Notes_Chapter_13 - CHAPTER 13: Relevant Costs for Decision...

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CHAPTER 13: Relevant Costs for Decision Making I. MANAGEMENT’S DECISION-MAKING PROCESS A. Cost Definitions and Concepts 1. Relevant Costs - future costs that differ among the alternatives (also applies to revenues) 2. Opportunity Cost - benefits foregone (i.e., income) by choosing the best alternative 3. Sunk Cost - a cost that has already been incurred (cannot be changed, thus not relevant!!) 4. Avoidable Costs – a cost that can be eliminated (in whole or in part) by choosing one alternative over another. 5. Incremental Revenues/Costs - total difference in revenues/costs among two alternatives B. Incremental (or differential) Analysis Approach o the process in which managers identify data that change under alternative actions to allow managers to choose among alternatives (compare to Total cost approach) Every decision involves choosing from among at least two alternatives. Managers need different information for different purposes. To make a decision: 1) Eliminate costs and benefits that do not differ, in total, between alternatives. 1
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2) Base the decision on the remaining costs and benefits. EXAMPLE: RELEVANT COSTS Tim’s Tools normally sells 10,000 sets of its specialized tools to craftsmen for $20.00 per set. The costs associated with each set include variable costs of $10.00/ set and fixed costs are currently $30,000. A distributor outside of Tim’s Tools sales region has contacted the owner (Tim) and would like to buy 200 sets of tools for $15.00 each. Tim’s Tools has idle capacity but will have to rent additional equipment for $2,000 to meet the additional demand. When Tim is considering whether or not to accept the special order, which of the following are relevant to making the decision ? a. Will the $10.00 per set variable cost be covered? b. Will the total fixed costs of $32,000 be covered? c. Will the additional $2,000 of fixed cost be covered? d. a and b above e. a and c above II. DECISIONS BASED ON INCREMENTAL ANALYSIS A. ADDING AND DROPPING SEGMENTS Focus on RELEVANT Info. If any segment is eliminated: Total Revenues will decrease by amount of that division's revenues, Total variable costs will be reduced by that division’s VC, but only avoidable Fixed Costs can be eliminated o Beware of common fixed costs: o Decision Rule : Retain the segment unless fixed costs eliminated exceed the contribution margin lost 2
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o Should also consider effect on related product lines EXAMPLE: Due to the declining popularity of digital watches, Sweiz Company’s digital watch line has not reported a profit for several years. An income statement for last year follows: Segment Income Statement—Digital Watches Sales. ................................................. $ 500,000 Variable expenses: Variable manufacturing costs. ..... $120,000 Variable shipping costs. ............... 5,000 Commissions. ................................  
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This note was uploaded on 06/01/2011 for the course ACCOUNTING 230 taught by Professor Allen during the Spring '11 term at Texas A&M.

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Notes_Chapter_13 - CHAPTER 13: Relevant Costs for Decision...

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