11th Edition

Chapter 13

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 Relevant Costs for Decision
Making

Chapter Thirteen

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 Cost Concepts for Decision Making

A relevant cost is a cost that differs

between alternatives.

2
1

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 Identifying Relevant Costs

An avoidable cost can be eliminated (in whole or

in part) by choosing one alternative over
another. Avoidable costs are relevant costs.
Unavoidable costs are irrelevant costs.

Two broad categories of costs are never

relevant in any decision and include:
Sunk costs.
Future costs that do not differ between the
alternatives.

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 Relevant Cost Analysis: A Two-Step
Process

Step 1 Eliminate costs and benefits that do not differ

between alternatives.
Step 2 Use the remaining costs and benefits that do
differ between alternatives in making the
decision. The costs that remain are the
differential, or avoidable, costs.

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 Different Costs for Different Purposes

Costs that are

relevant in one
decision situation
may not be relevant
in another context.

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 Identifying Relevant Costs

Cynthia, a Boston student, is considering visiting her friend in New York.

She can drive or take the train. By car it is 230 miles to her friend’s
apartment. She is trying to decide which alternative is less expensive
and has gathered the following information:
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.050
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.569

$45 per month × 8 months $1.60 per gallon ÷ 32 MPG

$18,000 cost – $4,000 salvage value ÷ 5 years

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 Identifying Relevant Costs

Automobile Costs (based on 10,000 miles driven per year)

Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.050
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.569

Some Additional Information

7 Reduction in resale value of car per mile of wear $ 0.026
8 Round-tip train fare $ 104
9 Benefits of relaxing on train trip ????
10 Cost of putting dog in kennel while gone $ 40
11 Benefit of having car in New York ????
12 Hassle of parking car in New York ????
13 Per day cost of parking car in New York $ 25

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 Identifying Relevant Costs

Which costs and benefits are relevant in Cynthia’s

decision?

The cost of the The annual cost of

car is a sunk cost insurance is not
and is not relevant. It will remain
relevant to the the same if she drives
current decision. or takes the train.

However, the cost of gasoline is clearly relevant

if she decides to drive. If she takes the drive the
cost would now be incurred, so it varies
depending on the decision.
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 Identifying Relevant Costs

Which costs and benefits are relevant in Cynthia’s

decision?
The monthly
The cost of school parking
maintenance and fee is not
repairs is relevant. In relevant because
the long-run these it must be paid if
costs depend upon Cynthia drives or
miles driven. takes the train.

At this point, we can see that some of the average

cost of $0.569 per mile are relevant and others are
not.
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 Identifying Relevant Costs

Which costs and benefits are relevant in Cynthia’s

decision?

The decline in resale The round-trip train

value due to additional fare is clearly relevant.
miles is a relevant If she drives the cost
cost. can be avoided.

Relaxing on the train is The kennel cost is not

relevant even though it relevant because
is difficult to assign a Cynthia will incur the
dollar value to the cost if she drives or
benefit. takes the train.
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 Identifying Relevant Costs

Which costs and benefits are relevant in Cynthia’s

decision?

The cost of parking is

relevant because it can
be avoided if she takes
the train.

The benefits of having a car in New York and

the problems of finding a parking space are
both relevant but are difficult to assign a
dollar amount.

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 Identifying Relevant Costs

From a financial standpoint, Cynthia would be better

off taking the train to visit her friend. Some of the
non-financial factor may influence her final decision.
Relevant Financial Cost of Driving
Gasoline (460 @ $0.050 per mile) $ 23.00
Maintenance (460 @ $0.065 per mile) 29.90
Reduction in resale (460 @ $0.026 per mile) 11.96
Parking in New York (2 days @ $25 per day) 50.00
Total $ 114.86

Relevant Financial Cost of Taking the Train

Round-trip ticket $ 104.00

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 Total and Differential Cost Approaches

The management of a company is considering a new laborsaving

machine that rents for $3,000 per year. Data about the company’s
annual sales and costs with and without the new machine are:
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000

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 Total and Differential Cost Approaches

As you see, the only costs that differ between the alternatives are the
direct labor costs savings and the increase in fixed rental costs.
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
We can efficiently analyze the decision by62,000
Other 62,000 -
Rent on new machine
- 3,000 (3,000)
looking at the different costs and revenues and
Total fixed expenses
62,000 65,000 (3,000)
Net operating income
$ 18,000 $ 30,000 12,000
arrive at the same solution.
Net Advantage to Renting the New Machine
Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Increase in fixed rental expenses (3,000)
Net annual cost saving from renting the new machine $ 12,000

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 Total and Differential Cost Approaches

Using the differential approach is desirable for

two reasons:
1. Only rarely will enough information be
available to prepare detailed income
statements for both alternatives.
2. Mingling irrelevant costs with relevant costs
may cause confusion and distract attention
away from the information that is really
critical.

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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.

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 Adding/Dropping Segments

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.

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 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.

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 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 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
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 Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Investigation has revealed
Variable manufacuring coststhat
$ total
120,000fixed general
Variablefactory
shippingoverhead
costs and general
5,000
Commissions expenses would not
administrative 75,000
be affected200,000
if
Contribution margin $ 300,000
the
Less: digital
fixed watch line is dropped. The fixed
expenses
general
General factory
factory overhead$ and
overhead general
60,000
administrative expenses assigned
Salary of line manager to this product
90,000
Depreciation of equipment 50,000
would be reallocated to other100,000
Advertising - direct
product lines.
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)

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 Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable
The manufacturing
equipment used tocosts $ 120,000
manufacture
Variable shipping costs 5,000
digital watches has no resale
Commissions 75,000 200,000
valuemargin
Contribution or alternative use. $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct Should Lovell
100,000retain or drop
Rent - factory space the digital70,000
watch segment?
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)

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 A Contribution Margin Approach

Contribution Margin
Solution
Contribution margin lost if digital
  watches are dropped $ (300,000)
Less fixed costs that can be avoided
Salary of the line manager $ 90,000
Advertising - direct 100,000
Rent - factory space 70,000 260,000
Net disadvantage $ (40,000)

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 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.

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 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000
Salary of line manager 90,000
Depreciation 50,000 If the digital watch
Advertising - direct 100,000
Rent - factory space 70,000
line is dropped, the
General admin. expenses 30,000 company gives up
Total fixed expenses 400,000 its contribution
Net operating loss $ (100,000)
margin.

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 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000
Depreciation 50,000
Advertising - direct On 100,000
the other hand, the general
Rent - factory space factory overhead would be the
70,000
General admin. expenses 30,000
Total fixed expenses
same. So this cost really isn’t
400,000
Net operating loss $ (100,000) relevant.

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 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses
But we wouldn’t
120,000
need a
- 120,000
Shipping manager for5,000 the product -line 5,000
Commissions anymore.
75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)

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 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
If variable
Less the digital watch line is dropped, the net -book value
expenses:
Manufacturing expenses 120,000 -
of the equipment would be written off. The 120,000
Shipping 5,000 - 5,000
depreciation that would have
Commissions been taken- will flow75,000
75,000
through
Total variable the income statement
expenses 200,000as a loss -instead.200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)

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 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000 - 100,000
Rent - factory space 70,000 - 70,000
General admin. expenses 30,000 30,000 -
Total fixed expenses 400,000 140,000 260,000
Net operating loss $ (100,000) $ (140,000) $ (40,000)

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 Beware of Allocated Fixed Costs

Why should we keep the

digital watch segment
when it’s showing a
$100,000 loss?

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 Beware of Allocated Fixed Costs

The answer lies in the

way we allocate
common fixed costs to
our products.

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 Beware of Allocated Fixed Costs

Our allocations can

make a segment look
less profitable than it
really is.

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 The Make or Buy Decision

When a company is involved in more than one

activity in the entire value chain, it is vertically
integrated. A decision to carry out one of the
activities in the value chain internally, rather than
to buy externally from a supplier is called a
“make or buy” decision.

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 Vertical Integration- Advantages

Smoother flow of
parts and materials

Better quality
control

Realize profits

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 Vertical Integration- Disadvantage

Companies may fail

to take advantage of
suppliers who can
create economies of
scale advantage by
pooling demand from
numerous
companies.

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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

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 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?

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

Direct materials $ 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

20,000 × $9 per unit = $180,000

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

Direct materials $ 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 special equipment has no resale

value and is a sunk cost.

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

Direct materials $ 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.

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

Direct materials $ 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?

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 Opportunity Cost

An opportunity cost is the benefit that is foregone as a

result of pursuing some course of action.
Opportunity costs are not actual dollar outlays and
are not recorded in the formal accounts of an
organization.

How would this concept potentially relate to the Essex

Company?

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 Key Terms and Concepts

A special order is a one-time

order that is not considered
part of the company’s normal
ongoing business.

When analyzing a special

order only the incremental
costs and benefits are
relevant.

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 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.

Should Jet accept the offer?

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 Special Orders

Jet, Inc.
Contribution Income Statement
Revenue (5,000 × $20) $ 100,000
Variable costs:
Direct materials $ 20,000
Direct labor 5,000
Manufacturing overhead 10,000 $8 variable cost
Marketing costs 5,000
Total variable costs 40,000
Contribution margin 60,000
Fixed costs:
Manufacturing overhead $ 28,000
Marketing costs 20,000
Total fixed costs 48,000
Net operating income $ 12,000
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 Special Orders

If Jet accepts the offer, net operating income will

increase by $6,000.

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 fixed costs are

unaffected by the order and that variable marketing
costs must be incurred on the special order.

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 Quick Check 

Northern Optical ordinarily sells the X-lens for $50.

The variable production cost is $10, the fixed
production cost is $18 per unit, and the variable
selling cost is $1. A customer has requested a
special order for 10,000 units of the X-lens to be
imprinted with the customer’s logo. This special
order would not involve any selling costs, but
Northern Optical would have to purchase an
imprinting machine for $50,000.
(see the next page)

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 Quick Check 

What is the rock bottom minimum price below which

Northern Optical should not go in its negotiations
with the customer? In other words, below what
price would Northern Optical actually be losing
money on the sale? There is ample idle capacity to
fulfill the order and the imprinting machine has no
further use after this order.
a. $50
b. $10
c. $15
d. $29

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 Quick Check 

What is the rock bottom minimum price below which

Northern Optical should not go in its negotiations
with the customer? In other words, below what
price would Northern Optical actually be losing
money on the sale? There is ample idle capacity to
fulfill the order and the imprinting machine has no
further use after this order.
a. $50
Variable production cost $100,000
Additional fixed cost 50,000
b. $10
Total relevant cost $150,000
c. $15
Number of units 10,000
d. $29 Average cost per unit $15
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 Key Terms and Concepts

When a limited resource

of some type restricts
the company’s ability to
satisfy demand, the
company is said to have
a constraint.

The machine or process

that is limiting overall
output is called the
bottleneck – it is the
constraint.

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 Utilization of a Constrained Resource

• When a constraint exists, a company should

select a product mix that maximizes the total
contribution margin earned since fixed costs
usually remain unchanged.
• A company should not necessarily promote those
products that have the highest unit contribution
margin.
• Rather, it should promote those products that
earn the highest contribution margin in relation to
the constraining resource.

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 Utilization of a Constrained Resource: An
Example

Ensign Company produces two products and

selected data is shown below:
Product
1 2
Selling price per unit $ 60 $ 50
Less variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.

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 Utilization of a Constrained Resource

• Machine A1 is the constrained resource and

is being used at 100% of its capacity.
• There is excess capacity on all other
machines.
• Machine A1 has a capacity of 2,400 minutes
per week.

Should Ensign focus its efforts on

Product 1 or 2?

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 Quick Check 

How many units of each product can be

processed through Machine A1 in one minute?

Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2.0 units
c. 2 units 1.0 unit
d. 2 units 0.5 unit

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 Quick Check 

How many units of each product can be

processed through Machine A1 in one minute?

Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2.0 units
c. 2 units 1.0 unit
d. 2 units 0.5 unit

I was just checking to make sure you are

with us.
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 Quick Check 

What generates more profit for the company,

using one minute of machine A1 to process
Product 1 or using one minute of machine A1
to process Product 2?
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.

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 Quick Check 
With one minute of machine A1, we could
makegenerates
What 1 unit of Product 1, with
more profit for athe
contribution
company,
margin
using oneofminute
$24, orof2 machine
units of Product 2, each
A1 to process
with a contribution margin of $15.
Product 1 or using one minute of machine A1
2 × $15
to process Product 2?= $30 > $24
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.

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 Utilization of a Constrained Resource

The key is the contribution margin per unit of the

constrained resource.
Product
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.
Contribution margin per minute $ 24 $ 30

Product 2 should be emphasized. Provides more

valuable use of the constrained resource machine A1,
yielding a contribution margin of $30 per minute as
opposed to $24 for Product 1.

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 Utilization of a Constrained Resource

The key is the contribution margin per unit of the

constrained resource.
Product
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.
Contribution margin per minute $ 24 $ 30

If there are no other considerations, the best

plan would be to produce to meet current
demand for Product 2 and then use remaining
capacity to make Product 1.

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 Utilization of a Constrained Resource

Let’s see how this plan would work.

Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

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 Utilization of a Constrained Resource

Let’s see how this plan would work.

Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Utilization of a Constrained Resource

Let’s see how this plan would work.

Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.
Time required per unit ÷ 1.00 min.
Production of Product 1 1,300 units

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Utilization of a Constrained Resource

According to the plan, we will produce 2,200 units

of Product 2 and 1,300 of Product 1. Our
contribution margin looks like this.

Product 1 Product 2
Production and sales (units) 1,300 2,200
Contribution margin per unit $ 24 $ 15
Total contribution margin $ 31,200 $ 33,000

The total contribution margin for Ensign is $64,200.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Quick Check 

Colonial Heritage makes reproduction colonial

furniture from select hardwoods.
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only be

able to supply 2,000 board feet this month. Is this
enough hardwood to satisfy demand?
a. Yes
b. No

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Quick Check 

Colonial Heritage makes reproduction colonial

furniture from select hardwoods.
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only be

able to supply 2,000 board feet this month. Is this
enough hardwood to satisfy demand?
a. Yes
b. No
(2  600) + (10  100 ) = 2,200 > 2,000
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Quick Check 

Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only

be able to supply 2,000 board feet this month.
What plan would maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Quick Check 
Chairs Tables
Selling price $ 80 $ 400
Variable cost
Chairs Tables 30 200
Selling price per unit
Contribution $80
margin $400
$ 50 $ 200
Variable cost per unit
Board feet $30 $200
2 10
Board feet per unit 2 10
Monthly demandCM per board foot
600 $ 25 $ 20
100
The company’s supplier of hardwood will only
be able to supply 2,000 board
Production feet this600
of chairs month.
What plan wouldBoard feet required
maximize profits? 1,200
Board
a. 500 chairs and 100feet remaining
tables 800
Board feet per table 10
b. 600 chairs and 80 tables
Production of tables 80
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Quick Check 

As before, Colonial Heritage’s supplier of

hardwood will only be able to supply 2,000
board feet this month. Assume the company
follows the plan we have proposed. Up to how
much should Colonial Heritage be willing to pay
above the usual price to obtain more hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Quick Check 

As before,
The Colonial
additional woodHeritage’s
would be supplier
used toofmake
hardwood
tables. will onlyuse,
In this be able
eachto board
supplyfoot
2,000of
board feet this month. Assume the company
additional wood will allow the company to earn
follows the plan we have proposed. Up to how
an additional
much $20 of contribution
should Colonial margintoand
Heritage be willing pay
above the usual price profit.
to obtain more hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Managing Constraints

Finding ways to At the bottleneck itself:

process more • Improve the process
units through a • Add overtime or another shift
resource
bottleneck
• Hire new workers or acquire
more machines
• Subcontract production
• Reduce amount of defective
units produced
• Add workers transferred from
non-bottleneck departments

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 Joint Costs

• In some industries, a number of end

products are produced from a single raw
material input.
• Two or more products produced from a
common input are called joint products.
• The point in the manufacturing process
where each joint product can be
recognized as a separate product is
called the split-off point.
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 Joint Products

Oil

Common
Joint
Production Gasoline
Input
Process

Chemicals

Split-Off
Point

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 Joint Products

Joint
Separate Final
Costs Oil
Sale
Processing

Common
Joint Final
Production Gasoline
Input Sale
Process

Separate Final
Chemicals
Processing Sale

Split-Off Separate
Point Product
Costs
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 The Pitfalls of Allocation

Joint costs are often

allocated to end products on
the basis of the relative
sales value of each product
or on some other basis.

Although allocation is needed for

some purposes such as balance
sheet inventory valuation,
allocations of this kind are very
dangerous for decision making.
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Sell or Process Further

Joint costs are irrelevant in decisions

regarding what to do with a product from the
split-off point forward.

It will always be profitable to continue

processing a joint product after the split-off
point so long as the incremental revenue
exceeds the incremental processing costs
incurred after the split-off point.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 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.”

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 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

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 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

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 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)

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 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)

Should we process the lumber further

and sell the sawdust “as is?”

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Activity-Based Costing and Relevant
Costs

ABC can be used to help identify potentially

relevant costs for decision-making purposes.

However, before making a

decision, managers must
decide which of the potentially
relevant costs are actually
avoidable.

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 End of Chapter 13

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.