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AFM 182 > Chapter 10: Relevant Costs & Benefits > Flashcards

Chapter 10: Relevant Costs & Benefits Flashcards

1
Q

what can’t you do in terms of revenue and cost analysis

A

Can’t just compare all revenues and costs from one option against the revenues and costs of another and deciding

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2
Q

what needs to be done in terms of cost and revenue analysis

A

Need to conduct a relevant cost and benefit analysis

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3
Q

what is relevant cost and benefit analysis

A

its considering what revenues and costs that will change if one alternative is chosen over the other

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3
Q

what is incremental revenue

A

Additional revenue one alternative generates over the other (relevant benefit)

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4
Q

what is relevant cost

A

Revenue lost; the decrease in revenue of one alternative compared to the other (Also considered an opportunity cost)

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4
Q

what happens if two alternatives generate the same revenue

A

then the revenue is not relevant to the analysis

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5
Q

what is relevant benefit

A

Cost saving; the reduction in cost of one alternative compared to the other (avoidable cost)

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5
Q

what is incremental cost

A

Additional cost one alternative incurs over the other (relevant cost)

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6
Q

what are unavoidable costs

A

If two alternatives incur the same costs; they are not relevant to the analysis

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7
Q

if revenues decrease compared to its alternative what is it considered

A

Relevant Cost / Opportunity Cost

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7
Q

if revenues increase compared to its alternative what is it considered

A

Relevant Benefit / Incremental Revenue

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8
Q

what is differential revenue

A

Difference in revenues between the two alternatives

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9
Q

if there are no changes to revenues compared to its alternative what is it considered

A

Irrelevant

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9
Q

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

A

an incremental revenue of $0.5M (more than the rings)

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10
Q

if costs increase compared to its alternative what is it considered

A

Relevant Cost / Incremental Cost

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10
Q

if costs decrease compared to its alternative what is it considered

A

Relevant Benefit / Avoidable Cost

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10
Q

if there are no changes to costs compared to its alternative what is it considered

A

Irrelevant / Unavoidable Cost

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10
Q

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

A

Watches have a relevant benefit because they have an incremental revenue of $0.5M more than rings

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11
Q

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?

A

Secure storage is irrelevant/unavoidable cost since it’s required and costs the same for both options

11
Q

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?

A

Watches have a relevant/incremental cost, having $5k more compared to the rings due to maintenance

11
Q

when would revenues be irrelevant to the analysis

A

If the revenues for both options were the same

12
Q

what is differential cost

A

Difference in costs between the two alternatives

12
Q

when is differential costs irrelevant to the analysis

A

if they were the same under both options

12
Q

what are sunk costs

A
  • Costs that have already been incurred and wouldn’t affect any decision now or in the future
  • are irrelevant to the analysis
12
Q

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?

A
  • 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
12
Q

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

A

it would be an opportunity cost of $0.5M (less than the watches)

13
Q

what are the steps to identify what is relevant and not

A
  1. Eliminate irrelevant costs (unavoidable and sunk costs), and those costs and benefits that are the same across all alternatives
  2. Make the decision based on an analysis of the relevant costs and benefits remaining
13
Q

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

A
  1. 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
13
Q

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

A
  1. 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

13
Q

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

A
  1. 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

13
Q

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

A
13
Q

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?

A
  • 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
13
Q

what are the different ways relevant and cost benefit analysis is used for (for a company)

A
  • deciding to keep or drop a product or business segment
  • choosing office locations
  • accepting or rejecting a special order
13
Q

what is the formula for deciding to continue or discontinue a product or business segment

A

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

14
Q

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

A

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

14
Q

what are relevant benefits that exists for when doing analysis for choosing office locations

A
  • 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
14
Q

what is something choosing office locations might not always include

A
  • relevant benefits
  • incremental revenues and/or no cost savings to be compared to the pre-decision position
14
Q

what are some examples relevant benefits when deciding to keep or drop a product or business segment

A
  • 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
14
Q

when you are analyzing a keep or drop question what is the perspective you should always approach it from

A

you always approach it from the perspective of the impact of the discontinuation

14
Q

what are relevant costs that exists for when doing analysis for choosing office locations

A
  • Incremental costs: variable and fixed costs based on each location
  • Opportunity costs: any potential foregone sales from relocating
14
Q

what are some examples relevant costs when deciding to keep or drop a product or business segment

A
  • CM lost on a discontinued product or segment
  • Includes lost revenue and savings of variable costs related to the product/segment
15
Q

since making decisions around changing office location won’t always include relevant benefits, what is the decision made based on?

A
  • 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
15
Q

what is a special order

A

An order that is not within the parameters of what the company would consider normal business operations and is not recurring

16
Q

what are relevant benefits to consider when deciding to accept or reject a special order

A

Incremental revenue from the order

16
Q

what are relevant costs to consider when deciding to accept or reject a special order

A
  • 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
16
Q

what is the formula used to help determine if a special order should be accepted or rejected

A

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

AFM 182 (11 decks)

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