Chapter 9: Relevant Costs Flashcards
Every decision involves choosing between at least ____ alternatives, after comparing the ____ costs and and the benefits of the alternatives
2
Relevant
Relevant costs
Costs that differ between alternatives in a particular decision. (That are yet to be incurred)
In managerial accounting, this term is synonymous with avoidable costs, incremental costs, and differential costs.
Differential costs (aka Incremental costs)
Any cost that differs between alternatives in a decision-making situation. In managerial accounting, this term is synonymous with avoidable cost, incremental cost, and relevant cost.
Example
Family is deciding whether or not to go to the movie theater or renting a movie, the relevant costs, those that differ between the two alternatives, include 1) Cost of renting a movie, 2) Ticket price at the theater, 3) Cost of popcorn and drinks at the theater
If you go to the movie, no rent cost
If you rent the movie, no movie ticket cost
Avoidable cost
Any cost that can be eliminated (in whole or in part) by choosing one alternative over another in a decision-making situation.
In managerial accounting, this term is synonymous with incremental cost, relevant cost, and differential cost.
Example: Choosing the movie ticket rather than renting a movie, renting a movie is an avoidable cost
Any costs that are unavoidable across the alternatives being considered is ______
Irrelevant
if mortgage is $2000 a month regardless it should not be involved in the decision making
Opportunity cost (are relevant costs)
The potential benefit given up when one alternative is selected over another.
Example: Giving up work to go the movie, the opportunity cost is the $35 you would have made working
Sunk cost (irrelevant cost)
Any cost that has already been incurred and cannot be changed by any decision made now or in the future.
Example: Already bought the movie ticket, now it cant be refunded
TWO important conclusions to relevant costs
1) They differ among alternatives
2) They are costs that will be incurred in the future
Costs that are always relevant
Avoidable
Incremental
Differential costs
Opportunity costs
To figure out if costs that are avoidable (differential) in a particular decision situation and therefore relevant, follow these steps:
1) Eliminate costs and benefits that do not differ between alternatives (these irrelevant costs consist of (a) sunk costs and (b) future costs that do not differ between alternatives
2) Use the remaining costs and benefits that do differ between alternatives in making the decision. he costs that remain are the differential or avoidable costs
Common fixed cost
A fixed cost that supports the operations of more than one segment of an organization and is not avoidable in whole or in part by eliminating any one segment.
Rent may split 4 ways between the segments, but the total rent amount per month is the same (dropping the segment still means there is a rent expense)
Segment margin
The difference between the revenue generated by a segment and its own traceable cost.
Unless another product can get generate more than the segment margin, the company is better off keeping the line
Make-or-buy decision (aka outsourcing or subcontracting)
A decision on whether an item should be produced internally or purchased from an outside supplier.
Special order
A one-time order not considered part of the company’s normal ongoing business.
Remember to drop fixed overhead
In general, a special order is profitable as long as the incremental revenue from the special order exceeds the incremental costs of the order
Incremental revenue is the sell price x quantity
Target costing
A method of costing in which, before launching a new product, management estimates how much the market will be willing to pay for the product and then takes steps to ensure that the cost will be low enough to provide an adequate profit margin.
The company’s required profit margin is subtracted from the estimated selling price to determine the target cost for the new product – if it becomes clear meeting the target cost is not possible, drop the new product immediately
Advantages to target costing (over cost-plus markup approach)
1) Product is not made unless the company is reasonably confident that customers will be willing to buy the product at a price that provides the company with adequate profit
2) The target costing approach inspires a much higher level of cost-consciousness than the cost-plus approach and probably results in less expensive products that are more attractive to customers
Constraint
A limitation under which a company must operate—such as limited machine time available or limited raw materials available—that restricts the company’s ability to satisfy demand.
When a limited resource of some type restricts the company’s ability to satisfy demand
Fixed costs do not matter, choose option that maximizes the firms TOTAL contribution margin
Bottleneck
A machine or process that limits total output because it is operating at capacity. (a constraint)
When demand for a company’s products and services exceeds its ability to supply them
Contribution margin per unit of the constrained resource
equation kinda
Computed by dividing the contribution margin by the amount of the constrained resource that a unit of product requires
Example: $15 CM per unit, 2minutes to make, $7.50/min (Higher number wins)
Relaxing the constraint (elevating the constraint)
An action that increases the capacity of a bottleneck
Example: asking the stitching machine operator to work overtime
The capacity of a bottle neck can be effectively increase in a number of ways, including:
- Working overtime on the bottleneck
- Subcontracting some of the processing that would be done at the bottleneck
- Investing in additional machines at the bottleneck
- Shifting workers from processes that are not bottlenecks to the process that is a bottleneck
- Focusing business process improvement efforts, such as TQM and business process reengineering, on the bottleneck
- Reducing defective units
Last three are ideal as they are free and may yield additional savings
Split-off point
That point in the manufacturing process where some or all of the joint products can be recognized as individual products.
Joint products
Two or more products that are produced from a common input.
Example: A chicken contains breasts, wings, legs, thighs, etc
Intermediate product
Partially finished product
End product
Fully finished product
Joint cost (common cost : allocated among products)
A cost item among those incurred up to the split-off point in a process that produces joint products.
The cost incurred up to the split-off point
Sell-or-process-further decisions
Decisions as to whether a joint product should be sold at the split-off point or sold after further processing.
It is profitable to continue processing a joint product after the split-off point
so long as the incremental revenue from such processing exceeds the incremental processing cost incurred after the split-off point
Even if a joint product was disposed of at the split-off point without any further processing
All of the joint costs must be incurred and no part is avoidable by disposing of any one of the products that emerge from the split-off point
For each end product, use these three steps to make sell-or-process-further decision (equation)
1) Calculate the sales value if processed further minus the sale value at each split-off point.
The sales value is quantity of product x the unit price of each unit
2) Determine the cost of further processing beyond the split-off-point
3) Take the amount in step 1 and subtract it from the amount in step 2. If the result is a positive number, than choose to process further. If it is a negative number, than choose to sell at the split-off point
Depreciation of equipment is a ______ cost and should be _____
Sunk cost
SHOULD BE IGNORED
Allocations of common fixed costs like _______________ should be _______________
General overhead (DO NOT INCLUDE GENERAL OVERHEAD)
IGNORED
When is data relevant
Only costs and benefits that differ in TOTAL between alternatives are relevant in decision making
If fixed costs are ___ more than then the contribution margin, you should ____ keep the line
more
Keep
Idle Space that has no alternative use
Has an opportunity cost of zero
To maximize total contribution margin,
A firm should promote those products or accept those orders that provide the highest unit contribution margin PER UNIT OF THE CONSTRAINED RESOURCE
Managers should focus much of their attention on managing ___________
Bottlenecks
Managers should emphasize products that most
profitably utilize the constrained resource
Four steps to help determine the most profitable use of a constrained resource
1) Calculate each product’s contribution margin per unit
2) Identify the constringing resource, and calculate the quantity of that resource used to make one unit of each product
3) Calculate each product’s contribution margin per unit of the constraining resource (Step 1 / Step 2)
4) Rank the products from the highest contribution margin per unit of the constraining resource to the lowest
Note that the joint costs of buying the wool and separating the wool (joint costs) are ______ when considering the profitability of the _____ operation
Relevant
Entire
The joint costs could be avoided if the entire operation was shut down
Joint costs are not relevant when
Considering the profitability of any one product
General Rule #1b
Costs relevant in one decision situation are not necessarily relevant in another
General Rule #2a
If, by dropping a segment, the company is able to avoid more in fixed costs than it loses in contribution margin, then it would be better off dropping the segment (i.e. overall net income should improve)
If the company would not be able to avoid as much in fixed costs as it would lose in contribution margin, then it would not be better off dropping the segment
General Rule #2b
If, by adding a segment, the company is able to increase contribution margin by more than any related increase in fixed costs, then it would be better off adding the segment (i.e. overall net income should improve)
If the company would have to incur more fixed costs than any related increase in contribution margin, then it would not be better off adding the segment
General Rule #3
The company should outsource only if the outside purchase price is less than the costs that can be avoided by not producing internally
