SHORT-RUN DECISION MAKING:

RELEVANT COSTING

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 Learning Objectives
1. Describe the short-run decision-making model,
and explain how cost behavior affects the
information used to make decisions.
2. Apply relevant costing and decision-making
concepts in a variety of business situations.

▪ Accept or reject a special offer

▪ Make or buy (or outsource) a product or service
▪ Add or delete a product, service or department
▪ Joint product - Sell or process further

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 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.

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 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.

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 The Decision-Making Model
▪ A decision model, 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.
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 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.

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 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.

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 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.
▪ An opportunity cost is never an accounting cost,
because accountants do not record the cost of
what might happen in the future (i.e., they do not
appear in financial statements).
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 Sunk Costs
• Sunk cost: IRRELEVANT
– Cost that has already been incurred.
– It does not affect any future cost and cannot
be changed by any current or future action.
Thus, it is irrelevant to decisions about the
future.
– Historical cost accounting records are
sunk costs!

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 Sunk Costs (cont.)
▪ Although managers should ignore sunk costs for
relevant decisions, it unfortunately is human
nature to allow sunk costs to affect these
decisions.
▪ For 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.
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 Quiz
Q1. Jaspar Ltd has 1000 units in inventory that
cost $2.00 per unit to produce. Due to changing
technology, the sales department is having
difficulty selling the product. It will cost $500 to
scrap the units. The company should consider
any price over:
A. $2 000
B. $2 500
C. $500
D. $0

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 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.

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 Cost Behavior and
Relevant Costs (cont.)
▪ If changes in demand and supply for resources
across alternatives bring about changes in
spending, then the changes in resource spending
are the relevant costs that should be used in
assessing the relative desirability of the two
alternatives.

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 Quiz
Q2. Xebex Pty Ltd is considering whether to make or buy a component
used in the production of Fax Machines. The annual cost of producing
the 100 000 components used by the company is as follows:
Direct variable manufacturing costs = $300,000
Direct fixed manufacturing costs = $100,000
Allocated overhead = $50,000
If Xebex were to discontinue production of the component, direct
FMOH would be reduced by 80 per cent. What are the irrelevant costs
in the decision?
A. $50 000
B. $70 000 (1-80%) x $100,000 + $50,000 = $70,000
C. $80 000
D. $100 000

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 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.
▪ Though by no means an exhaustive list, many of
the same decision-making principles apply to a
variety of problems.
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 Make-or-Buy Decisions
▪ Managers 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.
▪ A 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).
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 Make-or-Buy Decisions
• The key is on incremental costs. There are no
incremental revenues.
• Note that not all fixed costs are irrelevant.
– If fixed costs are unavoidable, they should be
IRRELEVANT for the decision.
– If fixed costs are avoidable, they should be factored
into this decision
– Be aware of opportunity cost if there is any.

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 Make-or-Buy Decisions
• A Melbourne bakery has offered to supply the in-flight
desserts for 21¢ each.
• Here are Worldwide’s current costs for dessert

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 Make-or-Buy Decisions

Make Buy Incremental

Variable Costs: $0.21 ($0.21)
Direct material $0.06 $0.06
Direct labour $0.04 $0.04
Variable overhead $0.04 $0.04
Fixed costs:
Supervisory salaries $0.04 $0.03 $0.01
Depreciation of equipment (irrelevant) $0.07 (irrelevant) $0.07 0
Total cost per dessert $0.18 $0.24 ($0.06)

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 Make-or-Buy Decisions

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 Structuring a Make-or-Buy Problem

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 Structuring a Make-or-Buy Problem

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 Quiz

Q3. Vest Industries manufactures 40,000 components per year. The manufacturing cost of the
components was determined as follows:

Direct materials $ 75,000

Direct labor 120,000
Variable overhead 45,000
Fixed overhead 60,000
Total $300,000
An outside supplier has offered to sell the component for $12.75. Fixed cost will remain the same if
the component is purchased from an outside supplier.

Vest Industries can rent its unused manufacturing facilities for $45,000 if it purchases the component
from the outside supplier.

What is the effect on income if Vest purchases the component from the outside supplier?
a. $225,000 decrease
b. $195,000 increase
c. $165,000 decrease
d. $135,000 increase

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 Quiz Solution

Make:
Direct materials $ (75,000)
Direct labor (120,000)
Variable overhead (45,000)
Total $(240,000)

Buy:
Purchase price (40,000  $12.75) $(510,000)
Rental income 45,000
Total $(465,000)

$465,000 − $240,000 = $225,000 decrease in income

Decision: Do not buy the product externally, otherwise there is

a decrease income of $225,000.

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 Special Order Decisions
▪ A company may consider offering a product or
service at a price different from the usual price.
▪ Firms have the opportunity to 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.

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 Accept or reject a special order

▪ Excess capacity: meaning no alternative uses

for resources needed to fill the order
– if incremental revenues > incremental costs, accept
the special order on financial grounds
– allocated fixed costs should not be included
• No excess capacity
– include opportunity costs
• Other factors
– qualitative factors
▪ any adverse effects on regular business
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 Accept or reject a special order

• A travel agency offers Worldwide Airways

$150,000 to charter a round-trip flight from
Hawaii to Japan on a jumbo jet.
• Worldwide usually receives $280,000 in revenue
from this flight.
• The airline is not currently planning to add any
new routes and has two planes that are idle and
could be used to meet the needs of the travel
agency.

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 Accept or reject a special order

Worldwide will save about $5,000 in reservation

and ticketing costs if the charter is accepted.
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 Accept or reject a special order

Decision: Since the charter will contribute to fixed costs

and Worldwide has idle capacity, it should accept the charter.
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 Accept or reject a special order
What if Worldwide had no excess capacity? If we accept
the charter, we will have to cut our least profitable route
that currently contributes $80,000 to fixed costs and
profits. Should we still accept the charter?

Decision: Do not accept this charter!

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 Quiz
Q4. Meco Company produces a product that has a regular selling price of $360
per unit. At a typical monthly production volume of 2,000 units, the product's
average unit cost of goods sold amounts to $270. Included in this average is
$120,000 of fixed manufacturing costs. All selling and administrative costs are
fixed and amount to $30,000 per month.

Meco Company has just received a special order for 1,000 units at $240 per
unit. The buyer will pay transportation, and the regular selling price will not be
affected if Meco accepts the order.

Assuming Meco Company has excess capacity, the effect on profits of

accepting the order would be
a. $60,000 increase.
1,000  [$240 − ($270 − $120,000/2,000)] = $30,000 increase
b. $60,000 decrease.
c. $30,000 increase.
d. $30,000 decrease.
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 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.

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 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 prepared on a variable-
costing basis provide valuable information for
these keep-or-drop decisions.

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 Structuring a Keep-or-Drop
Product Line Problem

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 Structuring a Keep-or-Drop
Product Line Problem (cont.)

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 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.

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 Structuring a Keep-or-Drop Product
Line Problem with Complementary Effects

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 Structuring a Keep-or-Drop Product Line
Problem with Complementary Effects

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 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.
▪ 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).

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 Further Processing of
Joint Products
A number of products are produced
from a single raw material input.

Product 1

Product 2

Product 3
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 Joint Product Processes
Joint cost – costs of processing joint products prior to
the split-off point.
Final product – ready for sale without further
processing.
Intermediate product – requires further processing
before sale.

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 Joint Products: An Example

Managers often face the further processing decision.

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 Joint Product Processes

Joint Common
Production
Input
Process

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 The Further Processing Decision

Value is added ONLY if the

incremental value from
processing EXCEEDS the
incremental processing costs.
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 Joint Product Processes

Joint Common
Production
Input
Process

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 Structuring the
Sell-or-Process Further Decision
Information:
Appletime grows apples and then sorts them into one of three grades, A, B, or C, based on
their condition. Appletime must decide whether to sell the Grade B apples at split-off or to
process them into apple pie filling. The company normally sells the Grade B apples in 120 five-
pound bags at a per-unit price of $1.25. If the apples are processed into pie filling, the result
will be 500 cans of filling with additional costs of $0.24 per can. The buyer will pay $0.90 per
can.

Required:
Should Appletime continue to sell the Grade B apples in bags or process them further into pie
filling?

Solution:
Revenue from apples in bags = $1.25 * 120 = $150
Revenue from further processing = $0.90 * 500 = $450
Incremental revenue = 450 -150 = 300
Incremental cost = 0.24 * 500 = 120
Incremental profit = 180, thus process further

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 Quiz
Q1. Bozo Inc. manufactures two products from a joint production process. The joint process costs
$110,000 and yields 6,000 pounds of LTE compound and 14,000 pounds of HS compound. LTE can
be sold at split-off for $55 per pound. HS can be sold at split-off for $9 per pound. A buyer of HS
asked Bozo to process HS further into CS compound. If HS were processed further, it would cost
$34,000 to turn 14,000 pounds of HS into 4,000 pounds of CS. The CS would sell for $45 per
pound.

Should Bozo continue to sell the HS at split-off or process it further into CS?

Revenue from selling CS if process HS further $ 180,000 (4,000*45)

Revenue from selling HS at split-off $ 126,000 (14,000*9)
Incremental Revenue $ 54,000
Incremental Cost $ 34,000
Incremental profit $ 20,000
Thus Bozo Inc. should process HS further into CS

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