Relevant Costs for Decision Making Learning Objectives Show 1. Identify relevant and irrelevant costs and benefits in a decision situation. Lecture Notes A. Cost Concepts for Decision-Making. Every decision involves a choice from among at least two alternatives. The costs and benefits of the alternatives should be compared when making the decision. 1. Identifying relevant costs. A relevant cost or benefit is a cost or benefit that differs between alternatives. Differential costs are relevant costs. Any cost or benefit that does not differ between alternatives is irrelevant and can be ignored in a decision. This is a tremendously powerful concept that allows us to ignore mounds of data when making decisions since most things are not affected by any given decision.a. All sunk costs (i.e., costs already irrevocably incurred) are irrelevant since they will be the same for any alternative. All future costs that do not differ between alternatives are irrelevant. B. Adding or Dropping a Segment. Decisions relating to dropping old products (or segments) and adding new products (or segments) are among the most difficult that a manager makes. Two basic approaches can be used to analyze data in this type of decision. 1. Compare contribution margins and fixed costs. A segment should be added only if the increase in total contribution margin is greater than the increase in fixed cost. A segment should be dropped only if the decrease in total contribution margin is less than the decrease in fixed cost. C. The Make or Buy Decision. A make or buy decision is concerned with whether an item should be made internally or purchased from an external supplier. 1. Advantages of making an item internally.a. Producing a part internally reduces dependence on suppliers and may ensure a smoother flow of parts and material for production. D. Special Order.Special orders are one-time orders that do not affect a company's normal sales. The profit from a special order equals the incremental revenue less the incremental costs. As long as the incremental revenue exceeds the incremental costs, the order should be accepted. If there is no idle capacity, opportunity costs should be included as part of the incremental costs. E. Utilization of a Constrained Resource. A constraint is whatever prevents an individual or organization from getting more of what it wants. There is always a constraint as long as desires are unsatisfied. The chapter focuses on one particular kind of constraint-a production constraint. A production constraint can be a raw material, a part, a machine, or a workstation. If the constraint is a machine or workstation, it is called a bottleneck. 1. Contribution Margin Per Unit of the Constrained Resource. Whenever demand exceeds productive capacity, there is a production constraint. This means that the company is unable to fill all orders and some choices have to be made concerning which orders are filled and which are not filled. The problem is how to most effectively use the constrained resource.a. Whether this order or that order is filled, the fixed costs will usually be the same. Therefore, maximizing the total contribution margin will also maximize profit. F. Joint Product Costs and the Contribution Approach. In some manufacturing processes, several end products are produced from a single input. Such end products are known as joint products. The costs associated with making these products up to the point where they can be recognized as separate products (the split-off point) are called joint product costs. 1. The pitfalls of allocation. Joint product costs are really common costs that are incurred to simultaneously produce a variety of end products. Unfortunately, these common costs are routinely allocated to the joint products. Allocated joint product costs are often misinterpreted as costs that could be avoided by producing less of one of the joint products. However, joint product costs can only be avoided by producing less of all of the joint products simultaneously. If any of the joint products is made, then all of the joint product costs up to the split-off point will have to be incurred. G. Activity-Based Costing and Relevant Costs. Activity-based costing is a resource consumption model, not a spending model. Activity-based costing gives an idea of the magnitude of resources involved in carrying out activities, but it should be used with a great deal of caution in making particular decisions. The costs assigned to products and other cost objects are only potentially relevant costs. Whether they are relevant or not in any particular situation should be carefully considered. For example, in most activity-based costing systems the fixed depreciation costs of a sophisticated milling machine would be allocated to products based upon their usage of that resource. Suppose you are trying to decide whether to drop a product that uses the milling machine. The fact that the product uses the milling machine is relevant only if the milling machine is a bottleneck (and opportunity costs are involved in its use) or somehow future cash flows associated with the machine will be affected by how much it is used. If the machine is not a bottleneck and using some of its excess capacity has no effect on future spending, then there really is no cost associated with using the machine. In this case, the costs assigned by the activity-based costing system to the product would not be relevant. Which cost can be eliminated?Understanding an Avoidable Cost
Avoidable costs are expenses that can be eliminated if a decision is made to alter the course of a project or business. For example, a manufacturer with many product lines can drop one of the lines, thereby taking away associated expenses such as labor and materials.
Which of the following costs are always relevant for decision making?variable costs. Variable costs are relevant for decision making as they change when a decision is made.
Which of the following is a cost that does not differ between decisions?Irrelevant costs are those that will not change in the future when you make one decision versus another. Examples of irrelevant costs are sunk costs, committed costs, or overheads as these cannot be avoided.
Which of the following costs are irrelevant in decision making?Fixed costs are irrelevant in a decision. 2. Any cost that is avoidable is relevant for decision purposes.
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