CHAPTER 3

Decision Making:
Relevant Costs and
Benefits

Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Decision Making – Six Key
Concepts
Key Concept #1
Every decision involves choosing from among at least two
alternatives. Therefore, THE FIRST STEP IN
DECISION-MAKING IS TO DEFINE THE
ALTERNATIVES BEING CONSIDERED.
Key Concept #2
Once you have defined the alternatives, YOU NEED TO
IDENTIFY THE CRITERIA FOR CHOOSING
AMONG THEM.
•Relevant costs and relevant revenues should be
considered when making decisions.
•Irrelevant costs and irrelevant revenues should be ignored
when making decisions.
Decision Making – Six Key Concepts
Key Concept #3

The key to effective decision making is DIFFERENTIAL

ANALYSIS – FOCUSING ON THE FUTURE COSTS AND
REVENUES THAT DIFFER BETWEEN THE
ALTERNATIVES. Everything else is irrelevant and should be
ignored.
•A future cost that differs between any two alternatives is
known as a differential cost.
•A future revenue that differs between any two alternatives is
known as a differential revenue.
•An incremental cost is an increase in cost between two
alternatives.
•An avoidable cost is a cost that can be eliminated by
Decision Making – Six Key
Concepts
Key Concept #4
SUNK COSTS ARE ALWAYS IRRELEVANT when
choosing among alternatives.
•A sunk cost is a cost that has already been incurred and
cannot be changed regardless of what a manager decides to
do.

Key Concept #5
FUTURE COSTS AND REVENUES THAT DO NOT
DIFFER BETWEEN ALTERNATIVES ARE
IRRELEVANT to the decision-making process.
Decision Making – Six Key
Concepts
Key Concept #6

OPPORTUNITY COSTS ALSO NEED TO BE

CONSIDERED WHEN MAKING DECISIONS.
•An opportunity cost is the potential benefit that is given
up when one alternative is selected over another.
Relevant Information
Information is relevant to a decision
problem when . . .
1. It has a bearing on the future,
2. It differs among competing alternatives.

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Identifying Relevant
Costs and Benefits
Sunk costs
Costs that have already been incurred. They do not affect
any future cost and cannot be changed by any current or
future action.

Sunk costs are irrelevant to decisions.

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Analysis of Special Decisions
Let’s take a close look at some special decisions faced by
many businesses.

We just received
An unexpected
a special order. Do order arrived from
you think we should a potential
accept it? customer.

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Accept or Reject a Special Order
A travel agency offers Worldwide Airways
$150,000 for a round-trip flight from Hawaii to
Japan on a jumbo jet.
Worldwide usually gets $250,000 in revenue from
this flight.
The airline is not currently planning to add any
new routes and has two planes that are idle and
could be used to meet the needs of the agency.
The next screen shows cost data developed by
managerial accountants at Worldwide.

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Accept or Reject a Special Order

Worldwide will save $5,000 in reservation

and ticketing costs if the charter is accepted.
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Accept or Reject a Special Order

Since the charter will contribute to fixed costs and

Worldwide has idle capacity, the company should
accept the flight.

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Accept or Reject a Special Order
What if Worldwide had no excess capacity? If Worldwide
adds the charter, it will have to cut its least profitable route
that currently contributes $80,000 to fixed costs and
profits. Should Worldwide still accept the charter?

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Accept or Reject a Special Order

Worldwide has no excess capacity, so it

should reject the special charter.
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Accept or Reject a Special Order
With excess capacity(Idle) . . .
 Relevant costs will usually be the variable costs associated
with the special order.

Without excess capacity . . .

 Same as above but opportunity cost of using the firm’s
facilities for the special order are also relevant.

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Special Order
EXERCISE 1

Jones Co. makes Barry Bears under its

own label for exclusive children’s stores.
Jones has adequate capacity to consider
a special order from a major retailer for
100,000 bears. The retailer has offered
an average price of $18 per bear. Use the
following unit cost information to advise
Jones whether or not to accept the order.
Special Order
Example
Unit
Cost
Direct Material $ 8.00
Direct Labor 6.00
Variable Overhead 2.00
Fixed Overhead 4.00
Total $ 20.00

Fixed overhead totals $2,000,000 for a capacity of 500,000 bears. Jones

normally sells its bears wholesale for an average price of $30 per bear.
 Special Order
Example
Unit
Cost
Direct Material $ 8.00 Total unit
variable
Direct Labor 6.00 cost is $16.00
Variable Overhead 2.00
Fixed Overhead 4.00
Total $ 20.00

Total fixed overhead will not change if the special

order is accepted and is irrelevant to the decision.
 Special Order
Example
Unit
Cost
Direct Material $ 8.00 Total unit
variable
Direct Labor 6.00 cost is $16.00
Variable Overhead 2.00
Fixed Overhead 4.00
Total $ 20.00

Unit contribution on special order = $18 - $16 = $2

Total contribution on order = 100,000 units × $2 = $200,000
Accept the order. Income will increase by $200,000.
 Special Orders Example
Arlington Brewing Company operates a brewery with a
monthly capacity of one million barrels of a beer product
(Champion) that has gained significant market share.
Current production and sales are 600,000 barrels a
month. The selling price is $90 per barrel. The costs are
as follows:
VC /barrel FC /barrel
Direct material (barley, etc.) $ 7
Direct labor 22
Overhead 6 $13
Marketing costs* 5 16
Distribution costs 9 8
* Variable marketing cost is sales commission.
Special Orders Example
A Canadian brewery wants to buy 250,000 barrels of
Champion for each of the next four months until its
current brewery is renovated. It is willing to pay $45
per barrel. If Arlington accepts this order, an additional
$300,000 in manufacturing costs will be incurred each
month. No additional costs will be incurred for
marketing & distribution.
Should Arlington accept the special order?
 Special Orders Example

Items of differential monthly revenues and costs are:

Total revenue $11,250,000
Variable costs $8,750,000
Additional costs 300,000 9,050,000
Differential profit $ 2,200,000
Based on profit alone, Arlington should accept the
offer.
Special Orders
 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.
Special Orders
 Special
. Orders
If Jet
. accepts the special order, the incremental revenue will
exceed the incremental costs. In other words, net
operating income will increase by $6,000. This suggests
that Jet should accept the order.

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 the fixed costs are

unavoidable and that variable marketing costs must be
incurred on the special order.
 Special Orders
 Acki Company receives a one-time order that is not
considered part of its normal ongoing business.
 Acki Company only produces one type of silver key chain
with a unit variable cost of 16. Normal selling price is 40 per
unit.
 A company in KKTC offers to purchase 3,000 units for 20
per unit.
 Annual capacity is 10,000 units, and annual fixed costs total
78,000, but Acki company is currently producing and selling
only 5,000 units.

Should Acki accept the offer?

Special Orders
 Special Orders
If Acki accepts the offer, net income will increase by
TL 12.000.

Increase in revenue (3,000 × 20) TL60,000

Increase in costs (3,000 × TL16 variable cost) 48,000
Increase in net income TL12,000

Using the incremental approach:

Special order contribution margin = TL20 – TL 16 = TL 4
Change in income = TL 4 × 3,000 units = TL 12.000.
Outsource a Product or Service
A decision concerning whether an item should be produced
internally or purchased from an outside supplier is often
called a “make or buy” decision.

Let’s look at another decision faced by the management of

Worldwide Airways.

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Outsource a Product or Service
An Atlanta bakery has offered to supply the in-
flight desserts for 21¢ each.
Here are Worldwide’s current cost for desserts:

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Outsource a Product or Service
Not all of the allocated fixed costs will be saved
if Worldwide purchases from the outside bakery.

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Outsource a Product or Service
If Worldwide purchases the dessert for 21¢, it will
only save 15¢ so Worldwide will have a loss of 6¢
per dessert purchased.

Wow, that’s
no deal!

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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 labor 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary 2
General factory overhead 10
Unit product cost $ 30
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 labor 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 we accept the supplier’s offer?

The
. Make or Buy Decision
Cost
. Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 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

The avoidable costs associated with making part 4A include direct

materials, direct labor, variable overhead, and the supervisor’s salary.
The
. Make or Buy Decision
Cost
. Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 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

The depreciation of the special equipment represents a sunk

cost. The equipment has no resale value, thus its cost and
associated depreciation are irrelevant to the decision.
The
. Make or Buy Decision
Cost
. Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 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 avoidable; irrelevant. If the product is

dropped, it will be reallocated to other products.
The
. Make or Buy Decision
Cost
. Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 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

Should we make or buy part 4A? Given that the total

avoidable costs are less than the cost of buying the part,
Essex should continue to make the part.
Add or Drop a Service,
Product, or Department

One of the most important

decisions managers make is
whether to add or drop a
product, service, or
department.

Let’s look at how the concept of

relevant costs should be used in
such a decision.

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Add or Drop a Product
Worldwide Airways offers its passengers
the opportunity to join its World
Express Club. Club membership
entitles a traveler to use the club
facilities at the airport in Atlanta.
Club privileges include a private lounge
and restaurant, discounts on meals and
beverages, and use of a small health
spa.

14-39
Add or Drop a Product
Sales $200,000
Less: Variable Costs:
Food/Beverage $70,000
Personnel 40,000
Variable overhead 25,000 (135,000)
Contribution Margin 65,000
Less: Fixed Costs:
Depreciation $30,000
Supervisor salary 20,000
Insurance 10,000
Airport fees 5,000
Allocated overhead 10,000 ( 75,000)
Loss $ ( 10,000)
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Add or Drop a Product
KEEP CLUB ELIMINATE DIFFERENTIAL
Sales $200,000 0 $200,000
Food/Beverage (70,000) 0 (70,000)
Personnel (40,000) 0 (40,000)
Variable overhead (25,000) 0 (25,000)
Contribution Margin 65,000 0 65,000
Depreciation (30,000) (30,000) 0
Supervisor salary (20,000) 0 (20,000)
Insurance (10,000) (10,000) 0
Airport fees ( 5,000) 0 ( 5,000)
Allocated overhead (10,000) (10,000) 0
Loss $ (10,000) $(50,000) $ 40,000

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Add or Drop a Product
KEEP CLUB ELIMINATE DIFFERENTIAL
Sales $200,000
N 0 A $200,000
Food/Beverage (70,000)
O 0 V (70,000)
Personnel (40,000)
T 0 O (40,000)
Variable overhead (25,000) 0 (25,000)
A I
Contribution Margin 65,000 0 65,000
Depreciation V
(30,000) (30,000) D 0
Supervisor salary O
(20,000) 0 A (20,000)
I
Insurance (10,000)
D (10,000) B 0
Airport fees ( 5,000)
A 0 L ( 5,000)
Allocated overhead (10,000) B (10,000) E 0
Loss L
(10,000) (50,000) 40,000
E
The positive $40,000 differential amount reflects the fact that the
company is $40,000 better off by keeping the club.
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Add or Drop a Product
KEEP CLUB ELIMINATE DIFFERENTIAL
Sales $200,000 0 $200,000
Food/Beverage (70,000) 0 (70,000)
Personnel (40,000) 0 (40,000)
Variable overhead (25,000) 0 (25,000)
Contribution Margin 65,000 0 65,000
Avoidable fixed costs
Supervisor salary (20,000) 0 (20,000)
Airport fees ( 5,000) 0 ( 5,000)
Profit/Loss $ 40,000 $ 40,000
Worldwide airlines would also lose the contribution
margin of $65,000. The club contributes $40,000 to
Worldwide’s fixed costs.
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 Adding/Dropping Segments
One of the most important decisions managers make is
whether to add or drop a business segment, such as a
product or a store.
Let’s see how relevant costs should be used in this
type of decision.
Due to the declining popularity of digital watches,
Lovell Company’s digital watch line has not reported a
profit for several years. Lovell is considering dropping
this product line.
 A Contribution Margin Approach

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

Let’s look at this solution.

 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 80,000
Rent - factory space 70,000
General admin. expenses 30,000 380,000
Net operating loss $ (80,000)
 Adding/Dropping Segments
Investigation has revealed that total fixed general factory overhead
and general administrative expenses would not be affected if the
digital watch line is dropped. The fixed general factory overhead and
general administrative expenses assigned to this product would be
reallocated to other product lines.

The equipment used to manufacture digital watches has no resale value or

alternative use.

Should Lovell retain or drop the digital watch segment?

 A Contribution Margin Approach
Contribution Ma rgin
Solution
Contribution m argin lost if digita l
  w a tche s a re droppe d ?

Le ss fix e d costs tha t ca n be a voide d

Sa la ry of the line m a na ge r ?
Adve rtising - dire ct ?
Re nt - fa ctory spa ce ? -
Ne t (dis)a dva ntage $ -
Comparative Income Approach

The Lovell solution can also be obtained by preparing

comparative income statements showing results with and
without the digital watch segment.

Let’s look at this second approach.

 Comparative Income Approach
Comparative Income ApproachSolution
Keep Drop
Digital Digital
W atches W atches Difference
Sales $ 500,000 $ -
Less variable expenses: -
Manufacturing expenses 120,000 -
Shipping 5,000 -
Commissions 75,000 -
Total variable expenses 200,000 - -
Contribution margin 300,000 - -
Less fixed expenses:
General factory overhead 60,000
Salary of line manager 90,000
Depreciation 50,000
Advertising - direct 80,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 380,000
Net operating loss $ (80,000)
Special Decisions in
Manufacturing Firms
Joint Products:
Sell or Process Further
A joint production process resulting in two or more
products. The point in the production process where the
joint products are identifiable as separate products is
called the split-off point.
Joint production processes make two or more different
products using some similar beginning process.
Examples of join products include:
Milk – butter, cream, cheese
Crude oil – fuel, gas, kerosene

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 Joint Products
For example,
Oil in the petroleum
refining industry,
a large number
Common of products are
Joint
Input
Production Gasoline extracted from
Process crude oil,
including
gasoline, jet fuel,
Chemicals
home heating oil,
lubricants,
asphalt, and
Split-Off
various organic
Point chemicals.
 Joint Products
Joint costs
are incurred
up to the Oil
Separate Final
split-off point Processing Sale

Common
Joint Final
Production Gasoline
Input Sale
Process

Separate Final
Chemicals
Processing
Sale

Split-Off Separate
Point Product
Costs
 Joint Processing Cocoa butter
of Cocoa Bean sales value
$750 for
1,500 pounds

Cocoa beans Joint Production

costing $500 process costing Split-off point
per ton $600 per ton

Cocoa powder Separable

sales value process
Total joint cost: $500 for costing
$1,100 per ton 500 pounds $800

Instant cocoa
mix sales value
$2,000 for
500 pounds
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Joint Products
Relative Sales Value Method

$750 ÷ $1,250 = 60%

60% × $1,100 = $660

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Joint Products
Cocoa butter is sold at the end of the joint
processing.
Cocoa powder may be sold now or processed into
instant cocoa mix. Further processing costs of $800
will be incurred if the company elects to make
instant cocoa mix.

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Joint Products

( )

The cocoa powder should be

processed into instant cocoa mix.

14-57
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.”
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
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
Profit (loss) from further processing
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)
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)

The lumber should be processed

further and the sawdust should be
sold at the split-off point.
 Joint Products – Sell or Process further
Example: Incur $2,000 in costs
and sell for $11,000

Get it painted and

Buy a new car Current market install new stereo
for $20,000 value is $8,000

You can sell as is

This is the
split-off point Get $8,000
 Joint Products – Sell or Process further
Example: Incur $2,000 in costs
and sell for $11,000

Get it painted and

Buy a new car To answer
Current
themarket install
question of sell as isnew
or stereo
for $20,000 process
value
further,
is $8,000
you need to examine the
incremental costs and incremental benefits

You can sell as is

This is the
split-off point Get $8,000
 Joint Products – Sell or Process further

Problem – Bass Chemicals Inc. produces three chemicals: Acetox, Denox, and Pectix through
one joint process costing $80,000. These chemicals can all be sold at the split-off point or
processed further and sold at a higher price.
Sales value at Additional costs of Sales value
split-off point processing further if processed further
Acetox $50,000 $23,000 $65,000
Denox $25,000 $44,000 $82,000
Pectix $85,000 $93,000 $184,000

Which of the products should be processed further and which ones should be sold at the split
of point?

If the joint processing costs were $120,000, would you change your answer?
End of Chapter 2

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