Chapter 8 & 9
Relevant Costs for Decision Making
This chapter focuses on developing skills which are necessary to be successful in decision
making. Managers will learn to tell the difference between relevant and irrelevant data and
will be able to correctly use the relevant data to analyze alternatives. The chapter will cover
concepts such as the:
•total and differential approaches
•analysis of various decision situations
o adding and dropping product lines and segments
o make or buy
o special orders
o utilization of constrained resource
o joint product costs and sell or process further
A. Cost Concepts for Decision Making. Every decision involves a choice from among at
least two alternatives. The costs and benefits of the alternatives should be compared when
making the decision.
1. Identifying relevant costs. Only those costs or benefits that differ between alternatives are
relevant in a decision. Any cost or benefit that does not differ across alternatives is
irrelevant and can be ignored. This is a tremendously powerful concept that allows us to
ignore mounds of data when making decisions since most things are not affected by any
a. All sunk costs (i.e., costs already irrevocably incurred) are irrelevant since they will be
the same for any alternative. All future costs that do not differ across alternatives are
b. Any cost that is avoidable is potentially relevant. An avoidable cost is a cost that can be
eliminated (in whole or in part) as a result of choosing one alternative over another.
2. Different costs for different purposes. Costs that are relevant in one decision situation are
not necessarily relevant in another. In each situation the manager must examine the data
and isolate the relevant costs.
3. Human frailties. Many (most?) people have a great deal of difficulty ignoring irrelevant
costs when making decisions. People are especially reluctant to ignore sunk costs when the
sunk costs are a consequence of a past decision that in retrospect was unwise. People have
a tendency to become committed to courses of action that have not worked out.
B. Adding or Dropping a Segment.
Decisions related to dropping old products (or segments) and adding new products (or segments)
are among the most difficult that a manager makes. Two basic approaches can be used to
analyze data in this type of decision.
www.notesolution.com 1. Compare contribution margins and fixed costs. A segment should be added only if the
increase in total contribution margin is greater than the increase in fixed cost. A segment should
be dropped only if the decrease in total contribution margin is less than the decrease in fixed
2. Compare net operating incomes. A second approach is to calculate the total net operating
income under each alternative. The alternative with the highest net operating income is
preferred. This approach requires more information than the first approach since costs and
revenues that don’t differ across the alternatives must be included in the analysis when the
net operating incomes are compared.
3. Beware of allocated common costs. Allocated common costs can make a segment look
unprofitable even though dropping the segment might result in a decrease in overall
company net operating income. Allocated common costs that would not be affected by a
decision are irrelevant and should be ignored in a decision relating to adding or dropping a
C. The Make or Buy Decision. (A make or buy decision is concerned with whether an
item should be made internally or purchased from an external supplier.
1. Advantages of making an item internally.
a. Producing a part internally reduces dependence on suppliers and may ensure a
smoother flow of parts and material for production.
b. Quality control may be easier when parts are produced internally.
c. Profits can be realized on the parts and materials.
2. Advantages of buying an item from an external supplier.
a. By pooling the requirements of a number of users, a supplier can realize economies of
scale and may be able to move more quickly up the learning curve.
b. A specialized supplier may be able to respond more quickly and at less cost to
changing future needs.
c. Changing technology may make producing one’s own parts riskier than purchasing
from the outside.
3. Opportunity Cost. Opportunity costs should be considered in decisions. There is no
opportunity cost involved in using a resource that has excess capacity. However, if the
resource is a constraint (i.e., there is no excess capacity) then there is an opportunity cost.
The opportunity costs may be far more important than the costs typically recorded in
D. Special Order. Special orders are one-time orders that do not affect a company’s normal
sales. The profit from a special order equals the incremental revenue less the incremental costs.
As long as the incremental revenue exceeds the incremental costs, the order should be accepted.
If the special order requires a constrained resource, opportunity costs should be included as part
of the incremental costs.
www.notesolution.com E. Utilization of a Constrained Resource. A constraint is whatever prevents an
individual or organization from getting more of what it wants. There is always a constraint as
long as desires are unsatisfied. The chapter focuses on one particular kind of constraint—a
production constraint. A production constraint can be a raw material, a part, a machine, or a
workstation. If the constraint is a machine or workstation, it is called a bottleneck.
1. Contribution Margin Per Unit of the Constrained Resource. Whenever demand exceeds
productive capacity, a production constraint exists. This means that the company is unable
to fill all orders and some choices have to be made concerning which orders are filled and
which are not filled. The problem is how to most effectively use the constrained resource.
a. Whether this order or that order is filled, the fixed costs will usually be the same.
Therefore, maximizing the total contribution margin will also maximize profit.
b. The total contribution margin is maximized by ranking products in terms of their
contribution margin per unit of the constrained resource. (The profitability index in
Chapter 14 is an application of this idea. In that chapter, the constrained resource is
investment funds and the net present value of a project is analogous to the project’s
2. Managing constraints. Ordinarily, a system has only one constraint. The capacity of an
entire factory or of an entire service organization is determined by the capacity of the
constraint, which could be a single machine or work centre. In addition to making sure that
the best product mix is chosen by ranking products based on the contribution margin per
unit of the constrained resource, managers should seek ways to increase the effective
capacity of the constraint.
a. Increasing the capacity of the constraint or bottleneck is called “relaxing the constraint”
or “elevating the constraint.” Conceptually, the capacity of the bottleneck can be
increased by the increasing rate of output at the bottleneck or increasing the time
available at the bottleneck. Some specific examples of ways to elevate the constraint
• Pay workers overtime to keep the bottleneck running after normal working hours. As
discussed below, the potential payoff from taking such an action is often well worth
the additional expense. In contrast, paying workers overtime to keep non-bottleneck
processes running after normal working hours is a total waste of money.
• Shift workers from non-bottleneck areas to the bottleneck.
• Hire more workers or acquire more machines specifically to augment the bottleneck.
• Subcontract some of the production that would use the bottleneck. If an unimportant
part requires a lot of time on the bottleneck and can be purchased cheaply from an
external supplier, this is a great way to increase profits. The bottleneck can be shifted
to more profitable uses.