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Chapter 12

Chapter 12- rsm222.docx

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University of Toronto St. George
Rotman Commerce
Donna Losell

Chapter 12: Relevant Costs for Decision Making COST CONCEPT FOR DECISION MAKING  Key is to identify and compare only the relevant costs and benefits for each alternative o Relevant costs: a cost that differs among the alternatives in a particular decision and will be incurred in the future; this term is synonymous w avoidable cost and differential cost  Purpose of this chapter is to distinguish btwn relevant and irrelevant cost by illustrating their use in a wide range of decision making situations  2 important aspects o None of the situations involve capital expenditures where the time value of money can be important o The key criterion used in the various decision situations is the max of operating income COST CONCEPTS FOR DECISION MAKING  Remember these terms: DiffC, IncC, OC, SC Identifying relevant costs and benefits  If a cost will be the same regardless of the alternative selected, its ignored  Avoidable cost: any cost that can be eliminated (in whole or in part) by choosing one alternative over another in a decision making situation; also called relevant cost and differential cost  Irrelevant costs: o Sunk costs o Future costs that do not differ btwn the alternatives  Avoidable cost, diff cost, incre cost, and relevant cost all interchangeable  To identify the costs and benefits that are relevant: o Eliminate costs and benefits that do not differ btwn alternatives ^ o Use the remaining costs and benefits that do differ btwn alternatives in making the decision; those are Diff or avoidable costs Different costs for different purposes  Costs could be relevant in one decision but not another Example on pg 556-557 Reconciling the total and differential approaches  A positive # in differential costs and benefits means that the diff btwn the alternatives favours the new thing, a negative # indicates that the diff favours the current situation o Zero means that total amount for the item is same for both alternatives  Since diff in operating income = sum of the diff for the individual items, any cost of benefit that is the same for both alts will have no impact on which alt is preferred o Why they are irrelevant Why isolate relevant costs?  Using 2 approaches: one was to consider only the relevant costs and the other was to consider all costs o Obtain same answer under both  We still do it bc o Only rarely will enough info be available to prepare a detailed IS for both alts o Combining irrelevant costs w relevant ones may cause confusion o Irrelevant piece of data may be used improperly ANALYSIS OF VARIOUS DECISION SITUATIONS  When dealing with non routine or special decisions do the same thing o The relevant costs and benefits must be quantified, and the alt with the most favourable impact on operating income is selected Adding and dropping product lines and other segments  An ABC may be used to help identify the relevant costs  To determine how dropping the line will affect the overall profits of company, can compare the CM that will be lost to the costs that can be avoided if the line is dropped Beware of allocated fixed costs  One of the dangers of allocating common fixed costs is that such allocations can make a product line or segment look less profitable than it really is o Whereas in fact, it can be and the overall operating income can be higher than if the product line was dropped  Sometimes can still keep though even if unprofitable product line bc it is a magnet to customers eg bread- we need that shit  Keep or drop? Pg 565*** The make or buy decision  Sep companies may carry out each step in the value chain (getting shit to us) or a single company may do it all  Vertical integration: involvement of a single company in more than one of the steps of the value chai from production of basic raw materials to the manu and distribution of a FG  Make or buy decision: whether an item should be produced internally or purchased from an outside supplier Strategic aspects of the make or buy decision  Integration has advantages: less dependent on supplier and may be able to ensure smoother flow of part and materials for production than a non integrated firm  Advantages of external suppliers: supplier may be able to realize economies of scale In R&D and in manu which can result in higher quality and lower u
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