1. CORNERSTONES of Managerial Accounting, 5e

2. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CHAPTER 13: SHORT-RUN DECISION MAKING: RELEVANT COSTING Cornerstones of Managerial Accounting, 5e

3. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Short-Run Decision Making  Short-run decision making consists of choosing among alternatives with an immediate or limited end in view.  Also referred to as tactical decisions because they involve choosing between alternatives with an immediate or limited time frame in mind. LO-1

4. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Short-Run Decision Making (cont.)  Example: Accepting a special order for less than the normal selling price to utilize idle capacity and to increase this year’s profits.  Some decisions tend to be short run in nature.  Short-run decisions often have long-run consequences. LO-1

5. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Decision-Making Model  A decision model, a specific set of procedures that produces a decision, can be used to structure the decision maker’s thinking and to organize the information to make a good decision.  The following is an outline of one decision- making model:  Step 1. Recognize and define the problem.  Step 2. Identify alternatives as possible solutions to the problem. Eliminate alternatives that clearly are not feasible. LO-1

6. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Decision-Making Model (cont.)  Step 3. Identify the costs and benefits associated with each feasible alternative. Classify costs and benefits as relevant or irrelevant, and eliminate irrelevant ones from consideration.  Step 4. Estimate the relevant costs and benefits for each feasible alternative.  Step 5. Assess qualitative factors.  Step 6. Make the decision by selecting the alternative with the greatest overall net benefit. LO-1

7. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Relevant Costs Defined  The decision-making approach just described emphasized the importance of identifying and using relevant costs.  Relevant costs possess two characteristics:  they are future costs AND  they differ across alternatives.  All pending decisions relate to the future.  Accordingly, only future costs can be relevant to decisions. LO-1

8. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Opportunity Costs  Opportunity cost is the benefit sacrificed or foregone when one alternative is chosen over another.  An opportunity cost is relevant because it is both a future cost and one that differs across alternatives. LO-1

9. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Opportunity Costs (cont.)  An opportunity cost is never an accounting cost  Accountants do not record the cost of what might happen in the future  (i.e., they do not appear in financial statements)  It is an important consideration in decision making. LO-1

10. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sunk Costs  A sunk cost is a cost that cannot be affected by any future action.  It is important to note the psychology behind managers’ treatment of sunk costs LO-1

11. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sunk Costs (cont.)  Although managers should ignore sunk costs for relevant decisions, it is human nature to allow sunk costs to affect these decisions.  Example: Depreciation, a sunk cost, is sometimes allocated to future periods though the original cost is unavoidable.  In choosing between the two alternatives, the original cost of an asset and its associated depreciation are not relevant factors. LO-1

12. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost Behavior and Relevant Costs  Most short-run decisions require extensive consideration of cost behavior.  It is easy to fall into the trap of believing that variable costs are relevant and fixed costs are not.  But this assumption is not true.  The key point is that changes in supply and demand for resources must be considered when assessing relevance. LO-1

13. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost Behavior and Relevant Costs (cont.)  Changes in demand and supply for resources across alternatives can bring about changes in spending  The changes in resource spending are the relevant costs that should be used in assessing the relative desirability of the two alternatives. LO-1

14. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Some Common Relevant Cost Applications  Relevant costing is of value in solving many different types of problems. Traditionally, these applications include decisions:  to make or buy a component.  to keep or drop a segment or product line.  to accept a special order at less than the usual price.  to further process joint products or sell them at the split-off point. LO-2

15. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Some Common Relevant Cost Applications (cont.)  Though by no means an exhaustive list, many of the same decision-making principles apply to a variety of problems. LO-2

16. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Make-or-Buy Decisions  Managers often face the decision of whether to make a particular product (or provide a service) or to purchase it from an outside supplier.  Make-or-buy decisions are those decisions involving a choice between internal and external production. LO-2

17. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Make-or-Buy Decisions (cont.)  One type of relevant cost that is becoming increasingly large due to globalization and the green environmental movement concerns the disposal costs associated with electronic waste (or e-waste). LO-2

18. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Special Order Decisions  From time to time, a company may consider offering a product or service at a price different from the usual price. LO-2

19. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Special Order Decisions (cont.)  Firms can consider special orders from potential customers in markets not ordinarily served.  Special-order decisions focus on whether a specially priced order should be accepted or rejected.  These orders often can be attractive, especially when the firm is operating below its maximum productive capacity. LO-2

20. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Keep-or-Drop Decisions  A manager needs to determine whether a segment, such as a product line, should be kept or dropped.  Segmented reports prepared on a variable- costing basis provide valuable information for these keep-or-drop decisions. LO-2

21. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Keep-or-Drop Decisions (cont.)  Both the segment’s contribution margin and its segment margin are useful in evaluating the performance of segments.  Segmented reports provide useful information for keep-or-drop decisions  Relevant costing describes how the information should be used to arrive at a decision. LO-2

22. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Keep-or-Drop with Complementary Effects  Sometimes dropping one line would lower sales of another line, as many customers buy both lines at the same time.  This information can affect the keep-or-drop decision. LO-2

23. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Further Processing of Joint Products  Joint products have common processes and costs of production up to a split-off point.  At that point, they become distinguishable as separately identifiable products.  The point of separation is called the split-off point. LO-2

24. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Further Processing of Joint Products  Sometimes it is more profitable to process a joint product further, beyond the split-off point, prior to selling it (sell or-process-further decision). LO-2

25. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Product Mix Decisions  Organizations have wide flexibility in choosing their product mix.  Product mix refers to the relative amount of each product manufactured (or service provided) by a company.  Decisions about product mix can have a significant impact on an organization’s profitability. LO-3

26. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Product Mix Decisions (cont.)  Every firm faces limited resources and limited demand for each product.  These limitations are called constraints.  A manager must choose the optimal mix given the constraints found within the firm. LO-3

27. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Multiple Constrained Resources  The presence of only one constrained resource might not be realistic.  Organizations often face multiple constraints, including:  limitations of raw materials  limitations of skilled labor  limited demand for each product LO-3

28. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Multiple Constrained Resources (cont.)  The solution of the product mix problem in the presence of multiple constraints is considerably more complicated and requires the use of a specialized mathematical technique known as linear programming, which is reserved for advanced cost management courses. LO-3

29. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost-Based Pricing  Demand is one side of the pricing equation; supply is the other side.  Since revenue must cover all costs for the firm to make a profit, many companies start with cost to determine price.  That is, they calculate product cost and add the desired profit.  The mechanics of this approach are straightforward. Usually, there is a cost base and a markup. LO-4

30. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost-Based Pricing (cont.)  The markup is a percentage applied to the base cost.  It includes desired profit and any costs not included in the base cost.  Companies that bid for jobs routinely base bid price on cost. LO-4

31. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Target-Costing and Pricing  Many American and European firms set the price of a new product as the sum of the costs and the desired profit. The rationale is that the company must earn sufficient revenues to cover all costs and yield a profit. LO-4

32. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Target-Costing and Pricing (cont.)  Target costing is a method of determining the cost of a product or service based on the price (target price) that customers are willing to pay.  The marketing department determines what characteristics and price for a product are most acceptable to consumers. LO-4