Principles of MANAGEMENT

ACCOUNTING

Class 7 : Relevant costs &

Bottleneck analysis

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 The Managerial Accountant’s Role
in Decision Making
Managerial
Accountant

Designs and implements Managers who make

accounting information production, marketing,
system and finance decisions

Make substantive
economic decisions
affecting operations

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Relevant Information

Information is relevant to a decision

problem when . . .
• It has a bearing on the future,
• It differs among competing alternatives.

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Analysis of special decisions
 Examples of some special decisions:
 Accept an extra order
 Make or buy decision – outsourcing
 Remove a product, service or region
 …

 Identification of relevant costs & revenues when

comparing alternatives as support for the
decision process

 « Different costs for different purposes »

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Identification of relevant costs and
revenues

 Decision process in the short term

 Comparing two or more alternatives
 Costs/revenues that will ∆ in the
FUTURE and differences between
alternatives
 Not taking into account irrelevant costs:
depreciations current assets, ...
 Take into account “opportunity costs”
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Identification of relevant costs and
revenues: Example
 Outsource accounting with 2
accountants or not?
 Wage 2 accountants: €100.000/year
 Accounting software: €10.000, just
bought

=> Relevant cost: €100.000 can be

saved, software = irrelevant cost!
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Misunderstandings concerning
relevant costs

 Relevant costs ≠ variable costs

 Even fixed costs can be relevant costs, depending
on:
 Time horizon
 Nature of the decision
 Variable costs are not relevant if they are the
same for all alternatives.

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Which costs are relevant?
 Relevant material costs
 Must materials be bought?
 Can we use the current stock?
 Has the current stock a selling value?
 Relevant labour cost?
 Excess capacity?
 Variable costs?
 Full capacity and not expandable
OPPORTUNITY COSTS

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Analysis of Special Decisions

Let’s take a close look at some special

decisions faced by many businesses.
We just received
a special order. Do
you think we should
accept it?

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 Accept or Reject a Special Order

 A travel agency offers Worldwide Airways

$150.000 for a round-trip flight from Hawaii to
Japan on a jumbo jet.
 Worldwide usually gets $250.000 in revenue
from this flight.
 The airlines is not currently planning to add any
new routes and has two planes that are idle and
could be used to meet the needs of the agency.
 The next screen shows cost data developed by
managerial accountants at Worldwide.
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 Accept or Reject a Special Order (2)
Typical Flight Between Japan and Hawaii
Revenue:
Passenger $ 250.000
Cargo 30.000
Total $ 280.000
Expenses:
Variable expenses 90.000
Allocated fixed expenses 100.000
Total 190.000
Profit $ 90.000

Worldwide will save about $5.000 in reservation

and ticketing costs if the charter is accepted.
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 Accept or Reject a Special Order (3)

Assumes excess capacity

Special price for charter $ 150.000
Variable cost per flight $ 90.000
Reservation cost savings (5.000)
Variable cost of charter 85.000
Contribution from charter $ 65.000

Since the charter will contribute to fixed costs and

Worldwide has idle capacity, the company should
accept the flight.
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 Accept or Reject a Special Order (4)

What if Worldwide had no excess capacity? If

Worldwide adds the charter, it will have to
cut its least profitable route that currently
contributes $80.000 to fixed costs and
profits. Should Worldwide still accept the
charter?

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 Accept or Reject a Special Order (5)

Assumes no excess capacity

Special price for charter $ 150.000
Variable cost per flight $ 90.000
Reservation cost savings (5.000)
Variable cost of charter 85.000
Opportunity cost:
Lost contribution on route 80.000 165.000
Total $ (15.000)

Worldwide has no excess capacity, so it should reject

the special charter.
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Accept or Reject a Special Order (6)

With excess capacity . . .

 Relevant costs usually will be the variable
costs associated with the special order.

Without excess capacity . . .

 Same as above but opportunity cost of
using the firm’s facilities for the special
order are also relevant. 15
Outsource a Product or Service

A decision concerning whether an item

should be produced internally or
purchased from an outside supplier is
often called a “make or buy” decision.
Let’s look at another decision faced by the
management of Worldwide Airways.

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 Outsource a Product or Service (2)

 An Atlanta bakery has offered to supply the in-

flight desserts for 21¢ each.
 Here are Worldwide’s current cost for desserts:
Variable costs:
Direct material $ 0,06
Direct labor 0,04
Variable overhead 0,04
Fixed costs:
Supervisory salaries 0,04
Depreciation of equipment 0,07
Total cost per dessert $ 0,25

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 Outsource a Product or Service (3)

Not all allocated fixed costs will be saved if desserts are

purchased externally.
External purchase price:
0,21
Fixed costs (internal):
Supervisory salaries 0,04
Depreciation of equipment 0,07

Total cost per dessert 0,32

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Outsource a Product or Service (4)
Purchasing desserts for 21 ¢ doesn’t decrease
our fixed costs. We have a loss of 7 ¢ per
sold dessert.
Wow, that’s
no deal!

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Outsource a Product or Service (5)

Beware of Unit-Cost Data

For decision-making purposes, unitized fixed
costs can be misleading.

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 Decisions Involving Limited
Resources

 Firms often face the problem of deciding

how limited resources are going to be used.
 Usually, fixed costs are not affected by this
decision, so management can focus on
maximizing total contribution margin.

Let’s look at the Martin, Inc. example.

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 Limited Resources

Martin, Inc. produces two products and

selected data is shown below:
Products
Auto Manual
Selling price per unit $ 60 $ 50
Less: variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2.000 2.200
Processing time required
on the coffee machine per unit 1,00 min. 0,50 min.

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 Limited Resources (2)

 The coffee machine is the scarce resource

because there is excess capacity on other
machines. The coffee machine is being used at
100% of its capacity.
 The coffee machine capacity is 2.400 minutes per
week.

Should Martin focus its efforts

on Auto or Manual?
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 Limited Resources (3)

Let’s calculate the contribution margin per unit

of the scarce resource, the coffee machine.
Products
Auto Manual
Contribution margin per unit $ 24 ?
Time required to produce one
unit ÷ 1,00 min. ?
Contribution margin per minute $ 24 min. ?

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 Limited Resources (4)

Let’s calculate the contribution margin per unit

of the scarce resource, the coffee machine.
Products
Auto Manual
Contribution margin per unit $ 24 $ 15
Time required to produce one
unit ÷ 1,00 min. ÷ 0,50 min.
Contribution margin per minute $ 24 min. $ 30 min.

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 Limited Resources (5)

Let’s calculate the contribution margin per unit

of the scarce resource, the coffee machine.
Products
Auto Manual
Contribution margin per unit $ 24 $ 15
Time required to produce one
unit ÷ 1,00 min. ÷ 0,50 min.
Contribution margin per minute $ 24 min. $ 30 min.

Manual should be emphasized. It is the more valuable

use of the scarce resource, the coffee machine, yielding a
contribution margin of $30 per minute as opposed to $24
per minute for the Auto.
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 Limited Resources (6)

Let’s calculate the contribution margin per unit

of the scarce resource, the coffee machine.
Products
Auto Manual
Contribution margin per unit $ 24 $ 15
Time required to produce one
unit ÷ 1,00 min. ÷ 0,50 min.
Contribution margin per minute $ 24 min. $ 30 min.

If there are no other considerations, the best plan would

be to produce to meet current demand for Manual and
then use any capacity that remains to make Auto.

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Limited Resources (7)

Let’s see how this plan would work.

Alloting the Scarce Recource - The Coffee machine

Weekly demand for Manual 2.200 units

Time required per unit × 0,50 min.
Time required to make Manual 1.100 min.

Total time available 2.400 min.

Time used to make Manual 1.100 min.
Time available for Auto 1.300 min.
Time required per unit ÷ 1,00 min.
Production of Auto 1.300 units

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 Limited Resources (8)

According to the plan, Martin will produce

2.200 Manual and 1.300 Auto. Martin’s
contribution margin looks like this.
Auto Manual
Production and sales (units) 1.300 2.200
Contribution margin per unit $ 24 $ 15
Total contribution margin $ 31.200 $ 33.000

The total contribution margin for Martin, Inc. is $64.200.

Any other combination would result in less contribution.

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Theory of Constraints

Binding constraints can limit a company’s

profitability.
To relax constraints management can . . .

Outsource Work overtime

Reduce non-value-
Retrain employees
added activities

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 Other Issues in Decision Making

Short-Run
Incentives for Versus
Decision Makers Long-Run
Decisions

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Other Issues in Decision Making (2)

Pitfalls to Avoid
Irrelevant Allocated
costs. fixed costs.

Unitized Opportunity
fixed costs. costs.

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