IPE 4439

Principles of Economics
and Cost Accounting
Course Teacher: Sharmin Akter Urmee
Lecturer, Department of MPE
Room No: 111, Old Academic Building
 CHAPTER 12

RELEVANT COSTS FOR

DECISION MAKING
 ENHANCING PRODUCT OFFERINGS TO STAY
COMPETITIVE AT WESTJET

Which revenues and costs are relevant when evaluating the financial effects of adding or
discontinuing a product line? This and other related topics are considered in this chapter
 Relevant Costs
A cost that differs among the alternatives in a particular
decision and will be incurred in the future. In
managerial accounting, this term is synonymous with
avoidable cost and differential cost.
 Identifying Relevant Costs and Benefits
For Example:
You are trying to decide whether to go to a movie or to
download a movie for the evening, the lease payments on
your car are irrelevant. Whether you go to a movie or stay
home, the lease payments will be exactly the same and are
therefore irrelevant in the decision. On the other hand, the
cost of the movie ticket and the cost of downloading the
movie are relevant in the decision because they are avoidable
costs.
 Identifying Relevant Costs and Benefits
Avoidable cost
Any cost that can be eliminated (in whole or in part) by
choosing one alternative over another in a decision-
making situation. In managerial accounting, this term is
synonymous with relevant cost and differential cost.

Avoidable costs are relevant costs. Unavoidable costs

are irrelevant costs.
 Identifying Relevant Costs and Benefits
For Example:
By choosing the alternative of going to the movie, the
cost of downloading a movie can be avoided. By
choosing the alternative of downloading a movie, the
cost of the movie ticket can be avoided. Therefore, the
cost of the movie ticket and the cost of downloading a
movie are both avoidable costs.
 Identifying Relevant Costs and Benefits
Two broad categories of costs are never relevant in
decisions. These irrelevant costs are

1. sunk costs (e.g., a previously owned computer used

to download the movie), and
2. future costs that do not differ between the
alternatives (e.g., car lease payments when making a
“go to a movie” versus “download a movie” decision).
 Identifying Relevant Costs and Benefits
In managerial accounting, the terms avoidable cost, differential cost,
incremental cost, and relevant cost are often used interchangeably. To
identify the costs and benefits that are relevant in a particular decision
situation, these steps can be followed:

1. Eliminate costs and benefits that do not differ between alternatives.

These irrelevant costs consist of (a) sunk costs and (b) future costs and
benefits that do not differ between alternatives.
2. Use the remaining costs and benefits that do differ between
alternatives in making the decision. The costs that remain are the
differential, or avoidable, costs
An Example of Identifying Relevant Costs and
Benefits
An Example of Identifying Relevant Costs and
Benefits
An Example of Identifying Relevant Costs and
Benefits
Reconciling the Total and Differential
Approaches
Reconciling the Total and Differential
Approaches
Reconciling the Total and Differential
Approaches
 Adding and Dropping Product Lines and Other
Segments

allocated

inventory
allocated OvH
Adding and Dropping Product Lines and Other
Segments
Adding and Dropping Product Lines and Other
Segments
A Comparative Format
 Beware of Allocated Fixed Costs
By allocating the common fixed costs among all
product lines, the digital camera line has been made
to look as if it were unprofitable, whereas, in fact,
dropping the line would result in a decrease in overall
company operating income.
 Beware of Allocated Fixed Costs
By allocating the common fixed costs among all
product lines, the digital camera line has been made
to look as if it were unprofitable, whereas, in fact,
dropping the line would result in a decrease in overall
company operating income.
Beware of Allocated Fixed Costs

will occur for sure

 Beware of Allocated Fixed Costs
Additionally, we should note that managers may choose to
retain an unprofitable product line if the line is necessary to
the sale of other products or if it serves as a “magnet” to
attract customers. Bread, for example, is not an especially
profitable line in food stores, but customers expect it to be
available, and many would undoubtedly shift their buying
elsewhere if a particular store decided to stop carrying bread.
Accordingly, to the extent that dropping a product line or
segment results in decreases (or increases) to sales of other
products or segments, the related impact on contribution
margin should be included in the keep versus drop analysis.
 The Make or Buy Decision
To illustrate a make or buy decision, let’s consider OSN Cycles. The company is now
producing the heavy-duty gear shifters used in its most popular line of mountain
bikes. The company’s Accounting Department reports the following costs of
producing the shifter internally:
 The Make or Buy Decision
An outside supplier has offered to sell OSN Cycles 8,000
shifters per year at a price of only $19 each. Should the
company stop producing the shifters internally and start
purchasing them from the outside supplier?
 The Make or Buy Decision
The company should purchase outside only if the
outside purchase price is less than the costs that
can be avoided internally as a result of stopping
production of the shifters.
 The Make or Buy Decision

dite hobei...
 Opportunity Cost
If the space now being used to produce the shifters would otherwise be idle, then
OSN Cycles should continue to produce its own shifters and the supplier’s offer
should be rejected, as stated above. Idle space that has no alternative use has an
opportunity cost of zero.

To illustrate, assume that the space now being used to produce shifters could be
used to produce disc brakes that would generate a segment margin of $60,000
per year. Under these conditions, OSN Cycles would be better off to accept the
supplier’s offer and to use the available space to produce the new product line:
 Opportunity Cost

jodi onno production

line chalatam, 60k
profit hoto, jeta ekhon holo na,
tai seta expense hisabe dhorchi...
 Special Orders
To illustrate, OSN Cycles has just received a request from the police
department of a large Canadian city to produce 100 specially modified
mountain bikes at a price of $560 each. The bikes would be used to
patrol some of the more densely populated residential sections of the
city. OSN Cycles can easily modify its City Cruiser model to fit the
specifications of the police department. The normal selling price of the
City Cruiser bike is $700, and its unit product cost is $564, as shown
below:
 Special Orders

tarmane 102-12=90 will go away anyway

The variable portion of the above manufacturing overhead is $12 per unit. The
order would have no effect on the company’s total fixed manufacturing overhead
costs.
The modifications to the bikes consist of welded brackets to hold radios,
nightsticks, and other gear. These modifications would require $34 in incremental
variable costs per unit. In addition, the company would have to pay a graphic
design studio $1,200 to design and cut stencils that would be used for spray
painting the police department’s logo and other identifying marks on the bikes.
Special Orders
 Special Orders
However, in performing the analysis it is important to make
sure that there is indeed idle capacity and that the special
order does not affect the company’s ability to meet normal
demand. For example, what if OSN Cycles is already operating
at 100% of capacity and normally sells all the bikes it can
produce for $700 each?
What is the opportunity cost of accepting the order? Should
the company accept the $560 price? If not, what is the
minimum price it should accept? To answer these questions,
the analysis can be conducted as follows:
 Special Orders

700+34+12
normally production line
e ami egulo banacchi...

bananor por police er jonno modify korchi...mane avoidable ba relevant cost...

 Joint Product Costs and the Sell or Process
Further Decision

16-12=4
4-5=-1
Sell or Process Further Decisions
 Sell or Process Further Decisions

whyyyy
 Utilization of a Constrained Resource
To illustrate, OSN Cycles makes a line of panniers—saddlebags for bicycles. There
are two models of panniers—a touring model and a mountain model. Cost and
revenue data for the two models of panniers are given below:

CMr=CM/Sales * 100
40 e CM 10
1 e CM 10/40
100 e 25%
 Utilization of a Constrained Resource
But now let’s add one more piece of information—the plant that makes
the panniers is operating at capacity. Ordinarily this does not mean
that every machine and every person in the plant is working at the
maximum possible rate. Because machines have different capacities,
some machines will be operating at less than 100% of capacity.
However, if the plant as a whole cannot produce any more units, some
machine or process must be operating at capacity. The machine or
process that is limiting overall output is called the bottleneck—it is the
constraint.
 Utilization of a Constrained Resource
At OSN Cycles, the bottleneck is a particular stitching machine. The
mountain pannier requires four minutes of stitching time, and each
unit of the touring pannier requires two minutes of stitching time.
Since this stitching machine already has more work than it can handle,
production will have to be cut back on one of the models.
In this situation, which product is more profitable?
Utilization of a Constrained Resource
 Utilization of a Constrained Resource
Suppose an hour of additional stitching time is available and that there
are unfilled orders for both products. The additional hour on the
stitching machine could be used to make either 15 mountain panniers
(60 minutes ÷ 4 minutes) or 30 touring panniers (60 minutes ÷ 2
minutes), with the following consequences:
Review Problem
Review Problem
Review Problem
Review Problem