1. MANAGERIAL ACCOUNTING Eighth Canadian Edition GARRISON, CHESLEY, CARROLL, WEBB
Prepared by:
Robert G. Ducharme, MAcc, CA University of Waterloo, School of Accounting and Finance

2. Relevant Costs for Decision Making
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Relevant Costs for Decision Making
Chapter Twelve
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.

3. Distinguish between relevant and irrelevant costs in decision making.
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Learning Objective 1
Distinguish between relevant and irrelevant costs in decision making.
Learning objective number 1 is to distinguish between relevant and irrelevant costs in decision making.

4. Cost Concepts for Decision Making
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Cost Concepts for Decision Making
A relevant cost is a cost that differs between alternatives. 1 2
A relevant cost is a cost that differs between alternatives.

5. Identifying Relevant Costs
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Identifying Relevant Costs
An avoidable cost can be eliminated, in whole or in part, by choosing one alternative over another. Avoidable costs are relevant costs. Unavoidable costs are irrelevant costs.
Two broad categories of costs are never relevant in any decision. They include:
Sunk costs.
Future costs that do not differ between the alternatives.
An avoidable cost is a cost that can be eliminated, in whole or in part, by choosing one alternative over another. Avoidable costs are relevant costs. Unavoidable costs are irrelevant costs.
Two broad categories of costs are never relevant in any decision:
A sunk cost is a cost that has already been incurred and cannot be avoided regardless of what a manager decides to do.
A future cost that does not differ between alternatives is never a relevant cost.

6. Relevant Cost Analysis: A Two-Step Process
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Relevant Cost Analysis: A Two-Step Process
Eliminate costs and benefits that do not differ between alternatives.
Use the remaining costs and benefits that differ between alternatives in making the decision. The costs that remain are the differential, or avoidable, costs.
Step 1
Step 2
Relevant cost analysis is a two-step process.
The first step is to eliminate costs and benefits that do not differ between alternatives. These irrelevant costs consist of sunk costs and future costs that do not differ between alternatives.
The second step is to use the remaining costs and benefits that differ between alternatives in making the decision. The costs that remain are the differential, or avoidable, costs.

7. Different Costs for Different Purposes
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Different Costs for Different Purposes
Costs that are relevant in one decision situation may not be relevant in another context.
Costs that are relevant in one decision situation may not be relevant in another context. Thus, in each decision situation, the manager must examine the data at hand and isolate the relevant costs.

8. Identifying Relevant Costs
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Identifying Relevant Costs
Cynthia, an Ottawa student, is considering visiting her friend in Waterloo. She can drive or take the train. By car, it is 230 miles to her friend’s apartment. She is trying to decide which alternative is less expensive and has gathered the following information:
$18,000 cost – $4,000 salvage value ÷ 5 years
$1.60 per gallon ÷ 32 MPG
Part I
Assume the following information with respect to Cynthia, an Ottawa student who is considering visiting her friend in Waterloo. Cynthia is trying to decide whether it would be less expensive to drive or take the train to Waterloo. She has compiled the following information with respect to her automobile.
Part II
The straight-line depreciation is calculated as cost minus salvage value divided by useful life.
Part III
Gasoline per mile is calculated by taking the price per gallon of gasoline and dividing it by the number of miles per gallon of the car.
Part IV
The parking fee at school is $45 a month. Cynthia attends school only eight months out of the year.
$45 per month × 8 months

9. Identifying Relevant Costs
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Identifying Relevant Costs
She has also gathered this additional information to aid in her decision.

10. Identifying Relevant Costs
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Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s decision?
The cost of the car is a sunk cost and is not relevant to the current decision.
The annual cost of insurance is not relevant. It will remain the same if she drives or takes the train.
Part I
Which costs are relevant to her decision?
The cost of the car is irrelevant to the decision because it is a sunk cost.
The annual cost of auto insurance is irrelevant because it does not differ between alternatives.
Part II
The cost of the gasoline is relevant because it is avoidable if she takes the train.
However, the cost of gasoline is clearly relevant if she decides to drive. If she takes the train, the cost would now be incurred, so it varies depending on the decision.

11. Identifying Relevant Costs
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Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s decision?
The monthly school parking fee is not relevant because it must be paid if Cynthia drives or takes the train.
The cost of maintenance and repairs is relevant. In the long-run these costs depend upon miles driven.
Part I
The cost of maintenance and repairs is relevant because in the long-run these costs depend upon miles driven.
The parking fee is irrelevant because it is not a differential cost.
Part II
At this point, we can see that some of the average cost of $0.569 per mile are relevant and others are not.
At this point, we can see that some of the average cost of $0.569 per mile are relevant and others are not.

12. Identifying Relevant Costs
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Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s decision?
The decline in resale value due to additional miles is a relevant cost.
The round-trip train fare is clearly relevant. If she drives the cost can be avoided.
Part I
The decline in resale value is relevant due to the additional miles driven.
The round trip train fare is relevant because it is avoidable if she drives her car.
Relaxing on the train is relevant, but difficult to quantify.
Part II
The kennel cost is irrelevant because it is not a differential cost.
Relaxing on the train is relevant even though it is difficult to assign a dollar value to the benefit.
The kennel cost is not relevant because Cynthia will incur the cost if she drives or takes the train.

13. Identifying Relevant Costs
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Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s decision?
The cost of parking is relevant because it can be avoided if she takes the train.
The cost of parking is relevant because it is avoidable if she takes the train.
The benefits of having a car in New York and the problem of finding a parking space are both relevant, but difficult to quantify.
The benefits of having a car in New York and the problems of finding a parking space are both relevant but are difficult to assign a dollar amount.

14. Identifying Relevant Costs
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Identifying Relevant Costs
From a financial standpoint, Cynthia would be better off taking the train to visit her friend. Some of the non-financial factor may influence her final decision.
From a financial standpoint, Cynthia would be better off taking the train. But, as with any decision we may face, it may be the non-financial or non-quantitative factors that have the most impact on our decision.

15. Total and Differential Cost Approaches
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Total and Differential Cost Approaches
The management of a company is considering a new labour saving machine that rents for $3,000 per year. Data about the company’s annual sales and costs with and without the new machine are:
Assume the following information for a company considering a new labour-saving machine that rents for $3,000 per year.
The total approach requires constructing two contribution format income statements – one for each alternative.
The difference between the two income statements of $12,000 equals the differential benefits shown at the bottom of the right-hand column.

16. Total and Differential Cost Approaches
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Total and Differential Cost Approaches
As you can see, the only costs that differ between the alternatives are the direct labour costs savings and the increase in fixed rental costs.
We can efficiently analyze the decision by looking at the different costs and revenues and arrive at the same solution.
The most efficient means of analyzing this decision is to use the differential approach to isolate the relevant costs and benefits as shown.

17. Total and Differential Cost Approaches
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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:
First, only rarely will enough information be available to prepare detailed income statements for both alternatives.
Second, mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical.

18. Prepare analyses for various decision situations.
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Learning Objective 2
Prepare analyses for various decision situations.
Learning objective number 2 is to prepare analyses for various decision situations.

19. Adding/Dropping Segments
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Adding/Dropping Segments
One of the most important decisions managers make is whether to add or drop a business segment, such as a product or a store.
Let’s see how relevant costs should be used in this type of decision.
One of the most important decisions managers make is whether to add or drop a business segment. Ultimately, a decision to drop an old segment or add a new one is going to hinge primarily on the impact the decision will have on operating income. To assess this impact it is necessary to carefully analyze the costs.
Let’s see how relevant costs should be used in this type of decision.

20. Adding/Dropping Segments
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Adding/Dropping Segments
Due to the declining popularity of digital watches, Lovell Company’s digital watch line has not reported a profit for several years. Lovell is considering dropping this product line.
Assume that Lovell Company’s digital watch line has not reported a profit for several years; accordingly, Lovell is considering discontinuing this product line.

21. A Contribution Margin Approach
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A Contribution Margin Approach
DECISION RULE
Lovell should drop the digital watch segment only if its profit would increase. This would only happen if the fixed cost savings exceed the lost contribution margin.
Let’s look at this solution.
To determine how dropping this line will affect the overall profits of the company, Lovell will compare the contribution margin that would be lost to the costs that would be avoided if the line was to be dropped.
Lovell should drop the digital watch segment only if its profit would increase. This would only happen if the fixed cost savings exceed the lost contribution margin.

22. Adding/Dropping Segments
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Adding/Dropping Segments
Assume a segmented income statement for the digital watches line is as shown.

23. Adding/Dropping Segments
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Adding/Dropping Segments
Investigation has revealed that total fixed general factory overhead and general
administrative expenses would not be affected if the digital watch line is dropped. The fixed general factory overhead and general administrative expenses assigned to this product would be reallocated to other product lines.
An investigation has revealed that the fixed general factory overhead and fixed general administrative expenses will not be affected by dropping the digital watch line. The fixed general factory overhead and general administrative expenses assigned to this product would be reallocated to other product lines.

24. Adding/Dropping Segments
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Adding/Dropping Segments
The equipment used to manufacture
digital watches has no resale
value or alternative use.
Part I
The equipment used to manufacture digital watches has no resale value or alternative use.
Part II
Should Lovell retain or drop the digital watch segment?
Should Lovell retain or drop
the digital watch segment?

25. A Contribution Margin Approach
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A Contribution Margin Approach
A contribution margin approach reveals that the contribution margin lost ($300,000) exceeds the fixed costs avoided ($260,000) by $40,000. Therefore, Lovell should retain the digital watch segment.
Retain

26. Comparative Income Approach
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Comparative Income Approach
The Lovell solution can also be obtained by preparing comparative income statements showing results with and without the digital watch segment.
Let’s look at this second approach.
Comparative income statements can also be prepared to help make the decision.
Let’s look at this second approach.

27. 12-27
If the digital watch line is dropped, the company gives up its contribution margin.
These income statements show that if the digital watch line is dropped, the company loses $300,000 in contribution margin.

28. 12-28
The general factory overhead would be the same under both alternatives, so it is irrelevant.
On the other hand, the general factory overhead would be the same. So this cost really isn’t relevant.

29. But we wouldn’t need a manager for the product line anymore.
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But we wouldn’t need a manager for the product line anymore.
The salary of the product line manager would disappear, so it is relevant to the decision.

30. 12-30
If the digital watch line is dropped, the net book value of the equipment would be written off. The depreciation that would have been taken will flow through the income statement as a loss instead.
The depreciation is a sunk cost. Also, remember that the equipment has no resale value or alternative use, so the equipment and the depreciation expense associated with it are irrelevant to the decision.

31. 12-31
The complete comparative income statements reveal that Lovell would earn $40,000 of additional profit by retaining the digital watch line.

32. Beware of Allocated Fixed Costs
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Beware of Allocated Fixed Costs
Why should we keep the digital watch segment when it’s showing a $100,000 loss?
Lovell’s allocated fixed costs can distort the keep/drop decision.
Lovell’s managers may ask “why keep the digital watch segment when its segmented income statement shows a $100,000 loss?”

33. Beware of Allocated Fixed Costs
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Beware of Allocated Fixed Costs
The answer lies in the way we allocate common fixed costs to our products.
The answer lies in the way common fixed costs are allocated to products.

34. Beware of Allocated Fixed Costs
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Beware of Allocated Fixed Costs
Our allocations can make a segment look less profitable than it really is.
Including unavoidable common fixed costs in the segmented income statement makes the digital watch product line appear to be unprofitable, when in fact, dropping the product line would decrease the company’s overall operating income.

35. The Make or Buy Decision
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The Make or Buy Decision
When a company is involved in more than one activity in the entire value chain, it is vertically integrated. A decision to carry out one of the activities in the value chain internally, rather than to buy externally from a supplier is called a “make or buy” decision.
When a company is involved in more than one activity in the entire value chain, it is vertically integrated.
A decision to carry out one of the activities in the value chain internally, rather than to buy externally from a supplier, is called a make or buy decision.

36. Vertical Integration- Advantages
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Vertical Integration- Advantages
Smoother flow of parts and materials
Better quality control
Vertical integration provides certain advantages.
An integrated company may be able to ensure a smoother flow of parts and materials for production than a nonintegrated company.
Some companies feel that they can control quality better by producing their own parts and materials.
Integrated companies realize profits from the parts and materials that they choose to make instead of buy.
Realize profits

37. Vertical Integration- Disadvantage
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Vertical Integration- Disadvantage
Companies may fail to take advantage of suppliers who can create economies of scale advantage by pooling demand from numerous companies.
The primary disadvantage of vertical integration is that a company may fail to take advantage of suppliers who can create an economies of scale advantage by pooling demand from numerous companies.
While the economies of scale factor can be appealing, a company must be careful to retain control over activities that are essential to maintaining its competitive position.

38. The Make or Buy Decision: An Example
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The Make or Buy Decision: An Example
Essex Company manufactures part 4A that is used in one of its products.
The unit product cost of this part is:
Assume that Essex Company manufactures part 4A with a unit product cost as shown.

39. The Make or Buy Decision
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The Make or Buy Decision
The special equipment used to manufacture part 4A has no resale value.
The total amount of general factory overhead, which is allocated on the basis of direct labour hours, would be unaffected by this decision.
The $30 unit product cost is based on 20,000 parts produced each year.
An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part.
Should we accept the supplier’s offer?
Also, assume the following information as shown with respect to part 4A.
Given these additional assumptions, should Essex make or buy part 4A?

40. The Make or Buy Decision
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The Make or Buy Decision
The avoidable costs associated with making part 4A include direct materials, direct labour, variable overhead, and the supervisor’s salary.
20,000 × $9 per unit = $180,000

41. The Make or Buy Decision
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The Make or Buy Decision
The depreciation of special equipment represents a sunk cost. Furthermore, the equipment has no resale value, thus the special equipment and its associated depreciation expense are irrelevant to the decision.
The special equipment has no resale value and is a sunk cost.

42. The Make or Buy Decision
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The Make or Buy Decision
The general factory overhead represents future costs that will be incurred regardless of whether Essex makes or buys part 4A; hence, it is also irrelevant to the decision.
Not avoidable; irrelevant. If the product is dropped, it will be reallocated to other products.

43. The Make or Buy Decision
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The Make or Buy Decision
The total avoidable costs of $340,000 are less than the $500,000 cost of buying the part, thereby suggesting that Essex should continue to make the part.
Should we make or buy part 4A?

44. How would this concept potentially relate to the Essex Company?
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Opportunity Cost
An opportunity cost is the benefit that is foregone as a result of pursuing some course of action.
Opportunity costs are not actual dollar outlays and are not recorded in the formal accounts of an organization.
How would this concept potentially relate to the Essex Company?
An opportunity cost is the benefit that is foregone as a result of pursuing a course of action. These costs do not represent actual cash outlays and they are not recorded in the formal accounts of an organization.
In the Essex Company example that we just completed, if Essex had an alternative use for the capacity that it used to make part 4A, there would have been an opportunity cost to factor into the analysis.
The opportunity cost would have been equal to the segment margin that could have been derived from the best alternative use of the space.

45. 12-45
Key Terms and Concepts
A special order is a one-time order that is not considered part of the company’s normal ongoing business.
When analyzing a special order, only the incremental costs and benefits are relevant.
A special order is a one-time order that is not considered part of the company’s normal ongoing business.
When analyzing a special order, only the incremental costs and benefits are relevant. Since the existing fixed manufacturing overhead costs would not be affected by the order, they are not relevant.

46. Special Orders Should Jet accept the offer?
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Special Orders
Jet, Inc. makes a single product whose normal selling price is $20 per unit.
A foreign distributor offers to purchase 3,000 units for $10 per unit.
This is a one-time order that would not affect the company’s regular business.
Annual capacity is 10,000 units, but Jet, Inc. is currently producing and selling only 5,000 units.
Assume the following information with respect to a special order opportunity for Jet, Inc.
Should Jet accept the offer?
Should Jet accept the offer?

47. Special Orders $8 variable cost Part I
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Special Orders
$8 variable cost
Part I
A contribution format income statement for Jet’s normal sales of 5,000 units is as shown.
Part II
Assume variable cost is $8 a unit. Total variable cost would be 5,000 units times $8 a unit.

48. If Jet accepts the offer, operating income will increase by $6,000.
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Special Orders
If Jet accepts the offer, operating income will increase by $6,000.
If Jet accepts the special order, the incremental revenue of $30,000 will exceed the incremental costs of $24,000 by $6,000. This suggests that Jet should accept the order. Notice that this answer assumes that the fixed costs are unavoidable and that variable marketing costs must be incurred on the special order.
Note: This answer assumes that fixed costs are unaffected by the order and that variable marketing costs must be incurred on the special order.

49. 12-49
Quick Check 
Northern Optical ordinarily sells the X-lens for $50. The variable production cost is $10, the fixed production cost is $18 per unit, and the variable selling cost is $1. A customer has requested a special order for 10,000 units of the X-lens to be imprinted with the customer’s logo. This special order would not involve any selling costs, but Northern Optical would have to purchase an imprinting machine for $50,000.
(see the next page)
Take a minute and read the information provided about Northern Optical.

50. 12-50
Quick Check 
What is the rock bottom minimum price below which Northern Optical should not go in its negotiations with the customer? In other words, below what price would Northern Optical actually be losing money on the sale? There is ample idle capacity to fulfill the order and the imprinting machine has no further use after this order.
a. $50
b. $10
c. $15
d. $29
What is the rock bottom minimum price below which Northern Optical should not go in its negotiations with the customer?

51. Quick Check  Variable production cost $100,000
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Quick Check 
What is the rock bottom minimum price below which Northern Optical should not go in its negotiations with the customer? In other words, below what price would Northern Optical actually be losing money on the sale? There is ample idle capacity to fulfill the order and the imprinting machine has no further use after this order.
a. $50
b. $10
c. $15
d. $29
Variable production cost $100,000
Additional fixed cost ,000
Total relevant cost $150,000
Number of units ,000
Average cost per unit = $15
$15. Take a minute and review the solution to this problem before proceeding to the next slide.

52. 12-52
Joint Costs
In some industries, a number of end products are produced from a single raw material input.
Two or more products produced from a common input are called joint products.
The point in the manufacturing process where each joint product can be recognized as a separate product is called the split-off point.
In some industries, a number of end products are produced from a single raw material input. When two or more products are produced from a common input these products are known as joint products. The split-off point is the point in the manufacturing process at which the joint products can be recognized as separate products.

53. Joint Products Split-Off Point Oil Common Production Process Joint
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Joint Products
Oil
Common
Production
Process
Joint
Input
Gasoline
For example, in the petroleum refining industry a large number of products are extracted from crude oil, including gasoline, jet fuel, home heating oil, lubricants, asphalt, and various organic chemicals.
Chemicals
Split-Off
Point

54. Joint Products Joint Costs Final Sale Final Sale Separate Split-Off
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Joint Products
Joint
Costs
Separate
Processing
Final
Sale
Oil
Common
Production
Process
Joint
Input
Final
Sale
Gasoline
Separate
Processing
Final
Sale
The term joint cost is used to describe costs incurred up to the split-off point. Joint costs are common costs incurred to simultaneously produce a variety of end products.
Chemicals
Separate
Product
Costs
Split-Off
Point

55. The Pitfalls of Allocation
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The Pitfalls of Allocation
Joint costs are often allocated to end products on the basis of the relative sales value of each product or on some other basis.
Although allocation is needed for some purposes such as balance sheet inventory valuation, allocations of this kind are very dangerous for decision making.
Joint costs are traditionally allocated among different products at the split-off point. A typical approach is to allocate joint costs according to the relative sales value of the end products.
Although allocation is needed for some purposes such as balanced sheet inventory valuation, allocations of this kind are very dangerous for decision making.

56. Sell or Process Further
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Sell or Process Further
Joint costs are irrelevant in decisions regarding what to do with a product from the split-off point forward.
It will always be profitable to continue processing a joint product after the split-off point so long as the incremental revenue exceeds the incremental processing costs incurred after the split-off point.
Joint costs are irrelevant in decisions regarding what to do with a product from the split-off point forward. Therefore, these costs should not be allocated to end products for decision making purposes.
With respect to sell or process further decisions, it is profitable to continue processing a joint product after the split-off point so long as the incremental revenue from such processing exceeds the incremental processing costs incurred after the split-off point.

57. Sell or Process Further: An Example
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Sell or Process Further: An Example
Sawmill, Inc. cuts logs from which unfinished lumber and sawdust are the immediate joint products.
Unfinished lumber is sold “as is” or processed further into finished lumber.
Sawdust can also be sold “as is” to gardening wholesalers or processed further into “presto-logs.”
Assume the facts as shown with respect to Sawmill, Inc.

58. Sell or Process Further
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Sell or Process Further
Data about Sawmill’s joint products includes:
Sawmill has two joint products – lumber and sawdust. Selected financial information is shown for each joint product.

59. Sell or Process Further
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Sell or Process Further
The incremental revenue from further processing of the lumber and sawdust is $130 and $10, respectively.

60. Sell or Process Further
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Sell or Process Further
The profit (loss) from further processing is $80 for the lumber and negative $10 for the sawdust.

61. Sell or Process Further
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Sell or Process Further
Should we process the lumber further and sell the sawdust “as is?”
The lumber should be processed further and the sawdust should be sold at the split-off point.

62. 12-62
Learning Objective 3
Determine the most profitable use of a constrained resource and the value of obtaining more of the constrained resource.
Learning objective number 3 is to determine the most profitable use of a constrained resource and the value of obtaining more of the constrained resource.

63. 12-63
Key Terms and Concepts
When a limited resource of some type restricts the company’s ability to satisfy demand, the company is said to have a constraint.
The machine or process that is limiting overall output is called the bottleneck – it is the constraint.
When a limited resource of some type restricts the company’s ability to satisfy demand, the company is said to have a constraint. The machine or process that is limiting overall output is called the bottleneck – it is the constraint.

64. Utilization of a Constrained Resource
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Utilization of a Constrained Resource
When a constraint exists, a company should select a product mix that maximizes the total contribution margin earned since fixed costs usually remain unchanged.
A company should not necessarily promote those products that have the highest unit contribution margin.
Rather, it should promote those products that earn the highest contribution margin in relation to the constraining resource.
Fixed costs are usually unaffected in these situations, so the product mix that maximizes the company’s total contribution margin should ordinarily be selected.
A company should not necessarily promote those products that have the highest unit contribution margin.
Rather, total contribution margin will be maximized by promoting those products or accepting those orders that provide the highest contribution margin in relation to the constraining resource.

65. Utilization of a Constrained Resource: An Example
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Utilization of a Constrained Resource: An Example
Ensign Company produces two products and selected data are shown below:
Assume that Ensign Company produces two products and selected data are as shown.

66. Utilization of a Constrained Resource
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Utilization of a Constrained Resource
Machine A1 is the constrained resource and is being used at 100% of its capacity.
There is excess capacity on all other machines.
Machine A1 has a capacity of 2,400 minutes per week.
Should Ensign focus its efforts on Product 1 or Product 2?
In addition, assume that:
 Machine A1 is the constraint.
There is excess capacity on all other machines.
Machine A1 has a capacity of 2,400 minutes per week.
Should Ensign focus its efforts on Product 1 or Product 2?

67. 12-67
Quick Check 
How many units of each product can be processed through Machine A1 in one minute?
Product Product 2
a unit unit
b unit units
c units unit
d units unit
How many units of each product can be processed through Machine A1 in one minute?

68. I was just checking to make sure you are with us.
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Quick Check 
How many units of each product can be processed through Machine A1 in one minute?
Product Product 2
a unit unit
b unit units
c units unit
d units unit
One unit of Product 1 and two units of Product 2.
I was just checking to make sure you are with us.

69. 12-69
Quick Check 
What generates more profit for the company, using one minute of machine A1 to process Product 1 or using one minute of machine A1 to process Product 2?
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.
What generates more profit for the company, using one minute of machine A1 to process Product 1 or using one minute of machine A1 to process Product 2?

70. 12-70
Quick Check 
With one minute of machine A1, we could make 1 unit of Product 1, with a contribution margin of $24, or 2 units of Product 2, each with a contribution margin of $15.
2 × $15 = $30 > $24
What generates more profit for the company, using one minute of machine A1 to process Product 1 or using one minute of machine A1 to process Product 2?
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.
Product 2. With one minute of machine A1, we could make 1 unit of Product 1, with a contribution margin of $24, or 2 units of Product 2, each with a contribution margin of $15.

71. Utilization of a Constrained Resource
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Utilization of a Constrained Resource
The key is the contribution margin per unit of the constrained resource.
As suggested by the answer to the Quick Check question, Ensign should emphasize Product 2 because it generates a contribution margin of $30 per minute of the constrained resource relative to $24 per minute for Product 1.
Product 2 should be emphasized. Provides more valuable use of the constrained resource machine A1, yielding a contribution margin of $30 per minute as opposed to $24 for Product 1.

72. Utilization of a Constrained Resource
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Utilization of a Constrained Resource
The key is the contribution margin per unit of the constrained resource.
Ensign can maximize its contribution margin by first producing Product 2 to meet customer demand and then using any remaining capacity to produce Product 1.
If there are no other considerations, the best plan would be to produce to meet current demand for Product 2 and then use remaining capacity to make Product 1.

73. Utilization of a Constrained Resource
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Utilization of a Constrained Resource
Let’s see how this plan would work.
The calculations would be performed as follows.
Satisfying the weekly demand of 2,200 units for Product 2 would consume 1,100 minutes of available capacity on machine A1.

74. Utilization of a Constrained Resource
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Utilization of a Constrained Resource
Let’s see how this plan would work.
This implies that 1,300 constraint minutes would still be available to satisfy demand for Product 1.

75. Utilization of a Constrained Resource
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Utilization of a Constrained Resource
Let’s see how this plan would work.
Since each unit of Product 1 requires one minute of A1 machine time, Ensign could produce 1,300 units of Product 1 with its remaining capacity.

76. Utilization of a Constrained Resource
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Utilization of a Constrained Resource
According to the plan, we will produce 2,200 units of Product 2 and 1,300 of Product 1. Our contribution margin looks like this.
This mix of production would yield a total contribution margin of $64,200 dollars.
The total contribution margin for Ensign is $64,200.

77. 12-77
Quick Check 
Colonial Heritage makes reproduction colonial furniture from select hardwoods.
The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. Is this enough hardwood to satisfy demand?
a. Yes
b. No
Review the information provided about Colonial Heritage. Is this enough hardwood to satisfy demand?

78. Quick Check  (2  600) + (10  100 ) = 2,200 > 2,000
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Quick Check 
Colonial Heritage makes reproduction colonial furniture from select hardwoods.
The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. Is this enough hardwood to satisfy demand?
a. Yes
b. No
No. Colonial Heritage needs 2,200 board feet to satisfy its demand.
(2  600) + (10  100 ) = 2,200 > 2,000

79. Quick Check  a. 500 chairs and 100 tables b. 600 chairs and 80 tables
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Quick Check 
The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. What plan would maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. What plan would maximize profits?

80. Quick Check  a. 500 chairs and 100 tables b. 600 chairs and 80 tables
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Quick Check 
The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. What plan would maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
Production of 600 chairs and 80 tables would maximize contribution margin.

81. 12-81
Quick Check 
As before, Colonial Heritage’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume the company follows the plan we have proposed. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero
Read this information about Colonial Heritage. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood?

82. 12-82
Quick Check 
As before, Colonial Heritage’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume the company follows the plan we have proposed. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero
The additional wood would be used to make tables. In this use, each board foot of additional wood will allow the company to earn an additional $20 of contribution margin and profit.
The additional wood would be used to make tables. In this use, each board foot of additional wood will allow the company to earn an additional $20 of contribution margin and profit.

83. Finding ways to process more units through a resource bottleneck
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Managing Constraints
At the bottleneck itself:
Improve the process
Add overtime or another shift
Hire new workers or acquire
more machines
Subcontract production
Reduce amount of defective
units produced
Add workers transferred from
non-bottleneck departments
Finding ways to process more units through a resource bottleneck
It is often possible for a manager to increase the capacity of a bottleneck, which is called relaxing (or elevating) the constraint, in numerous ways such as:
Focusing business process improvement efforts on the bottleneck.
Working overtime on the bottleneck.
Investing in additional machines at the bottleneck.
Subcontracting some of the processing that would be done at the bottleneck.
Reducing defective units processed through the bottleneck.
Shifting workers from non-bottleneck processes to the bottleneck.
These methods and ideas are all consistent with the Theory of Constraints, which was introduced in Chapter 1.
If a company has more than one potential constraint, the proper “mix” of products can be found using a quantitative method known as linear programming, which is covered in quantitative methods and operations management courses.

84. Activity-Based Costing and Relevant Costs
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Activity-Based Costing and Relevant Costs
ABC can be used to help identify potentially relevant costs for decision-making purposes.
However, before making a decision, managers must decide which of the potentially relevant costs are actually avoidable.
Activity-based costing can be used to help identify potentially relevant costs for decision-making purposes. However, managers should exercise caution against reading more into this “traceability” than really exists. People have a tendency to assume that if a cost is traceable to a segment, then the cost is automatically avoidable, which is untrue. Before making a decision, managers must decide which of the potentially relevant costs are actually avoidable.

85. Pricing Products and Services
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Pricing Products and Services
Appendix 12A
Appendix 11B: Marketing Expense

86. Compute selling prices based on costs.
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Learning Objective 4
Compute selling prices based on costs.
Learning objective number 4 is to compute selling prices based on costs.

87. Selling Price = Cost + (Markup percentage x Cost)
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Cost-Plus Pricing
The usual approach in pricing is to mark up cost. A product’s markup is the difference between its selling price and its cost. The markup is usually expressed as a percentage of cost.
The usual approach in pricing is to mark up cost. A product’s markup is the difference between its selling price and its cost. The markup is usually expressed as a percentage of cost. This approach is called cost-plus pricing because the predetermined markup percentage is applied to the cost base to determine a target selling price.
Selling price = Cost + (Markup percentage x Cost)
For example, if a company uses a markup of 50%, it adds 50% to the costs of its products to determine the selling price. If a product costs $10, then the company would charge $15 for the product.
There are two key issues when the cost-plus approach to pricing is used. First, what costs are relevant to the pricing decision? Second, how should the markup be determined? Several alternative approaches are considered in this appendix.
As discussed in Chapters 2 through 8 and Chapter 10, various definitions of cost exist, each of which could be used as the base for setting a selling price. To provide a coherent illustration of cost-plus pricing, absorption costing as described in Chapters 2, 3, 4, and 8 will be presented first. We will then present an example of cost-plus pricing using the total variable costing approach.
Selling Price = Cost + (Markup percentage x Cost)

88. The Absorption Costing Approach
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The Absorption Costing Approach
Under the absorption approach to cost-plus pricing, the cost base is the absorption costing unit product cost rather than the variable cost.
The absorption costing approach to product pricing is based on full absorption costing rather than variable costing. The cost base includes direct materials, direct labour, and both variable and fixed manufacturing overhead.

89. Setting a Target Selling Price
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Setting a Target Selling Price
Here is information provided by the management of Ritter Company.
We have gathered information from Ritter Company to help establish the selling price of a new product. Ritter hopes to produce and sell 10,000 units of the new product when it is introduced. Notice that some of the product costs are expressed per unit and other costs are expressed in total. Ritter wants to produce and sell 10,000 units of a new product and typically uses a 50 percent markup percentage.
Assuming Ritter will produce and sell 10,000 units of the new product, and that Ritter typically uses a 50 percent markup percentage, let’s determine the unit product cost.

90. Setting a Target Selling Price
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Setting a Target Selling Price
The first step in the absorption costing approach to cost-plus pricing is to compute the unit product cost. Under absorption costing, the unit product cost is $20. The fixed manufacturing overhead of $70,000 is to be spread over the 10,000 units to be produced and sold. Let’s assume that in the past when Ritter introduced new products it used a markup of 50 percent of cost.
Ritter has a policy of marking up unit product costs by 50 percent. Let’s calculate the target selling price.

91. Setting a Target Selling Price
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Setting a Target Selling Price
Ritter would establish a target selling price to cover selling, general, and administrative expenses and contribute to profit $30 per unit.
The second step is to calculate the target selling price ($30) by assigning the appropriate markup ($10) to the unit product cost ($20).

92. Determining the Markup Percentage
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Determining the Markup Percentage
The markup percentage can be based on an industry “rule of thumb,” company tradition, or it can be explicitly calculated. The equation to calculate the markup percentage is:
Markup % on absorption cost
(Required ROI × Investment) + SG&A expenses Unit sales × Unit product cost =
Now, we will take a closer look at how Ritter may calculate the markup percent on absorption cost. The markup must be high enough to cover SG&A expenses and to provide an adequate return on investment. The numerator of the equation takes the product of the company’s return on investment times the investment funds required and adds to this the selling, general, and administrative expenses. The denominator is the projected unit sales times the unit product cost.

93. Determining the Markup Percentage
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Determining the Markup Percentage
Let’s assume that Ritter must invest $100,000 in the product and market 10,000 units of product each year. The company requires a 20 percent ROI on all investments. Let’s determine Ritter’s markup percentage on absorption cost.
Now, let’s assume Ritter must invest $100,000 in the new product. The company requires an ROI of 20 percent on all investments made.

94. Determining the Markup Percentage
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Determining the Markup Percentage
Markup % on absorption cost
(20% × $100,000) + ($2 × 10,000 + $60,000) 10,000 × $20 =
Variable SG&A per unit
Total fixed SG&A
Markup % on absorption cost =
($20,000 + $80,000) $200,000
50%
Part I
Here are the basic equations. Part II
The variable selling, general and administrative expenses per unit are $2 and the fixed SG&A expenses are $60,000. Recall that Ritter expects to produce and sell 10,000 units. Part III
Under these conditions, the markup percent on absorption cost will be 50 percent. If Ritter actually sells 10,000 units at the price of $30 per unit, the ROI on this product will indeed be 20 percent. However, if more than (less than) 10,000 units are sold, the ROI will be higher than (less than) 20 percent.

95. Problems with the Absorption Costing Approach
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Problems with the Absorption Costing Approach
The absorption costing approach assumes that customers need the forecasted unit sales and will pay whatever price the company decides to charge. This is flawed logic simply because customers have a choice.
There are several restrictive assumptions underlying the absorption costing approach. The absorption costing approach essentially assumes that customers need the forecasted unit sales and will pay whatever price the company decides to charge. This is flawed logic simply because customers have a choice.

96. Problems with the Absorption Costing Approach
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Problems with the Absorption Costing Approach
Let’s assume that Ritter sells only 7,000 units at $30 per unit, instead of the forecasted 10,000 units. Here is the income statement.
Part I
What would happen if Ritter produced all 10,000 units, but was able to sell only 7,000 at $30 per unit?
Part II
The unit cost would now be $23 rather than the $20 originally projected. The reason is that the $70,000 fixed manufacturing overhead would be spread over 7,000 units, thus raising the absorption cost by $3 per unit. The product line would show a net loss of $25,000 and the project would fail to meet management’s return on investment goal.

97. Problems with the Absorption Costing Approach
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Problems with the Absorption Costing Approach
Let’s assume that Ritter sells only 7,000 units at $30 per unit, instead of the forecasted 10,000 units. Here is the income statement.
Absorption costing approach to pricing is a safe approach only if customers choose to buy at least as many units as managers forecasted they would buy.
As you can clearly see, the absorption costing approach is only safe when customers purchase at least the number of units forecasted by management.

98. Compute target costs based on selling prices.
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Learning Objective 5
Compute target costs based on selling prices.
Learning objective number 5 is to compute target costs based on selling prices.

99. 12-99
Target Costing
Target costing is the process of determining the maximum allowable cost for a new product and then developing a prototype that can be made for that maximum target cost figure. The equation for determining the target price is shown below:
Target cost = Anticipated selling price – Desired profit
Under the target costing approach, we begin by determining the anticipated selling price of our product in the marketplace. We can look at competitors to help us determine the appropriate selling price for our product. Once we establish the anticipated selling price, we subtract the desired profit needed to invest in the product. This yields the target cost to the company. Once the target cost is determined, the product development team is given the responsibility of designing the product to see if it can be made for no more than the target cost.

100. Reasons for Using Target Costing
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Reasons for Using Target Costing
Two characteristics of prices and product costs:
The market (i.e., supply and demand) determines price.
Most of the cost of a product is determined in the design stage.
Target costing grew out of the notion that the marketplace determines price under normal circumstances and that most of the cost of a product is derived as the product is being designed. Other approaches allow engineers to design products without considering market prices. These approaches attempt to squeeze costs out of the manufacturing process after they come to the realization that the cost of a manufactured product does not bear a profitable relationship to the existing market price.
Target costing was developed in recognition of these two characteristics.

101. Reasons for Using Target Costing
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Reasons for Using Target Costing
Target costing was developed in recognition of the two characteristics shown on the previous screen. More specifically, Target costing begins the product development process by recognizing and responding to existing market prices.
In target costing, management must begin with product development and design by recognizing and responding to existing market prices. Target costing begins the product development process by recognizing and responding to existing market prices. Other approaches allow engineers to design products without considering market prices.

102. Reasons for Using Target Costing
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Reasons for Using Target Costing
Target costing focuses a company’s cost reduction efforts in the product design stage of production.
In target costing, management must be sensitive to the marketplace and focus efforts on cost reduction in the design of a product. Other approaches attempt to squeeze costs out of the manufacturing process after they come to the realization that the cost of a manufactured product does not bear a profitable relationship to the existing market price.

103. Let see how we determine the target cost.
12-103
Target Costing
Handy Appliance feels there is a niche for a hand mixer with certain features. The Marketing Department believes that a price of $30 would be about right and that about 40,000 mixers could be sold. An investment of $2,000,000 is required to gear up for production. The company requires a 15 percent ROI on invested funds.
Let see how we determine the target cost.
Let’s look at a specific example of target costing at Handy Appliance. The marketing department believes a new mixer selling for $30 per unit would be able to carve out about 40,000 units from the existing market. It will cost Handy Appliance $2,000,000 to gear up for production, and management requires a return on investment of 15 percent.

104. 12-104
Target Costing
Each functional area within Handy Appliance would be responsible for keeping its actual costs within the target established for that area.
The total anticipated sales of the new mixer will be $1,200,000. Handy’s desired profit is 15 percent on its $2,000,000 investment, or $300,000. The target cost of the 40,000 mixers must be $900,000, so each mixer must be produced at a cost no greater than $ It is now the function of Handy’s development team to see to it that all parties involved understand that the mixer must be manufactured at $22.50 or less with the features specified by the marketing department.

105. 12-105
End of Chapter 12
End of chapter 12.