Chapter 10: Relevant Costs & Benefits Flashcards
what can’t you do in terms of revenue and cost analysis
Can’t just compare all revenues and costs from one option against the revenues and costs of another and deciding
what needs to be done in terms of cost and revenue analysis
Need to conduct a relevant cost and benefit analysis
what is relevant cost and benefit analysis
its considering what revenues and costs that will change if one alternative is chosen over the other
what is incremental revenue
Additional revenue one alternative generates over the other (relevant benefit)
what is relevant cost
Revenue lost; the decrease in revenue of one alternative compared to the other (Also considered an opportunity cost)
what happens if two alternatives generate the same revenue
then the revenue is not relevant to the analysis
what is relevant benefit
Cost saving; the reduction in cost of one alternative compared to the other (avoidable cost)
what is incremental cost
Additional cost one alternative incurs over the other (relevant cost)
what are unavoidable costs
If two alternatives incur the same costs; they are not relevant to the analysis
if revenues decrease compared to its alternative what is it considered
Relevant Cost / Opportunity Cost
if revenues increase compared to its alternative what is it considered
Relevant Benefit / Incremental Revenue
what is differential revenue
Difference in revenues between the two alternatives
if there are no changes to revenues compared to its alternative what is it considered
Irrelevant
Example: ESI is considering to offer luxury women’s accessories but didn’t know if they should do high-end watches or high-end rings
Based on estimates from the sales and FP&A teams:
Revenue of watches = $3M
Revenue of rings = $2.5
Both options requires secure storage costing $50k annually
Watches requires additional $5k annual maintenance cost to ensure batteries are at 100% charge when sold
ESI has display cases that can be used to store both watches or rings
from the watches perspective, what would be the incremental revenue
an incremental revenue of $0.5M (more than the rings)
if costs increase compared to its alternative what is it considered
Relevant Cost / Incremental Cost
if costs decrease compared to its alternative what is it considered
Relevant Benefit / Avoidable Cost
if there are no changes to costs compared to its alternative what is it considered
Irrelevant / Unavoidable Cost
Example: ESI is considering to offer luxury women’s accessories but didn’t know if they should do high-end watches or high-end rings
Based on estimates from the sales and FP&A teams:
Revenue of watches = $3M
Revenue of rings = $2.5
Both options requires secure storage costing $50k annually
Watches requires additional $5k annual maintenance cost to ensure batteries are at 100% charge when sold
ESI has display cases that can be used to store both watches or rings
what is a relevant benefit between the 2 options
Watches have a relevant benefit because they have an incremental revenue of $0.5M more than rings
Example: ESI is considering to offer luxury women’s accessories but didn’t know if they should do high-end watches or high-end rings
Based on estimates from the sales and FP&A teams:
Revenue of watches = $3M
Revenue of rings = $2.5
Both options requires secure storage costing $50k annually
Watches requires additional $5k annual maintenance cost to ensure batteries are at 100% charge when sold
ESI has display cases that can be used to store both watches or rings
what is a irrelevant cost?
Secure storage is irrelevant/unavoidable cost since it’s required and costs the same for both options
Example: ESI is considering to offer luxury women’s accessories but didn’t know if they should do high-end watches or high-end rings
Based on estimates from the sales and FP&A teams:
Revenue of watches = $3M
Revenue of rings = $2.5
Both options requires secure storage costing $50k annually
Watches requires additional $5k annual maintenance cost to ensure batteries are at 100% charge when sold
ESI has display cases that can be used to store both watches or rings
what is a relevant cost?
Watches have a relevant/incremental cost, having $5k more compared to the rings due to maintenance
when would revenues be irrelevant to the analysis
If the revenues for both options were the same
what is differential cost
Difference in costs between the two alternatives
when is differential costs irrelevant to the analysis
if they were the same under both options
what are sunk costs
- Costs that have already been incurred and wouldn’t affect any decision now or in the future
- are irrelevant to the analysis
Example: ESI is considering to offer luxury women’s accessories but didn’t know if they should do high-end watches or high-end rings
Based on estimates from the sales and FP&A teams:
Revenue of watches = $3M
Revenue of rings = $2.5
Both options requires secure storage costing $50k annually
Watches requires additional $5k annual maintenance cost to ensure batteries are at 100% charge when sold
ESI has display cases that can be used to store both watches or rings
what is a sunk cost?
- The display cases are sunk costs, and irrelevant to the analysis
- If new display cases needed to be bought, they would be relevant or not based on if the cost of the display cases would differ between the two options
Example: ESI is considering to offer luxury women’s accessories but didn’t know if they should do high-end watches or high-end rings
Based on estimates from the sales and FP&A teams:
Revenue of watches = $3M
Revenue of rings = $2.5
Both options requires secure storage costing $50k annually
Watches requires additional $5k annual maintenance cost to ensure batteries are at 100% charge when sold
ESI has display cases that can be used to store both watches or rings
from the rings perspective, what would an opportunity cost
it would be an opportunity cost of $0.5M (less than the watches)
what are the steps to identify what is relevant and not
- Eliminate irrelevant costs (unavoidable and sunk costs), and those costs and benefits that are the same across all alternatives
- Make the decision based on an analysis of the relevant costs and benefits remaining
Example:
After graduating from university, you bought a small condo
Mortgage = $2k per month
Want to go on a month-long vacation to Croatia and want to know if $5k in savings is enough to fund the trip
Decide you will only go on the trip if you can pay for it in full with the savings
Monthly income = $5k ($1,250 would be unpaid; only have 3 weeks of paid vacation)
monthly expenses:
utilities = $100 (only $60 if going)
groceries = $1k
gasoline = $250 (based on regular usage)
trip expenses:
flight + transportation = $1.5k
accommodations = $1.5k
food & entertainment = $1k
souvenirs = $500
perform the second step of a relevant cost and benefit analysis: what are the avoidable costs
- Make the decision based on an analysis of the relevant costs and benefits remaining
- Utilities of $40
- Would only incur $60 instead of $100 if you go on vacation
- So you would be avoiding/saving $40
- Groceries of $1,000
- Wouldn’t need to pay for these at all since you wouldn’t be home
- Gasoline of $250
- Won’t be driving while on vacation, so no gas expenses
Example:
After graduating from university, you bought a small condo
Down payment = $100k
Want to go on a month-long vacation to Croatia and want to know if $5k in savings is enough to fund the trip
Decide you will only go on the trip if you can pay for it in full with the savings
Monthly income = $5k ($1,250 would be unpaid; only have 3 weeks of paid vacation)
monthly expenses:
mortgage = $2k
utilities = $100 (only $60 if going)
groceries = $1k
insurance = $300
gasoline = $250 (based on regular usage)
car parking = $100
trip expenses:
flight + transportation = $1.5k
accommodations = $1.5k
food & entertainment = $1k
souvenirs = $500
perform the first step of a relevant cost and benefit analysis
- eliminate irrelevant costs (unavoidable and sunk costs), and those costs and benefits that are the same across all alternatives
Unavoidable costs: Costs that don’t change regardless if you take the trip or not
- Mortgage
- Insurance
- Car parking
Sunk Costs: Costs made before the decision and won’t affect the vacation decision
- Condo down payment
Example:
After graduating from university, you bought a small condo
Mortgage = $2k per month
Want to go on a month-long vacation to Croatia and want to know if $5k in savings is enough to fund the trip
Decide you will only go on the trip if you can pay for it in full with the savings
Monthly income = $5k ($1,250 would be unpaid; only have 3 weeks of paid vacation)
monthly expenses:
utilities = $100 (only $60 if going)
groceries = $1k
gasoline = $250 (based on regular usage)
trip expenses:
flight + transportation = $1.5k
accommodations = $1.5k
food & entertainment = $1k
souvenirs = $500
perform the second step of a relevant cost and benefit analysis: what are the incremental costs
- Make the decision based on an analysis of the relevant costs and benefits remaining
Incremental costs: costs that increase if you take the vacation
- Lost of income of $1,250
- Cost of a week of unpaid vacation
- Would’ve earned this amount if you don’t go on the trip
- Trip expenses of $4,500
- All trip expenses are incremental, since they won’t exist if you don’t go
Example:
After graduating from university, you bought a small condo
Down payment = $100k
Want to go on a month-long vacation to Croatia and want to know if $5k in savings is enough to fund the trip
Decide you will only go on the trip if you can pay for it in full with the savings
Monthly income = $5k ($1,250 would be unpaid; only have 3 weeks of paid vacation)
monthly expenses:
mortgage = $2k
utilities = $100 (only $60 if going)
groceries = $1k
insurance = $300
gasoline = $250 (based on regular usage)
car parking = $100
trip expenses:
flight + transportation = $1.5k
accommodations = $1.5k
food & entertainment = $1k
souvenirs = $500
arrange the costs and benefits to compare
Example:
After graduating from university, you bought a small condo
Down payment = $100k
Mortgage = $2k per month
Want to go on a month-long vacation to Croatia and want to know if $5k in savings is enough to fund the trip
Decide you will only go on the trip if you can pay for it in full with the savings
Monthly income = $5k ($1,250 would be unpaid; only have 3 weeks of paid vacation)
will you go on the trip?
- Based on the relevant cost and benefit analysis, the total relevant cost of taking the vacation is $4,460
- Since you have $5,000 in savings, you have enough to fund the entire vacation
what are the different ways relevant and cost benefit analysis is used for (for a company)
- deciding to keep or drop a product or business segment
- choosing office locations
- accepting or rejecting a special order
what is the formula for deciding to continue or discontinue a product or business segment
Continue/(Discontinue) = CM Lost - (Fixed Costs Avoided + CM gained elsewhere)
- If CM lost > fixed costs + CM gained from other products/segments, the product/segment should be kept
- If CM lost < fixed costs + CM gained from other products/segments, the product/segment should be discontinued
when doing a relevant cost and benefit analysis, what would be irrelevant costs that are included when deciding whether to keep a product or business segment
irrelevant costs can include those that would be incurred regardless of whether a product continued to be sold or sunk costs that have already been incurred to open a store, even if it ends up being closed
what are relevant benefits that exists for when doing analysis for choosing office locations
- Incremental revenue: from new sales in the geographical territory of the new location
- Variable and fixed costs avoided: if status quo location is closed/lease terminated
what is something choosing office locations might not always include
- relevant benefits
- incremental revenues and/or no cost savings to be compared to the pre-decision position
what are some examples relevant benefits when deciding to keep or drop a product or business segment
- Fixed costs avoided if a product is discontinued or a store closed
- CM gained on other products/segments from repurposing the space previously used for the discontinued product/segment
when you are analyzing a keep or drop question what is the perspective you should always approach it from
you always approach it from the perspective of the impact of the discontinuation
what are relevant costs that exists for when doing analysis for choosing office locations
- Incremental costs: variable and fixed costs based on each location
- Opportunity costs: any potential foregone sales from relocating
what are some examples relevant costs when deciding to keep or drop a product or business segment
- CM lost on a discontinued product or segment
- Includes lost revenue and savings of variable costs related to the product/segment
since making decisions around changing office location won’t always include relevant benefits, what is the decision made based on?
- The decision made is based on which option has the lowest costs
- If there are benefits that outweigh the relevant costs, that’s even better
what is a special order
An order that is not within the parameters of what the company would consider normal business operations and is not recurring
what are relevant benefits to consider when deciding to accept or reject a special order
Incremental revenue from the order
what are relevant costs to consider when deciding to accept or reject a special order
- Incremental costs; variable and fixed costs of accepting the order
- Opportunity costs of accepting the order; potentially foregone sales of other products to accommodate the special order
what is the formula used to help determine if a special order should be accepted or rejected
Incremental Revenue - Total Relevant Costs = Accept/(Reject) Special Order
- If incremental revenue > total relevant costs associated with the order, the special order should be accepted
- If incremental revenue < total relevant costs associated with the order, the special order should not be accepted
