CHAPTER 12

Relevant Costs
for Decision
Making

Prepared by
Shannon Butler,
CPA, CA
Carleton University

© 2018 McGraw-Hill Education

 Foundational Exercise
Cane Company manufactures two products called Alpha and Beta that sell
for $120 and $80, respectively. Each product uses only one type of raw
material that costs $6 per pound. The company has the capacity to annually
produce 100,000 units of each product. Its unit costs for each product at this
level of activity are given below:
Alpha Beta
Direct materials $ 30 $12
Direct labour $ 20 $15
Variable manufacturing overhead $ 7 $ 5

Traceable fixed manufacturing overhead $ 16 $18

Variable selling expenses $ 12 $ 8

Common fixed expenses $ 15 $10
Cost per unit 100 $68

Assume that Cane expects to produce and sell 50,000 Alphas during the current
year. A supplier has offered to manufacture and deliver 50,000 Alphas to Cane for a
price of $80 per unit. If Cane buys 50,000 units from the supplier instead of making
those units, how much will profits increase or decrease?
3
 Make Buy
Cost of purchasing (50,000 units × $80) ........ $4,000,000
Direct materials (50,000 units × $30) ............. $1,500,000
Direct labor (50,000 units × $20) ................... 1,000,000
Variable manufacturing overhead
(50,000 units × $7) .................................... 350,000
Traceable fixed manufacturing overhead ......... 1,600,000
Total costs .................................................... $4,450,000 $4,000,000
Difference in favor of buying
Alphas from the supplier ..... $450,000

© 2018 McGraw-Hill Education 4

 Utilization of a Constrained
Resource
Learning Objective 3: Determine the most profitable use of a constrained
resource and the value of obtaining more of the constrained resource.

• Another decision situation that managers often face is the problem of

how to utilize a constrained resource.

• When a limited resource of some type restricts the company’s ability

to satisfy demand, the company is said to have a constraint.

• The theory of constraints (TOC) maintains that effectively managing

a constraint is important to the financial success of an organization.

• The challenge is deciding how to best utilize the constrained resource

to maximize the company’s profits.

© 2018 McGraw-Hill Education 5

 Contribution Margin in Relation
to a Constrained Resource
• When a constraint exists, a company should select a
product mix that maximizes the total contribution
margin earned since fixed costs usually remain
unchanged.
• A company should not necessarily promote those
products that have the highest unit contribution
margin.
• Rather, it should promote those products that earn the
highest contribution margin in relation to the
constraining resource.

© 2018 McGraw-Hill Education 6

Contribution Margin in Relation to a
Constrained Resource – An Example

Ensign Company produces two products and

selected data are shown below:
Product
1 2
Selling price per unit $ 60 $ 50
Less variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.

© 2018 McGraw-Hill Education 7

 Contribution Margin in Relation to a
Constrained Resource – An Example

• Machine A1 is the constrained resource

and is being used at 100% of its
capacity.
• There is excess capacity on all other
machines.
• Machine A1 has a capacity of 2,400
minutes per week.
Should Ensign focus its efforts on
Product 1 or Product 2?
© 2018 McGraw-Hill Education 8
 Contribution Margin in Relation to a
Constrained Resource – An Example

Step 1: Calculate the contribution margin per

constraining resources

• What is the constraining resources in this

example ?

© 2018 McGraw-Hill Education 9

 Quick Check 

How many units of each product can be

processed through Machine A1 in one
minute?

Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2.0 units
c. 2 units 1.0 unit
d. 2 units 0.5 unit

© 2018 McGraw-Hill Education 10

Contribution Margin in Relation to a
Constrained Resource – An Example

Ensign Company produces two products and

selected data are shown below:
Product
1 2
Selling price per unit $ 60 $ 50
Less variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.

© 2018 McGraw-Hill Education 11

 Quick Check 

How many units of each product can be

processed through Machine A1 in one
minute?

Answer:
Product 1 Product 2
b. 1 unit 2.0 units

© 2018 McGraw-Hill Education 12

 Quick Check 

What generates more profit for the company,

using one minute of machine A1 to process
Product 1 or using one minute of machine A1 to
process Product 2?

a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.

© 2018 McGraw-Hill Education 13

Contribution Margin in Relation to a
Constrained Resource – An Example

Ensign Company produces two products and

selected data are shown below:
Product
1 2
Selling price per unit $ 60 $ 50
Less variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.

© 2018 McGraw-Hill Education 14

 Quick Check 
With one minute of machine A1, we could
What
make generates
1 unit of more profit
Product 1, for
withthea company,
contribution
using one minute
margin of $24, of
ormachine A1Product
2 units of to process
2, each
Productwith
1 orausing one minute
contribution of machine
margin of $15.A1 to
process Product 2?
2 × $15 = $30 > $24
Answer:
b. Product 2

© 2018 McGraw-Hill Education 15

 CM in Relation to a Constrained
Resource – An Example

• The key is the contribution margin per

unit of the constrained resource.
Product
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.
Contribution margin per minute $ 24 $ 30

Product 2 should be emphasized. Provides more

valuable use of the constrained resource machine A1,
yielding a contribution margin of $30 per minute as
opposed to $24 for Product 1.
© 2018 McGraw-Hill Education 16
 CM in Relation to a Constrained
Resource – An Example

Step 1: Calculate the contribution margin

per constraining resources

Step 2: Based on CM per constraining

resources choose the product mix

© 2018 McGraw-Hill Education 17

 CM in Relation to a Constrained
Resource – An Example
• The key is the contribution margin per
unit of the constrained resource.
Product
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.
Contribution margin per minute $ 24 $ 30

If there are no other considerations, the best

plan would be to produce to meet current
demand for Product 2 and then use remaining
capacity to make Product 1.
© 2018 McGraw-Hill Education 18
CM in Relation to a Constrained
Resource – An Example
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)
(2400 min.)
Weekly demand for Product 2
(Given) 2 200 units
Time required per unit × 0.50 min.
Total time required to make
Product 2 1 100 min.

© 2018 McGraw-Hill Education 19

CM in Relation to a Constrained
Resource – An Example
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)
(2400 min)
Weekly demand for Product 2 2 200 units
Time required per unit × 0.50 min.
Total time required to make
Product 2 1 100 min.

Total time available 2 400 min.

Time used to make Product 2 1 100 min.
Time available for Product 1 1 300 min.

© 2018 McGraw-Hill Education 20

CM in Relation to a Constrained
Resource – An Example
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.
Time required per unit ÷ 1.00 min.
Production of Product 1 1,300 units

© 2018 McGraw-Hill Education 21

 CM in Relation to a Constrained
Resource – An Example

Step 1: Calculate the contribution margin

per constraining resources

Step 2: Based on CM per constraining

resources choose the product mix

Step 3: Calculate the total CM based on

selected product mix

© 2018 McGraw-Hill Education 22

 CM in Relation to a Constrained
Resource – An Example

According to the plan, we will produce 2,200

units of Product 2 and 1,300 of Product 1.
Our contribution margin looks like this.

Product 1 Product 2
Production and sales (units) 1,300 2,200
Contribution margin per unit $ 24 $ 15
Total contribution margin $ 31,200 $ 33,000

The total contribution margin for Ensign is $64,200.

© 2018 McGraw-Hill Education 23

 Quick Check 
Colonial Heritage makes reproduction colonial
furniture from select hardwoods.
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only

be able to supply 2,000 board feet this month. Is
this enough hardwood to satisfy demand?
a. Yes
b. No
© 2018 McGraw-Hill Education 24
 Quick Check 
Colonial Heritage makes reproduction colonial
furniture from select hardwoods.
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only

be able to supply 2,000 board feet this month.
Is this enough hardwood to satisfy demand?
Answer:
b. No (2 × 600) + (10 × 100 ) = 2,200 > 2,000
© 2018 McGraw-Hill Education 25
 Quick Check 
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only

be able to supply 2,000 board feet this month.
What plan would maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables

© 2018 McGraw-Hill Education 26

 Quick Check 
Chairs Tables
Selling price Chairs Tables
$ 80 $ 400
Selling price per unit $80 $400
Variable cost 30 200
Variable cost per unit $30 $200
Board feetContribution
per unit margin2 $ 1050 $ 200
Board feet
Monthly demand 600 100 2 10
CM per board foot $ 25 $ 20
The company’sProduction
supplierofof hardwood600
chairs
will only
be able to supply 2,000
Board board feet this
feet required 1,200month.
What plan would maximize
Board profits? 800
feet remaining
Board feet per table 10
Answer: Production of tables 80

b. 600 chairs and 80 tables

© 2018 McGraw-Hill Education 27

 Quick Check 
As before, Colonial Heritage’s supplier of
hardwood will only be able to supply 2,000 board
feet this month. Assume the company follows the
plan we have proposed. Up to how much should
Colonial Heritage be willing to pay above the usual
price to obtain more hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero

© 2018 McGraw-Hill Education 28

 Quick Check 
As before, Colonial Heritage’s supplier of
The additional
hardwood wood
will only would
be able be used
to supply to board
2,000 make
feet tables.
this month. Assume
In this use,the company
each boardfollows
foot ofthe
plan we havewood
additional proposed.
will Up to how
allow themuch shouldto
company
Colonial
earn Heritage be$20
an additional willing to pay above the
of contribution usual
margin
price to obtain more hardwood?
and profit.
Answer:
c. $20 per board foot

© 2018 McGraw-Hill Education 29

 Managing Constraints
• Profits can be increased by effectively managing
constraint. One aspect of managing constraints is to
decide how best to utilize them.
• Managers should focus on managing bottlenecks and find
ways to increase the capacity at the bottlenecks, which
can be accomplished in a number of ways:
• Improve the process
• Add overtime or another shift
• Hire new workers or acquire more machines
• Subcontract production
• Reduce amount of defective units produced
• Add workers transferred from non-bottleneck
departments
© 2018 McGraw-Hill Education 30
 The Problem of Multiple
Constraints

What if a firm has more than one

potential constraint?
How would it find the right
combination of products to produce?

The right combination of products or “mix” of

products can be found using a quantitative
method called linear programming.
© 2018 McGraw-Hill Education 31
 Appendix 12A

Pricing Products and

Services

© 2018 McGraw-Hill Education 32

 Cost-Plus Pricing
Learning Objective 4: Compute selling prices based on costs.

The usual approach in pricing is to mark up cost.

A product’s markup is the difference between its
selling price and its cost. The markup is usually
expressed as a percentage of cost.
Selling Price = Cost + (Markup percentage × Cost)
Cost-Plus Pricing: A pricing method in which a
predetermine markup is applied to a cost base to
determine the target selling price.
© 2018 McGraw-Hill Education 33
 Cost-Plus Pricing
• There are two key issues when the cost-plus approach to
pricing is used.
• First, what costs are relevant to the pricing decision?
• Second, how should the markup be determined?

• Two approaches can be used:

• Setting a Target Selling Price Using the Absorption Costing
Approach
• Setting a Target Selling Price Using the Variable Costing
Approach

© 2018 McGraw-Hill Education 34

 1) Setting a Target Selling
Price – Absorption Costing

Under the absorption approach to

cost-plus pricing, the cost base is
the absorption costing unit product
cost rather than the variable cost.

Absorption unit Cost = DM +DL+ V.MOH + F.MOH

© 2018 McGraw-Hill Education 35

 Setting a Target Selling Price
– Absorption Costing
Here is information provided by the management
of Ritter Company.
Per Unit Total
Direct materials $ 6
Direct labour 4
Variable manufacturing overhead 3
Fixed manufacturing overhead $ 70,000
Variable S & A expenses 2
Fixed S & A expenses 60,000

Assuming Ritter will produce and sell 10,000

units of the new product, and that Ritter
typically uses a 50% markup percentage, let’s
determine the unit product cost.
© 2018 McGraw-Hill Education 36
 Setting a Target Selling Price
– Absorption Costing
Per Unit
Direct materials $ 6
Direct labour 4
Variable manufacturing overhead 3
Fixed manufacturing overhead 7
Unit product cost $ 20

($70,000 ÷ 10,000 units = $7 per unit)

Ritter has a policy of marking up unit product costs

by 50%. Let’s calculate the target selling price.

© 2018 McGraw-Hill Education 37

 Setting a Target Selling Price
– Absorption Costing
Ritter would establish a target selling price to
cover selling, general, and administrative
expenses and contribute to profit $30 per unit.
Per Unit
Direct materials $ 6
Direct labour 4
Variable manufacturing overhead 3
Fixed manufacturing overhead 7
Unit product cost $ 20
50% markup 10
Target selling price $ 30

© 2018 McGraw-Hill Education 38

 Determining the Markup
Percentage
The markup percentage can be based on
an industry “rule of thumb,” company
tradition, or it can be explicitly calculated.
The equation to calculate the markup
percentage is:

© 2018 McGraw-Hill Education 39

Determining the Markup
Percentage

Let’s assume that Ritter must invest

$100,000 in the product and market
10,000 units of product each year. The
company requires a 20% ROI on all
investments. Let’s determine Ritter’s
markup percentage on absorption
cost.

© 2018 McGraw-Hill Education 40

 Determining the Markup
Percentage

Markup %
(20% × $100,000) + ($2 × 10,000 + $60,000)
on absorption = 10,000 × $20
cost
Total fixed SG&A
Variable SG&A per unit

Markup %
($20,000 + $80,000)
on absorption = $200,000
= 50%
cost

© 2018 McGraw-Hill Education 41

 Problems with the Absorption
Costing Approach

The absorption costing approach assumes

that customers need the forecasted unit
sales and will pay whatever price the
company decides to charge. This is flawed
logic simply because customers have a
choice.

© 2018 McGraw-Hill Education 42

 Problems with the Absorption
Costing Approach
Let’s assume that Ritter sells only 7,000 units at $30
per unit, instead of the forecasted 10,000 units.
Here is the income statement.
RITTER COMPANY
Income Statement
For the Year Ended December 31, 2013
Sales (7,000 units × $30) $ 210,000
Cost of goods sold (7,000 units × $23) 161,000
Gross margin 49,000
SG&A expenses 74,000
Net operating loss $ (25,000)

$ (25,000)
ROI = = -25%
$ 100,000
© 2018 McGraw-Hill Education 43
 Problems with the Absorption
Costing Approach
Let’s assume that Ritter sells only 7,000 units at $30
per unit, instead of the forecasted 10,000 units.
Absorption costing approach to pricing is
Here is the income statement.
a safe approach only if
RITTER COMPANY
customers choose
to buy at least as many
Income Statementunits as managers

forecasted they would buy.

For the Year Ended December 31, 2013
Sales (7,000 units × $30) $ 210,000
Cost of goods sold (7,000 units × $23) 161,000
Gross margin 49,000
SG&A expenses 74,000
Net operating loss $ (25,000)

$ (25,000)
ROI = = -25%
$ 100,000
© 2018 McGraw-Hill Education 44
 2) Setting a Target Selling Price
– Variable Costing
• Some companies use a variable costing approach
to determine the target selling price based on
either variable manufacturing costs or total
variable costs.
• The key advantages of the variable costing
approach are:
1. It is consistent with cost-volume-profit analysis
and
2. It avoids the need to arbitrarily allocate
common fixed costs to specific products.
© 2018 McGraw-Hill Education 45
2) Setting a Target Selling Price
– Variable Costing

© 2018 McGraw-Hill Education 46

 EXERCISE 12A–1
Nolan Limited is considering introducing a new product. Management has
gathered the following information:
Number of units to be produced and sold each year 10,000
Unit product cost $ 16

Projected annual selling and administrative expenses $ 40,000

Estimated investment required by the company $400,000

Desired return on investment (ROI) 8%

Required:
• Assume that the $16 unit product cost includes $3 per unit for fixed
manufacturing overhead based on producing and selling 10,000 units
each year. Also assume that $26,000 of the total selling and administrative
expenses of $40,000 is fixed. The remainder is variable. Use the total
variable costing approach to calculate the markup the company will have
to use to achieve the desired ROI.

© 2018 McGraw-Hill Education 47

2. Mark-up percentage based on total variable costs:
= [(8% × $400,000) + $26,000 + $30,000*] ÷ (10,000 × $14.40**)
= $88,000 ÷ $144,000
= 61.11%
*Fixed manufacturing overhead: $3 × 10,000 = $30,000
** Total variable costs per unit: ($16–$3) + ($40,000–$26,000)/10,000 =
$14.40

© 2018 McGraw-Hill Education 48

 Setting a Target Selling Price for
Service Companies Using Time and
Materials Pricing

Time and material pricing: A pricing

method, often used in service firms, in
which two pricing rates are established-
one based on direct labour time and the
other based on direct material used.

© 2018 McGraw-Hill Education 49