Accounting for Managers

Module 11: Relevant Revenues and Costs

Cost Types
Differential Cost

• When we work to make decisions, we must look at pros and cons: differential analysis
• Defined as the difference in cost between any two alternative choices
Avoidable Costs

• Cost that can be eliminated completely depending on the alternative we pick

• Avoidable cost is a relevant cost
Sunk Costs

• Costs that happened and there is not one thing we can do about it
• They are never relevant in decision making process
• Always irrelevant
Opportunity Costs

• Loss of wages for week is called opportunity cost: cost of what is lost if one decision is
made over another
• Definition: “Opportunity cost refers to a benefit that a person could have received, but gave
up, to take another course of action… represents an alternative given up when a decision is
made.”
• We can talk about opportunity costs when we think about making component needed for
product as opposed to buying from supplier already made
Analyzing Costs

• What matters in one decision may make no difference in a different

• Need to use skills we have learned to determine whether particular cost matters
• You will need different costs for different purposes
• Every decision made will require you to analyze costs, determine which ones are relevant or
not, and analyze remaining costs
• Must look at total cost followed by differential costs
Relevant Costs
Add or Drop Decisions

• Adding, retaining or dropping a product or service can be a tough decision.

Example: Recovery Sandals
Fixed Expenses Totals Assigned to Not Avoidable Avoidable
Recovery Sandals
Salaries $22,500 – $22,500

Advertising $5,000 – $5,000

Utilities $1,000 $1,000 –

Depreciation $1,000 $1,000 –

Interest expense (mortgage) $2,000 $2,000 –

Insurance $500 $500 –

General Administrative $2,000 $2,000 –

Total fixed expenses $34,000 $6,500

Net operative income (loss) $18,500 $13,000 $27,500

Make or Buy Decisions Example: Hupana
Cost Categories Relevant Costs: Make Relevant Costs: Buy

Direct Materials $5,000 –

Direct Labor $4,000 –

Variable Overhead $600 –

Depreciation of equipment (not – –

relevant)

Allocation of fixed overhead (not – –

relevant)

Cost of buying – $10,000

Total cost $9,600 $10,000

Different in favor of MAKING $400 –

Special Order Decisions

A call just came in to Hupana for a special order shoe. A basketball team would like Hupana to
make 50 pair of their shoes, with the awesome soles, but a high top version in fuschia!

They have never made high tops before, nor do they have the material in fuschia. The team is
willing to pay $150 a pair for these custom shoes. What information does Hupana need to
decide if taking this special order is a good idea or not?
Example: Special Order

• Expected Revenue: (50 pair for $150 each) = $7,500

Expenses Amount (USD)

Material-fuschia (50 x 7 units x $3.5 per unit) $1,225

Direct labor (5 0x .8 x $30) $1,200

Variable overhead (30 hours x $3 per hour) $150

Total Variable Expenses $2,575

Fixed Expense – Dye for material cutter $1,200

Total expenses for special order $3,775

Incremental net operating income $3,725

Constrained Resources
Constrained Resource

• Something that you have a limited amount of (time, labor hours, raw materials)
• When resource is constrained, you must determine best way to use this resource to bring
most money to net profit
• How would you stock your store? What else would you want to look at in your retail space?
How do we figure out best usage?
Quick Review

Only the costs that vary between different options matter

Those that stay the same are irrelevant to your decision making process, and ignoring them will
save tons of time

Relevant costs differ depending on decision needed

Keep practicing decision making skills by reviewing examples and thinking through which
costs are most important