Relevant Costing

1. Relevant Costing Decision Making Process Relevant Cost Concept Illustrative examples of relevant cost applications Make or Buy Accept or reject special order Sell or process further Product Mix

2. Tactical Decision Making Steps of the tactical decision making process • Recognize and define the problem. • Identify alternatives as possible solutions to the problem, and eliminate alternatives that are not feasible. • Identify the predicted costs and benefits associated with each feasible alternative. Eliminate the costs and benefits that are not relevant to the decision.

3. Tactical Decision Making • Compare the relevant costs and benefits for each alternative, and then relate each alternative to the overall strategic goals of the firm and other important qualitative factors. 5. Select the alternative with the greatest benefit which also supports the organization’s strategic objectives.

4. Quantitative Analysis The Decision-Making Process 1. Clarify the Decision Problem 2. Specify the Criterion 3. Identify the Alternatives 4. Develop a Decision Model 5. Collect the Data 6. Make a Decision

5. The Decision-Making Process 1. Clarify the Decision Problem 2. Specify the Criterion Primarily the responsibility of the managerial accountant. 3. Identify the Alternatives 4. Develop a Decision Model 5. Collect the Data Information should be: 1. Relevant 2. Accurate 3. Timely 6. Make a Decision

6. The Decision-Making Process 1. Clarify the Decision Problem Relevant Pertinent to a decision problem. 2. Specify the Criterion 3. Identify the Alternatives Accurate Information must be precise. 4. Develop a Decision Model 5. Collect the Data Timely Available in time for a decision 6. Make a Decision

7. The Decision-Making Process 1. Clarify the Decision Problem 2. Specify the Criterion 3. Identify the Alternatives Qualitative Considerations 4. Develop a Decision Model 5. Collect the Data 6. Make a Decision

8. Relevant Costs and Revenues • Relevant costs • future costs that differ across alternatives • Irrelevant Costs • Past costs:already incurred “sunk costs” are the same across alternatives; ignore

9. Relevant Information Information is relevant to a decision problem when . . . • It has a bearing on the future, • It differs among competing alternatives.

10. Identifying RelevantCosts and Benefits Sunk costsCosts that have already been incurred. They do not affect any future cost and cannot be changed by any current or future action. Sunk costs are irrelevant to decisions.

11. Relevancy, Cost Behavior, and the Activity Resource Usage Model • Flexible Resources • Easily purchased in the amount needed • Purchased at the time of use • Committed resources • Purchased before they are used

12. Illustrative Examples ofTactical Decision Making Make-or-Buy Decision Talmage Company produces a mechanical part used in one of its engines. (Talmage produces engines for snowblowers.) An outside supplier has offered to sell a part (Part 34B) for $4.75. The company normally produces 100,000 units of the part each year. • Flexible resources: • Using materials • Using direct labor • Moving materials • Providing power • Inspecting products • Committed resources: • Providing supervision • Moving materials • Inspecting products • Setting up equipment

13. Demand changes relevant Demand constant not relevant Relevancy, Cost Behavior, and the Activity Resource Usage Model • Flexible resources • The activity resources demanded equal the resources supplied

14. Illustrative Examples of Relevant Cost Applications • Make or Buy • Accept or reject special order • Sell or process further • Keep or drop • Product mix

15. ABC: buy the part Illustrative Examples ofTactical Decision Making Make-or-Buy Decision

16. Functional: make the part Illustrative Examples ofTactical Decision Making 4. Make-or-Buy Decision

17. Illustrative Examples ofTactical Decision Making Accept or reject a special order Polarcreme, Inc., an ice-cream company, is operating at 80 percent of its 20 million half-gallon capacity. A distributor from another geographic region offered to buy 2 million units of premium ice cream at $1.75 per unit. Distributor will provide their own label and pay transportation costs. This sale is not subject to a sales commission. Impact of special order on non-unit level activities: Purchase orders increase 10,000 Receiving orders increase 20,000 Setups increase 13

18. Illustrative Examples ofTactical Decision Making Accept or reject a special order Special order unit revenue $1.75 Unit-level variable costs: Dairy ingredients $0.70 Sugar 0.10 Flavoring 0.15 Direct labor 0.25 Packaging Commissions Distribution 0.03 Other 0.05 Unit-level costs $1.450 Non-unit-level variable costs for special order Purchasing ($8 × 10,000) ÷ 2M 0.040 Receiving ($6 × 20,000) ÷ 2M 0.060 Setting up ($8,000 × 13) ÷ 2M 0.052 Non-unit-level costs 0.1521.602 Net benefit per unit on special order $0.148

19. Make or Buy Swasey Manufacturing currently produces an electronic component used in one of its printers. Swasey must produce 10,000 of these parts. The firm has been approached by a supplier who offers to build the component to Swasey’s specifications for RM4.75 per unit.

20. Make or Buy The full absorption cost for the 10,000 parts is computed as follows: Total Cost Unit Cost Rental of equipment RM12,000 RM1.20 Equipment depreciation 2,000 0.20 Direct materials 10,000 1.00 Direct labor 20,000 2.00 Variable overhead 8,000 0.80 General fixed overhead 30,000 3.00 Total RM82,000 RM8.20 Enough material is on hand to make 5,000 parts.

21. Make or Buy The cost to make or buy 5,000 units follows: Alternatives Differential Make Buy Cost to Make Rental of equipment RM12,000 ------- RM12,000 Direct materials 5,000 ------- 5,000 Direct labor 20,000 ------- 20,000 Variable overhead 8,000 ------- 8,000 Purchase cost ------- RM47,500 -47,500 Receiving Dept. labor ------- 8,500 - 8,500 Total RM45,000 RM56,000 RM-11,000 Make

22. Blocks Bricks Tile Total Sales revenue $500 $800 $150 $1,450 Less: Variable expenses 250 480 140 870 Contribution margin $250$320$ 30$ 580 Less direct fixed expenses: Advertising $ 10 $ 10 $ 10 $ 30 Salaries 37 40 35 112 Depreciation 53 40 10 103 Total $100$ 90$ 55$ 245 Segment margin $150 $230 $- 45 $ 335 Less: Common fixed exp. 125 Operating income $ 210 Keep-or-Drop Decisions Norton Materials, Inc. produces concrete blocks, bricks, and roofing tile. The controller prepared the following income statements:

23. Keep-or-Drop Decisions Differential Keep Drop Amount to Keep Sales $150 ---- $150 Less: Variable expenses 140---- 140 Contribution margin $ 10 ---- $ 10 Less: Advertising -10 ---- -10 Cost of supervision -35---- -35 Total relevant benefit (loss) $- 35 $ 0 $- 35 Preliminary figures indicate that the tile segment should be dropped!

24. Keep-or-Drop Decisions Tom Blackburn determines that dropping the tile section will reduce sales in all sections as follows: $50,000 for blocks, $64,000 for bricks, and $150,000 for roofing tile. His summary in thousands is shown below: Differential Keep Drop Amount to Keep Sales $1,450 $1,186.0 $264.0 Less: Variable expenses 870 666.6 203.4 Contribution margin $ 580 $ 519.4 $ 60.6 Less: Advertising -30 -20.0 -10.0 Cost of supervision -112 -77.0 -35.0 Total $ 438 $ 422.4 $ 15.6 Keep roofing tile segment!

25. Sales $100,000 Less: Variable expenses 40,000 Contribution margin $ 60,000 Less: Direct fixed expenses 55,000 Segment margin $ 5,000 Keep-or-Drop Decisions Alternate Use of Facilities The marketing manager sees the market for floor tile as stronger and less competitive than roof tile. He submits the following figures for floor tile sales:

26. Keep-or-Drop Decisions Alternate Use of Facilities Drop and Differential Keep Replace Amount to Keep $1,450 – $150 –$50 – $64 + $100 Sales $1,450 $1,286.00 $164.00 Less: Variable expenses 870 706.60 163.40 Contribution margin $ 580 $ 579.40 $ 0.60 $870 – $140 – $25 – $38.40 + $40 Decision: Continue making roof tile!

27. Bagged 120 Bags Cost $0.05/Bag Sell for $1.30/Bag Applesauce 500 16-oz Cans Cost $0.10/lb Sell for $0.75 can Sell or Further Process Yield at Split-Off Further Processing Grade A 800 lb Sell for $0.40 lb Grade B 600 lb Joint Cost $300 Grade C 600 lb

28. Sell or Further Process Process Differential Amount Further Sell to Process Further Revenues $450 $150 $300 Processing cost 120 ---- 120 Total $330 $150 $180 Further process!