11th Edition

Chapter 13

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 Relevant Costs for Decision
Making

Chapter Thirteen

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 Learning Objectives

• 1. Identification of relevant costs.

• 2. Drop or retain a segment.
• 3. Make or buy decision.

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 Cost Concepts for Decision Making

A relevant cost is a cost that differs

between alternatives.

2
1

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 Identifying Relevant Costs

An avoidable cost can be eliminated (in whole or

in part) by choosing one alternative over
another. Avoidable costs are relevant costs.
Unavoidable costs are irrelevant costs.

Two broad categories of costs are never

relevant in any decision and include:
Sunk costs. is a cost that has already been
incurred and cannot be avoided regardless of
what a manager decides to do.
Future costs that do not differ between the
alternatives.

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 Relevant Cost Analysis: A Two-Step
Process

Step 1 Eliminate costs and benefits that do not differ

between alternatives.
Step 2 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.

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 Different Costs for Different Purposes

Costs that are

relevant in one
decision situation
may not be relevant
in another context.

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 Adding/Dropping Segments

One of the most important decisions

managers make is whether to add or
drop a business segment such as a
product or a store.

Let’s see how relevant costs should

be used in this type of decision.

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 The Make or Buy Decision

When a company is involved in more than one activity in the entire

value chain, it is vertically integrated. A decision to carry out one
of the activities in the value chain internally, rather than to buy
externally from a supplier is called a “make or buy” decision.

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 The Make or Buy Decision: An Example

• Essex Company manufactures part 4A that is

used in one of its products.
• The unit product cost of this part is:

Direct materials $ 9
Direct labor 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary 2
General factory overhead 10
Unit product cost $ 30

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 The Make or Buy Decision

• The special equipment used to manufacture part 4A

has no resale value.
• The total amount of general factory overhead, which
is allocated on the basis of direct labor hours, would
be unaffected by this decision.
• The $30 unit product cost is based on 20,000 parts
produced each year.
• An outside supplier has offered to provide the
20,000 parts at a cost of $25 per part.
Should we accept the supplier’s offer?

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 The Make or Buy Decision
Cost
Per Unit Cost of 20,0
Make
Outside purchase price $ 25

Direct materials $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30
20,000 × $9 per unit = $180,000 $ 340,000

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 The Make or Buy Decision
Cost
Per Unit Cost of 20,0
Make
Outside purchase price $ 25

Direct materials $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory
The overhead
The special
special equipment
equipment has 10no
has resale -
no resale
Total cost value
value and
and is $ 30
is aa sunk
sunk cost. $ 340,000
cost.

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 The Make or Buy Decision
Cost
Per Unit Cost of 20,0
Make
Outside purchase price $ 25

Direct materials $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General
Not factory overhead
Not avoidable;
avoidable; irrelevant. the10
irrelevant. IfIf the product is -
product is
Total cost itit will
dropped,
dropped, will be
be reallocated
reallocated toto$other
30 products.
other $ 340,000
products.

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 The Make or Buy Decision
Cos t
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip.(Not 3 -
Supervisor's salary 2 40,000
General factory overhead( Not) 10 -
Total cost $ 30 $ 340,000 $ 500,000

Should we make or buy part 4A?

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 Example 2
• Our Company manufactures a part for its production
cycle. The costs per unit for 5,000 units of this part are
as follows:
Direct materials $3
Direct labor 5
Variable factory overhead 4
Fixed factory overhead 4
Total costs $16

• The fixed factory overhead costs are unavoidable.

Spalding Corporation has offered to sell 5,000 units of
the same part to our Company for $15 a unit.
Assuming no other use for the facilities, Should we
make or buy this part ?
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 Example 3
• Crispy Company manufactures a part for its production cycle. The
costs per unit for 5,000 units of this part are as follows:
• Direct materials $3
• Direct labor 5
• Variable factory overhead 4
• Fixed factory overhead 2
• Total costs $14
•
• The fixed factory overhead costs are unavoidable.
• Assume that Crispy Company has been offered 5,000 units of
the part from another producer for $15 each. The facilities currently
used to make the part could be rented out to another manufacturer
for $20,000 a year. Crispy Company should MAKE OR BUY
• (calculate the advantage or disadvantage per unit).

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 End of Chapter 13

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