2. GOOD NEWS, BAD NEWS FOR C&C
CISD wants 1,000 standard practice jerseys, with a couple of special modifications
Bonadeo Embroidery wants to supply chenille letters at a low cost
There are problems with the jersey fabric order at Bradley Textile Mills
It looks like some sales territories are losing money and might need to be shut down
What’s the real story on these issues?

4. WHAT IS RELEVANT INFORMATION?
Information that is directly related to the decision being made
Information about something that will happen in the future
Information that differs between alternatives
© Lev Mei/iStockphoto

5. LET’S IDENTIFY RELEVANT INFORMATION
Accord
Mazda 6
Relevant?
MSRP
$22,565
$22,550
MPG, City 21 24
MPG, highway 31 34
Warranty
36,000 miles,
36 months
Leg room (front)
42.5”
Trunk capacity
14.0 ft3
16.6 ft3 ✔ ✔ ✔ ✖ ✖ ✔

6. SO WHEN IS A COST RELEVANT?

7. IMPORTANT TERMS TO KNOW
Avoidable cost
Cost associated with a particular alternative that will be eliminated if alternative is eliminated
Unavoidable cost
Cost that will continue regardless of the alternative selected

8. Is it cheaper to drive the 500 miles or fly?
LET’S PRACTICE
© kickers/iStockphoto
You are getting ready to take a trip and are trying to decide whether to drive or fly. You know that it costs you $1,000 per year plus $0.10/mile to operate your car. Based on the 20,000 miles you drive each year, you calculate total costs to be $0.15/mile. You have just gotten wind of a special $65 round trip airfare.
Is it cheaper to drive the 500 miles or fly?
© fotoVoyager/iStockphoto

9. The temptation is to make this comparison…
LET’S PRACTICE
You are getting ready to take a trip and are trying to decide whether to drive or fly. You know that it costs you $1,000 per year plus $0.10/mile to operate your car. Based on the 20,000 miles you drive each year, you calculate total costs to be $0.15/mile. You have just gotten wind of a special $65 round trip airfare.
The temptation is to make this comparison…
Cost to Drive
Cost to Fly
500 $0.15/mile = $75
$65

10. But, that comparison includes irrelevant costs…
LET’S PRACTICE
You are getting ready to take a trip and are trying to decide whether to drive or fly. You know that it costs you $1,000 per year plus $0.10/mile to operate your car. Based on the 20,000 miles you drive each year, you calculate total costs to be $0.15/mile. You have just gotten wind of a special $65 round trip airfare.
But, that comparison includes irrelevant costs…
Cost to Drive
Cost to Fly
500 $0.10/mile = $50
$65

11. WATCH OUT FOR SUNK COSTS
Sunk costs are NEVER relevant to a decision
These costs have been incurred in the past and nothing you can do today can change them

12. A RELEVANT COST DECISION MODEL
Identify the decision
Identify the alternatives
Identify the relevant revenues and costs
Identify the qualitative issues to consider
Identify the alternative with the greatest benefit or least cost

13. PRACTICE TIME
Exercise 8-3
© malerapaso/iStockphoto

14. E 8-3 SOLUTION a. Stat-Max Buy Tracker Purchase price $912,000
$500,000
Programmer hours
80 hours
125 hours
Annual License fee $0
$10,000
Technical support
24-hour
8 a.m. – 5 p.m. CST
not relevant: disk storage space and hours of user training
b. Ease of report customization, customer satisfaction/testimonies, frequency of upgrades, other potential future costs
c. The out-of-pocket cost will be more than the relevant cost due to the cost of the disk storage space.

16. SPECIAL ORDER PRICING DECISIONS
Sometimes a company may get an order from a customer asking for a “special price” that is less than the stated selling price
Could be a grocery chain approaching Kleenex maker Kimberly-Clark to produce a “private label” facial tissue
Sometimes the price requested appears to be less than the full product cost

17. WHY ACCEPT SPECIAL ORDER PRICING?
For product made to customer specs
For unusual order (quantity, packaging, means of delivery, etc.)
For one-time job
To utilize idle production facilities

18. QUALITATIVE ISSUES TO CONSIDER
What precedent does this special order set for future jobs?
How will regular customers react?
Is there enough capacity to produce the order without reducing normal production?

19. What costs are relevant? Should Coopersmith accept the special order?
AN EXAMPLE…
Coopersmith produces premium wooden barrels. A one liter barrel sells for $25, but a fancy Swiss ski resort has offered to buy 10,000 barrels for $18 each for its St. Bernard patrol. The barrel has the following product costs, based on annual production of 30,000 barrels:
Fixed costs will not change with the special order. Accepting the special order will result in an extra $80,000 in contribution margin:
($8/barrel x 10,000 barrels)
ACCEPT IT!
What costs are relevant? Should Coopersmith accept the special order?
DM $ 5 ✔
DL 2 ✔
VOH 3 ✔
FOH 9 ✖
$ 19 $ 10
DM $ 5
DL 2
VOH 3
FOH 9
$ 19

20. AN EXAMPLE…
Coopersmith produces premium wooden barrels. A one liter barrel sells for $25, but a fancy Swiss ski resort has offered to buy 10,000 barrels for $18 each for its St. Bernard patrol. The barrel has the following product costs, based on annual production of 30,000 barrels:
Assume that the ski lodge requires special packaging that will cost Coopersmith $2 per barrel. Should Coopersmith accept the special order?
Additional variable costs of $2/barrel will be incurred, thus the relevant cost per barrel is $12. Accepting the special order will result in an extra $60,000 in contribution margin:
($6/barrel x 10,000 barrels)
ACCEPT IT!
DM $ 5
DL 2
VOH 3
FOH 9
$ 19
DM $ 5 ✔
DL 2 ✔
VOH 3 ✔
FOH 9 ✖
$ 19 $ 10
VS&A 2 ✔
$ 12

21. RECAP OF SPECIAL ORDER PRICING
Decision: Should we accept an order at a price less than normal selling price?
Factors: differential income for the order
Qualitative issues: affect on regular sales, expectation of continued special treatment
Watch out: unavoidable fixed costs
Decision Rule: as long as the special order covers differential costs and provides profit, accept the order

22. A SPECIAL TIME
Exercise 8-6
© Robert Lehmann/iStockphoto

23. E 8-6 SOLUTION Sales price $35 Variable costs per unit:
Direct materials 6
Direct labor 4
Variable overhead ($15  .4) 6
Total variable costs 16
Contribution margin $19  15,000 pairs = $285,000
Lybrand’s income will increase by $285,000

25. WHAT IS OUTSOURCING? Moving production outside the organization
Offshoring is moving production to a foreign country (It may or may not be outsourcing)
Outsourcing is a big trend in business today
Sometimes referred to as a “make-or-buy” decisions (Do I make a component myself, or do I but it already fabricated from someone else?)

26. WHAT COSTS ARE RELEVANT?
Price we have to pay to buy the component
All avoidable costs we would incur to make the component
Watch out for fixed overhead per unit; it may or may not be avoidable

27. AN EXAMPLE (Exercise 8-9)
Thomas Company makes bicycles. It has always made its own tires but has recently received a bid from Tiny Tires, Inc. to supply the tires for $13 each. Thomas’s tire costs are shown below. Of the fixed overhead, 40% is related to plant occupancy costs that will continue even if tires are purchased from Tiny.
Should Thomas make or buy the 5,000 tires it needs?
DM $ 3
DL 4
VOH 1
FOH 6
$ 14

28. Should Thomas make or buy the 5,000 tires it needs?
AN EXAMPLE…
Thomas Company makes bicycles. It has always made its own tires but has recently received a bid from Tiny Tires, Inc. to supply the tires for $13 each. Thomas’s tire costs are shown below. Of the fixed overhead, 40% is related to plant occupancy costs that will continue even if tires are purchased from Tiny.
Should Thomas make or buy the 5,000 tires it needs?
DM $ 3 ✔
DL 4 ✔
VOH 1 ✔
FOH 6 ✔ But only $3.60
$ 14
DM $ 3
DL 4
VOH 1
FOH 6
$ 14
So, the relevant cost to make a tire is only $11.60
Which costs are relevant?

29. WHAT ABOUT OPPORTUNITY COSTS?
Opportunity costs of using our facilities may be relevant
What alternative uses of the capacity exist?
Can we generate additional income by using the freed up facilities in some way?

30. Should Thomas make or buy the 5,000 tires it needs?
WHAT IF…
Suppose that if Thomas Company buys tires from Tiny, it could use the freed up manufacturing capacity to produce a new line of tricycles. The new tricycles are expected to generate $6,000 in net income.
Should Thomas make or buy the 5,000 tires it needs?
Make
Buy
$11.60 x 5,000 = $58,000
$58,000
$12 x 5,000 = $60,000
Less new income ($6,000)
$54,000

31. QUALITATIVE FACTORS TO CONSIDER…
Relative net advantage given uncertainty of estimates (costs, risks, etc.)
Reliability and number of sources of supply
Ability to assure quality
Future bargaining position with suppliers
Perceptions regarding possible future price changes

32. RECAP OF OUTSOURCING DECISION
Decision: Do you make a component in house or buy it from an outsider?
Factors: avoidable costs to make, purchase price, alternative uses of facility
Qualitative issues: supplier reliability and quality, theft of intellectual property, transfer or technological risk
Watch out: non-differential fixed costs
Decision Rule: If purchase price is less than avoidable costs, buy from outside

33. PRACTICE TIME
Exercise 8-8
© Briansullivan/iStockphoto

34. E 8-8 SOLUTION a. Direct Materials $ 2 Direct Labor 3
Variable Overhead 4
Relevant cost to make $9
Outland should continue to make as the relevant cost to make ($9) is less than the cost to buy ($12). b.
Now it makes financial sense to buy the parts and use the facilities to earn an additional $5,000 in contribution margin.
Make
Buy
Total relevant cost to make
$9  1,000 = $9,000
Total cost to buy
$12  1,000 = $12,000
Contribution margin from released facilities
(5,000)
Net cost to buy
$7,000

36. CONSTRAINED RESOURCE ALLOCATION
Most businesses face some constraint in terms of available resources
We need a way to decide how to allocate those scarce resources aross the business
Focus on the highest contribution margin per unit of scarce resource

37. AN EXAMPLE (Exercise 8-14)
Wendy’s Windy Things manufactures kites and banners. This month Wendy has orders for 3,000 Valentine banners and Easter 1,200 kites. Wendy only has 1,000 sewing machine hours available.
Banners
Kites
Sales Price
$ 12
$ 15
Variable Costs
$ 9
$ 14
CM/unit
$ 3
$ 1
Machine hours/unit
1 hour
0.25 hour
CM/machine hour
$ 3
$ 4
Banners
Kites
Sales Price
$ 12
$ 15
Variable Costs
$ 9
$ 14
CM/unit
$ 3
$ 1
What is relevant?

38. WHAT SHOULD WENDY PRODUCE?
As many kites as she can sell
1000 kites x .25 hours = 250 hours
How many hours are left?
1,000 – 250 = 750 hours
Produce as many banners as she can with remaining hours
X banners x 1 hour = 750 hours
X = 750 banners

39. RECAP OF CONSTRAINED RESOURCE ALLOCATION DECISION
Decision: How should we allocate a scarce resource across all products?
Factors: scarce resource, CM per unit of scarce resource, demand for products
Qualitative factors: customer preferences for products, customer service issues
Watch out: CM per unit of product
Decision Rule: Make the product with the highest contribution margin per unit of scarce resource

40. LET’S PRACTICE
Exercise 8-13
© Skip Odonnell/iStockphoto

41. E 8-13 SOLUTION A B C Sales price per unit $3.00 $5.00 $16.00
Variable costs per unit
1.20
3.40
10.00
Contribution margin per unit
1.80
1.60
6.00
Labor hours per unit
 1.20
 .50
 5.00
Contribution margin/labor hour
$1.50
$3.20
$1.20
Preference #2 #1 #3
Produce
Hours per unit
Hours used
Hours available
1,800 B
600
.50
300
1,500 A
500
1.20
900 C
180*
5.00
* Since only 900 hours remain to make product C, and it takes 5 hours to make one C, only 180 Cs can be made (900  5).

43. MAKING THE OPERATIONS DECISION
How do we know when to add or drop a portion of operations?
Decision should be based on relevant costs of those operations
A lot of costs that a company incurs support the entire company, not a specific segment; these common costs are often allocated to segments and are the ones that cause the problems

44. WHAT IS RELEVANT TO THE DECISION?
All direct costs associated with the segment
Variable costs
Direct avoidable fixed costs
Calculate the segment margin
Revenues – Variable Costs – Avoidable Fixed Costs
Watch out for allocated common fixed costs

45. AN EXAMPLE…
TOTALS
Dept. A
Dept. B
Dept. C
Sales
$ 65,000
$20,000
$15,000
$30,000
COGS
Variable
29,000
4,000
10,000
15,000
Direct Fixed
9,000
2,000
1,000
6,000
S, G, & A
3,000
Common FC
13,000
Net Income
$ 1,000
$ 7,000
$ (5,000)
$ (1,000)
If we eliminate departments B and C, what revenues and costs will disappear?

46. AN EXAMPLE…
TOTALS
Dept. A
Dept. B
Dept. C
Sales
$ 65,000
$20,000
$15,000
$30,000
Variable
COGS
29,000
4,000
10,000
15,000
S, G, & A
9,000
2,000
3,000
Product CM
27,000
14,000
1,000
12,000
Avoidable FC
6,000
Segment Margin
$ 14,000
$ 11,000
$ (2,000)
$ 5,000
Department C is contributing $5,000 in segment margin to cover common fixed costs. Do not drop this department.

47. RECAP OF PRODUCT LINE DECISION
Decision: Should we keep an existing segment that appears to have a net loss?
Factors: contribution margin, segment margin, direct fixed costs
Qualitative issues: customer relations, preferences
Watch out: allocated common fixed costs
Decision Rule: If segment margin is positive, keep the segment

48. LET’S PRACTICE
Exercise 8-16
© John Solie/iStockphoto

49. E 8-16 SOLUTION Segment margin of Round: Sales $6,600
Variable costs ,000
Contribution margin 3,600
Avoidable fixed costs 1,680 ($4,200  40%)
Segment margin $1,920
Since the Round Game’s segment margin is positive, dropping the Round Game before the last quarter would have resulted in a lower operating income:
Operating income with Round $3,250
Lost segment margin without Round (1,920)
Operating income without Round $1,330