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
An avoidable
avoidable cost
cost can
can be
be eliminated
eliminated (in
(in whole
whole or
or
in
in part)
part) by
by choosing
choosing one
one alternative
alternative over
over
another.
another. Avoidable
Avoidable costs
costs are
are relevant
relevant costs.
costs.
Unavoidable
Unavoidable costs
costs are
are irrelevant
irrelevant costs.
costs.

Two
Two broad
broad categories
categories of
of costs
costs are
are never
never
relevant
relevant in
in any
any decision
decision and
and include:
include:
Sunk
Sunk costs.
costs.
Future
Future costs
costs that
that do
do not
not differ
differ between
between the
the
alternatives.
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
$45 per
per month
month × 8 months $1.60 per gallon ÷ 32 MPG

$18,000
$18,000 cost
cost – $4,000 salvage value ÷÷ 55 years
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
Let’s see
see how
how relevant
relevant costs
costs should
should
be
be used
used in
in this
this type
type of
of decision.
decision.

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 Adding/Dropping Segments

Due
Due to
to the
the declining
declining popularity
popularity of
of digital
digital
watches,
watches, Lovell
Lovell Company’s
Company’s digital
digital
watch
watch line
line has
has not
not reported
reported aa profit
profit for
for
several
several years.
years. Lovell
Lovell is
is considering
considering
dropping
dropping this
this product
product line.
line.

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 A Contribution Margin Approach

DECISION RULE
Lovell
Lovell should
should drop
drop the
the digital
digital watch
watch segment only
ifif its
its profit
profit would
would increase.
increase. This
This would
would only
only
happen
happen ifif the
the fixed
fixed cost
cost savings exceed
exceed the
the lost
lost
contribution
contribution margin.
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
Investigation has
has revealed
Variable manufacuring coststhat
revealed $ total
that total fixed
120,000 fixed general
general
Variablefactory
shippingoverhead
factory overhead
costs and
and general
general
5,000
Commissions expenses would not
administrative 75,000
be affected200,000
ifif
administrative
Contribution margin
expenses would not be affected
$ 300,000
the
the
Less: digital
digital
fixed watch
watch line
expenses line is
is dropped.
dropped. The The fixed
fixed
general
general
General factory
factoryfactory overhead
overhead
overhead $ and
and general
general
60,000
administrative expenses
expenses assigned
Salary of line manager
administrative assigned to
to this
90,000
this product
product
Depreciation of equipment 50,000
would
would be be -reallocated
Advertising reallocated
direct
to
to other product
product lines.
other100,000 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
The
The equipment
Variable used
used to
manufacturing
equipment to manufacture
costs $ 120,000
manufacture
Variable shipping costs 5,000
digital
digital watches
Commissions watches hashas no
no resale
resale
75,000 200,000
value
value
Contribution or
or alternative
marginalternative use.
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
Should Lovell
Lovell retain or drop
100,000 retain or drop
Rent - factory space the
the digital watch
watch segment?
digital70,000 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
Let’s look
look at
at this
this second
second approach.
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 IfIf the
the digital
digital watch
watch
Advertising - direct 100,000
Rent - factory space 70,000
line
line is is dropped,
dropped, thethe
General admin. expenses 30,000 company
company gives gives upup
Total fixed expenses 400,000 its
its contribution
contribution
Net operating loss $ (100,000)
margin.
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 the
the other
On 100,000 other hand,
hand, the
the general
general
Rent - factory space factory
factory overhead
overhead would
70,000 would bebe the
the
General admin. expenses 30,000
Total fixed expenses
same.
same. So
400,000So this
this cost
cost really
really isn’t
isn’t
Net operating loss $ (100,000) relevant.
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
wouldn’t need -aa
But we 120,000 need 120,000
Shipping manager
manager for the
the product
for5,000 product-line line 5,000
Commissions 75,000
anymore. - 75,000
Total variable expenses
anymore.
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)
IfIfvariable
Less the
the digital
digital watch
watch line
expenses: line is
is dropped,
dropped, the the net
net-book
book value
value
Manufacturing expenses 120,000 - 120,000
of
of the
the equipment
equipment would
would be
be written
written off.
off. The
The
Shipping 5,000 - 5,000
depreciation
depreciation that
Commissions that would
would havehave been
been taken
75,000 taken- willwill flow
flow75,000
through
through
Total variable the
the income
expensesincome statement 200,000as
statement as aa loss
loss-instead.
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
When aa company
company is is involved
involved in in more
more than
than one
one activity
activity
in
in the
the entire
entire value
value chain,
chain, itit is
is vertically
vertically integrated.
integrated.
A
A decision
decision to
to carry
carry out
out one
one of of the
the activities
activities in
in the
the
value
value chain
chain internally,
internally, rather
rather thanthan toto buy
buy externally
externally
from
from aa supplier
supplier isis called
called aa “make
“make or or buy”
buy” decision.
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
Should we
we accept
accept the
the supplier’s
supplier’s offer?
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
The special
special equipment
equipment hashas no
no resale
resale
value
value and
and is
is aa sunk
sunk cost.
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
Not avoidable;
avoidable; irrelevant.
irrelevant. IfIf the
the product
product is
is
dropped,
dropped, itit will
will be
be reallocated
reallocated toto other
other products.
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
An opportunity
opportunity cost
cost is
is the
the benefit
benefit that
that is
is foregone
foregone asas aa
result
result of
of pursuing
pursuing some
some course
course of of action.
action.
Opportunity
Opportunity costs
costs are
are not
not actual
actual dollar
dollar outlays
outlays and
and
are
are not
not recorded
recorded in in the
the formal
formal accounts
accounts of of an
an
organization.
organization.

How
How would
would this
this concept
concept potentially
potentially relate
relate to
to the
the Essex
Essex
Company?
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,
Jet, Inc.
Inc. makes
makes aa single
single product
product whose
whose normal
normal selling
selling
price
price is
is $20
$20 per
per unit.
unit.
AA foreign
foreign distributor
distributor offers
offers to
to purchase
purchase 3,000
3,000 units
units for
for $10
$10
per
per unit.
unit.
 This
This is
is aa one-time
one-time order
order that
that would
would not
not affect
affect the
the
company’s
company’s regular
regular business.
business.
 Annual
Annual capacity
capacity isis 10,000
10,000 units,
units, but
but Jet,
Jet, Inc.
Inc. is
is currently
currently
producing
producing and and selling
selling only
only 5,000
5,000 units.
units.

Should Jet accept the offer?

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 Special Orders

$8 variable cost

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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.
Variable production cost $100,000
a. $50
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
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 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.

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

 Utilization of a Constrained Resource

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

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

 Utilization of a Constrained Resource: An
Example

Ensign Company produces two products and

selected data is shown below:

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

 Utilization of a Constrained Resource

• Machine
Machine A1 A1 is
is the
the constrained
constrained resource
resource and
and
is
is being
being used
used atat 100%
100% of
of its
its capacity.
capacity.
• There
There is
is excess
excess capacity
capacity on
on all
all other
other
machines.
machines.
• Machine
Machine A1 A1 has
has aa capacity
capacity ofof 2,400
2,400 minutes
minutes
per
per week.
week.

Should
Should Ensign
Ensign focus
focus its
its efforts
efforts on
on
Product
Product 11 or
or 2?
2?

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

 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

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

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

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

 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
to process Product 2?= $30 > $24
2 × $15
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.

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

 Utilization of a Constrained Resource

The key is the contribution margin per unit of the

constrained resource.

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.

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

 Utilization of a Constrained Resource

The key is the contribution margin per unit of the

constrained resource.

IfIf there
there are
are no
no other
other considerations,
considerations, the
the best
best
plan
plan would
would be
be to
to produce
produce to
to meet
meet current
current
demand
demand for for Product
Product 22 and
and then
then use
use remaining
remaining
capacity
capacity to
to make
make Product
Product 1.
1.

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

 Utilization of a Constrained Resource

Let’s see how this plan would work.

Alloting
Alloting Our
Our Constrained
Constrained Resource
Resource (Machine
(Machine A1)
A1)

Weekly
Weeklydemand
demand for
for Product
Product22 2,200
2,200 units
units
Time
Time required
required per
per unit
unit ×× 0.50
0.50 min.
min.
Total
Total time
time required
required to
to make
make
Product
Product22 1,100
1,100 min.
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
Alloting Our
Our Constrained
Constrained Resource
Resource (Machine
(Machine A1)
A1)

Weekly
Weeklydemand
demand for
for Product
Product22 2,200
2,200 units
units
Time
Time required
required per
per unit
unit ×× 0.50
0.50 min.
min.
Total
Total time
time required
required to
to make
make
Product
Product22 1,100
1,100 min.
min.

Total
Total time
time available
available 2,400
2,400 min.
min.
Time
Time used
used to
to make
make Product
Product22 1,100
1,100 min.
min.
Time
Time available
available for
for Product
Product11 1,300
1,300 min.
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
Alloting Our
Our Constrained
Constrained Resource
Resource (Machine
(Machine A1)
A1)

Weekly
Weeklydemand
demand for
for Product
Product22 2,200
2,200 units
units
Time
Time required
required per
per unit
unit ×× 0.50
0.50 min.
min.
Total
Total time
time required
required to
to make
make
Product
Product22 1,100
1,100 min.
min.

Total
Total time
time available
available 2,400
2,400 min.
min.
Time
Time used
used to
to make
make Product
Product22 1,100
1,100 min.
min.
Time
Time available
available for
for Product
Product11 1,300
1,300 min.
min.
Time
Time required
required per
per unit
unit ÷÷ 1.00
1.00 min.
min.
Production
Production of ofProduct
Product11 1,300
1,300 units
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
Production
be able to supply of chairs
2,000 board feet this600
month.
What plan wouldBoard feet required
maximize profits? 1,200
Board feet remaining 800
a. 500 chairs and 100 tables
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 wood Heritage’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
follows the plan will allowproposed.
we have the company
Up totohow
earn
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 units • Improve the process
through a resource • Add overtime or another shift
bottleneck
• Hire new workers or acquire
more machines
• Subcontract production
• Reduce amount of defective
units produced
• Add workers transferred from
non-bottleneck departments

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

 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
joint products.
products
• The point in the manufacturing process
where each joint product can be
recognized as a separate product is
called the split-off
split-off point.
point
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Joint Products

Oil

Common
Joint
Production Gasoline
Input
Process

Chemicals

Split-Off
Point

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

 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,
Sawmill, Inc.
Inc. cuts
cuts logs
logs from
from which
which unfinished
unfinished
lumber
lumber andand sawdust
sawdust are are the
the immediate
immediate jointjoint
products.
products.
• Unfinished
Unfinished lumber
lumber is is sold
sold “as
“as is”
is” or
or processed
processed
further
further into
into finished
finished lumber.
lumber.
• Sawdust
Sawdust can can also
also bebe sold
sold “as
“as is”
is” to
to gardening
gardening
wholesalers
wholesalers or or processed
processed further
further into
into “presto-
“presto-
logs.”
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

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

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.

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

 End of Chapter 13

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