12-1

MANAGERIAL
ACCOUNTING
Tenth Canadian Edition
GARRISON, LIBBY, WEBB

Relevant Costs for Decision Making

Chapter 12

Robert G. Ducharme, MAcc, CPA, CA

University of Waterloo, School of Accounting and Finance
Managerial Accounting
 12-2

Identifying Relevant Costs

A relevant cost is a cost that differs between
alternatives.
An avoidable cost 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:
 Sunk costs.

 Future costs that do not differ between the alternatives.


Managerial Accounting
 12-3

Relevant Cost Analysis:

A 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.
Managerial Accounting
 12-4

Total and Differential Cost Approaches

The management of a company is considering a new labour saving
machine that rents for $3,000 per year. Data about the company’s
annual sales and costs with and without the new machine are:

Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labour (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
Total fixed expenses 62,000 65,000 (3,000)
Operating income $ 18,000 $ 30,000 12,000

Managerial Accounting
 12-5

Total and Differential Cost Approaches

As you can see, the only costs that differ between the alternatives are
the direct labour costs savings and the increase in fixed rental costs.
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labour (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
We can efficiently analyze the decision by 62,000
Other
Rent on new machine
-
62,000
3,000
-
(3,000)
looking at the different costs and revenues
Total fixed expenses
Operating income
$
62,000
18,000 $
65,000
30,000
(3,000)
12,000

and arrive at the same solution.

Net Advantage to Renting the New Machine
Decrease in direct labour costs (5,000 units @ $3 per unit) $ 15,000
Increase in fixed rental expenses (3,000)
Net annual cost saving from renting the new machine $ 12,000

Managerial Accounting
 12-6

Total and Differential Cost Approaches

Using the differential approach is desirable for

two reasons:
1. Only rarely will enough information be
available to prepare detailed income
statements for both alternatives.
2. Mingling irrelevant costs with relevant costs
may cause confusion and distract attention
away from the information that is really
critical.

Managerial Accounting
 12-7

Adding/Dropping Segments

Due
Due to
to the
the declining
declining popularity
popularity of
of digital
digital watches,
watches,
Lovell
Lovell Company’s
Company’s digital
digital watch
watch line
line has
has not
not reported
reported
aa profit
profit for
for several
several years.
years. Lovell
Lovell is
is considering
considering
dropping
dropping this
this product
product line.
line.

DECISION
DECISION RULERULE
Lovell
Lovell should
should drop
drop the
the digital
digital watch
watch segment
segment only
only ifif its
its
profit
profit would
would increase.
increase. This
This would
would only
only happen
happen ifif the
the
fixed
fixed cost
cost savings
savings exceed
exceed the
the lost
lost contribution
contribution margin.
margin.

Managerial Accounting
 12-8

Adding/Dropping Segments

Segment Income Statement

Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
Managerial Accounting
 12-9

Adding/Dropping Segments
Investigation
Investigation has revealed
hasSegment that
that total
revealedIncome total fixed
fixed general
Statement general
factory
factory overhead and
Digital
overhead general
Watches
and general
Sales $ 500,000
administrative
administrative expenses
Less: variableexpenses
would not be affected if
expenses would not be affected if
the
the digital watch
watch line
line is
digitalmanufacuring
Variable dropped.
iscosts
dropped. The
The fixed
$ 120,000 fixed
general factory
factory overhead
generalshipping
Variable overhead and
costs and general
general
5,000
Commissions 75,000 200,000
administrative
administrative expenses assigned to this
expenses assigned to this product product
Contribution margin $ 300,000
would
would be
be reallocated
Less: fixed expenses to
reallocated to other
other product
product lines.
lines.
General factory overhead $ 60,000
The
The equipment
equipment
Salary of line manager
used
used to
to manufacture
manufacture
90,000
digital
digital
watches
watches has
hasof
Depreciation no resale
resale value
noequipment value or alternative
alternative use.
or50,000 use.
Advertising - direct 100,000
Should
Should
Rent - factory
Lovell
Lovell retain
space retain or drop
or70,000
drop
Generalthe
the digital
digital
admin. watch
watch segment?
expenses segment?
30,000 400,000
Net operating loss $ (100,000)
Managerial Accounting
 12-10

Adding/Dropping Segments
A Contribution Margin Approach

Contribution Margin
Solution
Contribution margin lost if digital
  watches are dropped $ (300,000)
Less fixed costs that can be avoided
Salary of the line manager $ 90,000
Advertising - direct 100,000
Rent - factory space 70,000 260,000
Net disadvantage $ (40,000)
RRe
ettaai
inn

Managerial Accounting
 12-11
Adding/Dropping Segments
Comparative Income Approach
Comparative Income Approach
Solution
IfIf the
the digital
digital watch
watch lineline is
is Keep Drop
dropped,
dropped, the the company
company Digital Digital
gives Watches Watches Difference
gives up up its
its contribution
contribution
Sales $ 500,000 $ - $ (500,000)
margin.
margin.
Less variable expenses: -
Manufacturing
On expenses 120,000 - 120,000
On the the other
other hand,
hand, the the general
general factory
factory
Shipping 5,000 - 5,000
overhead
overhead would
would be
be the
the same.
same. So
So this
this
Commissions 75,000 - 75,000
Total variable
cost
cost really isn’t relevant.
really isn’t relevant. 200,000
expenses - 200,000
Contribution margin 300,000 - (300,000)
But
Less fixedBut we
we wouldn’t
wouldn’t need
expenses: need aa manager
manager forfor
General factory overhead
the
the product
product line anymore. 60,000
line anymore. 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000 - 100,000
Rent - factory space
IfIf the
the digital
digital watch
watch line
line is
is dropped,
dropped, thethe70,000
net
net book value -
book value 70,000
General admin. expenses 30,000 30,000 -
of
of the
the equipment
equipment would
would be
be written
written off.
off. The
The
Total fixed expenses 400,000 140,000 260,000
depreciation
depreciation
Net operating loss that would have
that would have been been taken will flow
taken will flow
$ (100,000) $ (140,000) $ (40,000)
through
through the
the income
income statement
statement as
as aa loss
loss instead.
instead.
Managerial Accounting
 12-12
Adding/Dropping Segments
Comparative Income Approach
Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000 - 100,000
Rent - factory space 70,000 - 70,000
General admin. expenses 30,000 30,000 -
Total fixed expenses 400,000 140,000 260,000
Net operating loss $ (100,000) $ (140,000) $ (40,000)
Managerial Accounting
 12-13

Adding/Dropping Segments
Beware of Allocated Fixed Costs

Why should we The answer lies in the Our allocations can

keep the digital way we allocate make a segment look
watch segment common fixed costs to less profitable than it
when it’s showing our products. really is.
a $100,000 loss?

Managerial Accounting
 12-14

Adding & Dropping Segments

 focus on relevant costs and benefits
 contribution margin foregone/lost
 fixed costs avoided
 CM lost/gained on other products/segments
 consider other qualitative factors
 do not focus on irrelevant costs and benefits
 ignore common fixed costs that will continue to be
incurred
 ignore sunk costs (eg. depreciation, amortization of
goodwill, …)
 watch for opportunity costs

Managerial Accounting
 12-15

Adding & Dropping Segments

 Decision Rule:

 Keep if: CM lost (all products/segments) > fixed costs

avoided + CM gained (other products/segments)

 Drop if: CM lost (all products/segments) < fixed costs

avoided + CM gained (other products/segments)

Managerial Accounting
 12-16

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 vertical integration

advantages disadvantages
Smoother flow
of parts and Companies may fail to take
materials advantage of suppliers who
can create economies of
Better quality
scale advantage by pooling
control
demand from numerous
companies.
Realize profits
Managerial Accounting
 12-17

The Make or Buy Decision: An Example

 Essex Company manufactures part 4A that is used in

one of its products.
 The unit product cost of this part is:

Direct materials $ 9
Direct labour 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary 2
General factory overhead 10
Unit product cost $ 30

Managerial Accounting
 12-18

The Make or Buy Decision


 The special equipment used to manufacture part
4A has no resale value.
 The total amount of general factory overhead,

which is allocated on the basis of direct labour
hours, would be unaffected by this decision.
 The $30 unit product cost is based on 20,000

parts produced each year.
 An outside supplier has offered to provide the

20,000 parts at a cost of $25 per part.

Should
Should we
we accept
accept the
the supplier’s
supplier’s offer?
offer?

Managerial Accounting
 12-19

The Make or Buy Decision

Cost
The
The special
special equipment
equipment has has no
no Per
resale
resale value
value and
and is
is aa sunk
sunk cost.
cost. Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials $ 9 180,000

Direct labour 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

Not
Not avoidable;
avoidable; irrelevant.
irrelevant. IfIf the
the product
product is
is dropped,
dropped, itit will
will be
be
reallocated
reallocated toto other
other products.
products.

Should we make or buy part 4A?

Managerial Accounting
 12-20

The Make or Buy Decision: Opportunity Cost

An opportunity cost is the benefit that is foregone as

a result of pursuing some course of action.
Opportunity costs are not actual dollar outlays and
are not recorded in the formal accounts of an
organization.

How would this concept potentially relate to the

Essex Company?

e.g., if the part is outsourced (purchased) can the unused

manufacturing factory space no longer necessary be rented for
additional income?
Managerial Accounting
 12-21

Make vs. Buy Decisions

 Focus on:
 Costs that can be avoided by outsourcing (i.e., internal
production costs)
 Costs of purchasing from outside supplier

 Ignore fixed costs that will continue to be incurred

and those that are “sunk”

 Watch for opportunity costs

 Consider qualitative factors

Managerial Accounting
 12-22

Make vs. Buy Decisions

 Decision rule:

 Make if: (incremental costs of making + opportunity costs)

< outside purchase price

 Buy if: (incremental costs of making + opportunity costs)

> outside purchase price

Managerial Accounting
 12-23

Special Orders: Key Terms and Concepts

A special order is a one-time order that is not

considered part of the company’s normal
ongoing business.

When analyzing a special order only the

incremental costs and benefits are relevant.

Managerial Accounting
 12-24

Special Orders: An Example

 Jet, Inc. makes a single product whose normal selling


price is $20 per unit.
 A foreign distributor offers to purchase 3,000 units for

$10 per unit.
 This is a one-time order that would not affect the

company’s regular business.
 Annual capacity is 10,000 units, but Jet, Inc. is

currently producing and selling only 5,000 units.

Should Jet accept the offer?

Managerial Accounting
 12-25

Special Orders: An Example

(current Jet income statement before effects of special order)

Jet, Inc.
Contribution Income Statement
Revenue (5,000 × $20) $ 100,000
Variable costs:
Direct materials $ 20,000
Direct labour 5,000
Manufacturing overhead 10,000 $8 variable cost
Marketing costs 5,000
Total variable costs 40,000
Contribution margin 60,000
Fixed costs:
Manufacturing overhead $ 28,000
Marketing costs 20,000
Total fixed costs 48,000
Net operating income $ 12,000

Managerial Accounting
 12-26

Special Orders: An Example

If Jet accepts the offer, operating income will increase

by $6,000.

Increase in revenue (3,000 × $10) $ 30,000

Increase in costs (3,000 × $8 variable cost) 24,000
Increase in net income $ 6,000

Note: This answer assumes that fixed costs are

unaffected by the order and that variable marketing
costs must be incurred on the special order.
Managerial Accounting
 12-27

Special Order Decisions

 focus on relevant costs and benefits
 if excess capacity exists, focus on:
 incremental revenues from the order
 incremental costs of filling the order (variable & fixed)
 if operating at capacity, also consider opportunity
cost of filling the order
 do not focus on irrelevant costs and benefits
 ignore allocated common costs, sunk costs and
other costs unaffected by the special order
 consider qualitative factors

total relevant costs = incremental costs + opportunity costs

Managerial Accounting
 12-28

Special Order Decisions

 Decision rule:

 Accept if: incremental revenues > incremental costs +

opportunity costs

 Reject if: incremental revenues < incremental costs +

opportunity costs

Managerial Accounting
 12-29

Joint Costs and Joint Products


 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
joint products.
products


 The point in the manufacturing process where
each joint product can be recognized as a
separate product is called the split-off
split-off point.
point

Managerial Accounting
 12-30

Joint Costs and Joint Products

Joint Products
Joint
Costs Oil
Separate Final
Processing Sale

Common
Joint Final
Production Gasoline
Input Sale
Process

Separate Final
Chemicals
Processing
Sale

Split-Off Separate
Point Product
Costs
Managerial Accounting
 12-31

Joint Products: Sell or Process Further

 Joint costs are irrelevant in decisions regarding what to

do with a product from the split-off point forward.

  ignore joint allocated product costs (which are

usually allocated to end products on the basis of the
relative sales value or some other basis). Although
allocation is needed for some purposes such as balance
sheet inventory valuation, allocations of this kind are
very dangerous for decision making.

 It will always be profitable to continue processing a joint

product after the split-off point so long as the
incremental revenue exceeds the incremental
processing costs incurred after the split-off point.
Managerial Accounting
 12-32

Sell or Process Further: An Example


 Sawmill,
Sawmill, Inc.
Inc. cuts
cuts logs
logs from
from which
which unfinished
unfinished
lumber
lumber andand sawdust
sawdust are are the
the immediate
immediate jointjoint
products.
products.
 Unfinished
 Unfinished lumber
lumber is is sold
sold “as
“as is”
is” or
or processed
processed
further
further into
into finished
finished lumber.
lumber.
 Sawdust
 Sawdust can can also
also bebe sold
sold “as
“as is”
is” to
to gardening
gardening
wholesalers
wholesalers or or processed
processed further
further into
into “presto-
“presto-
logs.”
logs.”

Managerial Accounting
 12-33

Sell or Process Further

Data about Sawmill’s joint products includes:

Per Log
Lumber Sawdust
Sales value at the split-off point $ 140 $ 40

Sales value after further processing 270 50

Allocated joint product costs 176 24
Cost of further processing 50 20

Managerial Accounting
 12-34

Sell or Process Further

Analysis of Sell or Process Further

Per Log
Lumber Sawdust

Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing 50 20
Profit (loss) from further processing $ 80 $ (10)

Should we process the lumber further

and sell the sawdust “as is?”

Managerial Accounting
 12-35

Joint Products: Sell Now vs. Process Further

 focus on relevant costs and benefits

 incremental revenues from further processing
 incremental costs of further processing

 do not focus on irrelevant costs and benefits

 ignore joint product costs (which are allocated common
costs)
 ignore sunk costs

 consider qualitative factors

Managerial Accounting
 12-36

Joint Products: Sell Now vs. Process Further

 Decision rule:

 Process further if: Incremental revenues > incremental

costs of further processing

 Sell at split-off if: Incremental revenues < incremental

costs of further processing

Managerial Accounting
 12-37

Utilization of 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.
Managerial Accounting
 12-38

Utilization of a Constrained Resource: An Example

Ensign Company produces two products and selected data

are shown below:

Managerial Accounting
 12-39

Utilization of a Constrained Resource


 Machine
Machine A1A1 is
is the
the constrained
constrained resource
resource and
and is
is
being
being used
used atat 100%
100% ofof its
its capacity.
capacity.
 There
 There is
is excess
excess capacity
capacity onon all
all other
other
machines.
machines.
 Machine
 Machine A1A1 has
has aa capacity
capacity of of 2,400
2,400 minutes
minutes
per
per week.
week.

Should
Should Ensign
Ensign focus
focus its
its efforts
efforts on
on
Product
Product 11 or
or Product
Product 2?2?

Managerial Accounting
 12-40

Utilization of a Constrained Resource

The key is the contribution margin per unit of the

constrained resource.

Product 2 should be emphasized.

IfIf there
there are
are no
no other
other considerations,
considerations, the
the best
best plan
plan would
would
be
be to to produce
produce to
to meet
meet current
current demand
demand for
for Product
Product 22 and
and
then
then use
use remaining
remaining capacity
capacity to
to make
make Product
Product 1.
1.
Managerial Accounting
 12-41

Utilization of a Constrained Resource

Let’s see how this plan would work.

Allocating
Allocating Our
Our Constrained
Constrained Resource
Resource (Machine
(Machine A1)
A1)

Weekly
Weeklydemand
demand for
for Product
Product22 2,200
2,200 units
units
Time
Time required
required per
per unit
unit ×× 0.50
0.50 min.
min.
Total
Total time
time required
required to
to make
make
Product
Product22 1,100
1,100 min.
min.

Total
Total time
time available
available 2,400
2,400 min.
min.
Time
Time used
used to
to make
make Product
Product22 1,100
1,100 min.
min.
Time
Time available
available for
for Product
Product11 1,300
1,300 min.
min.
Time
Time required
required per
per unit
unit ÷÷ 1.00
1.00 min.
min.
Production
Production of ofProduct
Product11 1,300
1,300 units
units

Managerial Accounting
 12-42

Utilization of a Constrained Resource

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.

Managerial Accounting
 12-43

Utilization of a Constrained Resource

 Could be caused by short-term constraints on

production inputs (labour, machine hours, etc.)

 Contribution per unit of output no longer appropriate

 Calculate contribution per unit of the scarce resource

(labour hours, machine hours, etc.)

Managerial Accounting
 12-44

Managing Constraints

“Theory of Constraints”
Finding ways to At the bottleneck itself:
process more units • Improve the process
through a resource • Add overtime or another shift
bottleneck
• Hire new workers or acquire
more machines
• Subcontract production
• Reduce amount of defective
units produced
• Add workers transferred from
non-bottleneck departments

Managerial Accounting
 12-45

Pricing Products and Services

Appendix 12A

Managerial Accounting
 12-46

Pricing Decisions
 Cost + mark-up approach if you are a price setter (i.e., not a price taker)
 How to determine mark-up?
 ROI approach
 Rule of thumb
 Industry norms (if you can determine them)
 Problems with ROI approach?
 assumes that customers need forecasted unit sales and will pay whatever
price the company decides to charge
 however, customers have a choice; if the price is too high they can buy from
a competitor or choose not to buy at all
 Target costing approach. How does it differ from the cost plus approach to
pricing?
 cost plus approach: start with a cost base and apply a predetermined
markup to arrive at target selling price
 selling price = cost + (markup percentage × cost)
 target costing: start with expected selling price less desired profit to
determine the maximum allowance cost
 target cost = anticipated selling price – desired profit

Managerial Accounting
 12-47

Setting a Target Selling Price

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.
Managerial Accounting
 12-48

Setting a Target Selling Price

Ritter would establish a target selling price of $30

per unit to cover selling, general, and
administrative expenses and contribute to profit.
Per Unit
Direct materials $ 6
Direct labour 4
Variable manufacturing overhead 3
Fixed manufacturing overhead 7
($70,000 ÷ 10,000 units = $7 per unit)
Unit product cost $ 20
50% markup 10
Target selling price $ 30
Managerial Accounting
 12-49

Absorption Costing Approach:

Determining the Markup Percentage
Let’s
Let’s assume
assume that
that Ritter
Ritter must
must invest
invest $100,000
$100,000 in
in the
the product
product
and
and market
market 10,000
10,000 units
units of
of product
product each
each year.
year. The
The company
company
requires
requires aa 20%
20% ROI
ROI on
on all
all investments.
investments. Let’s
Let’s determine
determine
Ritter’s
Ritter’s markup
markup percentage
percentage on on absorption
absorption cost.
cost.
Markup %
(Required ROI × Investment) + SG&A expenses
on absorption = Unit sales × Unit product cost
cost
Markup %
on absorption = (20% × $100,000) + ($2 × 10,000 + $60,000)
cost 10,000 × $20
Variable SG&A per unit Total fixed SG&A

Markup %
($20,000 + $80,000)
on absorption = $200,000 = 50%
cost
Managerial Accounting
 12-50

Reasons for Using Target Costing

Target cost = Anticipated selling price – Desired profit

Two characteristics of prices and product costs:
1. The market (i.e., supply and demand) determines price.
2. Most of the cost of a product is determined in the design
stage.

Target
Target costing
costing was
was developed
developed in
in recognition
recognition of
of
these
these two
two characteristics.
characteristics.
Target costing begins the product development
process by focusing on cost reduction efforts in the
product design stage of production and recognizing
and responding to existing market prices.
Managerial Accounting
 12-51

Target Costing

Handy
Handy Appliance
Appliance feels
feels there
there is
is aa niche
niche for
for aa
hand
hand mixer
mixer with
with certain
certain features.
features. The
The
Marketing
Marketing Department
Department believes
believes that
that aa price
price ofof
$30
$30 would
would be
be about
about right
right and
and that
that about
about
40,000
40,000 mixers
mixers could
could be
be sold.
sold. An
An investment
investment of of
$2,000,000
$2,000,000 isis required
required to
to gear
gear up up for
for
production.
production. The
The company
company requires
requires aa 15%
15% ROIROI
on
on invested
invested funds.
funds.
Let
Let see
see how
how we
we determine
determine the
the target
target cost.
cost.
Managerial Accounting
 12-52

Target Costing

Projected sales ( 40,000 units × $30 ) $ 1,200,000

Desired profit ( $2,000,000 × 15% ) 300,000
Target cost for 40,000 mixers $ 900,000

Target cost per mixer ( $900,000 ÷ 40,000 ) $ 22.50

Each functional area within Handy Appliance

would be responsible for keeping its actual costs
within the target established for that area.

Managerial Accounting
 12-53

End of Chapter 12

Managerial Accounting