Relevant Costs for Decision

Making

Chapter Thirteen
Heba Sami-5200012

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Learning Objective 5

Determine the most

profitable use of a
constrained resource and
the value of obtaining
more of the constrained
resource.

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Key Terms and Concepts

When a limited resource

of some type restricts
the company’s ability to
satisfy demand, the
company is said to have
a constraint.

The machine or process

that is limiting overall
output is called the
bottleneck – it is the
constraint.

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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.

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Utilization of a Constrained Resource: An
Example

Ensign Company produces two products and

selected data are shown below:

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Utilization of a Constrained Resource

• 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?

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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

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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

I was just checking to make sure

you are with us.
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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.

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Quick Check ✔

With one minute of machine A1, we could

makegenerates
What 1 unit of Product 1, with
more profit a contribution
for the company,
margin
using oneof $24, or
minute of2machine
units of A1
Product 2, each
to process
with
Product a contribution
1 or margin
using one minute ofof $15. A1
machine
to process Product 2?= $30 > $24
2 × $15
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.

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Utilization of a Constrained Resource

The key is the contribution margin per unit of the

constrained resource.

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.

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Utilization of a Constrained Resource

The key is the contribution margin per unit of the

constrained resource.

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.

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Utilization of a Constrained Resource

Let’s see how this plan would work.

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Utilization of a Constrained Resource

Let’s see how this plan would work.

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Utilization of a Constrained Resource

Let’s see how this plan would work.

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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.

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

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Quick Check ✔

Colonial Heritage makes reproduction colonial

furniture from select hardwoods.

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

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Quick Check ✔

Colonial Heritage makes reproduction colonial

furniture from select hardwoods.

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
(2 × 600) + (10 × 100 ) = 2,200 > 2,000

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Quick Check ✔

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

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Quick Check ✔

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

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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

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Quick Check ✔

As before, Colonial Heritage’s supplier of hardwood will

The additional
only be wood
able to supply would
2,000 boardbe used
feet to make
this month.
tables.
Assume In this use,
the company each
follows board
the plan foot of
we have
additional
proposed. Upwood willmuch
to how allow the Colonial
should company to earn
Heritage be
willing
an to pay above
additional $20the
of usual price to obtain
contribution moreand
margin
hardwood? profit.
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero

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Managing Constraints

Finding ways to At the bottleneck itself:

process more • Improve the process
units through a • Add overtime or another shift
resource
bottleneck
• Hire new workers or acquire
more machines
• Subcontract production
• Reduce amount of defective
units produced
• Add workers transferred from
non-bottleneck departments

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Theory of Constraints

The Big Idea – Every process has a constraint (bottleneck) and focusing
improvement efforts on that constraint is the fastest and most effective
path to improved profitability.
• The Theory of Constraints is a methodology for identifying the most
important limiting factor (i.e. constraint) that stands in the way of
achieving a goal and then systematically improving that constraint until
it is no longer the limiting factor. In manufacturing, the constraint is
often referred to as a bottleneck.

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Types of Constraints (Internal/External

1. There is not sufficient demand in the market to match the supply

of your product.

2. There is not sufficient supply of your product to match the

demand in the market.

3.here are three types of internal constraints. The way

the equipment is used may be limiting output, the training
and/or mindset of people could be preventing the system
from producing more, or it could be the policy
of a company that is the real source of the system not being
able to achieve its goals.

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Five Focusing Steps to identify and
eliminate constraints
Step Objective

Identify Identify the current constraint (the single part of the

process that limits the rate at which the goal is achieved).

Exploit Make quick improvements to the throughput of the

constraint using existing resources (i.e. make the most of
what you have).

Subordinate Review all other activities in the process to ensure that

they are aligned with and truly support the needs of the
constraint.

Elevate If the constraint still exists (i.e. it has not moved),

consider what further actions can be taken to eliminate it
from being the constraint. Normally, actions are
continued at this step until the constraint has been
“broken” (until it has moved somewhere else). In some
cases, capital investment may be required.

Repeat The Five Focusing Steps are a continuous improvement

cycle. Therefore, once a constraint is resolved the next
constraint should immediately be addressed. This step is
a reminder to never become complacent – aggressively
improve the current constraint…and then immediately
move on to the next constraint.

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 Successful Theory of Constraints implementation will have the following

benefits:
• Increased profit (the primary goal of TOC for most companies)
• Fast improvement (a result of focusing all attention on one critical area –
the system constraint).
• Improved capacity (optimizing the constraint enables more product to be
manufactured)
• Reduced lead times (optimizing the constraint results in smoother and
faster product flow)
Reduced inventory (eliminating bottlenecks means there will be less work-in-
process)

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Learning Objective 6

Prepare an analysis
showing whether joint
products should be sold at
the split-off point or
processed further.

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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.

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Joint Products

Oil

Common
Joint
Production Gasolin
Inpu
Process e
t

Chemical
s

Split-
Off
Point
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Joint Products

Joint
Costs Oil
Separate Fina
Processin l
g
Sale
Common
Joint Final
Production Gasolin
Inpu Sale
Process e
t

Separate Fina
Chemical
Processin
s l
g
Sale
Split- Separate
Off Product
Point Costs
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The Pitfalls of Allocation

Joint costs are often

allocated to end products on
the basis of the relative
sales value of each product
or on 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.
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Sell or Process Further

Joint costs are irrelevant in decisions regarding

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

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.

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Sell or Process Further: An Example

• Sawmill, Inc. cuts logs from which unfinished

lumber and sawdust are the immediate joint
products.
• Unfinished lumber is sold “as is” or processed
further into finished lumber.
• Sawdust can also be sold “as is” to gardening
wholesalers or processed further into “presto-
logs.”

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Sell or Process Further

Data about Sawmill’s joint products includes:

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Sell or Process Further

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Sell or Process Further

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Sell or Process Further

Should we process the lumber further

and sell the sawdust “as is?”

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Activity-Based Costing and Relevant
Costs

ABC can be used to help identify potentially

relevant costs for decision-making purposes.

However, before making a

decision, managers must decide
which of the potentially relevant
costs are actually avoidable.

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End of Chapter 13

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