Chapter 12 Relevant Costs for Decision Making.docx

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Department
Accounting & Financial Management
Course
AFM 102
Professor
Tom Vance
Semester
Winter

Description
13– capitalbudgetingdecisions Chapter 12: Relevant Costs for Decision Making Cost Concepts forDecisionMaking  relevant cost: a cost that differs between alternatives in a particular decision. In managerial accounting, this term is synonymous with avoidable cost and differential cost Identifying Relevant Costs and Benefits  avoidable cost: any cost that can be eliminated by choosing one alternative over another in a decision- making situation  ex – by choosing to go to the movies instead of renting, the cost of renting can be avoided  2 broad categories of costs are never relevant in decisions:  sunk cost  future costs that don’t differ between the alternatives  sunk cost: any cost that has already been incurred and that cannot be changed by any decision made now or in the future  differential cost: any cost that differs between alternatives in a decision-making situation  to identify the costs and benefits that are relevant in a particular decision situation, follow these steps:  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  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 Different Costs for Different Purposes  the manager needs different costs for different purposes  a particular group of costs may be relevant for one purpose and another group of costs for another purpose  for each decision situation the manager must examine the data at hand and isolate relevant costs An Example of Identifying Relevant Costsand Benefits  Cynthia is deciding between driving or taking the train  determine which costs are relevant Item Relevant? Annual straight-line depreciation on car Cost of gasoline X Annual cost of auto insurance and license Maintenance and repairs X Parking fee at university Tires X Total average cost per km X Cost of round-trip VIA ticket X Benefit of relaxing and studying during the train ride instead of driving X Cost of putting the cat in a kennel while gone Benefit of having a car available in Moncton X Hassle of parking the car in Moncton X Cost of parking the car in Moncton X Reconciling the Total and Differential Approaches  the difference between the operating income with the new machine and the operating income for the current situation  a positive number in the differential costs and benefits column indicates that the difference between the alternatives favours the new machine  a negative number indicates that the difference favours the current situation  zero in that column means that there is no difference in income between the 2 alternatives  we can arrive at the solution more quickly if we ignore the irrelevant costs and benefits  selling price, # of units sold, DM cost and variable cost per unit, # of units produced,etc page 1 of 5 13– capitalbudgetingdecisions  the costs that do differ: DL cost per unit and fixed rental cost for example should be examined Why Isolate Relevant Costs?  only rarely will enough info be available to prepare a detailed income statement for both alternatives  it would be almost impossible to prepare an i/s  would have to rely on your ability to recognize which costs are relevant and which are not in order to assemble the data necessary to make a decision  combining irrelevant costs with relevant costs may be confusing and distract attention from what’s important  if an irrelevant piece of data is used improperly , than an incorrect decision may occur  the best approach is to discard irrelevant data and base the decision entirely on the relevant data Analysisof Various Decision Situations Adding and Dropping Product Lines and Other Segments  dropping a line will cause the company to lose the contribution margin, but also save some fixed costs  if the company is able to avoid more fixed costs than it loses in contribution margin, then it will be better off if the line is eliminated because overall operating income should improve if salaries, advertising and insurance can be avoided: Total cost Not avoidable Avoidable Salaries 6,400 6,400 Advertising 5,200 5,200 Utilities 800 800 Depreciation – fixtures 1,600 1,600 Rent 3,200 3,200 Insurance 400 400 General administrative 4,800 4,800 Total fixed expenses 22,400 10,400 12,000 Not avoidable costs are either sunk costs or future costs that will not change if the line is dropped. Beware of Allocated Fixed Costs  by allocating the common fixed costs among all product lines, the cameras line has been made to look as if it was unprofitable, whereas in fact, dropping the line would result in a decrease in overall income  the managers may choose to retain an unprofitable product line if the lnie ie necessary to the sale of other products or if it serves as a magnet to attract customers The Make or Buy Decision  steps to get a finished product to the customer  getting raw materials  processing raw materials  preliminary fabrication  actual manufacturing of the finished product  distribution of goods  vertical integration: the involvement by a company in more than one of the steps from production of basic raw materials to the manufacture and distribution of a finished product  some firms control all of the activities in the value chain  other firms purchase many of its parts and materials that go into their finished products  make or buy decision: a decision as to whether an item should be produced internally or purchased from an outside supplier Strategic Aspects of the Make or Buy Decision  an integrated firm is less dependent on its suppliers and may be able to ensure a smoother flow of parts and materials for production than a non-integrated firm  if a strike occurred at the supplier, the operations may be interrupted for non-integrated firms  a supplier may be able to sell at a lower cost than the firm can produce  the supplier enjoys economies of scales because it sells to a large number of firms page 2 of 5 13– capitalbudgetingdecisions  a company must retain control over activites that are essential to maintaining its competitive position Example ofMake or Buy  should focus on differential costs and ignore sunk cost and future costs  depreciation of special equipment is a sunk cost since the equipment is already bought  but, if the equipment could be sold, its salvage value would be relevant  or if the equipment could be used to make othe rprodcuts  variabl
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