Relevant Costs for Managerial Decisions

Incremental revenues: Additional revenues generated by selecting one action over another.
Incremental costs: Additional costs incurred if a company pursues a certain course of action.
Incremental income: Incremental revenues minus incremental costs.
Rule: Choose the alternative that most increases income.

Sunk cost: Arises from a past decision and cannot be avoided or changed; irrelevant to current and future decisions.
Out-of-pocket cost: Requires a future outlay of cash; relevant.
Opportunity cost: The potential benefit lost by taking an action over an alternative action; relevant.
Avoidable cost: Can be eliminated by choosing one alternative versus another; relevant.

Decision Rule: Make the part if it saves cost per unit.
Example: FasTrac currently buys a key part for $1.20$ per unit. The cost to make is $1.05$ and includes direct materials, direct labor, and incremental overhead. Making the part saves $0.15$ per unit.

Companies must decide whether to sell partially completed products as is or to process them further.
The decision depends on the costs and revenues of processing further.
The company will select the action with the higher income.
Decision Rule: Select the alternative with the higher income.
Process further to earn incremental income. Previously incurred costs are sunk costs and are not relevant.

A variation of sell or process.
Often in manufacturing, we have products that do not pass inspection and are therefore, defective.
We can either scrap them or rework them.
Decision Rule: Selection option with the highest income.

When a company sells a variety of products, some are likely to be more profitable than others.
Management looks for the most profitable sales mix of products.
If production facilities are limited, producing more of one product usually means producing less of others.
In this case, management must identify the most profitable combination, or sales mix of products.
Management focuses on the contribution margin per unit of scarce resources.
Decision Rule: Produce the model that yields the highest contribution margin per machine hour until market demand is satisfied.

Decision rule: If demand for products is unlimited, devote all machine hours to the production of the most profitable product (per unit of scarce resource).

Decision rule: If demand for products is limited, produce the most profitable product (per unit of scarce resource) up to the point of total demand. Use remaining capacity to produce the next most profitable product.

A segment is a candidate for elimination if its contribution margin is less than its avoidable fixed costs.
Avoidable costs are amounts that are eliminated when the segment is eliminated.
Unavoidable costs are amounts that would remain even if the segment was eliminated.
Decision Rule: A segment should be eliminated if income increases from elimination. It should continue if income decreases from elimination.

Managers must periodically decide whether to keep using a plant asset or replace it.
Compare revenues and costs of keeping the old asset versus replacing it with a new asset.
Decision Rule: Replace an asset if overall income increases. Keep the asset if overall income decreases with replacement.

Companies can be a price taker or a price setter (or somewhere in between).
Price takers: Have less control over setting prices; use more target pricing type methods.
Price setters: Have more control over setting prices; use more cost-plus pricing.

Target costing can be used when competition is high.
Example: Expected selling price is $80$ . Company wants a profit of $14$ per unit. Company must reduce the target cost per unit to $66$ ( $80$ price - $14$ target profit).

Step 1: Determine markup percentage.
$Markup\ percentage = \frac{Target\ profit + Total\ fixed\ costs}{Total\ variable\ cost}$
Step 2: Determine dollar markup per unit.
$Markup\ per\ unit = Variable\ cost\ per\ unit \times Markup\ percentage$
Step 3: Determine selling price per unit.
$Selling\ price\ per\ unit = Variable\ cost\ per\ unit + Markup\ per\ unit$

Companies sometimes receive special offers at prices lower than the normal selling price.
The decision to accept special offers should be based on their income effects.
Decision Rule: Accept the special offer if income increases (and reject it if income decreases).

Commonly used to price services.
Companies set a price for direct labor, direct materials, overhead, and a target profit.
Follows three steps:
1. Compute time charge (in $) per hour of direct labor. This rate includes a charge for non-materials overhead.
2. Compute the materials markup (%), which includes the overhead costs relating to buying, storing, and handling materials, plus a target profit margin on the materials’ cost.
3. Estimate direct labor hours and costs, direct materials cost, and the markup to get price.