1. Relevant Costs for Decision Making
May 27, 2009 – Part 2
Relevant Costs for Decision Making
Chapter 11: Relevant Costs for Decision Making.
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.

2. Today’s Agenda Relevant Costs vs. Irrelevant Costs
Differential Approach vs. Total Cost Approach
Product Transfer Decision Example
Constrained Resources

3. Relevant Costs
Costs that are relevant to decision making are those costs which differ between two or more alternatives
Differential costing
Costs that are irrelevant to decision making are those that cannot be altered
Sunk costs
Future costs that cannot be changed
By definition, these costs will not be different from each other in differing scenarios
These costs are unavoidable
Costs that are relevant to one decision may not be relevant to a different decision
One can use a total cost approach as opposed to a differential cost approach

4. Total Cost versus Differential Cost Approach
Total Cost Approach
Factor in ALL costs
More time consuming
Provides a complete picture and budget basis
Differential Cost Approach
Only factor in relevant costs; ie, those that differ between scenarios
Quicker
Does not provide the full cost picture
Either approach should lead to the same business decision conclusion

5. 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:
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.

6. Production Transfer Decision
James Company manufactures Switches
It manufactures and sells its products in North America
Its best customer has received a price quote from James Co’s competitor for $7,000 per unit
The customer expects to grow significantly and says that costs are its #1 issue
What would happen to the company if it matched the competitor’s quote?
What should James Co do?

7. Production Transfer Decision
James Co options:
Keep prices the same and hope the customer stays
Suggest the extra cost is provided in value added service
Argue that James Co knows the customer better & can better serve it
Argue that James Co quality and timeliness of delivery is superior
Match the price, lose money and try to cut costs over time
Manufacture in a lower cost location
Investigate whether James Co can manufacture the product profitably elsewhere

8. Production Transfer Decision
You are the head of managerial accounting and you learn the following about producing in China:
Component parts can be sourced for 70% of current costs
Because they are made in China and would not require shipping
Labour costs are 20% of what they are in North America
Shipping completed product back to North America would cost $250 per unit AND it would add two weeks to the delivery schedule
Power is approximately the same cost in both locations
If the company transferred, the customer would conduct a detailed one-time facility inspection at a cost to James Co of $2 million
There are other “one-time” costs
Building up extra inventory for the transfer period to ensure continuity of supply
Parallel production until China facility is in steady-state
It would take a full 12 months to sub-lease the North American facility
What information is missing to make a decision whether to transfer production?

9. Product Transfer Decision

10. Product Transfer Decision
Do you have a conclusion? Is there anything analysis still missing?

11. Product Transfer Decision
There has been no consideration for additional inventory required due to increase in delivery time
Two weeks additional inventory costs
However, there is less inventory ($ value) because it now costs less
Also, still need to consider “on-time” costs
How can these one-time costs be addressed?

12. Tutorial Assignment Review Build versus Buy Decisions
Study Review Problems
Complete Alternative Question