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Relevant Costs: Make or Buy?

Relevant Costs: Make or Buy?. OVC—Managerial Accounting, Fall 2002 David B. Hamm, MBA, CPA. Steps in the Decision-Making Process (the Five D’s). Define the problem Develop alternatives Decide which alternative is best Do what is indicated

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Relevant Costs: Make or Buy?

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  1. Relevant Costs: Make or Buy? OVC—Managerial Accounting, Fall 2002 David B. Hamm, MBA, CPA

  2. Steps in the Decision-Making Process (the Five D’s) • Define the problem • Develop alternatives • Decide which alternative is best • Do what is indicated • Determine if the decision was a good one (feedback)

  3. “Relevant” Information • Information is relevant if is pertinent to a decision problem—it will directly affect, or be affected by, the decision • Information must also be accurate • Information must also be timely

  4. Cost considerations • Sunk costs: have already been incurred and can not be changed by any current or future decision. Therefore no longer relevant. • Differential costs: difference between the costs of two (or more) decision alternatives • Incremental costs: additional cost differential of one alternative • Opportunity costs: potential benefit that must be given up when an alternative is selected

  5. Accept or Reject • We receive a “special” order—not part of routine production/services. Do we accept the order? • YES, if the order’s contribution margin (Sales – VC) will cover any incremental fixed costs or opportunity costs and still provide a net margin toward other operations • NO, if the order does not

  6. Accept or Reject—Illustration (text, p. 612) WorldWide Airways is offered a special charter flight paying $150,000. Its routine costs assigned to each flight are $190,000 (VC= $90,000, allocated FC=$100,000). Initially, WWA considers declining the charter because of a $40,000 loss.

  7. Accept or Reject Illustration (2) But—the fixed costs are not incremental to this flight; they are fixed for all current operations. Only the variable costs need be considered. Also, since the charter doesn’t involve reservations or ticketing, there is a variable cost savings: Since the CM of the special “order” is positive and can contribute to other operations, the offer should be accepted.

  8. Accept or Reject Illustration (3) • Above illustration assumes there is excess production capacity, i.e., plane, crew, facilities are available for the flight. • If there is no excess capacity and another job must be cancelled to accept the special order, the contribution margin of the alternative job becomes an opportunity cost that must be included in the special order. Now it may not be as attractive. (See p. 613)

  9. Make or Buy (Outsourcing) • Involves a choice between producing a product/service in-house or outsourcing it. • Decision criteria is the similar to special orders: • Allocate relevant costs to each alternative • Compare for cost savings (or not)

  10. Make or Buy—Illustration (p. 615) WWA considers cost of making desserts vs. outsourcing: initial costs of making appear higher because of FC allocation, but when considering relevant costs:

  11. Make or Buy Illustration (2) Alternative evaluation—consider only incremental costs & savings: Conclusion—don’t assume outsourcing will eliminate all current production costs—some are sunk costs!

  12. Add or Drop (Service / Product / Segment) • This is identical to segment reporting—must consider the “segment margin” each product or service or department/division/segment contributes to the firm. • Again—don’t assume all fixed costs will be eliminated—some are “sunk.” Consider only incremental / relevant costs.

  13. Joint Products: Sell or Process Further • If a production process can result in two or more products, how do we allocate costs between/among them? • Common allocation method is “relative sales value method” in which costs are allocated based on their sales values at the split-off point • See pg. 619 for illustration of relative sales value allocation

  14. Joint Costs (2) • But—when deciding whether to sell a product at split-off point, or whether to process it further, remember that the “joint cost” has already been incurred—it is already “sunk.” • Consider only incremental revenue from processing further less incremental (separable) processing costs required to earn that incremental revenue! (see pg. 620)

  15. Pitfalls to avoid in cost allocation • Sunk costs—ignore them! • Unitized fixed costs (FC per unit): beware—may be a way to hide sunk costs • Allocated fixed costs—beware—identify the avoidable costs, others are sunk • Opportunity costs—don’t ignore these! Be sure to include in your analysis.

  16. Stop for Class Exercises

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