13: Chapter ShortRun Decision Making: Relevant Costing
Cornerstones of Managerial Accounting, 4e
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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. 3. Choose the optimal product mix when faced with one constrained resource. 4. Explain the impact of cost on pricing decisions.
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ShortRun Decision Making
Short-run decision making consists of choosing among alternatives with an immediate or limited end in view. Short-term decisions sometimes are referred to as tactical decisions because they involve choosing between alternatives with an immediate or limited time frame in mind. Accepting a special order for less than the normal selling price to utilize idle capacity and to increase this year's profits is an example. Thus, some decisions tend to be short run in nature. However, it should be emphasized that short-run decisions often have long-run consequences.
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The DecisionMaking 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. 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 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. overall net benefit.
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Step 1: Recognize and Define the Problem
For example, if the members of a management team recognized the need for additional productive capacity as well as increased space for raw materials and finished goods inventories, they would consider the important dimensions of:
The number of workers and the amount of space needed, The reasons for the need, and How the additional space would be used are all important dimensions of the problem. However, the central question is how to acquire the additional capacity.
The first step is to recognize and define a specific problem.
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Step 2: Identify the Alternatives as Possible Solutions
The second step is to list and consider possible solutions. Some alternatives are dismissed due to too much risk, they are not proven, or are outside of cost constraints. One of the best strategies is to link the short-run decision (like an increase in productive capacity) to the company's overall growth strategy by rejecting alternatives that involve too much risk at a particular stage of a company's development.
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Step 3: Identify the Costs and Benefits Associated with Each Feasible Alternative
In the third step, the costs and benefits associated with each feasible alternative are identified. At this point, clearly irrelevant costs can be eliminated from consideration. (It is fine to include irrelevant costs and benefits in the analysis as long as they are included for all alternatives. We usually do not include them because focusing only on the relevant costs and benefits reduces the amount of data to be collected.)
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Step 4: Estimate the Relevant Costs and Benefits for Each Feasible Alternative
The differential cost is the difference between the summed costs of two alternatives in a decision. Typically, a differential cost compares the sum of each alternative's relevant costs only. Emphasis on differential cost allows decision makers to occasionally include irrelevant costs in the alternatives if they choose to do so. However, the inclusion of irrelevant costs is acceptable only if all irrelevant costs are included for each alternative.
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Step 5: Assess Qualitative Factors
Qualitative factors can significantly affect the manager's decision. Qualitative factors are simply those factors that are hard to put a number on, including things like political pressure and product safety.
Political Pressure: Some managers worry that such political pressure from customers can have long-term negative effects on sales that more than offset the labor cost savings that spurred the decision to offshore. Product Safety: Product safety represents another key qualitative factor for outsourcing organizations.
Finally, truly qualitative factors, such as the impact of late orders on customer relations, must be taken into consideration in the final step of the decision-making model-- the selection of the alternative with the greatest overall 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a benefit. license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Step 6: Make the Decision
Once all relevant costs and benefits for each alternative have been assessed and the qualitative factors weighed, a decision can be made. Ethical concerns revolve around the way in which decisions are implemented and the possible sacrifice of long-run objectives for short-run gain. Relevant costs are used in making short-run decisions. However, decision makers should always maintain an ethical framework. Whenever relevant costing is used, it is important to include all costs that are relevant--including those involving ethical ramifications.
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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: 1. they are future costs AND 2. 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. While 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), it is an important consideration in relevant decision making.
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Sunk Costs
A sunk cost is a cost that cannot be affected by any future action. It is important to note the psychology behind managers' treatment of sunk costs. 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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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. 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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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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MakeorBuy Decisions
Managers often 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. One type of 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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Structuring a MakeorBuy Problem
Cornerstone 131
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Structuring a MakeorBuy Problem (continued)
Cornerstone 131
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Special Order Decisions
From time to time, a company may consider offering a product or service at a price different from the usual price. Firms often 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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Structuring a Special Order Problem
Cornerstone 132
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Structuring a Special Order Problem (continued)
Cornerstone 132
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KeeporDrop Decisions
Often, 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. Both the segment's contribution margin and its segment margin are useful in evaluating the performance of segments. However, while segmented reports provide useful information for keep-or-drop decisions, relevant costing describes how the information should be used to 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a arrive distributed decision. or service or otherwise on a password-protected website for classroom use. at a with a certain product license
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Structuring a KeeporDrop Product Line Problem
Cornerstone 133
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Structuring a KeeporDrop Product Line Problem (continued)
Cornerstone 133
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KeeporDrop 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 KeeporDrop Product Line Problem with Complementary Effects
Cornerstone 134
The roofing tile line has a contribution margin of $10,000 (sales of $150,000 minus total variable costs of $140,000). All variable costs are relevant. Relevant fixed costs associated with this line include $10,000 in advertising and $35,000 in supervision salaries. Assume that dropping the product line reduces sales of blocks by 10 percent and sales of bricks by 8 percent. Required: 1. If the roofing tile line is dropped, what is the contribution margin for the block line? For the brick line? 2. Which alternative (keep or drop the roofing tile line) is now more cost effective and by how much?
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Structuring a KeeporDrop Product Line Problem with Complementary Effects (continued)
Cornerstone 134
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Relevant Decision Making
You Decide
You are an elected official in a major city that is considering whether or not to move forward with a proposed plan to demolish the city's existing professional sports stadium and build an elaborate new stadium. One of the most difficult aspects of this decision is estimating the new stadium's incremental revenues and costs that would result if it were built. What specific types of relevant revenues and costs would you consider in making this important decision?
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Relevant Decision Making (continued)
You Decide
There are many stadium events for which the associated relevant revenues and costs must be estimated accurately if the correct decision is to be made. These stadium events (and their relevant revenues and costs) include: Main attraction sporting events (e.g., ticket revenues from baseball, basketball, and/or football games for which the stadium would be built; additional staffing, cleanup, and insurance costs) Concessions and other sales (e.g., contribution margins or fees earned from product and service sales--most new stadiums boast as many high-end shopping opportunities as an upscale mall!) Television contract terms (e.g., the amount and percentage of revenue brought in by additional games being televised in the new stadium, perhaps in primetime slots) Offseason events (e.g., the ticket revenue from boxing matches, music concerts, etc.). For this relevant stadium decision, estimating the relevant revenues might be even more difficult than estimating the relevant costs. For instance, projecting how many more people will want to attend games in a new stadium can be unclear, as well as how much money they would be willing to spend for various seats located around the stadium.
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You Decide Relevant Decision Making (continued)
Several New York City area stadiums experienced tremendous difficulty in accurately estimating these same items. For example, the New York Yankees and New York Mets organizations built new stadiums with price tags of over $1.2 billion and $800 million, respectively! However, in the new Yankee stadium, many of the more expensive seats--the ones behind the batter and, thus, most visible on television--remained empty because of their hefty $2,500 per seat price tag. In fact, the Yankee organization decreased some of its highest ticket prices by 50 percent during the stadium's first season in an attempt to fill these high profile empty seats. In other words, decision makers struggled to estimate the amount of incremental revenue that would result from some of the more important seats in a new Yankee stadium. Undaunted by such challenging relevant analyses, however, the New York area also built a $1.6 billion new Meadowlands Stadium to be shared by the New York Jets and New York Giants. In addition to the previously mentioned relevant items, some citizens raise objections to such large amounts of money being spent on replacing existing fully functional sporting facilities with gargantuan sports palaces. They argue that $1 billion could be better spent on different causes. Such sentiments, whether you agree or disagree with them, represent potentially important qualitative factors that effective managerial accountants should take into account when performing relevant analyses for proposed new stadiums, especially when these citizens represent tax payers or potential fans the stadium builders count on for purchasing expensive tickets in the future. When making such an important decision, relevant costs for things like sporting events, concessions, television contracts, and off-season events must be considered in addition to qualitative factors like citizen sentiment.
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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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Structuring the SellorProcess Further Decision
Cornerstone 135
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: 1. What is the contribution to income from selling the Grade B apples in five-pound bags? 2. What is the contribution to income from processing the Grade B apples into pie filling? 3. Should Appletime continue to sell the Grade B apples in bags or process them further into pie filling?
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Structuring the SellorProcess Further Decision (continued)
Cornerstone 135
Solution: 1.Revenue from apples in bags = ($1.25 x 120) = $150 2.Revenue from further processing = $0.90 x 500 = $450 Further processing cost = $0.24 x 500 = $120 Income from further processing = $450 - $120 = $330 3. Appletime should process the Grade B apples into pie filling because the company will make $330 versus the $150 it would make by selling the apples in bags.
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Product Mix Decisions
Most of the time, organizations have wide flexibility in choosing their product mix. Product mix refers to the relative amount of each product manufactured (or service provided) by a company. Decisions about product mix can have a significant impact on an organization's profitability. Every firm faces limited resources and limited demand for each product. These limitations are called constraints. A manager must choose the optimal mix given the constraints found within the firm.
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Cornerstone 136 Determining the Optimal Product Mix with One Constrained Resource
Information: Jorgenson Company produces two types of gears, X and Y, with unit contribution margins of $25 and $10, respectively. Each gear must be notched by a special machine. The firm owns eight machines that together provide 40,000 hours of machine time per year. Gear X requires two hours of machine time, and Gear Y requires 0.5 hour of machine time. There are no other constraints. Required: 1. What is the contribution margin per hour of machine time for each gear? 2. What is the optimal mix of gears? 3. What is the total contribution margin earned for the optimal mix?
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Cornerstone 136 Determining the Optimal Product Mix with One Constrained Resource (continued)
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Cornerstone 137 Determining the Optimal Product Mix with One Constrained Resource and a Sales Constraint
Information: Jorgenson Company produces two types of gears, X and Y, with unit contribution margins of $25 and $10, respectively. Each gear must be notched by a special machine. The firm owns eight machines that together provide 40,000 hours of machine time per year. Gear X requires two hours of machine time, and Gear Y requires 0.5 hour of machine time. A maximum of 60,000 units of each gear can be sold. Required: 1. What is the contribution margin per hour of machine time for each gear? 2. What is the optimal mix of gears? 3. What is the total contribution margin earned for the optimal mix?
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Determining the Optimal Product Mix with One Constrained Resource and a Sales Constraint
(continued)
Cornerstone 137
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Multiple Constrained Resources
The presence of only one constrained resource might not be realistic. Organizations often face multiple constraints, including:
limitations of raw materials limitations of skilled labor limited demand for each product
The solution of the product mix problem in the presence of multiple constraints is considerably more complicated and requires the use of a specialized mathematical technique known as linear programming, which is reserved for advanced cost management courses.
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CostBased Pricing
Demand is one side of the pricing equation; supply is the other side. Since revenue must cover all costs for the firm to make a profit, many companies start with cost to determine price. That is, they calculate product cost and add the desired profit. The mechanics of this approach are straightforward. Usually, there is a cost base and a markup. The markup is a percentage applied to the base cost. It includes desired profit and any costs not included in the base cost. Companies that bid for jobs routinely base bid price on cost.
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Calculating Price by Applying a Markup Percentage to Cost
Cornerstone 138
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TargetCosting and Pricing
Many American and European firms set the price of a new product as the sum of the costs and the desired profit. The rationale is that the company must earn sufficient revenues to cover all costs and yield a profit. Target costing is a method of determining the cost of a product or service based on the price (target price) that customers are willing to pay. The marketing department determines what characteristics and price for a product are most acceptable to consumers.
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Calculating a Target Cost
Cornerstone 139
Information: Digitime manufactures wristwatches and is designing a new watch model that incorporates a PDA (personal digital assistant), which Digitime hopes consumers will view as a cool and valuable design feature. As such, the new PDA watch has a target price of $200. Management requires a 15 percent profit on new product revenues. Required: 1. Calculate the amount of desired profit. 2. Calculate the target cost. Solution: 1. Desired profit = 0.15 x Target price = 0.15 x $200 = $30 2. Target cost = Target price - Desired profit = $200 - $30 = $170
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