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Chapter 12

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ACTG 2020
Ben Kelly

Chapter 12: Relevant Cost for Decision Making Relevant Costs are those costs that differ among the alternatives under consideration and that will be incurred in the future (i.e., the cost has not already been incurred) ­ In managerial accounting, this term is synonymous with avoidable cost and differential cost Cost Concepts for Decision Making Identifying Relevant Costs and Benefits ­ Only costs and benefits that differ in total among alternatives and that will be incurred in the future are relevant in a decision ­ If a cost will be the same regardless of the alternative selected, then it can be ignored Avoidable cost is any cost that can be eliminated (in whole or in part) by choosing one alternative and that will be incurred in the future and are relevant ­ In managerial accounting this term is synonymous with ‘relevant cost’ and ‘differential cost’ ­ Two broad categories of costs are never relevant in decisions: (a) Sunk costs- like a DVD you already paid for; and (b) future costs that don’t differ b/w alternatives – for example, car lease payments when you’re deciding whether to watch a DVD at home or go to a movie theatre ­ To identify the costs and benefits that are relevant in a particular decision situation: 1. Eliminate the costs and benefits that don’t differ b/w alternatives (this includes sunk costs and future costs/benefits that don’t differ b/w alternatives) 2. Use the remaining costs and benefits that do differ b/w alternatives in making the decision. The costs that remain are the differential, or avoidable, costs. Different Costs for Different Purposes ­ Since different costs are relevant in different decision situations, the manager must examine the data at hand and isolate the relevant costs so that they can avoid being misled by irrelevant data Example of Identifying Relevant Costs and Benefits Page 556-558 Reconciling the Total and Differential Approaches ­ Since the differences in the operating incomes equals the sum of the differences for the individual items, any cost or benefit that is the same for both alternatives will have no impact on which alternative is preferred ­ This is why costs and benefits that don’t differ b/w alternatives are irrelevant – and why you can ignore them (if you properly account for them, they’ll cancel out when the two alternatives are compared) ­ If you just focus on relevant costs, the same answer is yielded as focusing on total costs – so to save time and effort, just focus on relevant costs ­ Isolating relevant costs is desirable for at least 2 reasons: (1) only rarely will enough info be available to prepare a detailed income statement for both alternatives as we have done in the preceding textbook examples; (2) combining irrelevant costs with relevant costs may cause confusion and distract attention from the matters that are really crucial Analysis of Various Decision Situations Adding and Dropping Product Lines and Other Segments ­ Essentially, if by dropping a product line, the company is able to avoid more in fixed costs than it loses in CM, then it’ll be better off if the line is eliminated -> Overall operating income should improve ­ ABC analysis may be used to help identify the relevant costs ­ To figure out which costs will decrease and which will stay the same -> compare a change in CM to change in costs A Comparative Format ­ Create a comparative I/S showing the effects on the company as a whole of either keeping or dropping a product line (Pg. 564 Exhibit 12-3, AFM Electronics) Beware of Allocated Fixed Costs ­ A reason for keeping a line that is showing a loss is because common fixed costs could be being allocated to product lines which makes them look unprofitable ­ It’s important to figure out the segment margin Segment margin is the sum of loss of segment margin plus loss of sunk costs; totals total loss that would result if a line were dropped ­ Managers might choose to keep an unprofitable line if the line is necessary to the sale of other products, it serves as a ‘magnet’ to attract customers Decision Aid – Page 565 The Make or Buy Decision ­ A single company may carry out several steps in the value chain, or separate companies may carry out each step in the value chain Vertical integration is the involvement by a single company in more than one of the steps of the value chain from production of basic raw materials to the manufacture and distribution of a finished product Make or buy decision is a decision as to whether an item should be produced internally or purchased from an outside supplier The 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 ­ By pooling demand from a number of firms, a supplier may be able to realize economies of scale in R & D and in manufacturing ­ Decision is made by exploring only RELEVANT costs – eliminate sunk costs and future costs that will continue regardless of make or buy decision – important to also consider opportunity cost Opportunity Cost ­ Consideration of space that would otherwise be idle; Essentially, in make or buy decisions, it’s important to consider what factory space would be used for: if it sits idle, no additional calculations are necessary; if the company could product other inventory, it’s important to factor those economic benefits that are foregone into the decision Decision Aid – Page 568 Special Orders Special order is a one-time order that isn’t considered part of the company’s normal ongoing business ­ The objective in setting a price for special orders is to achieve positive incremental operating income ­ Only the incremental costs and benefits are relevant – in order for a special order to be profitable, incremental revenue from the special order ne
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