RELEVANT COSTING

A. Management’s Decision-Making Process.

1. The steps are:

 Identify the problem and assign responsibility.
 Determine and evaluate possible courses of action.
 Make a decision.
 Review the results of the decision.

2. Accounting’s contribution to the decision-making process occurs

primarily in steps (b) and (d)—evaluating possible courses of action, and
reviewing results.

B. Incremental Analysis.

1. The process used to identify the financial data that change under
2. These data are relevant to the decision because they will vary in the
future among the possible alternatives.
3. Incremental analysis sometimes involves changes that might seem
contrary to your intuition. For example, sometimes:
 Variable costs do not change under the alternative courses of
action.
 Fixed costs do change.
4. Accept an order at a special price.
 The relevant information is the difference between the variable
manufacturing costs to produce the special order and expected
revenues.
 If other sales are affected, then the company would have to consider
the lost sales in making the decision.
 If the company is operating at full capacity, it is likely that the special
order would be rejected.
5. Make or buy.
 In a make or buy decision, the relevant costs are:
(1) The variable manufacturing costs that will be saved.
(2) The fixed manufacturing costs that can be eliminated.
(3) The purchase price.
(4) Opportunity costs: The potential benefit that may be obtained
by following an alternative course of action.
6. Sell or process further.
 Many manufacturers have the option of selling products at a given
point in the production cycle or continuing to process with the
expectation of selling them at a later point at a higher price.
 The basic decision rule is: Process further as long as the incremental
revenue from such processing exceeds the incremental processing
costs.
 In many industries, a number of end-products are produced from a
single raw material and a common production process. These
multiple end-products are referred to as joint products.
 All costs incurred prior to the point at which the two products are
separately identifiable (the split-off point) are called joint costs.
 Joint product costs must be allocated to individual products,
frequently done based on the relative sales value of the joint
products.
 The allocation of joint product costs is important for the determination
of product cost but is irrelevant for any sell-or-process-further
 decisions since these joint costs are sunk costs. They have already
been incurred and cannot be avoided by any subsequent decision.
7. Retain or replace equipment.
 Management often has to decide whether to continue using an asset
or replace it.
 The relevant items to be considered are:
(1) The effects on variable costs.
(2) The cost of the new equipment.
 Any disposal value of the existing asset must also be considered.
 The book value of the old asset does not affect the decision. Book
value is a sunk cost, which is a cost that cannot be changed by any
present or future decision.
8. Eliminate an unprofitable segment.
 In deciding whether to eliminate an unprofitable segment, the relevant
information is the contribution margin produced by the segment and
the disposition of the segment’s fixed expenses.
 In deciding on the future status of an unprofitable segment, management should
consider the effect of elimination on related segments.
 Management should also consider the effect of eliminating the segment on
employees who may have to be discharged or retrained.

Terminologies
Ad hoc discount a price concession that relates to real (or imagined) competitive
pressures rather than to location of the merchandising chain or volume purchased
Differential cost a cost that differs between or among the various decision alternatives
Incremental cost the additional cost of producing or selling a contemplated quantity of
output
Incremental revenue the additional revenue resulting from a contemplated sale or
provision of a service
Linear programming (LP) a method of mathematical programming used to find the
optimal allocation of scarce resources in a situation involving one objective and multiple
limiting factors
Make-or-buy (or outsourcing) decision a decision that compares the cost of internally
manufacturing a component of a final product (or providing a service function) with the
cost of purchasing it from outside suppliers or from another division of the company at a
specified internal transfer price
Mathematical programming a variety of techniques used to allocate limited resources
among activities to achieve a specific objective (From Appendix)
Opportunity cost the potential benefit foregone because one course of action is
chosen over another
Outsourcing decision the outsourcing decision is essentially a make-or-buy decision.
Management must decide whether to produce a good or service within the company, or
to contract out to another party.
Product contribution margin the difference between selling price and variable cost of
goods sold
Relevant costing an approach that focuses managerial attention on a decision's
relevant (or pertinent) fads
Robinson-Patman Act a federal law, passed in 1936, that prohibits companies from
pricing the same products at different levels to different customers when those amounts
do not reflect related cost differences. In other words, price discrimination is illegal.
Sales mix the relative combination of quantities of sales of the various products that
make up the total sales of a company
Scarce resource a resource that is essential to a production or service activity but is
available only in some limited quantity
Segment margin the excess of revenues over direct variable expenses and avoidable
fixed expenses
Slack variable a variable used in a linear programming problem that represents the
unused amount of a resource at any level of operation; associated with less-than-or-
equal-to constraints
Special order decision a situation that requires management to compute a reasonable
sales price for production or service jobs outside the company's normal realm of
operations
Sunk cost a cost incurred in the past that is not relevant to any future courses of action;
the historical or past cost associated with the acquisition of an asset or a resource
Surplus variable a variable used in a linear programming problem that represents
overachievement of a minimum requirement and is associated with greater-than-or-
equaI-to constraints
Outline
A. The Concept of Relevance
1. Information must be associated with the decision or question under
consideration in order for the information to be relevant.
a. Relevant costing is an approach that focuses managerial attention
on a decision's relevant (or pertinent) facts.
b. A differential cost is a cost that differs between or among the
various decision alternatives. A cost must be differential to be
relevant.
c. Incremental cost is the additional cost of producing or selling a
contemplated quantity of output. Incremental costs can be either
variable or fixed. Most variable costs are relevant while most fixed
costs are not relevant.
d. Incremental revenue is the additional revenue resulting from a
contemplated sale or provision of a service.
e. The difference between the incremental revenue and incremental
costs of a particular alternative is the positive or negative
incremental benefit of that course of action.
f. Management can compare the incremental benefits of various
alternatives to decide on the most profitable or least costly
alternative or set of alternatives.
g. Some relevant factors, such as prime product costs, are easily
identified and quantified; and are integral parts of the accounting
system.
h. Other factors, such as opportunity costs, may be relevant and
quantifiable, but are not part of the accounting system.
i. An opportunity cost represents the potential benefit foregone
because one course of action is chosen over another.
2. The need for specific information depends on how important the
information is relative to management objectives.
3. Information can be based on past or present data, but it can only be
relevant if it pertains to a future decision.
a. The future may be the short-run or the long-run; future costs are the
only costs that can be avoided; and, the longer into the future a
 decision's time horizon, the more costs are controllable, avoidable,
and relevant.
b. Only information that has a bearing on future events is relevant in
decision making.
B. Sunk Costs
1. A sunk cost is a cost incurred in the past that is not relevant to any future
courses of action.
2. Such a cost is the historical or past cost associated with the acquisition of
an asset or a resource.
C. Relevant Costs for Specific Decisions
1. Managers routinely make decisions on alternative courses of action that
have been identified as feasible solutions to problems or feasible methods
to use in the attainment of objectives.
a. All incremental revenues, costs, and benefits of all courses of
action are measured against a baseline alternative in determining
which course of action is best.
b. Managers, when evaluating alternative courses of action, should
select the alternative that provides the highest incremental benefit
to the company.
c. The "change nothing" alternative has a zero incremental benefit
since it represents current conditions from which all other
alternatives are measured, and it should be chosen only when it is
perceived to be the best available alternative solution.
d. The chosen course of action should be one that will make the
business better off in the future.
D. Outsourcing Decisions (Make-or-buy decisions)
1. Although most outsourcing decisions are of a make-or-buy nature, this
concept is sometimes easy to overlook when dealing with the outsourcing of
services. For example, deciding to outsource the accounting function to a
service company is essentially a make-or-buy decision; does the company want
to manufacture its own accounting services, or does it want to buy such services
from an outside vendor.
a. A make-or-buy (or outsourcing) decision is a decision that
compares the cost of internally manufacturing a component of a
final product (or providing a service function) with the cost of
purchasing it from outside suppliers or from another division of the
company at a specified internal transfer price.
b. Managers in manufacturing environments are constantly concerned
about whether the right quality components will be available at the
right time and at a reasonable price to assure production.
Companies often assure the availability of a component by
manufacturing it themselves.
c. Relevant information for this type of decision includes both
quantitative and qualitative factors.
d. A typical make-or-buy decision should be made only after proper
analysis, which should include comparing the cost of internally
producing a component to the cost of purchasing it from outside
suppliers or from other divisions at specified transfer prices, and
then assessing the best uses of the available facilities.
e. Variable production costs are relevant, and fixed production costs
may be relevant if they can be avoided when production is
discontinued.
f. The opportunity cost of the facilities being used by production may
also be relevant.
 g. Many service organizations also need to make the same kinds of
decisions.
2. Scarce resources decisions
a. A scarce resource is a resource that is essential to a production or
service activity but is available only in some limited quantity.
b. Scarce resources create constraints on producing goods or
providing services and can include machine hours, skilled labor
hours, raw materials, and production capacity.
c. Management may desire and be able to obtain a greater
abundance of a scarce resource in the long-run, but management
must make the best current use of the scarce resources it has in
the short-run.
d. The determination of the best use of a scarce resource requires
that specific company objectives be recognized by management.
e. The outcome of a scarce resource decision will always indicate that
a single type of product should be manufactured and sold when
one limiting factor is involved.
f. Linear programming is a method of mathematical programming
used to solve a problem that involves an objective function and
multiple limiting factors.
g. Company management must consider qualitative aspects of the
problem in addition to the quantitative ones.
3. Sales mix decisions
a. Sales mix is the relative combination of quantities of sales of the
various products that make up the total sales of a company.
b. Some important factors that affect the appropriate sales mix of a
company are product selling prices, sales force compensation, and
advertising expenditures; a change in one or all of these factors
may cause a company's sales mix to shift.
c. Managers must constantly monitor the relative selling prices of
company products, both in respect to each other as well as to
competitors' prices.
d. Product contribution margin is selling price minus total variable
production costs; it does not consider variable selling costs; it can
motivate a company's sales force when used as a basis for
determining sales Commission compensation.
e. A factor that may cause shifts in sales mix involves either adjusting
the proportion of the advertising budgets respective to each product
the company sells or increasing the total company’s advertising
budget.
4. Special order decisions
a. A special order decision is a situation that requires management
to compute a reasonable sales price for production or service jobs
outside the company's normal realm of operations.
b. The sales price quoted on a special order job typically should be
high enough to cover the job’s variable and incremental fixed costs
and to generate a profit.
c. Overhead costs tend to grow in response to increases in product
variety and complexity; such increases normally occur in receiving,
inspection, order processing, and inventory carrying costs.
d. Activity-based costing techniques allow managers to more precisely
determine these incremental costs and properly include them in
analyzing special orders.
e. Companies sometimes price a special order job with a "low-ball" bid
that produces no profit by barely covering costs or that is below
 cost. Such low-balling is used to penetrate a certain market
segment with the company's products or services.
f. Private label orders, in which the buyer's name appears on the
product's label, are used during slack periods in order to use
available capacity more effectively. Selling prices on private label
special orders are usually set high enough to cover actual variable
costs and partially cover ongoing fixed costs.
g. Special prices may be justified when orders are unusual, because
the products are being tailor-made to customer specifications, or
when goods are produced for a one-time job.
h. The Robinson-Patman Act is a federal law, passed in 1936, that
prohibits companies from pricing the same products at different
levels when those amounts do not reflect related cost differences.
i. An ad hoc discount is a price concession that relates to real (or
imagined) competitive pressures rather than to location of the
merchandising chain or volume purchased. Ad hoc discounts do
not normally require detailed legal justification since they are based
on a competitive market environment.
5. Operating results of multiproduct environments are frequently presented in
a disaggregated format that depicts results for separate product lines
within the organization or division.
a. Managers, in reviewing such statements, must distinguish relevant
from irrelevant information regarding individual product lines.
b. The segment margin represents the excess of revenues over
direct variable expenses and avoidable fixed expenses; the amount
remaining is available to cover unavoidable direct fixed expenses
and common expenses, and to provide profits.
c. The segment margin figure is the appropriate one on which to base
continuation or elimination decisions since it measures the
segment's contribution to the coverage of indirect and unavoidable
expenses.