Chapter 5

Relevant Costs for the Decision-Maker

Learning Objective 1

  • Objective: Develop a decision-making framework in a few simple steps.

Decision-Making Framework Steps

  • Step 1: Clearly outline the problem and its related unknowns.

    • Example: At Paisley’s Pâwtisserie, identify the problem of high demand exceeding supply and the exhaustion faced from current baking hours.

  • Step 2: Identify suitable options and gather relevant qualitative and quantitative information; make informed assumptions if necessary.

    • Options identified include:

    • Option 1: Raising prices (concern about demand reduction).

    • Option 2: Purchasing more equipment (risk-averse decision).

    • Option 3: Hiring an employee (qualitative requirement of maintaining quality).

  • Step 3: Calculate relevant costs and benefits for each option.

    • For hiring an employee:

    • No cost to post job ads on social media or Craigslist.

    • Additional cost calculation: $15/hour x 8 hours x 5 days = $600/week.

    • Additional productivity: 8 boxes/hour x 8 hours x 5 days = 320 boxes/week.

    • Selling price per box: $5.00.

    • Differential margin calculated as: 320 boxes x ($5.00 – ($1.25 + $0.10)) = $1,168.

    • Subtracting labor cost of $600 results in an additional contribution margin of $568 per week.

    • Fixed costs are ignored since capacity remains unchanged.

  • Step 4: Select the option that maximizes benefits to the organization while fulfilling qualitative criteria.

    • Profitability: Hiring a baker yields an extra $568 CM per week.

    • Considerations include training satisfaction for quality maintenance.

  • Step 5: Implement your decision.

    • Action taken: Drafting the job posting.

Learning Objective 2

  • Objective: Identify relevant information and costs for a given decision.

Relevant Cost Definition

  • Relevant costs:

    • Directly relate to the decision being addressed.

    • Aid in excluding irrelevant costs from consideration.

    • Change based on different decisions (not universally applicable).

Types of Relevant Costs

  1. Differential Costs:

    • Costs that differ between choices, influencing decisions.

    • Also known as incremental costs.

  2. Avoidable Costs:

    • Costs that can be avoided if certain decisions are made (vs. unavoidable costs, which exist in both scenarios).

  3. Irrelevant Costs:

    • Costs that are not helpful in current decision-making (often past costs).

  4. Future Costs:

    • Costs applicable to upcoming decisions; past costs are sunk and thus irrelevant.

Sunk Costs

  • Definition: Past costs that cannot be changed by current decisions and are incurred already.

    • Examples include the purchase costs of assets.

    • Sunk costs should be excluded from relevant costs since decisions are made for future conditions only.

Decision-Making Scenario Example

  • Scenario: Choosing between a friend's ride home or taking a bus:

    • Options:

    • Ride with a friend (cost: $20).

    • Take the bus (cost: $27 while assessing qualitative factors like comfort of travel).

    • Consideration of both quantitative and qualitative factors leads to final choice based on both metrics.

Learning Objective 3

  • Objective: Outline four types of management decisions within relevant costing.

Types of Management Decisions

  1. Insource versus Outsource:

    • Evaluate whether to produce in-house or purchase from suppliers.

    • Also termed as make versus buy decision.

  2. Keep versus Drop:

    • DECIDING on maintaining or discontinuing a product line.

    • Analysis should consider whether avoidable fixed costs from dropping outweigh total contribution margin.

  3. Product Mix Decisions:

    • Determining optimal combination of products to maximize contribution margin given available resources.

  4. Special Orders:

    • Short-term sales opportunities that don’t typically impact regular pricing strategies.

Insource versus Outsource Analysis

  • Core Process: Critical tasks that must be performed internally.

  • Critical Processes: Potentially can be outsourced based on vendor reputation.

  • Commodity Processes: Easier tasks that can be outsourced without losing a market edge.

Evaluating Insource versus Outsource Example

  • Scenario: A landscaping business considers growing grass versus buying from suppliers:

    • Plan A (Insource): Producing turf with costs of $1.15/yard for direct materials, and other associated costs leading to contribution margin calculations.

    • Plan B (Outsource): Costs from suppliers versus benefits of using internal grass production.

    • Decision based upon calculations of total costs versus differential costs.

Keep versus Drop Decision Example

  • Example: Product line with losses considered for discontinuation:

    • Robo-Dog revenue vs. variable and fixed costs evaluated.

    • Contribution margins assessed to conclude whether dropping would incur greater losses or benefits.

Product Mix Decisions Under Constrained Resources

  • Analysis for products to maximize contribution per constrained resource (e.g., machine hours) to optimize income.

Learning Objective 4

  • Objective: Explain how opportunity costs relate to decision-making.

Opportunity Costs

  • Definition: Costs associated with missed alternative opportunities when a particular choice is made.

  • These costs should be weighed when comparing decision routes to ensure effective allocation of resources.

Learning Objective 5

  • Objective: Describe how three types of fixed costs impact decision-making.

Types of Fixed Costs

  1. Direct Fixed Costs:

    • Directly tied to a product line and often avoidable if the line is dropped.

  2. Common Fixed Costs:

    • Shared overhead costs that persist regardless of product decisions, making them irrelevant for individual product lines unless reviewing overall company strategy.

  3. Allocated Fixed Costs:

    • Costs distributed from central functions to branches which remain unchanged when individual lines are dropped;

    • This can burden surviving branches with higher costs.

Implications in Strategic Decision Making

  • Overall analysis hinges on retaining profitable segments over marginally loss-making divisions to enhance overall organizational health.

Learning Objective Review

  • Covered decision-making frameworks, relevant cost identification, management decision types, concepts of opportunity costs, and the impacts of fixed costs.

Note: Each example, calculation, and framework illustrates practical applications to decision-making in cost accounting. Ensure analytical skills are applied in interpretation and application to real-world scenarios.