RELEVANT COSTING

Terminology

Ad hoc discount: a price concession made under competitive pressure (real or imagined) that
does not relate to the location of the merchandising chain or volume purchased
Common Expense: costs incurred for the benefit of the company as a whole but are
allocated to individual product lines or business segments, Differential cost: (see
incremental cost)

Differential revenue: (see incremental revenue)

Incremental cost: the amount of cost that differs across decision choices
Incremental revenue: is the amount of revenue that differs across decision choices
Linear programming (LP): a method used to find the optimal allocation of scarce resources in
a situation involving one objective and multiple limiting factors
Make-or-buy decision: (see outsourcing decision)
Mathematical programming: a variety of techniques used to allocate limited resources among
activities to achieve a specific goal or purpose
Offshoring: the practice of sending jobs formerly performed in the home country to other
countries
Opportunity cost: a potential benefit that is foregone because one course of action is chosen
over another
Outsourcing: the practice of having work performed for one company by an off-site
nonaffiliated supplier; it allows a company to buy a product (or service) from an outside supplier
rather than making the product or performing the service in-house
Outsourcing decision: an analysis that compares internal production and opportunity costs with
external purchase cost and assesses the best uses of facilities
Relevant costing: a process which focuses managerial attention on a decision’s relevant (or
pertinent) information
Robinson-Patman Act: a law that prohibits companies from pricing the same products at
different amounts when those amounts do not reflect related cost differences
Sales mix: the relative product quantities composing a company’s total sales
Scarce resource: a resource that is essential to production activity or service provision but that
has limited availability
Segment margin: the excess of revenues over direct variable expenses and avoidable fixed
expenses for a particular segment
Special order decision: a situation in which management must determine a sales price to charge
for manufacturing or service jobs outside the company’s normal production/service market

Sunk costs: costs incurred in the past to acquire an asset or a resource

Lecture Outline

LO.1: What factors determine the relevance of information to decision making?

A. Introduction

1. In decision making, managers should consider all relevant costs and revenues associated
with each decision alternative. There are four steps in this decision process:

a. Step 1: The necessity of making a decision becomes evident.

b. Step 2: Decision choices or alternatives are identified.

c. Step 3: The relevant costs and benefits associated with each decision alternative in
step 2 are calculated.

d. Step 4: The decision alternative providing the largest net benefit to the organization is
selected.

2. Relevant costing is an approach that focuses managerial attention on a decision’s

relevant (or pertinent) information.

3. This chapter introduces relevant costing by examining several recurring business

decisions such as replacing an asset, outsourcing a product or component, allocating
scarce resources, manipulating sales mix, and evaluating special orders.

B. The Concept of Relevance

1. General

a. There is a relationship between time and relevance.

i. As the decision time horizon is reduced, fewer costs and revenues are relevant.

b. For information to be relevant, it must possess three characteristics:

i. be associated with the decision under consideration; ii. be important to the

decision maker; and iii. have a connection to, or bearing on some future endeavor.
 2. Association with Decision

a. To be relevant, information must be associated with the decision or question under

consideration.

b. Incremental revenue (or differential revenue) is the amount of revenue that differs
across decision choices.

c. Incremental cost (or differential cost) is the amount of cost that varies across
decision choices.

i. Incremental costs can be either variable or fixed. Most variable costs are relevant
while most fixed costs are not relevant.

d. The difference between the incremental revenue and incremental cost of a particular
alternative is the incremental profit (incremental loss) of that course of action.

e. Management can compare the incremental benefits of various alternatives to decide

on the most profitable or least costly alternative or set of alternatives.

f. Some relevant factors, such as sales commissions or direct production costs, are easily
identified and quantified because they are captured by the accounting system.

i. Other factors, such as opportunity costs, may be relevant and quantifiable, but are
not captured by the accounting system.

ii. An opportunity cost represents the potential benefit foregone because one course
of action is chosen over another.

3. Importance to Decision Maker

a. The need for specific information depends on how important the information is
relative to management objectives.

4. Bearing on the Future

a. Information can be based on past or present data, but it can only be relevant if it
pertains to a future decision.

b. The future may be the short run or the long run; future costs are the only costs that
can be avoided; and the longer into the future a decision’s time horizon extends, the
more costs are controllable, avoidable, and relevant.

c. Only information that has a bearing on future events is relevant in decision making.

LO.2: What are sunk costs, and why are they not relevant in making decisions?
C. Sunk Costs

1. A sunk cost is a cost incurred in the past to acquire an asset or resource that is not
relevant to any future courses of action.

2. Sunk costs cannot be changed no matter what future course of action is taken because
historical transactions cannot be reversed currently.

3. The relevant costs that should be considered in making the decision.

a. A common analytical tendency is to include the historical cost of the old system but
this cost does not differ between the decision alternatives.

b. The relevant factors for making the keep-or-replace decision include:

i. cost of the new system; ii. current resale value of the original system; and iii.

annual operating savings associated with the new system.

D. Relevant Costs for Specific Decisions

1. Managers routinely make decisions on alternative courses of action that have been
identified as feasible solutions to problems or feasible methods to use in the attainment of
objectives.

a. All incremental revenues, costs, and benefits of all courses of action are measured
against a baseline alternative in determining which course of action is best.

b. When evaluating alternative courses of action, managers should select the alternative
that provides the highest incremental benefit to the company.

c. The “change nothing” alternative has a zero incremental benefit since it represents
current conditions from which all other alternatives are measured, and it should be
chosen only when it is perceived to be the best available alternative solution.

d. Rational decision-making behavior includes a comprehensive evaluation of the

quantifiable and non-quantifiable effects of all alternative courses of action.

e. The chosen course should be one that will make the business better off than it is
currently.
LO.3: What information is relevant in an outsourcing decision?

E. Outsourcing Decisions

1. General

a. Outsourcing refers to having work performed by an off-site nonaffiliated supplier; it

allows the company to buy a product (or service) from an outside supplier rather than
making the product or performing the service in-house.

b. Offshoring sends jobs formerly performed in the home country to other countries.

i. In 2010, financial services ($25.2 billion), manufacturing ($17.1 billion) and

energy ($8.5 billion) were the most common types of work taken offshore.

c. The outsourcing (or make-or-buy) decision is a decision that compares internal

production and opportunity costs to external purchase cost and then assesses the best
use of facilities.

i. Relevant information for this type of decision includes both quantitative and
qualitative factors.

d. Relevant costs, regardless of whether they are variable or fixed, are avoidable because
one decision alternative was chosen over another. In an outsourcing decision, variable
production costs are relevant. Fixed production costs are relevant only if they can be
avoided if production is discontinued.

e. The opportunity cost of the facilities being used by production are also relevant since
outsourcing will allow the company to use its facilities for an alternative purpose.

f. If a more profitable alternative is available, management should consider diverting the

capacity to this use.

g. Even if quantitative analysis supports outsourcing, qualitative factors (e.g., financial

health of the supplier) may overrule.

h. A theoretically short-run decision can have many potential long-run effects thus
suggesting that the term fixed cost may actually be a misnomer because, while such
costs do not vary with volume in the short-run, they will vary in the long-run. Thus,
fixed costs are relevant for long-run decision making.

i. Many service organizations (accounting and law firms, medical practices, and
schools) also need to make outsourcing decisions.

j. Outsourcing can include product and service design activities, accounting (e.g.,
preparation of income tax returns) and legal services, utilities, engineering services,
and employee health services.
LO.4: How can management achieve the highest return from use of a scarce resource?

2. Scarce Resources Decisions

a. A scarce resource is a resource that is essential to a production or service activity but

is available only in some limited quantity.

i. Scarce resources create constraints on producing goods or providing services and

can include machine hours, skilled labor hours, raw materials, and production
capacity.

b. Management may desire and be able to obtain a greater abundance of a scarce

resource in the long run, but management must make the best current use of the scarce
resources it has in the short run.

c. The determination of the best use of a scarce resource requires that specific company
objectives be recognized by management.

i. If an objective is to maximize company profits, a scarce resource is best used to

produce and sell the product having the highest contribution margin per unit of
the scarce resource.

d. Company management must consider qualitative aspects of the problem in addition to

the quantitative ones.

i. For example, how will customers react if the company only offers one product?

ii. Will concentrating on a single product result in market saturation?

e. When one limiting factor is involved, the outcome of a scarce resource decision
indicates which single type of product should be manufactured and sold.

i. Most situations, however, involve several limiting factors that compete in striving
to attain business objectives. To solve these types of problems requires the use of
mathematical programming which refers to a variety of techniques used to
allocate limited resources to achieve a specific purpose.

ii. Linear programming (LP) is one method used to find the optimal allocation of
scarce resources when there are multiple limiting factors.

LO.5: How are special prices set, and when are they used?
 4. Special order decisions

a. A special order decision is a situation that requires management to compute a

reasonable sales price for production or service jobs outside the company’s normal
realm of operations.

i. Special prices may be justified when orders are unusual, because the products are
being tailor-made to customer specifications, or when goods are produced for a
one-time job.

b. Companies sometimes price a special order job with a “low-ball” bid that produces no
profit by barely covering costs or that is below cost. Such low-balling is used to
penetrate a certain market segment with the company’s products or services.

c. The sales price quoted on a special order job typically should be high enough to
generate a positive contribution margin.

d. When setting a special order price, managers must consider qualitative as well as
quantitative issues. The following questions should be asked:

i. Will setting a low bid price establish a precedent for future prices?;

ii. Will the contribution margin be sufficient to justify the additional burdens placed
on management and employees?;

iii. Will the additional production activity require the use of bottleneck resources and
reduce company throughput?; iv. How will special order sales affect normal
sales?; and

v. If production of the order is scheduled during a slow period, is management willing

to take the business at a lower contribution margin simply to keep a trained
workforce employed
LO.6: How do managers determine whether a product line should be retained or
discontinued?

5. Product Line and Segment Decisions

a. Operating results of multiproduct environments are frequently presented in a

disaggregated format that depicts results for separate product lines within the
organization or division.

b. Managers, in reviewing such statements, must distinguish relevant from non-relevant

information regarding individual product lines.
 c. The segment margin represents the excess of revenues over direct variable expenses
and avoidable fixed expenses; the amount remaining is available to cover unavoidable
direct fixed expenses and common expenses, and to provide profits.

i. The segment margin figure is the appropriate one on which to base continuation
or elimination decisions since it measures the segment’s contribution to the
coverage of indirect and unavoidable expenses.
e. Before deciding to discontinue a product line, management should carefully consider
what resources would be required to turn the product line around and consider the
long-term ramifications of product line elimination.

f. Management’s task is to allocate effectively and efficiently its finite stock of

resources to accomplish its objectives.

i. Managers must have a reliable quantitative basis on which to analyze problems,

compare viable solutions, and choose the best course of action.

ii. Because management is a social rather than a natural science, it has no

fundamental truths and few related problems are susceptible to black or white
solutions.

iii. Relevant costing is a process of making human approximations of the costs of

alternative decision results.

Decision Making – is a fundamental part of management.

Managerial Accountant’s Role in Decision Making

- Managerial accountants are increasingly playing important roles as full-fledged members of

cross functional management teams. They face a broad array of decisions, including production,
marketing , financial an other decisions.

STEPS in the Decision Making Process:

1. Clarify the decision problem

2. Specify the criterion
3. Identify the alternatives
4. Develop a decision model
5. Collect the data
6. Select an alternative

Quantitative versus Qualitative Analysis

Qualitative characteristics are the factors in a decision problem that cannot be expressly effectively in
numerical terms.

Quantitative analysis can allow the decision maker to put a price on the sum total of the qualitative
characteristics.

CRITERIA in designing the accounting information:

1. Relevance – if it is pertinent to a decision problem

2. Accuracy – information must be precise
3. Timeliness – available in time for a decision

Criteria of relevant information:

1. Bearing on the future

2. Different under competing alternatives

Key Cost Concepts in Relevant cost analysis or Incremental analysis

1. Relevant costs – costs and revenues that differ between alternatives

2. Irrelevant costs – costs and revenues that do not differ across alternatives can be ignored when
trying to choose between alternatives.
3. Opportunity costs – lost benefit of choosing one alternative over the other
4. Sunk costs – costs that have already been incurred and will not be changed or avoided by any
present or future decisions
5. Differential costs – difference in a cost item under two decision alternatives

TYPES of Decisions:

1. Accept an order at a special price

2. Make or buy component parts or finished products
3. Sell products or process them further
4. Repair, retain or replace equipment

Eliminate an unprofitable business segment or product

 Multiple Choice Questions

1. Which of the following is not a required characteristic of relevant information?

[Link] be associated with the decision under consideration
[Link] have a connection to or bearing on some future endeavor
[Link] be important to the decision maker
[Link] be verifiable by an independent reviewer or auditor

2. Contribution to income that is foregone by not using a limited resource for its best alternative
use is referred to as
a. marginal cost.
b. incremental cost.
c. non-relevant cost.
d. opportunity cost.

3. Total unit costs are:

a. relevant for cost-volume-profit analysis.
b. needed for determining sunk costs.
c. non-relevant in marginal analysis.
d. needed for determining product contribution.

4. Sunk costs are:

a. relevant to decision making.
b. not relevant to decision making.
c. non-relevant to long-run decisions but not to short-run decisions.
d. fixed costs.

5. In equipment-replacement decisions, which one of the following does not affect the decision-
making process?
a. Historical cost of the old equipment
b. Cost of the new equipment
c. Operating costs of the new equipment
d. Current disposal price of the old equipment

6. Select the incorrect statement from the following.

a. A cost that is the same for multiple alternatives under consideration is not relevant.
b. The cost of acquiring the machine that is currently used to produce a component is relevant
in making an outsourcing decision.
c. The cost to acquire a component in a make or buy decision is relevant.
d. The salvage or residual value of a piece of machinery is relevant in a keep-or-replace
decision.

7. A company’s approach to a make-buy decision

a. involves an analysis of avoidable costs.
b. depends on whether the company is operating at or below breakeven.
 c. should use absorption costing.
d. should use activity-based costing.

8. P Company currently manufactures all component parts used in the manufacture of various
small appliances. A steel handle is used in three different products. The current year budget for
20,000 handles has the following unit cost:

Direct material $0.60

Direct labor 0.40
Variable overhead 0.10
Fixed overhead 0.20
Total unit cost $1.30

A steel company has offered to supply 20,000 handles to P Company for $1.25 each, which
includes delivery. Accepting the offer will:
a. decrease the handle unit cost by $0.15.
b. decrease the handle unit cost by $0.25.
c. increase the handle unit cost by $0.15.
d. Increase the handle unit cost by $0.05.

9. Select the incorrect statement concerning scarce resource decisions.

a. Unit contribution margin rather than gross margin is the appropriate measure of
profitability.
b. Scarce resources may include machine hours, skilled labor hours, and raw materials.
c. If the objective is to maximize profits, a scarce resource is best used to produce and sell the
product generating the highest contribution margin per unit.
d. Although in the long run, a company may acquire a higher quantity of the scarce resource, in
the short run, management must make the most efficient use of the currently available
resources.

10. D Company recently expanded its manufacturing capacity, which will allow it to produce up to
15,000 units of Products A and B. The sales department believes it can sell up to 13,000 units of
either product this year. Because the two products are very similar, D Company will produce
only one of the two products. The following information is available:

Per Unit Data

Product A Product B
Selling price $88.20 $80.00
Variable costs 52.80 52.80

Fixed costs will total $369,600 if Product A is produced but will be only $316,800 if Product B
is produced. D Company is subject to a 40% income tax rate. If the company desires an after-
tax profit of $24,000, how many units of Product B will the company have to sell? a. 4,460
b. 12,529
 c. 13,118
d. 13,853

11. Select the correct statement concerning special order decisions.

a. Such decisions must not violate the Robinson-Patman Act which prohibits companies from
pricing the same product at different levels when those amounts do not reflect related cost
differences.
b. Companies may give ad hoc discounts if such concessions relate to real or imagined
competitive pressures.
c. Special order decisions often hinge on productive capacity issues.
d. All of the above are correct.

12. R Company sells a product for $10.00 that has the following unit cost:

Direct material $1.60

Direct labor 2.40
Variable overhead 1.20
Fixed overhead 1.30
Total unit cost $6.50

A company that does not compete with R Company’s existing customers has made an offer to
purchase 1,000 units of the product at a proposed price of $6.00. R Company is currently selling
all of the units it can produce to its existing customers. Select the correct statement from the
following.
a. Reject the offer since the offer price is less than the unit production cost.
b. Accept the offer since the offer price exceeds the sum of the variable costs.
c. Reject the offer to avoid a $4.00 per unit decrease in profit on the 1,000 units.
d. Accept the offer since the offer price exceeds the unit fixed cost.

13. Select the correct definition of segment margin from the following:
a. Revenue – Expenses
b. Revenue – Variable Costs
c. Revenue – Variable Costs – Avoidable Fixed Costs
d. Revenue – Variable Costs – Unavoidable Fixed Costs