Chapter 23 Notes: Relevant Costs for Managerial Decisions

Relevant Costs for Managerial Decisions

Learning Objectives

• C1: Describe the use of relevant costs and benefits for short-term decisions.
• A1: Determine the price of services using time and materials pricing.
• P1: Evaluate make or buy decisions.
• P2: Evaluate sell or process decisions.
• P3: Determine sales mix with constrained resources.
• P4: Evaluate segment elimination decisions.
• P5: Evaluate keep or replace decisions.
• P6: Determine product selling price.
• P7: Evaluate special offer decisions.

Decision Making

• Decision making involves five steps (Exhibit 23.1).

Relevant Costs and Benefits

• 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.

Relevant vs. Irrelevant Costs

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

Make or Buy Analysis

• Scenario: FasTrac currently buys a key part for 1.20 per unit.
• Cost to make: 1.05 per unit, including direct materials, direct labor, and incremental overhead.
• Decision rule: Make the part to save 0.15 per unit.

Sell or Process

• Companies must decide whether to sell partially completed products as-is or process them further.
• The decision depends on the costs and revenues of further processing.
• The company selects the action with the higher income.

Sell or Process Analysis

• Decision rule: Select the alternative with the higher income.
• Example: Processing further yields 70,000 income versus selling as-is for 50,000.
  • The company should process further to earn 20,000 of incremental income (70,000 - 50,000).
  • Previously incurred costs of 30,000 are excluded from the analysis because these are sunk costs and are not relevant.

Scrap or Rework

• A variation of sell or process is scrap or rework.
• Often in manufacturing, defective products that do not pass inspection are either scrapped or reworked.
• Decision rule: Select the option with the highest income.

Segment Elimination

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

Keep or Replace

• 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.
• Scenario: FasTrac is considering replacing an existing machine with a new machine.
• Decision rule: Keep the current machine if it results in higher overall income.

Special Pricing

• 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.
• Scenario: Evaluate a special order to determine if it increases the company's income.
• Decision: FasTrac should accept the offer to earn additional income of 18,000.