Chapter 11
Relevant Costs – Decision Making
Category of Decision Making Problems:
1. Special Order Decisions
2. Make or Buy Decision
3. Keep/Drop Decisions
4. Constrained Resource
5. Sell or Process Further Decisions
Relevant Costs
Identifying relevant costs and relevant benefits when deciding between two
alternatives is a key to successfully understanding this topic:
Eliminate Irrelevant Costs:
Sunk Costs - are NOT relevant because they have already been incurred and
cannot be changed by the decision
Costs & benefits that will not change in the future between the alternatives are
also considered irrelevant in the decision making process
Relevant Costs & Benefits
Incremental Costs – all costs & benefits that remain should differ between the
two alternatives and are considered relevant. These costs will be used in deciding
between the alternatives.
Special Order Decision
A one-time order that is not considered part of the company’s normal ongoing
business.
▪ Often the proposal is for a lower/discounted selling price
▪ Must decide whether it should sell units below its regular selling price
▪ The decision is based on the premise that it is better to make some profit
than none at all
▪ Whenever multiple special orders are considered treat it to be a mutually
exclusive decision and choose the alternative that increases income the most
▪ Qualitative factors should be considered when making this decision
Fall into two categories:
1. Within Capacity
2. Without Capacity
Special Order Decisions - Example (Within Capacity)
Touchstone Manufacturing Inc. owns and operates a manufacturing facility where they produce
components to be used in common household electronics. The factory has a capacity of 50,000
units per year and is currently operating at 42,000 units. Each unit is sold for $5.
Management has been approached by an overseas customer who would like to purchase 8,000
units in bulk for $4.50/unit. The costs to produce one unit of the part are detailed below:
Direct Materials $0.50
Direct Labor $0.20
Variable Manufacturing Overhead $0.12
Fixed Manufacturing Overhead $0.75
Variable Selling Expenses $0.28
Fixed Selling Expenses $0.25
The customer requires a modification to the current design. This would increase materials cost
by $0.05 and require the acquisition of specialized equipment at a cost of $2,000.
Required:
Should management accept or reject this proposal? What will be the impact on operating
income?
Special Order Decisions - Example (Without Capacity)
Touchstone Manufacturing Inc. owns and operates a manufacturing facility where they produce
components to be used in common household electronics. The factory has a capacity of 50,000
units per year and is currently operating at 45,000 units. Each unit is sold for $5.
Management has been approached by an overseas customer who would like to purchase 8,000
units in bulk for $4.50/unit. The costs to produce one unit of the part are detailed below:
Direct Materials $0.50
Direct Labor $0.20
Variable Manufacturing Overhead $0.12
Fixed Manufacturing Overhead $0.75
Variable Selling Expenses $0.28
Fixed Selling Expenses $0.25
The customer requires a modification to the current design. This would increase materials cost
by $0.05 and require the acquisition of specialized equipment at a cost of $2,000.
Required:
Should management accept or reject this proposal? What will be the impact on operating
income?
Special Order Decisions - Example
Touchstone Company is currently operating at full production capacity producing 20,000 units
of product. Manufacturing costs per unit for the product are as follows:
Direct materials 10
Direct labor 7
*Manufacturing overhead 12
Total manufacturing cost per unit $27
* The per-unit manufacturing overhead cost is based on a $5 variable cost per unit and $140,000 fixed
costs.
In addition to the above, the company incurred nonmanufacturing costs (all variable) of $10 per
unit, and the sales price is $48 per unit. ABC Inc. has asked the company to produce 5,000 units
of a modification of the product. This modification would require the same manufacturing
processes. However, because of the nature of the proposed sale, the estimated
nonmanufacturing costs per unit are only $3 (not $10). The company would sell the modified
product to ABC Inc. for $36 per unit.
Required:
1. What is the impact on short-term operating profit of accepting the special sales order?
2. Suppose the company. had been working at less than full capacity to produce 16,000 units of
the product, what is the minimum price per unit that the company should accept for the
modified product under these conditions?
Special Order Decisions
Qualitative Considerations - Special Order Decisions
• Is the order likely to lead to further regular business with this customer?
• Is the order in the strategic best interest of the firm, for example, will it support
or undermine desired image in the market?
• Are there alternative uses of the capacity which will produce a greater
contribution?
• The effect of the special order on sales at regular prices.
• Other reasonable answers
Make or Buy Decision
Make or Buy Decision
A decision as to whether an item should be produced internally or purchased
from an outside supplier.
▪ We will compute the effect on income to determine which alternative is best
by determining which alternative is the cheapest.
▪ Note that in this decision the sales are usually not relevant since whether the
firm makes the product or buys it, it will sell it for the same price.
Make or Buy Decision - Example
Touchstone Company manufactures 20,000 units of Part AXR-14 each year. At this level of
activity, the cost per unit follows:
Direct materials $ 4.80
Direct labor $ 7.00
Variable manufacturing overhead $ 3.20
Fixed manufacturing overhead $ 10.00
Total cost per part AXR-14 $ 25.00
An outside supplier has offered to sell 20,000 units of Part AXR-14 each for $23.50 per part.
Touchstone Company has determined that $6 of the fixed manufacturing overhead being
applied to Part AXR-14 would continue even if the part was purchased from the outside
supplier.
Required:
a. Prepare computations showing how much profits will increase or decrease if the outside
supplier’s offer is accepted.
b. Assume if Touchstone Company accepts this offer, the facilities now being used to
manufacture Part AXR-14 could be rented to another company at an annual rental of
$150,000. Should the offer from the outside supplier be accepted or reject?
Make or Buy Decision – Example
Touchstone Company is trying to decide whether it should rent new equipment and continue to
make its products internally or whether it should discontinue production and purchase them
from an outside supplier. The alternatives follow:
Option 1: Rent new equipment for $147,000 per year.
Option 2: Purchase from an outside supplier for $18.80 each.
Touchstone Company’s costs per unit of producing the products internally (with the old
equipment) are given below. These costs are based on a current activity level of 30,000 units
per year:
Direct materials $5.60
Direct labor $9.00
Variable OH $1.60
Fixed OH (2.45 Supervisor, 1.80 $8.25
Depreciation, 4 General OH)
Total cost per part $24.45
The new equipment would reduce DL costs and VOH costs by 25%. Supervision cost ($73,500
per year) and direct materials cost per unit would not be affected by the new equipment. The
new equipment’s capacity would be 50,000 units per year.
The total general company overhead would be unaffected by this decision.
Required:
The company is unsure what to do and would like an analysis showing the total costs for each
of the two alternatives given above.
Which course of action would you recommend to the president? Assume that the following
units:
a. 30,000units
b. 42,000units
c. 50,000units
Make or Buy Decision
Qualitative Considerations - Make or Buy Decisions
• The ability of the outside supplier to meet required delivery schedules.
• The quality of the units purchased from the outside supplier.
• Alternative uses of the capacity that is used to make the units.
• The ability of the outside supplier to supply units if volume increases in
future years.
• The problem of alternative sources of supply if the outside supplier proves
undependable.
Keep/Drop Decision
▪ The company must decide whether product, division or department should
be kept or whether it should be dropped
o usually because managements opinion is product, division or
department is underperforming
▪ Evaluate this decision by investigating the effects of dropping on net income
▪ If the net effect on income is an increase then we drop the product or
division or department, else we keep it
▪ When we drop a product or division two obvious effects include:
o The loss of contribution margin that is generated by the product
o Reductions in direct fixed costs that are avoidable
▪ Note that sometimes by dropping a product the sales of another product are
affected they either become more or less profitable
Keep/Drop Decision - Example
Excellent Electronics Inc., has two departments, Electronic Repair and Electronic Sales. The
company’s most recent monthly contribution-format income statement follows:
Total Electronic Repair Electronics Sales
Sales 1,000,000.00 850,000.00 150,000.00
Variable expenses 320,000.00 275,000.00 45,000.00
Contribution margin 680,000.00 575,000.00 105,000.00
Fixed expenses 300,000.00 160,000.00 140,000.00
Operating income (loss) 380,000.00 415,000.00 (35,000.00)
Management has determined that $45,000 of the fixed expenses being charged to the
Electronic Sales Department are sunk costs or allocated costs that will continue even if the
Department is dropped. In addition, the elimination of the Electronic Sales Department would
result in a 5% decrease in the sales of the Service & Repair Department.
Required:
If the Sales Department is dropped, what will be the effect on the operating income of the
company as a whole? Should the Sales department be dropped?
Keep/Drop Decision - Example
Touchstone Company, is a retailer of consumer electronic products. Management is currently
examining a particular product line of 2 products, AX-14 & AX-15. The analysis found that the
sales for AX-15 are decreasing and the purchase costs are increasing. Consideration is being
given to drop AX-15. Touchstone Company allocates fixed costs to products on the basis of sales
revenue. If AX-15 is dropped, sales of AX-14 are expected to increase by 15% next year, but the
firm’s cost structure will remain the same.
AX-14 AX-15
Sales 175,000.00 235,000.00
Variable Costs:
Cost of Goods Sold 45,000.00 110,000.00
Selling & Admin 13,000.00 35,000.00
Contribution Margin 117,000.00 90,000.00
Fixed costs:
Fixed corporate costs 60,000.00 80,000.00
Fixed selling and administrative 12,000.00 25,000.00
Total fixed expenses 72,000.00 105,000.00
Operating Income $ 45,000.00 $ (15,000.00)
Required
1. Find the expected change in annual operating income by dropping AX-15 and selling only AX
14.
2. By what percentage would sales from AX-14 have to increase in order to make up the
financial loss from dropping AX-15?
3. What is the required percentage increase in sales (rounded to 2 decimal places) from AX-14
to compensate for lost margin from AX-15, if total fixed costs can be reduced by $25,000?
Keep/Drop Decision
Qualitative Considerations - Keep or Drop Decisions
• What will be the effect on the firm’s image if product, division or department is
dropped?
• If Drop, will this result in an unfavorable reaction from key customers and of
customers of other product lines?
• Can the production capacity released by product, division or department be
used for new products or in some other value-generating activity?
Constrained Resource Decisions
▪ Scenario where there exists a limitation under which a company must
operate
• Such as limited Machine Hours available or limited Raw Materials
available
• Restricts the company’s ability to satisfy demand for its products or
services.
▪ The company must decide which product to produce when there exists a
constraint on a resource
▪ The company will choose to produce the product that generates the highest
contribution margin per unit of scarce resource
Constrained Resource Decisions
Touchstone Company produces three products: AX-14, AX-15 & AX-16. Data (per unit)
concerning the three products follow:
Product AX-14 AX-15 AX-16
Selling Price $90 $120 $150
Variable costs:
Direct materials $28 $64 $80
Direct labor & VOH $37 $26 $16
Total variable cost $65 $90 $96
Contribution margin $25 $30 $54
All three products utilize a common raw material. Due to a global shortage, the raw material is
in limited supply. The material costs $8 per kilogram, with a maximum of 25,000 kilograms
available each month.
Required:
Which orders would you advise the company to accept first, those for AX-14, AX-15 or AX-16?
Which orders second? Third?
Constrained Resource Decisions
The following are the selling price, variable costs, and contribution margin for one unit of each
of Company’s three products:
A B C
Selling price $60 $90 $80
Variable costs:
Direct materials 27 14 40
Direct labor 12 32 16
Variable MOH 3 8 4
Total variable cost 42 54 60
Contribution margin. $18 $36 $20
Due to a strike in the plant of one of its competitors, demand for the company’s products far
exceeds its capacity to produce. Management is trying to determine which product(s) to
concentrate on next week in filling its backlog of orders. The direct labor rate is $8 per hour,
and only 3,000 hours of labor time are available each week.
Required:
1. Which orders would you recommend that the company work on next week—the orders
for product A, product B, or product C?
2. By paying overtime wages, more than 3,000 hours of direct labor time can be made
available next week. Up to how much should the company be willing to pay per hour in
overtime wages as long as there is unfilled demand for the three products?
Sell or Process Further Decisions
▪ A decision as to whether a joint product should be sold at the split-off point
or processed further and sold at a later time in a different form.
▪ Company must decide if joint products should be sold after the common
manufacturing phase at the split off point or whether they should be
processed further and sold after split off
▪ For example: Grapes can be crushed and sold as grape juice or they can be
aged (processed further) and be sold as wine; The company will choose the
alternative that generates the higher revenue
• The basic rule: worthwhile to process further provided that the incremental
revenue generated from this decision exceeds the incremental processing
costs.
Sell or Process Further Decisions - Example
Touchstone Ltd. produces several products through refining crude oil. Joint
processing costs total $60,000 per tonne. The diesel produced from a tonne of
crude oil can either be sold at the split-off point, or processed further at a cost of
$23,000 and then sold for $110,000. The sales value of crude oil at the split-off
point is $75,000.
Required:
Should the crude oil be processed further or sold at the split-off point?
Sell or Process Further Decisions - Example
Touchstone Co. manufactures products 1, 2, and 3 from a joint process. Joint costs are allocated
on the basis of relative sales value of the products at the split-off point. Additional information
for the company follows:
1 2 3
Units produced 15,000 12,000 6,000
Joint costs $ 250,000 $ 89,000 $ 66,000
Sales value before additional processing $ 350,000 $ 145,000 $ 78,000
Additional costs for further processing $ 45,000 $ 55,000 $ 20,000
Sales value if processed further $ 410,000 $ 200,000 $ 90,000
Required:
What is the impact on short-term operating income of processing each of the three products (1,
2, and 3) beyond the split-off point?
Sell or Process Further Decisions - Example
Touchstone Co. is a processor of meat products. The company is analyzing several options
available with respect to a quantity of T-bone steaks, and it is trying to decide whether to sell
the T-bone steaks as is or to process them further into filet mignon and New York-cut steaks.
Management believes that a kilogram of T-bone steak would yield the following profit:
Wholesale selling price (per kilogram) $16.00
Less joint costs incurred up to the split-off point: 12.00
Profit per kilogram $ 4.00
Additional details:
One 480-gram T-bone steak will yield one 181-gram filet mignon and one 241-gram New York
cut; the remaining grams are waste. The cost of processing the T-bone steaks into these cuts is
$1.40 per kilogram. The filet mignon can be sold retail for $26 per kilogram, and the New York-
cut can be sold wholesale for $22 per kilogram.
Required:
1. Determine the profit for each 480-gram T-bone steak processed further into filet mignon and
New York-cut steaks.
2. Would you recommend that the T-bone steaks be sold as is or processed further? Why?
