RELEVANT COSTING

DECISION MAKING- is the process of choosing from at least two alternatives. For business entities,
management must choose in favor of the option that is most beneficial to the company in order to achive
corporate objectives of maximizing profit

SHORT-TERM DECISION ALTERNATIVES

1. Accept or reject a special order
2. Sell or process further a product line
3. Make or buy a part or a product line
4. Continue or shutdown a business segment
5. Choosing the best product combination
6. Selecting a change in profit factors

TYPICAL DECISION MAKING PROCESS

1. Defining the problem
2. Specifying the objective and criteria
3. Identifying the alternative courses of action
4. Evaluating the possible consequences of the alternatives
5. Collecting the data needed to make decision
6. Choosing the best alternative and making the decision
7. Evaluating the results of the decision

FACTORS CONSIDERED IN DECISION MAKING

Qualitative factors- factors in a decision problem that cannot be expressed effectively in numerical terms
Quantitative factors- factors that can easily be expressed in terms of money or other numerical unit of
measure

APPROACHES IN PROBLEM-SOLVING INVOLVING DECISION MAKING

Total approach- Total revenues and costs are determined for each alternative, and the results are
compared to serve as a basis for the decision to make

Differential approach- only the differences or changes in costs and revenues are considered

TYPES OF COSTS AND TERMINOLOGIES USED IN SHORT-TERM DECISION MAKING

Relevant costs Future costs that are expected to be different
among alternatives; it is usually regarded as the
avoidable costs of a particular decision

Differential Costs Increases (increments) or decreases (decrements)

in total costs that result from selecting one
alternative instead of another [RELEVANT]

Avoidable costs Costs that will be saved or those that will not be
incurred if a certain decision is made. [RELEVANT]

Sunk costs Costs that will be saved or those that will not be
incurred if a certain decision is made.
[IRRELEVANT]

Out-of-pocket costs Costs that will require expenditure of cash or

incurrence of a liability as a consequence of a
management decision. [Usually relevant]
 Opportunity costs Income sacrificed or foregone when a certain
alternative is chosen over another alternative.
[RELEVANT]

Joint costs Costs incurred in simultaneously manufacturing two

or more(joint) products that are difficult to identify
individually as separate types of products until the
products reach a certain processing stage known
as the split-off point [IRRELEVANT]

Further processing costs Costs incurred beyond the split-off point as

separated joint products are to be processed
further. [RELEVANT]

Split off point A point in the manufacturing process where some

or all of joint products can be recognized as distinct
and separate products

Bottleneck resources Any resource or operation where the capacity is

less than the demand placed upon it.

⮚ Accept or Reject a Special Order

• A special order is outside the scope of normal sales. If the incremental revenue exceeds the
incremental costs of filling the special order, it will increase short-term profitability.
• If a company has excess capacity, only the variable costs of filling the special order are relevant.
• Fixed costs do not change in the short run and are therefore not included in the incremental analysis.
• If a company is operating at full capacity, the opportunity cost of lost sales is relevant and should be
incorporated into the incremental analysis.
• Other qualitative factors such as the effect on routine customers and the opportunity to capture new
customers must also be considered.

⮚ Make-or-Buy Decision
• Make-or-buy decisions involve deciding whether to perform a particular function in-house versus buying
it from an outside supplier. They are also called in source versus outsource decisions.
• The relevant costs of making a product or providing a service internally include all variable costs plus
any incremental fixed costs.
• The opportunity costs of making something internally include alternative uses for the internal resources.
• Many qualitative considerations including quality, reliability and environmental concerns are also
important in make-or-buy decisions.

⮚ Keep-or-Drop Decision
• Managers must often decide whether to eliminate a business segment that is not performing as well as
expected.
• To decide whether to eliminate a segment, managers should focus on the segment margin, or the
amount of profit generated by the segment after variable costs and direct fixed costs have been deducted.
• Common fixed costs would be incurred even if the segment is eliminated and are not relevant to the
decision.
• Managers must also consider how elimination of the segment would affect other segments or product
lines and whether alternative uses for the resources currently devoted to the business segment exist.
 ⮚ Sell-or-Process Further Decision
• A sell-or-process further decision determines whether to sell a product as is or continue to refine it.
• The incremental revenue should be compared to the incremental cost of continuing to enhance the
product or service.

⮚ Theory of Constraints
• A constrained resource occurs when its capacity is insufficient to meet the demands placed on it.
• The most constrained resource is also called the bottleneck, which limits the system’s overall output.
• To maximize short-term profit, managers should prioritize products based on the amount of contribution
margin earned per unit of time for the most constrained (bottleneck) process.