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COMPILED
REVIEWER
OUTPUT
COVERAGE:
1. Cost and Concepts Principles

2. Cost Volume Profit Analysis

3. Budgeting

4. Responsibility Accounting

5. Differential Analysis

Submitted by:
Reyza Mikaela Anglo

Submitted to:
Mrs. Rowena P. Tan, CPA

Subject Professor
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STRATEGIC BUSINESS ANALYSIS (MIDTERM COVERAGE)

Lesson 1: Cost and concepts principles

❖ Role of Accounting

Managerial accounting helps managers make good decisions. Managerial

accounting provides information about the cost of goods and services, whether a
product is profitable, whether to invest in a new business venture, and how to
budget. It compares actual performance to planned performance and facilitates
many other important decisions critical to the success of organizations.

❖ Compare managerial accounting with financial accounting

Whereas financial accounting provides financial information primarily for

external use, managerial accounting information is for internal use. By reporting on
the financial activities of the organization, financial accounting provides information
needed by investors and creditors.

Most managerial decisions require more detailed information than that

provided by external financial reports. For instance, in their external financial
statements, large corporations such as General Electric Company show single
amounts on their balance sheets for inventory. However, managers need more
detailed information about the cost of each of several hundred products.

❖ Financial Accounting

Financial accounting is a specific branch of accounting involving a process

of recording, summarizing, and reporting the myriad of transactions resulting from
business operations over a period of time. These transactions are summarized in
the preparation of financial statements, including the balance sheet, income
statement and cash flow statement, that record the company's operating
performance over a specified period.

❖ Management Accounting

Management accounting is designed for decision making within the

company. Managerial accounting uses more projections and estimates than seen
in financial accounting. The focus is within the company and is often applied to
specific jobs, processes, products or departments.

❖ Comparison of Financial Accounting & Management Accounting

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Financial accounting
● Reports to various interested parties (external and internal)
● Emphasis is on summaries of financial consequences of past activities.
● Objectivity and verifiability of data are emphasized.
● Precision of information is required.
● Only summarized data for the entire organization are prepared.
● Must follow IFRS.
● Mandatory for external reports.

Management accounting
● Reports to managers within the organization.
● Emphasis is on future-oriented data needed in decision-making.
● Relevance is emphasized.
● Timeliness of information is required.
● Detailed segment reports about departments, products, customers and
employees are prepared.
● Need not to follow IFRS.
● Not Mandatory to external reports.

❖ Cost management concepts

● Cost - is a financial measure of the resource used or given up to achieve a
stated purpose.
● Product costs - are the cost a company assigns to units produced.

Direct Materials
● Materials are unprocessed items to be used in the manufacturing process.
Materials used only in making the product and are clearly and easily
traceable to a particular product.

Direct Labor
● Cost included the labor cost of all employees actually working on materials
to convert them into finished goods. Include only those labor costs clearly
traceable to, or readily identifiable with, the finished product.

Overhead
● Generally called manufacturing overhead. Refers to all costs of making the
product or providing the service except those classified as direct materials
or direct labor.
Selling Expense
● Are costs incurred to obtain customer orders and get the finished product in
the customers’ possession. Advertising, market research, sales salaries,
and commissions, and delivery and storage of finished goods are selling
costs.
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Administrative expenses
● Nonmanufacturing costs that include the costs of top administrative and
various staff departments such as accounting, data processing, and
personnel.

Product Costs vs Period Expenses

● Product costs - are the costs incurred in the making of products
● Period expenses - are closely related to periods of time rather than units of
products. .

Fixed vs Variable Cost

● Fixed Cost - remain the same in total but changes per unit.
● Variable Cost - remain the same per unit but changes in total.

Direct vs Indirect Costs

● Direct cost - an amount that can be traced to a specific department,
process or job.
● Indirect cost - can be product cost like overhead or period costs like an IT
employee’s salary to the sales department.

Controllable vs Non-controllable Costs

● Controllable cost - are things the executive, manager, or department even
can control or change.
● Uncontrollable cost - if the executive. Manager, or department cannot
change or control the cost.

Differential Costs including Sunk and Opportunity Costs

● Differential costs represent the difference between two alternatives.
○ Opportunity cost - are what you give up by choosing one alternative
over another.
○ Sunk costs - are not relevant for decision making as the cost cannot
be recovered at a later date.

Lesson 2. Cost-Volume-Profit Analysis

Cost-volume-profit (CVP) analysis, also known as break-even analysis, is used

by companies to determine what affects changes in their selling prices, costs, and/or
volume will have on profits in the short run. A careful and accurate cost-volume-profit
(CVP) analysis requires knowledge of costs and their fixed or variable behavior as volume
changes.

A cost-volume-profit chart is a graph that shows the relationships among

sales, costs, volume, and profit.
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● Formula for Contribution Margin:

Contribution Margin = Sales – Variable Cost

The contribution margin indicates the amount of money remaining after the
company covers its variable costs. This remainder contributes to the coverage of fixed
costs and to net income.

● Formula for Contribution Margin Ratio:

Contribution Margin RATIO = (Sales – Variable Cost)/Sales

● Profit equation

Net income = Revenue – Total variable costs – Fixed costs

● Contribution Margin Income Statement

The contribution margin income statement is used quite frequently since

it separates fixed and variable costs to allow a company to see what it can directly
change and what it cannot change.

❖ Cost behavior vs Cost estimation

● Cost behavior - refers to how a cost will react or respond to changes in the
business activity. As the activity level rises and falls, a particular cost may
rise and fall as well or it may remain constant.

For planning purposes a manager must be able to anticipate which of

these will happen, and if a cost is expected to change, the manager must
determine how much it will change.

● Cost Estimation - Cost estimation in project management is the process of

forecasting the financial and other resources needed to complete a project
within a defined scope. Cost estimation accounts for each element required
for the project—from materials to labor—and calculates a total amount that
determines a project’s budget.

An initial cost estimate can determine whether an organization

greenlights a project, and if the project moves forward, the estimate can be
a factor in defining the project’s scope.

If the cost estimation comes in too high, an organization may decide

to pare down the project to fit what they can afford (it is also required to
begin securing funding for the project). Once the project is in motion, the
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cost estimate is used to manage all of its affiliated costs in order to keep the
project on budget.

❖ Fixed costs

It pertains to the items of cost which remain constant in total, irrespective of

the volume of production. It is not related to activity within the relevant range. The
cost per unit decreases as volume increases and increases when volume
decreases.

❖ Variable Cost

It pertains to the items of cost which vary directly, in total, in relation to the
volume of production. Here, the cost per unit remains constant as volume
changes within a relevant range.
❖ Mixed costs
Mixed costs are costs that contain a portion of both fixed and variable
costs. Common examples include utilities and telephone bills.

❖ Break even point(single product)

When a company's sales revenue and costs charged to that period are
equal, it has reached breakeven. As a result, the break-even point is the level of
operations at which a company generates no net income or loss.

A company's break-even point can be expressed in terms of dollars of sales

revenue or units produced or sold. The point of zero income or loss is the same
regardless of how a company expresses its break-even point.

If the objective is the break even in units, the formula is as shown below:

❖ Break even point(multiple product)

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Although cost-volume-profit analysis is more likely to be used for a single

product, it is more commonly used in multi-product situations. For a multi-product
company, the simplest way to use cost-volume-profit analysis is to use dollars/peso
of sales as the volume measure. A multi-product company must assume a specific
product mix or sales mix for CVP purposes. Product (or sales) mix refers to the
percentage of total sales allocated to each type of product sold by the company.

If the objective is the break even in sales (pesos), the formula is as shown
below:

Lesson 3: BUDGETING

❖ Budget
A budget is a financial plan of the resources needed to carry out tasks
and meet financial goals. It is also a quantitative expression of the goals the
organization wishes to achieve and the cost of attaining these goals.

The overall or master budget (also known as planning budget or budget

plan) indicates the sales levels, production and cost levels, income and cash flows
that are anticipated for the coming year.

The master budget is a summary of all phases of a company's plans and

goals for the future. In short, it represents a comprehensive expression of
management's plans for the future and how these plans are to be accomplished.

❖ Difference between planning & control

● Planning involves developing objectives and preparing various budgets to

achieve these objectives.

● Control involves the steps taken by management to ensure that the

objectives set down at the planning stage are attained and to ensure that all
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parts of the organization function in a manner consistent with organizational

policies. An effective budgeting system must provide for both planning and
control.

❖ Functions of budgeting

Properly conceived, budgeting can mean the difference between a general

drift that may or may not lead to a desired goal and a carefully plotted course
toward a predetermined objective that holds drift to a minimum. Budgets make the
decision-making process more effective by helping managers meet uncertainties.
The objective of budgeting is to substitute deliberate, well-conceived business
judgment for accidental success in enterprise management. Budgets should not be
expressions of wishful thinking but rather descriptions of attainable objectives.

❖ Purposes of the budget

A budget is a description in quantitative - usually monetary - terms of a

desired future result. The process of preparing the budget requires management at
all levels to focus on the future of the business entity. The benefits that may be
realized from a budgeting program are:
1. Defining broad objectives and goals and formulating strategies to achieve
such objectives;
2. Coordinating the activities of the organization by integrating the plans of
the various parts thereby pulling everyone in the same direction;
3. Allocating resources to those parts of the organization where they can be
used most effectively;
4. Communicating management's approved plans throughout the
organization;
5. Uncovering and preparing for potential bottlenecks in the operations
before they occur.
6. Motivating managers to achieve the desired results; and
7. Selling a standard or benchmark for evaluating actual performance.

❖ Advantages & limitations

Advantages:

1. It forces planning and exposes situations in which plans of subcomponents

are inadequate to attain the total organization's objectives.

2. It allows a reiterative process to bring the goals of the organization and the
subcomponents into agreement.

3. It provides a means of communicating organization goals down through the

organization and sub-unit operational limitations up though the organization.
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4. It provides a basis for financial planning, sub-unit coordination, resource

acquisition, inventory policy, scheduling and output distribution.

5. It provides a basis by which activity can be monitored, with actual results

being compared to the planned results.

Limitations:

1. Budgets tend to oversimplify the real situation and fail to allow for variations
in external factors. They do not reflect qualitative variables.

2. It is difficult to prepare a detailed budget for an organization that has never

existed or for a new division, product, or department of an existing firm

3. There may be lack of higher and lower management commitment because

of lack of understanding of the fundamentals of budget preparation and
utilization.

4. The budget is only a representation of future plans or a means to the goal of

profitable activity and not an end in itself. It may interfere with the
supervisor's style of leadership and can therefore stifle initiative.

5. Budget reports usually emphasize results, not reasons.

❖ Types of budgets
● Operation Budget is a forecast of the revenues and expenses expected
for one or more future periods. An operating budget is typically formulated
by the management team just prior to the beginning of the year, and shows
expected activity levels for the entire year. This budget may be supported by
a number of subsidiary schedules that contain information at a more
detailed level.

● Financial Budget A financial budget (a type of master budget) in budgeting

means predicting the income and expenses of the business on a long-term
and short-term basis. Accurate projections of cash flow help the business
achieve its targets in the right way.

● Capital Budget is the process that a business uses to determine which

proposed fixed asset purchases it should accept, and which should be
declined. This process is used to create a quantitative view of each
proposed fixed asset investment, thereby giving a rational basis for making
a judgment.

❖ Management process of preparing master budget

Organization for Budget Preparation

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It is essential that the manager of an entity assigns the most qualified

personnel to the preparation of the budget. A budget committee with
representation from the different functional areas (marketing, production, finance,
and administration) is generally considered an effective body to oversee the
preparation and administration of the budget. The controller may be selected to
serve as head of the committee for two major reasons:

1. Controller’s position is independent from the operating parts of the

organization.
2. He has the skills and experiences in coping with the intricacies of setting up
a budget.

The controller acts as a coordinator in the budgeting operation. He

recommends how budgets should be prepared, assembles the budgets, prepares
periodic reports showing variances of the actual results from the budgeted results,
interprets variances and offers suggestions for improvement whenever possible.

The budget committee decides how budgets shall be prepared, passes on

the final budget, and settles disputes in one segment of the business and another
when differences of opinion arise. The committee also receives budget reports and
makes policy decisions with respect to budget revisions and other problems of
budget administration.

Budget Period

As a general rule, the period covered by a budget should be long enough

to show the effect of managerial policies but short enough so that estimates
can be made with reasonable accuracy. This suggests that different types of
budgets should be made for different time spans.

● A master budget is an overall financial and operating plan for a coming

fiscal period and the coordinated program for achieving the plan. It is usually
prepared on a quarterly or an annual basis. Long range budgets called
capital budgets, which incorporate plans for major expenditures for plant
and equipment or the addition of product lines, might be prepared to cover
plans for as long as 5 to 10 years.

● Responsibility budgets which are segments of the master budget relating

the aspect of the business that is the responsibility of a particular manager
are prepared monthly.

● Cash budgets may be prepared on a day-to-day or Monthly basis. Some

companies follow a continuous budgeting plan whereby budgets are
constantly reviewed and updated. The updating is accomplished, for
example, by extending the annual budget one additional month at the end of
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each month. A review of the budget may also suggest that the budget be
changed as a result of changing business and operating conditions.

❖ Step in developing a master budget

1. Establish basic goals and long-range plans for the company. These will serve
as guidelines in the preparation of budget estimates.

2. Prepare a sales forecast for the budget period.

3. Estimate the cost of goods sold and operating expenses.

4. Determine the effect of budget operating results on assets liabilities and

ownership equity accounts. The cash budget is the largest part of this, since
changes in many asset and liability accounts will depend upon the cash flow
forecast.

5. Summarize the estimated data in the form of a projected income statement for
the budget period and the projected statement of financial position as of the end
of the budget period.
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STRATEGIC BUSINESS ANALYSIS (FINALS COVERAGE)

Lesson 4: Responsibility Accounting for Cost, Profit and Investment

Centers

● Responsibility accounting
○ This refers to an accounting system that collects, summarizes, and
reports accounting data relating to the responsibilities of individual
managers. Also, provides information to evaluate each manager on the
revenue and expense items over which that manager has primary control
(authority to influence).
○ A responsibility accounting report contains those items controllable by the
responsible manager.
○ When both controllable and uncontrollable items are included in the report,
accountants should separate the categories. The identification of
controllable items is a fundamental task in responsibility accounting and
reporting.
○ The organization chart below demonstrates lines of authority and
responsibility that could be used as a basis for responsibility reporting.
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○ To implement responsibility accounting in a company, the business entity

must be organized so that responsibility is assignable to individual
managers. The various company managers and their lines of authority (and
the resulting levels of responsibility) should be fully defined.

● Advantages of Responsibility Accounting

1. It facilitates delegation of decision-making.

2. It helps management promote the concept of management by objective

wherein managers agree on a common set of goals and their performance
evaluated on the basis of their attainment of goals.

3. It aids in establishing standards of performance which are used in evaluating

the efficiency and effectiveness of the different units in the organization.

4. It permits effective use of management by exception which provides that the

manager will maximize his efficiency by concentrating on those operational factors
which are deviations from plans.

● Decentralization

○ the dispersion of decision-making authority among individuals at lower

levels of the organization. In other words, the extent of decentralization
refers to the degree of control that segment managers have over the
revenues, expenses, and assets of their segments. When a segment
manager has control over these elements, the investment center concept
can be applied to the segment.

● Advantages of decentralized decision making

○ Managing segments trains managers for high-level positions in the

company. The added authority and responsibility also represent job
enlargement and often increase job satisfaction and motivation.
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○ Top management can be more removed from day-to-day decision making at

lower levels of the company which means they can devote more time to
long-range planning and to the company’s most significant problem areas.

○ Decisions can be made at the point where problems arise. It is often difficult
for top managers to make appropriate decisions on a timely basis when they
are not intimately involved with the problem they are trying to solve.

○ Since decentralization permits the use of the investment center concept,

performance evaluation criteria such as ROI and residual income can be
used.

● Responsibility Reports
○ provide reports to different levels of management. A performance report is
a budget that compares actual and budgeted amounts of controllable costs
for a department and its manager. The issued report is showing only the
performance of all the departments and additional items under the
manager’s control, such as the administrative expenses. The report sent to
the president of the company includes a summary total of all the
performance levels plus any additional items under the president’s control.
Also, the effect of this is that the president’s report should include all
revenue and expense items in summary form because the president is
responsible for controlling the profitability of the entire company.

● Management by exception
○ Upper-level management does not need to review operational details at
lower levels until there appears to be a problem, according to the idea of
management by exception. As organizations have grown more complicated,
accountants have found it necessary to filter and simplify accounting data in
order to examine it more rapidly. The majority of CEOs do not have the time
to go over thorough financial reports and look for red flags. Only reporting
summary totals shows any areas that need to be addressed and makes the
best use of the executive's time.

● Responsibility Centers
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● Segment - a relatively autonomous unit or division of a company that is

defined by function or product line. Owners have traditionally organized
their businesses along functional lines. The functionally organized segments
or departments each perform a specific function such as marketing, finance,
purchasing, production, or shipping. Large corporations have recently
tended to organize segments based on product lines, such as an electrical
products division, a shoe department, or a food division.

● Responsibility center - a section of an organization for which a specific

executive is in charge.

○ Responsibility centers are classified into three types:

■ Expense (or cost) centers- a responsibility center that solely

incurs expenses and does not generate money directly from
the sale of goods or services. Service centers (such as the
maintenance or accounting departments) and intermediate
manufacturing facilities (which generate pieces for assembly
into a final product) are examples of expenditure centers.
Managers of expense centers are solely held accountable for
specific expenditures.

■ Profit centers - a revenue and expense-generating

responsibility center. The manager must be able to handle
each of these areas since segmental earnings equal
segmental revenues minus associated costs. The
management must be able to oversee the selling price, sales
volume, and all expenditure items reported. The manager
must have power over all of these measurable items in order
to effectively evaluate performance. Deducting expenditures
under a manager's control from revenues under that
manager's control yields a segment's controllable profits.

■ Investment centers - closely tied to the profit center idea. A

responsibility center with income, costs, and an adequate
investment basis is known as an investment center. When a
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company assesses an investment center, it considers the rate

of return on its investment base.

Management must examine the characteristics of each segment as

well as the extent of the responsible manager's authority when designing a
responsibility accounting system. It is critical to ensure that the basis for
evaluating the performance of an expense center, profit center, or
investment center corresponds to the segment's characteristics and the
authority of the segment's manager.

Investment Center Analysis

● Return on Investment (ROI) A segment that has a large amount of assets usually
earns more in an absolute sense than a segment that has a small amount of
assets. Therefore, a firm cannot use absolute amounts of segmental income to
compare the performance of different segments.

ROI = segment income/investment base

ROI = (income/sales) x (sales/turnover)

A manager can increase ROI in the following three ways.

● By concentrating on increasing the profit margin while holding turnover constant

● By concentrating on increasing turnover by reducing the investment in assets while
holding income and sales constant
● By taking actions that affect both margin and turnover

● Residual income (RI) is defined as the amount of income a segment has in

excess of the segment’s investment base times its cost of capital percentage.

RI = amount ($)

RI = Income - (Investment x Cost of capital percentage)

Income = Operating Income

Investment x Cost of capital percentage = Desired minimum income

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Example: A company gives its department 1,000,000 of capital and charges it 15%
for the capital they employ. The department earned 200,000 profit. What is the
Residual Income?

RI = 200,000 - (1,000,000 x 15%)

RI = 200,000 - 150,000

RI = 50,000

Segmented Income Statements

● Segmented Income Statement

Cost may be directly or indirectly related to a particular cost object.

● Cost object - a segment, product, or other item for which costs may be
accumulated. In other words, a cost is not direct or indirect in and of itself. It
is only direct or indirect in relation to a given cost object.

○ Direct cost (expense) - specifically traceable to a given cost object.

○ Indirect cost (expense) - not traceable to a given cost object but has
been allocated to it.

● A particular cost (expense) can be designated by the accounts as direct or

indirect based on a given cost object. A cost that is direct to one cost
object may be indirect to another.

● Contribution Margin- is sales revenue less variable expenses. Notice that all
variable expenses are direct expenses of the segment. The second subtotal in the
contribution margin format income statement is the segment’s contribution to
indirect expenses.

● Contribution to indirect expenses- is sales revenue less all direct expenses of

the segment (both variable direct expenses and fixed direct expenses).
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● Segmental net income- is the final total in the income statement, a segmental
revenue less all expenses (direct expenses and allocated indirect expenses).

Arbitrary allocations of indirect fixed expenses

● Indirect fixed expenses can only be allocated to segments on some arbitrary

basis. The two guidelines for allocating indirect fixed expenses are by the benefit
received and by the responsibility for the incurrence of the expense.

Transfer Pricing

● Transfer Pricing
○ Profit centers and investment centers inside companies often exchange
products with each other. The company sets transfer prices that represent
revenue to the selling division and costs to the buying division.

Companies mostly based transfer prices on:

1. the market price of the product

2. the cost of the product

3. some amount negotiated by the buying and selling segment managers.

● Transfer price- an artificial price used when goods or services are transferred
from one segment to another segment within the same company. The transfer
price is an internal accounting transaction. The transfer price affects the profitability
of the buying and selling segments. Transfer price provides incentives for segment
managers to make decisions in the interests of the entire company.

For example, if the selling segment can sell everything it produces for 100
per unit, the buying segment should pay the market price of 100 per unit. A seller
with excess capacity, however, should be willing to transfer a product to the buying
segment for any price at or above the differential cost of producing and transferring
the product to the buying segment (typically all variable costs).

● Balanced scorecard
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○ a set of performance targets and results that show an organization’s

performance in meeting its objectives to its stakeholders. It is a
management tool that recognizes organizational responsibility to different
stakeholder groups, such as employees, suppliers, customers, business
partners, the community, and shareholders. Often different stakeholders
have different needs or desires that the managers of the organization must
balance. The balanced scorecard concept involves creating measurements
for four strategic perspectives.

○ These perspectives include:

1) financial
2) customer
3) internal business process
4) knowledge and growth
The measurements should be focused on a single strategy and be linked, consistent and
mutually reinforcing. Some generic measurements are presented in the table below.

Perspective Generic Measurement

Financial Return of Capital Employed, Economic value

added, Sales growth, Cash flow

Customer Customer satisfaction, retention, acquisition,

profitability, market share

Internal business process Includes measurements along the internal

value chain for:

Innovation - measures of how well the

company identifies the customers’ future
needs.

Operations - measures of quality, cycle time

and costs.
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Post sales service - measures for warranty,

repair and treatment of defects and returns.

Knowledge and growth Includes measurements for:

People - employee retention, training, skills,

morale.

Systems - measure of availability of critical

real time information needed for front line
employees.

DIFFERENTIAL ANALYSIS

Relevant Costs & Benefits

Relevant Cost - a cost that differs between alternatives

Relevant Benefit - a benefit that differs between alternatives

Identifying Relevant Costs

Avoidable Cost - is a cost that can be eliminated, in whole or in part, by choosing one
alternative over another. Avoidable costs are relevant costs. Unavoidable costs are
irrelevant costs

Two broad categories of costs are never relevant in any decision. They include:

1. Sunk costs
2. A future cost that does not differ between the alternatives
Decision Making: The Two-Step Process

Step 1 Eliminate costs and benefits that do not differ between alternatives

Step 2 Use the remaining costs and benefits that differ between alternatives in
making the decision. The costs that remain are the differential, or
avoidable, costs.

Different Costs for Different Purposes

Costs that are relevant in one decision situation may not be relevant in another
context. Thus, in each decision situation, the manager must examine the data at hand
and isolate the relevant costs
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Total and Differential Cost Approaches

Using the differential approach is desirable for two reasons:

❖ Only rarely will enough information be available to prepare detailed

income statements for both alternatives
❖ Mingling irrelevant costs with relevant costs may cause confusion and
distract attention away from the information that is really critical.

Adding/Dropping Segments

● One of the most important decisions managers make is whether to add or drop
a business segment. Ultimately, a decision to drop an old segment or add a new
one is going to hinge primarily on the impact the decision will have on net
operating income
● To asses this impact, it is necessary to carefully analyze the cost

The Make or Buy Decision

When a company is involved in more than one activity in the entire value chain, it is
vertically integrated. A decision to carry out one of the activities in the value chain
internally, rather than to buy externally from a supplier is called a “make or buy” decision

Vertical Integration-Advantages

○ Smoother flow of parts and materials

■ Better quality control
● Realize profits
Vertical Integration-Disadvantages

● Companies may fail to take advantage of suppliers who can create

economies of scale advantage by pooling demand from numerous
companies

● While the economics of scale factor can be appealing, a company must

be careful to retain control over activities that are essential to maintaining
its competitive position

Opportunity Cost

● The benefit that is foregone as a result of pursuing some course of action

● Opportunity costs are not actual cash outlays and are not recorded in the formal
accounts of an organization
Special Order

A one-time order that is not considered part of the company’s normal ongoing
business
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○ When analyzing a special order, only the incremental costs and benefits are
relevant
■ Since the existing fixed manufacturing overhead costs would not be
affected by the order, they are not relevant
Constraint

When a limited resource of some type restricts the company’s ability to satisfy
demand

Bottleneck

The machine or process that is limiting overall output – it is the constraint

Utilization of a Constrained Resource

 Fixed costs are usually unaffected in these situations, so the product mix that
maximizes the company’s total contribution margin should ordinarily be selected
 A company should not necessarily promote those products that have the
highest unit contribution margins
 Rather, total contribution margin will be maximized by promoting those products
or accepting those orders that provide the highest contribution margin in
relation to the constraining resource
Value of a Constrained Resource
Increasing the capacity of a constrained resource should lead to increased
production & sales
Managing Constraints
It is often possible for a manager to increase the capacity of a bottleneck, which is
called relaxing (or elevating) the constraint, in numerous ways such as:
❖ Working overtime on the bottleneck
❖ Subcontracting some of the processing that would be done at the bottleneck
❖ Investing in addition machines at the bottleneck
❖ Shifting workers from non-bottleneck processes to the bottleneck
❖ Focusing business process improvement efforts on the bottleneck
❖ Reducing defective units processed through the bottleneck
Joint Costs
● In some industries, a number of end products are produced from a single raw
material input
● Two or more products produced from a common input are called joint products
● The point in the manufacturing process where each joint product can be
recognized as a separate product is called the split-off point.
The Pitfalls of Allocation
● Joint costs are traditionally allocated among different products at the split-off
point. A typical approach is to allocate joint costs according to the relative sales
value of the end products
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● Although allocation is needed for some purposed such as balance sheet

inventory valuation, allocations of this kind are very dangerous for
decision making
Sell or Process Further
● Joint costs are irrelevant in decisions regarding what to do with a product from
the split- off point forward. Therefore, these costs should not be allocated to
end products for decision-making purposed
● With respect to sell or process further decisions, it is profitable to continue
processing a joint product after the split-off point so long as the incremental
revenue from such processing exceeds the incremental processing costs
incurred after the split-off point
Activity-Based Costing and Relevant Costs
● ABC can be used to help identify potential relevant costs for decision-making
purposes

● However, managers should exercise caution against reading more into this
“traceability” than really exists

● People have a tendency to assume that if a cost is traceable to a segment, then

the cost is automatically avoidable, which is untrue. Before making a decision,
managers must decide which of the potential relevant costs are actually
avoidable.