price based on total costs.
In this chapter, you will learn the following analytical objectives:
A1: Evaluate short-term managerial decisions using relevant costs.
A2: Determine product selling price based on total costs.

5. Procedural Learning Objectives
P1: Identify relevant costs and apply them to managerial decisions
In this chapter, you will learn the following procedural objectives:
P1: Identify relevant costs and apply them to managerial decisions

6. Let’s get started Managerial Decisions C 1
This chapter deals with using accounting information to make managerial decisions. The decisions that we will study are sometimes called special or non-routine decisions as they are not of the everyday variety of decisions that managers make.

7. Decision Making Decision making involves five steps:
Define the task and the goal.
Identify alternative actions.
Collect relevant information on alternatives.
Select the course of action.
Analyze and assess decision.
Managerial decision making involves five steps. These five steps represent an orderly, structured decision-making process that will lead to better decisions. First, we need to clearly define the problem and consider all feasible alternatives. Next, we need to gather information. Some of the information might not be relevant, so we need to discard that information and concentrate on using only relevant information to select the best alternative. After the decision is made, we should review the outcome in an effort to become even better decision makers in the future.

8. Relevant Costs Costs that are applicable to a particular decision.
Costs that should have a bearing on which alternative a manager selects.
Costs that are avoidable.
Future costs that differ between alternatives. 1 2
Relevant costs are future costs that differ between alternatives. A relevant cost is a cost that will be incurred if an alternative is selected but avoided if the alternative is rejected. For example, if you are deciding between walking to class and driving to class, the cost of gasoline would be a relevant cost.

9. Classification by Relevance: Sunk 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.
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.
Sunk costs cannot be changed by any decision we make as they have been incurred in the past and cannot possibly differ between any alternative that we might currently choose. Dwelling on sunk costs can frequently be the cause of decision errors. Sunk costs should not be considered in the decision process. For example, if you bought an automobile two years ago for ten thousand dollars, that amount is a sunk cost. Whether you drive the car, park it, trade it, or sell it, the ten thousand dollars cost will not change.

10. Classification by Relevance: Out-of-Pocket Costs
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.
Future outlays of cash associated with a particular decision.
Sometimes we hear the term out-of-pocket cost, meaning a future outlay of cash associated with a particular decision alternative. Out-of-pocket costs are relevant costs as they are future costs that differ between alternatives.

11. Classification by Relevance: Opportunity Costs
The potential benefit that is given up when one alternative is selected over another.
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.
Opportunity costs are the potential benefits that are given up when one alternative is selected over another. Opportunity costs are not actual dollar outlays; however, they may impact our decisions. For example, some of you may have made the decision to attend college rather than go straight into the work force. The opportunity cost of attending college is the lost salary that you could have earned, had you worked.

12. Managerial Decision Tasks
We will now examine several different types of managerial decisions.
Now that we have better knowledge of relevant costs and decision making, let’s look at several decisions that managers might make.

13. Accepting Additional Business
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.
On occasion, we may have the opportunity to accept additional business. We should make the decision to accept or reject the additional business using incremental revenues and incremental costs. Some of our costs may not change if we accept additional business. Those costs are not relevant as they do not differ between the alternatives: accept or reject the additional business.

14. Accepting Additional Business
Exh.
23-2
FasTrac currently sells 100,000 units of its product. The company has revenue and costs as shown below:
FasTrac makes one hundred thousand units of a single product that normally sells for ten dollars per unit. Total cost to make one unit is nine dollars, resulting in a one dollar profit per unit. The company operates at 80% of full capacity.

15. 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 foreign distributor offers to purchase ten thousand units at eight dollars and fifty cents each. FasTrack will have some additional costs if the order is accepted: Total factory overhead will increase by five thousand dollars; total selling expenses will increase by two thousand dollars; and total administrative expenses will increase by one thousand dollars.
We will assume that FasTrak has idle capacity to make the ten thousand units and that this is a one-time order which will not affect the company’s regular business.
Should FasTrac accept this special order from the foreign distributor?

16. Accepting Additional Business
First let’s look at incorrect reasoning that leads to an incorrect decision.
Our cost is $9.00 per unit. I can’t sell for $8.50 per unit.
First let’s look at an incorrect approach to the decision that does not consider incremental revenues and incremental costs. If we compare the foreign distributor’s offer with FasTrak’s unit cost, we see that the offer is fifty cents less than the unit cost. This comparison would lead us to reject the offer.

17. Accepting Additional Business
We can see from this correct analysis that the additional business at eight dollars and fifty cents per unit will increase income by twenty thousand dollars. Let’s look at the reasons why this is the case.
This analysis leads to the correct decision.

18. Accepting Additional Business
If we decide to accept this one time special order, revenue will increase by eighty five thousand dollars (ten thousand units at eight dollars and fifty cents per unit).
10,000 new units × $8.50 selling price = $85,000

19. Accepting Additional Business
Direct material is a variable cost that will increase in direct proportion to the increase in sales.
10,000 new units × $3.50 = $35,000

20. Accepting Additional Business
Direct labor is also a variable cost that will increase in direct proportion to the increase in sales. Factory overhead, selling expenses and administrative expenses are largely fixed costs that increase but not in direct proportion to sales as do the variable costs.
10,000 new units × $2.20 = $22,000

21. Accepting Additional Business
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.
By comparing incremental revenue of eighty five thousand dollars with the total incremental costs of sixty five thousand dollars, we see why the income from additional business is twenty thousand dollars. Now we can make the correct decision to accept the additional business.

22. Make or Buy Decisions A1
Incremental costs also are important in the decision to make a product 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.
The “Make or Buy” decision involves the question whether it is more economical to produce some goods internally or purchase them from an outside supplier. We will again concentrate on incremental cost for this decision.

23. Make or Buy Decisions A1
FasTrac currently makes part #417, assigning overhead at 100 percent of direct labor cost, with the following unit cost:
FasTrac is now making part number four seventeen which is a component part in its final product. The unit cost of the part includes direct material, direct labor, and factory overhead as shown on your screen.

24. Make or Buy Decisions A1
FasTrac can buy part #417 from a supplier for $ How much overhead do we have to eliminate before we should buy this part?
An outside supplier offers to make part number four seventeen, and sell it to FasTrac for one dollar and twenty cents per unit. We know that one dollar and twenty cents is less that FasTrak’s one dollar and forty five cents unit cost. Should Fastrak stop making the part and buy it from the outside supplier for one dollar and twenty cents per unit?
We know that FasTrack will avoid the direct material cost and the direct labor cost if they buy the part instead of making it. But that total is only ninety five cents. FasTrak cannot afford to pay one dollar and twenty cents per unit if they will only avoid ninety five cents per unit. They must also be able to avoid some of the factory overhead.
How much overhead does FasTrak avoid in order to justify buying the part?

25. Make or Buy Decisions A1
Exh.
23-5
FasTrac can buy part #417 from a supplier for $ How much overhead do we have to eliminate before we should buy this part?
We must eliminate $.25 per unit of overhead, leaving a maximum of $0.25 per unit.
FasTrak must be able to eliminate (avoid) a minimum of twenty five cents per unit in factory overhead costs to justify buying the part. If the avoidable amount of factory overhead per unit is greater than twenty five cents, then the incremental cost of making the part is greater than the one dollar and twenty cents outside price and FasTrack should buy the part instead of making it. On the other hand, if the avoidable amount of factory overhead per unit is less than twenty five cents, then the incremental cost of making the part is less than the one dollar and twenty cents outside price and FasTrack should continue making the part.
To make the correct make or buy decision, we must always determine the relevant (avoidable) costs of making the part and then compare these avoidable costs to the outside purchase cost. In almost all make or buy decisions, a significant amount of the factory overhead will be unavoidable, and therefore irrelevant to the decision as it will be the same for either alternative.

26. Scrap or Rework A1
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.
Often in production processes, we have product that does not pass inspection. We can either sell it as is, or rework it to improve the quality. Once reworked, the product will likely be sold for a higher price. The decision to rework or sell as is should be based on incremental revenues and incremental costs. The costs of manufacturing the product up to the inspection point are sunk and therefore irrelevant.

27. Should FasTrac scrap or rework?
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?
FasTrak has ten thousand defective units that can be sold as is for forty cents per unit, or reworked and sold for one dollar and fifty cents. The cost of reworking the defective units is eighty cents each. The one dollar per unit original cost to make the defective units is a sunk cost and irrelevant to the decision.
FasTrak does not have the capacity to rework the defective units and continue with its normal production. Reworking the defective units will prevent the production of ten thousand new units that would also sell for one dollar and fifty cents.
What should FasTrak do?

28. Scrap or Rework 10,000 units × $0.40 per unit
Sale of the ten thousand defective units as is for forty cents will generate four thousand dollars. Reworking and selling each unit for one dollar and fifty cents will generate fifteen thousand dollars.
10,000 units × $0.40 per unit
10,000 units × $1.50 per unit

29. Scrap or Rework 10,000 units × $0.80 per unit
The total cost to rework the ten thousand defective units at eighty cents each will be eight thousand dollars. We must also include the opportunity cost of ten thousand units of regular production that would be prevented by the rework. The regular units sell for one dollar and fifty cents each and cost one dollar per unit to make. We give up the opportunity to earn this five thousand dollars if we rework the defective units.
10,000 units × ($ $1.00) per unit

30. Scrap or Rework Defects
FasTrac should scrap the units now.
FasTrak should sell the defective units as is for four thousand dollars, as the net return is two thousand dollars higher than reworking the defective units. Note that if FasTrak does not include the opportunity cost of the displaced regular production, they will make an incorrect decision to rework the defective product. Failing to include the opportunity cost would result in an incorrect seven thousand dollars net return for the rework alternative.
If FasTrac fails to include the opportunity cost, the rework option would show a return of $7,000, mistakenly making rework appear more favorable.

31. Sell or Process A1
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.
Many products can be sold in an unfinished state, or processed further into a finished product that will sell for a higher price. The decision to sell or process should be based on incremental revenues and incremental costs. The costs of manufacturing the product up to the sell or process decision point are sunk and therefore irrelevant.

32. Sell or Process A1
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:
FasTrak has forty thousand partially completed units of product Q that can be sold for a total of fifty thousand dollars. FasTrak also has the option of further processing the forty thousand units of product Q to obtain products X, Y, and Z. The additional processing will cost eighty thousand dollars. The thirty thousand dollars cost to make product Q is a sunk cost and irrelevant to the decision.
What should FasTrak do? First, we need some additional information that is on the next slide before we can make a decision.
Continue

33. Sell or Process A1
The total revenue from selling products X, Y, and Z is two hundred, twenty thousand dollars. Since FasTrack would receive fifty thousand dollars for Product Q, the incremental revenue from processing is two hundred, twenty thousand dollars minus fifty thousand dollars, or one hundred seventy thousand dollars. The incremental cost of processing is eighty thousand dollars.
Now what should FaxTrak do?
Should FasTrac sell product Q or continue processing into products X, Y, and Z?

34. Sell or Process A1
Exh.
23-7
FasTrak should process because the incremental revenue of one hundred, seventy thousand dollars is greater that the incremental cost of eighty thousand dollars. Processing product Q into products X, Y, and Z results in a ninety thousand dollar advantage. Note that we did not use the thirty thousand dollars cost to make product Q. It was incurred before the sell or process decision so it is a sunk cost and irrelevant to the decision.
Should FasTrac sell product Q or continue processing into products X, Y, and Z?
FasTrac should continue processing. Note that the earlier $30,000 cost for product Q is sunk and therefore irrelevant to the decision.

35. Sales Mix Selection A1
When a company sells a variety of products, some are likely to be more profitable than others.
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, and
The demand for each product.
All businesses face constraints that affect production and sales decisions. They must make decisions to best utilize constrained resources. Usually fixed costs are not affected by this particular decision, so management can focus on maximizing the contribution margin given the constraints and the demand for products.
Let’s look at an example.

36. Consider the following data for two products made and sold by FasTrac.
Sales Mix Selection A1
Consider the following data for two products made and sold by FasTrac.
FasTrak produces Product A and Product B. Product A has a contribution margin of one dollar and fifty cents per unit and Product B has a contribution margin of two dollars per unit. If each product requires the same time to make, and the demand is unlimited for each product, FasTrac should produce only Product B because it has the highest contribution per unit.
If each product requires the same time to make, and the demand is unlimited, FasTrac should produce only Product B.

37. Consider this additional information.
Sales Mix Selection A1
Consider the following data for two products made and sold by FasTrac.
An important consideration is the time required to produce each product. It takes one hour to produce one unit of Product A, and it takes two hours to produce one unit of Product B. In other words, in the same time that it takes to produce one unit of Product B, we can produce two units of Product A.
If we divide the contribution per unit by the hours required to produce each unit, we find that we generate more contribution per hour if we make product A, even though its unit contribution is less.
The key to understanding the utilization of constrained resources is to determine the contribution margin per unit of the constrained resource used by each product.
Consider this additional information.

38. Consider the following data for two products made and sold by FasTrac.
Sales Mix Selection A1
Consider the following data for two products made and sold by FasTrac.
Product B has a greater
contribution margin than
Product A, but it
requires more machine
hours per unit to produce.
If demand for Products A and B is unlimited, we should produce as many units of Product A as possible, even if that means producing no Product B. By producing Product A we make one dollar and fifty cents per machine hour worked, which is higher than the one dollar per machine hour that product B generates.
With unlimited demand for A and B, produce as many units of A as possible since A provides more dollars per hour worked.

39. Consider the following data for two products made and sold by FasTrac.
Sales Mix Selection A1
Consider the following data for two products made and sold by FasTrac.
If demand for Product A is limited, then we should produce Product A first, until we satisfy the sales demand. After satisfying the sales demand for A, we should then use any remaining machine time to produce Product B.
If demand for A is limited, produce to meet that demand, then use the remaining facilities to produce B.

40. Segment Elimination A1
A segment is a candidate for elimination if its revenues are less than its avoidable expenses.
FasTrac is considering eliminating its Treadmill Division because total expenses of $48,300 are greater than its sales of $47,800.
Managers should consider eliminating poorly performing segments. A segment may be a division, territory, store, or product line. You have no doubt seen a segment eliminated. It might have been a large segment such as an automobile or it may have been a much smaller segment such as a store or restaurant closing.
How should we make segment elimination decisions? Let’s look at an example from FasTrak whose Treadmill Division’s total expenses are greater than its total costs.
Continue

41. Do not eliminate the Treadmill Division!
Segment Elimination A1
The Treadmill Division’s sale revenue is greater than its avoidable expenses by six thousand dollars. If FasTrak eliminates the Treadmill Division, the company’s income will be six thousand dollars less. We would have made an incorrect decision using total costs. We must compare avoidable expenses to sales revenue to make the correct decision.
Do not eliminate the Treadmill Division!

42. Qualitative Factors in Decisions
Qualitative factors are involved in most all
managerial decisions. For example:
Quality.
Delivery schedule.
Supplier reputation.
Employee morale.
Customer opinions.
We have seen how to analyze quantitative factors in business decisions, but qualitative factors are also important considerations in many decisions. For example in the make or buy decision, we must consider the supplier’s reputation for quality work as well as the supplier’s ability to deliver the goods when we need them. When making a segment elimination decision, employee morale will be affected. Negative publicity resulting from a segment elimination could also cause adverse reactions from customers or potential customers.

43. Setting Product PricesA2
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. The “cost
Plus” method, where management adds a mark-
up to the costs to reach a target price is most
common

44. Four Steps Using Total Cost Method
Determine the total costs (production and non-production)
Determine the total cost per unit.
Determine the markup per unit.
Determine the selling price per unit.
There are several methods that can assist management in setting prices. We will focus on the total cost method. In the first step, you calculate total costs by combining all the production costs (like direct materials, direct labor, and overhead.) To that you add any non-production costs (like selling and administrative costs.) The second step is to calculate the total cost per unit, by taking the total costs and dividing by the number of units. The next step is to determine the mark up per unit. This can be found by taking the total cost per unit and multiplying by a mark up percentage. At this point, the final step of setting the selling price can be computed, by taking the total cost per unit and adding in the markup per unit.

45. Identify relevant costs and apply them to managerial decisions.
Historical costs are generally not relevant to decisions. Instead the relevant costs are the additional costs, called incremental costs. They can also be called differential costs. These are costs incurred if a company decides on a specific course of action.

46. End of Chapter 23
Now that we have mastered some of the basic concepts and principles of relevant costing for managerial decisions, we are ready to put this knowledge to work.