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Chapter 12

Relevant costs for decision making

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Tuly Mazumder
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38 views16 pages

Chapter 12

Relevant costs for decision making

Uploaded by

Tuly Mazumder
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Relevant Costs for Decision Making

Chapter-12
Relevant Cost in Decision Making
 Consents Required:
-Relevant Cost vs. Irrelevant Cost
-Differential Analysis: Differential Cost, Incremental Cost/Revenue
-Traceable Fixed Cost vs. Common Fixed Cost
-Net Income vs. Segment Margin
 Two Types of Major Decisions:
-Make or Buy Decision
-Sell or Further Process Decision

Sales-Variable Exp=CM-Fixed Exp.=Net Income

Sales-Variable Exp=CM-Tracable Fixed Exp.=Segment Margin-Common Fixed


Exp.=Net Income
Cost Concepts for Decision Making

A relevant cost is a cost that differs


between alternatives.

2
1
Identifying Relevant Costs

An avoidable cost is a cost that 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. They include:
 Sunk
 costs.
 Future costs that do not differ between the

alternatives.
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
differ between alternatives in making the
decision. The costs that remain are the
differential, or avoidable, costs.
Identifying Traceable Fixed Costs

Traceable costs arise because of the


existence of a particular segment and
would disappear over time if the
segment itself disappeared.
No computer No computer
division means . . . division manager.

12-6
Identifying Common Fixed Costs

Common costs arise because of the overall


operation of the company and would not
disappear if any particular segment were
eliminated.

No computer We still have a


division but . . . company president.

12-7
Traceable Costs Can Become
Common Costs

It is important to realize that the traceable


fixed costs of one segment may be a
common fixed cost of another segment.

For example, the landing fee


paid to land an airplane at an
airport is traceable to the
particular flight, but it is not
traceable to first-class,
business-class, and
economy-class passengers.
12-8
Segment Margin
The segment margin, which is computed by
subtracting the traceable fixed costs of a segment
from its contribution margin, is the best measure
of the long-run profitability of a segment.
Profits

Time
12-9
Traceable and Common Costs

Fixed Don’t allocate


Costs common costs to
segments.

Traceable Common

12-10
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.
Joint Costs
 In some industries, a number of end
products are produced from a single
raw material input.
 Two or more products produced from
a common input are called joint
products.
 The point in the manufacturing
process where each joint product
can be recognized as a separate
product is called the split-off point.
Joint Products
For example,
Oil in the petroleum
refining industry,
a large number
Common of products are
Joint
Input
Production Gasoline extracted from
Process crude oil,
including
gasoline, jet fuel,
Chemicals
home heating oil,
lubricants,
asphalt, and
Split-Off
various organic
Point chemicals.
Joint Products
Joint costs
are incurred
up to the Oil
Separate Final
split-off point Processing Sale

Common
Joint Final
Production Gasoline
Input Sale
Process

Separate Final
Chemicals
Processing
Sale

Split-Off Separate
Point Product
Costs
13-14
The Pitfalls of Allocation
Joint costs are traditionally
allocated among different
products at the split-off point.
A typical approach is to allocate
joint costs according to the
relative sales value of the end
products.
Although allocation is needed for
some purposes such as balance
sheet inventory valuation,
allocations of this kind are very
dangerous for decision making.
13-15
Sell or Process Further
Joint costs are irrelevant in decisions regarding
what to do with a product from the split-off point
forward. Therefore, these costs should not be
allocated to end products for decision-making
purposes.

With respect to sell or process further decisions, it is


profitable to continue processing a joint product
after the split-off point so long as the incremental
revenue from such processing exceeds the
incremental processing costs incurred after the
split-off point.

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