Relevant Costing

Resource Allocation Decisions Accounting information can improve, but not perfect, management's understanding of the consequences of resource allocation decisions. To the extent that this information can reduce management's uncertainty about the economic facts, outcomes, and relationships involved in various courses of action, the information is valuable for decision making purposes and necessary for conducting business. Many decisions are made on the basis of incremental analysis. Such analysis encompasses the concept of relevant costing, which allows managers to focus on pertinent facts and disregard extraneous information. This chapter illustrates the use of relevant costing in decisions about making or buying a product part, allocating scarce resources, and determining the appropriate sales or production mix. While these decisions are often viewed by managers as short-run, each decision also has significant long-run implications that must be considered. © 2007 by Nelson, a division of Thomson Canada Limited.

Learning Objectives What constitutes relevance in a decision-making situation? Why is an opportunity cost relevant in decision making but a sunk cost is not? What are the relevant costs in equipment replacement decisions? © 2007 by Nelson, a division of Thomson Canada Limited.

Learning Objectives What are the relevant costs and qualitative factors that exist in a make-or-outsource (buy) decision? How can management best utilize a scarce resource? How does relevant costing relate to sales mix, sales price decisions, compensation changes, advertising budget and special order pricing decisions? How is product margin used to determine whether a product line should be retained, expanded, or eliminated? © 2007 by Nelson, a division of Thomson Canada Limited.

Relevance and Relevant Costing Relevant cost – a cost that is pertinent to, or logically associated with, a specific problem or decision and that differs between or among alternatives Relevant costing – a process that allows managers to focus on pertinent facts and disregard extraneous information by comparing, to the extent possible and practical, the differential, incremental revenues and costs of alternate decisions Differential – the different costs between or among the choices Incremental revenue – the additional revenue resulting from a contemplated sale of a quantity of output Incremental cost – the additional cost of producing or selling a contemplated additional quantity of output © 2007 by Nelson, a division of Thomson Canada Limited.

Relevance and Relevant Costing General rules for short-term decision making 1. most variable costs are relevant 2. most fixed costs are not relevant There are exceptions, for example, the cost of buying a new machine is an incremental fixed cost relevant to the decision to produce a new product line, or expand beyond the relevant range. © 2007 by Nelson, a division of Thomson Canada Limited.

Relevance and Relevant Costing Some relevant costs are easily identified – those factors which are integral parts of the accounting system. Examples are direct labour, direct material, commissions. Other relevant costs are not recorded in the accounting system, for example, an opportunity cost. Opportunity cost – the benefit foregone when one course of action is chosen over another. An opportunity cost is relevant. Benefits foregone are future benefits. Sunk cost – the historical or past cost that is associated with the acquisition of an asset or a resource. A sunk cost is not relevant. It is not a cost which will be incurred in the future. It has already been incurred. © 2007 by Nelson, a division of Thomson Canada Limited.

Sunk Costs and Joint Processes Joint process – a process in which one product cannot be manufactured without others being produced Joint products – two or more products that have relatively significant sales values and are not separately identifiable a individual products until the split-off point By-products – products that have minor sales value as compared with the sales value of the major products and are not separately identifiable as individual products until they have become split-off Scrap – inputs that do not become part of the outputs but have very minor values Waste – inputs that do not become part of the output Split-off point – the point at which the outputs of a joint process are first identifiable as individual products Joint cost – the cost incurred, up to the split-off point,for material, labour, and overhead in a joint process © 2007 by Nelson, a division of Thomson Canada Limited.

Sunk Costs and Joint Processes Historical costs (incurred in the past to acquire an asset or resource) are not relevant. These are sunk costs; they are not recoverable and cannot be changed regardless of which future course of action is taken. The joint process results in a basket of products.Output may be sold at the split-off point, if a market exists for products in that condition. Joint cost is allocated only to joint products on the basis of either a physical measure (kilos or units), or a monetary measure (final sales value). After the joint process cost has been incurred, it is a sunk cost. Some or all of the products may be processed further, in which case further costs will be incurred. These costs are relevant. Costs after split-off are assigned to the separate products for which those costs are incurred. © 2007 by Nelson, a division of Thomson Canada Limited.

Sunk Costs and Joint Processes Milk can be sold or further processed If half the milk is sold, and the other half is used to produce cheese, the additional cost is added to the cheese. If half the cream is sold and the other half is used to produce ice cream, the additional cost is added to the ice cream Split-off point Joint Costs Raw milk is pasteurized and separated into milk and cream Joint costs will be allocated to the milk and cream based on litres of output or final sales value. At split-off, these costs are sunk costs. Cream can be sold or further processed © 2007 by Nelson, a division of Thomson Canada Limited.

Sunk Costs and Joint Processes Assume that a creamery pasteurized and separated 990 litres of raw milk. The total cost of this process (material, labour and overhead) was $990.00. Output was 794 litres of milk and 196 litres of heavy cream. The milk sells for $2.00 per litre and the heavy cream sells for $6.00 per litre. Using sales value to allocate joint costs – Milk Cream Total Final sales value: (794 x $2) $1,588 (196 x $6) $1,176 $2,764 Cost allocated: (1,588 / 2,764) X $990 $ 568.78 (1,176 / 2,764) X $990 $ 421.22 $ 990 © 2007 by Nelson, a division of Thomson Canada Limited.

Sunk Costs and Joint Processes The decision to produce cheese with one half of the milk would be based on demand and profitability. The joint cost does not enter into this decision. It is a sunk cost and will not differ between alternatives. The relevant information is the increase in selling price (milk to cheese) and the cost to further process. The decision to produce ice cream with one half of the heavy cream would be based on demand and profitability as well. Again, the joint cost does not enter into this decision. It is a sunk cost. The relevant information is the incremental revenue and incremental cost. Quantitative information used to decide whether or not to further process is incremental revenues and expenses (after split-off). © 2007 by Nelson, a division of Thomson Canada Limited.

Equipment Replacement Decisions Carlton Industries is considering replacing a piece of equipment. The old equipment had cost $350,000 and had accumulated depreciation of $150,000. It could be traded-in for $50,000, resulting in a loss of $150,000. The variable production costs average $70,000 per year. This equipment was purchased just over three years ago and at that time, the estimated useful life was seven years. The replacement equipment would cost $300,000. The variable production costs are estimated to be $30,000 per year for four years. Increased efficiency of the new equipment would result in an increase in revenues of $45,000 per year for the next four years. © 2007 by Nelson, a division of Thomson Canada Limited.

Investing in New Technology to Ensure Profitability Merchandising Optimization Systems – systems that determine the right quantity, placement and price of items to maximize retailers' returns. RFID gives any object its own programmable digital identity that can be read wirelessly. An RFID tag emits a radio signal that can be picked up by a handheld or stationary reader, or even a computer network. Companies use it to better track their products. Organizations and companies have used it to track goods shipped to tsunami-stricken South Asia. Travelers will soon benefit as airports use RDIF to track luggage. © 2007 by Nelson, a division of Thomson Canada Limited.

Equipment Replacement Decisions KEEP OLDBUY NEW Trade in $ 50,000 Purchase price (300,000) Production costs $70,000 x 4 years $(280,000) $30,000 x 4 years (120,000) Incremental revenues $45,000 x 4 years 180,000 $(280,000) $(190,000) Benefit from purchasing new equipment is $90,000. Note: The only information included in the analysis is information that is relevant. Relevant information makes a difference, that is, changes the outcome of the analysis. On the next slide the same analysis is done, but including the old equipment. © 2007 by Nelson, a division of Thomson Canada Limited.

Equipment Replacement Decisions KEEP OLDBUY NEW Trade-in $ 50,000 Write-off old equipment (200,000) Depreciate old equipment (200,000) Purchase price (300,000) Production costs $70,000 x 4 years $(280,000) $30,000 x 4 years (120,000) Incremental revenues $45,000 x 4 years 180,000 $(480,000) $(390,000) Benefit from purchasing new equipment is $90,000. Note: Including the old equipment in the analysis does not change the fact that purchasing the new equipment will save the company $90,000 over the next four years. © 2007 by Nelson, a division of Thomson Canada Limited.

Make-or-Outsource (Buy) Decisions Outsource – use a source external to the company to provide a service or manufacture a needed product or component Make-or-outsource (buy) decision – a decision that compares the cost of internally manufacturing a product component with the cost of purchasing it from outside suppliers or from another division at a specified price and, thus, attempts to assess the best uses of available facilities Relevant information for a make-or-buy decision includes both quantitative and qualitative factors. © 2007 by Nelson, a division of Thomson Canada Limited.

Why Outsource? 1. Reduce and control operating costs 2. Improve company focus 3. Gain access to world-class capabilities 4. Free internal resources for other purposes 5. Resources are not available internally 6. Accelerate re-engineering benefits 7. Function difficult to manage / out of control 8. Make capital funds available 9. Share risks 10. Cash infusion © 2007 by Nelson, a division of Thomson Canada Limited.

Make-or-Outsource (Buy) Decisions • Relevant Quantitative Factors • Incremental production costs for each unit • Unit cost of purchasing from outside supplier (price less any discounts available plus shipping) • Availability of production capacity to manufacture components • Opportunity costs of using facilities for production rather than for other purposes • Availability of storage space for units and raw materials © 2007 by Nelson, a division of Thomson Canada Limited.

Make-or-Outsource (Buy) Decisions • Relevant Qualitative Factors • Relative net advantage given uncertainty of estimates (costs, risks, and so forth) • Reliability of source(s) of supply • Ability to assure quality when units are purchased from outside • Nature of the work to be subcontracted (such as the importance of the part to the whole product) • Number of available suppliers • Impact on customers and markets • Future bargaining position with supplier(s) • Perceptions regarding possible future price changes • Perceptions about current product prices (Is the price appropriate or – as may be the case with international suppliers – is product dumping involved?) • Strategic and competitive importance of component to long-run organizational success © 2007 by Nelson, a division of Thomson Canada Limited.

Relevant Costs in Make-or-Outsource (Buy) Decisions • Revenues associated with product • Variable costs associated with product • Avoidable fixed costs • Consider product margin Revenues - Variable costs - Avoidable fixed costs © 2007 by Nelson, a division of Thomson Canada Limited.

Make-or-Outsource (Buy) Decisions Newman Enterprises Ltd. manufactures Widgies for use in the production of Winkle, a major sales product for the company. The cost per unit for 10,000 Widgies is as follows: Direct Materials $ 3.00 Direct Labour 15.00 Variable Overhead 6.00 Fixed Overhead 8.00 Total $32.00 John Black Corporation has offered to sell Newman 10,000 Widgies for $30.00 each. Also $5 per unit of the fixed overhead applied to Widgies would be totally eliminated. What decision would you make and why? © 2007 by Nelson, a division of Thomson Canada Limited.

Relevant Costs in Make-or-Outsource (Buy) Decisions Present Cost Relevant Cost per Widgieper Widgie Direct Materials $ 3.00 $ 3.00 Direct Labour 15.00 15.00 Variable Overhead 6.00 6.00 Fixed Overhead* 8.00 5.00 Total $32.00 $29.00 *Of the $8.00 fixed overhead, $5.00 is directly linked to production of the widgies. This amount would be avoided if the firm chose not to produce widgies. The remaining $3.00 of fixed overhead is an allocated common cost that would continue even if production of widgies ceased. © 2007 by Nelson, a division of Thomson Canada Limited.

Make-or-Outsource (Buy) Decisions Relevant cost to manufacture Widgies Direct Material $ 3 Direct Labour 15 Variable Overhead 6 Fixed Overhead 5 Per Unit $ 29 Total Cost to Manufacture $ 29 x 10,000 = $290,000 Cost to Purchase Widgies Purchase Price 10,000 x $30 300,000 Savings by producing Widgies $ 10,000 © 2007 by Nelson, a division of Thomson Canada Limited.

Make-or-Outsource (Buy) Decisions Assume that if Newman accepts Black’s offer, the released facilities could be rented out for $45,000 annually . This is an opportunity cost incurred by using the facilities rather than renting them. The $45,000 can be treated as a reduction in the purchase cost because the facilities can be rented only if the Widgies are purchased. This is treated as a cash inflow, netted against the cash outflow to purchase the Widgies; or the $45,000 can be added to the production cost since the company is giving up this amount of cash inflow by choosing to make the Widgies. This second treatment is more consistent with the definition of an opportunity cost. Using either method results in a $35,000 advantage to purchase, rather than produce, the Widgies. © 2007 by Nelson, a division of Thomson Canada Limited.

Opportunity Cost in Make-or-Outsource (Buy) Decisions Cost to manufacture Widgies Direct Material $ 3 Direct Labour 15 Variable Overhead 6 Fixed Overhead 5 Cost to manufacture $ 29 x 10,000 = $290,000 Opportunity Cost 45,000 Total Cost to Manufacture $335,000 Cost to Purchase Widgies Total Cost to Purchase (10,000 x $30) 300,000 Savings if Widgies are Purchased $ 35,000 © 2007 by Nelson, a division of Thomson Canada Limited.

Relevant Costs in Scarce Resource Decisions Scarce resources – resources that are available only in limited quantity; they create constraints on producing goods or providing services and may include money, machine hours, skilled labour hours, raw materials, and production capacity In the short run management must make the best current use of the scarce resources it has. © 2007 by Nelson, a division of Thomson Canada Limited.

Relevant Costs in Scarce Resource Decisions Scarce resource: machine hours Hair DryersHot Rollers Selling price per unit (a) $ 30.00 $ 24.00 Variable productions cost per unit: Direct material 6.00 5.00 Direct labour 8.00 4.00 Variable overhead 6.002.00 Total variable production cost per unit (b) 20.0011.00 Unit contribution margin (c) (a – b) $ 10.00 $ 13.00 Units of output per machine hour (d) X 80X 40 Contribution margin per machine hour (c x d) $800.00$520.00 At first, it appears that rollers would be more profitable, since they have the higher contribution margin. However, one hour of machine time produces two times as many dryers as rollers. A great amount of contribution margin per scarce resource is generated by the production of dryers. If the company only had 100 machine hours per month, producing dryers would result in $80,000 contribution margin in total. Producing rollers would result in $52,000 contribution margin in total. However, they need to assess how this strategy would affect the company – limiting its assortment of complementary products, and the potential of saturating the market with hair dryers, causing future sales to decline. © 2007 by Nelson, a division of Thomson Canada Limited.

Sales Mix and Sales Price Decisions How many of each product? Sales mix – the relative combination of quantities of sales of the various products that make up the total sales of the company © 2007 by Nelson, a division of Thomson Canada Limited.

Sales Mix and Sales Price Decisions • One way a company can achieve its goals is to manage its sales mix effectively. Some factors affecting the appropriate sales mix of a company are • product selling prices • sales force compensation • advertising expenditures. • A change in one or more of these factors may cause a company's sales mix to change. © 2007 by Nelson, a division of Thomson Canada Limited.

Sales Price Changes and Relative Profitability of Products • Continuous monitoring of the selling prices of company products in relation to each • other as well at to competitor's prices is important. This process may provide • information that causes management to change one or more selling prices. • Factors that might influence price changes include • fluctuations in demand • production distribution costs • economic conditions • competition. • If profit maximization is the company's goal, a product's sales volume and unit contribution margin should be considered. Total company contribution margin is equal to the combined contribution margins of all products offered by the company. © 2007 by Nelson, a division of Thomson Canada Limited.

Sales Price Changes and Relative Profitability of Products • The sales volume of a product or service is almost always intricately related to its selling price. When selling price is increased and demand is elastic with respect to price, demand for that product decreases. • In making decisions to raise or lower prices, the relevant quantitative factors include • prospective or new contribution margin per unit of product • both short-term and long-term changes in product demand and production volume caused by the price increase or decrease, and • best use of any scarce resources. • Some relevant qualitative factors involved in decisions regarding price changes are • influence on customer goodwill, • customer product loyalty, and • competitors' reactions to the firm's new pricing structure. © 2007 by Nelson, a division of Thomson Canada Limited.

Special Order Pricing Special order pricing – determining a sales price to charge for manufacturing or service jobs that are outside the company's normal production or service realm Special order situations include jobs that require a bid, are taken during slack periods, or are manufactured to a particular buyer's specifications. Sales price should be high enough to cover the variable costs of the job and any incremental (additional) fixed costs caused by the job, and to generate a profit. Management also should consider the effect that the special order will have on all company activities (purchasing, receiving, warehousing, etc.) and whether these activities will create additional, unforeseen costs. When setting a special order price, management must consider the qualitative issues as well as the quantitative ones, for example, will the special price set a precedent for this or other customers. © 2007 by Nelson, a division of Thomson Canada Limited.

Special Order Pricing Jack Abbott Corporation, a company which manufactures sneakers (for all his running from Victor). The company has enough idle capacity available to accept a special order of 20,000 pairs of sneakers at $6.00 per pair from Brad Carlton Company. The normal selling price is $10.00 a pair. Variable manufacturing costs are $4.50 per pair, and fixed manufacturing costs are $1.50 per pair. Abbott will not incur any selling expenses as a result of the special order. What would be the effect on operating income if the special order could be accepted without affecting normal sales? © 2007 by Nelson, a division of Thomson Canada Limited.

Relevant Costs in Product Line Decisions To evaluate performance of products or product lines, operating results would be presented by product or product line. If all costs (variable and fixed) are allocated to the products or product lines, some may be perceived to operating at a loss when they are not. Product margin – the excess of a product's revenue over both its direct variable expenses and any avoidable fixed expenses related to the product; the amount remaining to cover unavoidable direct fixed expenses and common costs and then to provide a profit © 2007 by Nelson, a division of Thomson Canada Limited.

Relevant Costs in Product Line Decisions The following information relating to the company's three products was taken from the records of Chancellor Industries. Overhead is applied to the products based on direct labour hours. Fixed overhead is $100,000. Standard direct labour hours is 28,250. None of the fixed overhead is avoidable. © 2007 by Nelson, a division of Thomson Canada Limited.

Relevant Costs in Product Line Decisions Other data regarding the three products is shown in the schedule below. Management was surprised to see that product B operates at a loss. They decided to drop product B immediately. © 2007 by Nelson, a division of Thomson Canada Limited.

Relevant Costs in Product Line Decisions • Fixed costs should be separated into three categories: • those that could be avoided by elimination of the • product or product line; • those that are directly associated with the product or • product line but are unavoidable; and • those that are incurred for the division as a whole • (common costs) and are allocated to the individual • products or product lines. • The latter two categories are not relevant to the question of • whether to eliminate a product or product line. Only the • first category differs between the alternatives (keep or • eliminate). • Decisions to drop or keep a product or product line should • be based on product margin • (contribution margin – avoidable fixed costs) © 2007 by Nelson, a division of Thomson Canada Limited.

Relevant Costs in Product Line Decisions The fixed overhead is unavoidable. Unavoidable costs will be shifted to other products or product lines. Therefore, all of the overhead must be applied to Products A and C. Fixed overhead remains at $100,000. Standard hours to produce products A and C is 9,500. © 2007 by Nelson, a division of Thomson Canada Limited.

Relevant Costs in Product Line Decisions Management was surprised to learn that since dropping product B, they were operating at a loss. Irrelevant information was included in the original analysis. © 2007 by Nelson, a division of Thomson Canada Limited.

Relevant Costs in Product Line Decisions An evaluation of the products using only relevant costs shows that product B does contribute towards paying the fixed costs. Products A and C can only cover $95,000 of the $100,000 fixed costs, resulting in a loss of $5,000. Product B contributes $37,500. © 2007 by Nelson, a division of Thomson Canada Limited.

Product Expansion or Extension Expansion – the introduction of totally new products Extension – the introduction of offshoots of current products because the company decides that the market needs to be more highly segmented, or to meet competitive pressures. Incremental costs of expansions and extensions (other than the variable costs of the product) include market research, product and packaging development, product introduction, and advertising. Extensions have been viewed as fairly low-cost endeavours especially if a company has excess capacity. © 2007 by Nelson, a division of Thomson Canada Limited.

Relevant Costing