Cornerstones

1. Cornerstones of Managerial Accounting, 5e

2. Chapter 13:Short-Run Decision Making: Relevant Costing Cornerstones of Managerial Accounting, 5e

3. Short-Run Decision Making • Short-run decision making consists of choosing among alternatives with an immediate or limited end in view. • Also referred to as tactical decisions because they involve choosing between alternatives with an immediate or limited time frame in mind. LO-1

4. Short-Run Decision Making (cont.) • Example: Accepting a special order for less than the normal selling price to utilize idle capacity and to increase this year’s profits. • Some decisions tend to be short run in nature. • Short-run decisions often have long-run consequences. LO-1

5. The Decision-Making Model • A decisionmodel, a specific set of procedures that produces a decision, can be used to structure the decision maker’s thinking and to organize the information to make a good decision. • The following is an outline of one decision-making model: • Step 1. Recognize and define the problem. • Step 2. Identify alternatives as possible solutions to the problem. Eliminate alternatives that clearly are not feasible. LO-1

6. The Decision-Making Model (cont.) • Step 3. Identify the costs and benefits associated with each feasible alternative. Classify costs and benefits as relevant or irrelevant, and eliminate irrelevant ones from consideration. • Step 4. Estimate the relevant costs and benefits for each feasible alternative. • Step 5. Assess qualitative factors. • Step 6. Make the decision by selecting the alternative with the greatest overall net benefit. LO-1

7. Relevant Costs Defined • The decision-making approach just described emphasized the importance of identifying and using relevant costs. • Relevant costs possess two characteristics: • they are future costs AND • they differ across alternatives. • All pending decisions relate to the future. • Accordingly, only future costs can be relevant to decisions. LO-1

8. Opportunity Costs • Opportunity cost is the benefit sacrificed or foregone when one alternative is chosen over another. • An opportunity cost is relevant because it is both a future cost and one that differs across alternatives. LO-1

9. Opportunity Costs (cont.) • An opportunity cost is never an accounting cost • Accountants do not record the cost of what might happen in the future • (i.e., they do not appear in financial statements) • It is an important consideration in decision making. LO-1

10. Sunk Costs • A sunk cost is a cost that cannot be affected by any future action. • It is important to note the psychology behind managers’ treatment of sunk costs LO-1

11. Sunk Costs (cont.) • Although managers should ignore sunk costs for relevant decisions, it is human nature to allow sunk costs to affect these decisions. • Example: Depreciation, a sunk cost, is sometimes allocated to future periods though the original cost is unavoidable. • In choosing between the two alternatives, the original cost of an asset and its associated depreciation are not relevant factors. LO-1

12. Cost Behavior and Relevant Costs • Most short-run decisions require extensive consideration of cost behavior. • It is easy to fall into the trap of believing that variable costs are relevant and fixed costs are not. • But this assumption is not true. • The key point is that changes in supply and demand for resources must be considered when assessing relevance. LO-1

13. Cost Behavior and Relevant Costs (cont.) • Changes in demand and supply for resources across alternatives can bring about changes in spending • The changes in resource spending are the relevant costs that should be used in assessing the relative desirability of the two alternatives. LO-1

14. Some Common Relevant Cost Applications • Relevant costing is of value in solving many different types of problems. Traditionally, these applications include decisions: • to make or buy a component. • to keep or drop a segment or product line. • to accept a special order at less than the usual price. • to further process joint products or sell them at the split-off point. LO-2

15. Some Common Relevant Cost Applications (cont.) • Though by no means an exhaustive list, many of the same decision-making principles apply to a variety of problems. LO-2

16. Make-or-Buy Decisions • Managers often face the decision of whether to make a particular product (or provide a service) or to purchase it from an outside supplier. • Make-or-buy decisions are those decisions involving a choice between internal and external production. LO-2

17. Make-or-Buy Decisions (cont.) • One type of relevant cost that is becoming increasingly large due to globalization and the green environmental movement concerns the disposal costs associated with electronic waste (or e-waste). LO-2

18. Special Order Decisions • From time to time, a company may consider offering a product or service at a price different from the usual price. LO-2

19. Special Order Decisions (cont.) • Firms can consider special orders from potential customers in markets not ordinarily served. • Special-order decisions focus on whether a specially priced order should be accepted or rejected. • These orders often can be attractive, especially when the firm is operating below its maximum productive capacity. LO-2

20. Keep-or-Drop Decisions • A manager needs to determine whether a segment, such as a product line, should be kept or dropped. • Segmented reports prepared on a variable-costing basis provide valuable information for these keep-or-drop decisions. LO-2

21. Keep-or-Drop Decisions (cont.) • Both the segment’s contribution margin and its segment margin are useful in evaluating the performance of segments. • Segmented reports provide useful information for keep-or-drop decisions • Relevant costing describes how the information should be used to arrive at a decision. LO-2

22. Keep-or-Drop with Complementary Effects • Sometimes dropping one line would lower sales of another line, as many customers buy both lines at the same time. • This information can affect the keep-or-drop decision. LO-2

23. Further Processing of Joint Products • Joint products have common processes and costs of production up to a split-off point. • At that point, they become distinguishable as separately identifiable products. • The point of separation is called the split-off point. LO-2

24. Further Processing of Joint Products • Sometimes it is more profitable to process a joint product further, beyond the split-off point, prior to selling it (sell or-process-further decision). LO-2

25. Product Mix Decisions • Organizations have wide flexibility in choosing their product mix. • Product mix refers to the relative amount of each product manufactured (or service provided) by a company. • Decisions about product mix can have a significant impact on an organization’s profitability. LO-3

26. Product Mix Decisions (cont.) • Every firm faces limited resources and limited demand for each product. • These limitations are called constraints. • A manager must choose the optimal mix given the constraints found within the firm. LO-3

27. Multiple Constrained Resources • The presence of only one constrained resource might not be realistic. • Organizations often face multiple constraints, including: • limitations of raw materials • limitations of skilled labor • limited demand for each product LO-3

28. Multiple Constrained Resources (cont.) • The solution of the product mix problem in the presence of multiple constraints is considerably more complicated and requires the use of a specialized mathematical technique known as linear programming, which is reserved for advanced cost management courses. LO-3

29. Cost-Based Pricing • Demand is one side of the pricing equation; supply is the other side. • Since revenue must cover all costs for the firm to make a profit, many companies start with cost to determine price. • That is, they calculate product cost and add the desired profit. • The mechanics of this approach are straightforward. Usually, there is a cost base and a markup. LO-4

30. Cost-Based Pricing (cont.) • The markup is a percentage applied to the base cost. • It includes desired profit and any costs not included in the base cost. • Companies that bid for jobs routinely base bid price on cost. LO-4

31. Target-Costing and Pricing • Many American and European firms set the price of a new product as the sum of the costs and the desired profit. The rationale is that the company must earn sufficient revenues to cover all costs and yield a profit. LO-4

32. Target-Costing and Pricing (cont.) • Targetcosting is a method of determining the cost of a product or service based on the price (target price) that customers are willing to pay. • The marketing department determines what characteristics and price for a product are most acceptable to consumers. LO-4