Chapter Nine

Decision Making with Relevant

Costs and a Strategic Emphasis
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Learning Objectives
Define the decision-making process and identify the
types of cost information relevant for decision making
Use relevant and strategic cost analysis to make
special-order decisions
Use relevant and strategic cost analysis in the makelease-or-buy decision
Use relevant and strategic cost analysis in the decision
to sell before or after additional processing
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Learning Objectives (continued)

Use relevant and strategic cost analysis in the decision
to keep or drop products or services
Use relevant and strategic cost analysis to evaluate
programs
Analyze decisions with multiple products and limited
resources (so-called product-mix decisions)
Discuss behavioral, implementation, and legal issues in
decision making
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The Decision-Making Process

First: Determine the
Strategic Issues
Second: Specify the Criteria
and Identify the
Alternative Actions

Third: Relevant Cost Analysis

and Strategic Cost Analysis
Identify and Collect
Relevant Information
Predict Future Values of
Relevant Costs & Revenues

Fourth: Select and

Implement a
Course of Action

Consider Strategic Issues

Fifth: Evaluate
Performance
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Relevant Cost Analysis

A relevant cost is a future cost that differs between
the decision alternatives
Both characteristics must be present for a cost to be
relevant
Relevant costs can be variable or fixed, but variable costs
are generally relevant while fixed costs are not
Relevant cost analysis and total cost analysis produce the
same results

A sunk cost is a cost that has been incurred in the

past or committed for the future
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Equipment-Replacement
Decision Example
Which
Which costs
costs are
are not
not relevant
relevant to
to the
the decision
decision to
to keep
keep an
an old
old
machine
machine or
or replace
replace itit with
with aa new,
new, more
more efficient
efficient one?
one?

Original
Original cost
cost of
of old
old machine,
machine, $4,200
$4,200
Current
Current book
book value
value of
of old
old machine,
machine, $2,100
$2,100
Purchase
Purchase price
price of
of aa new
new machine,
machine, $7,000
$7,000
New
New machine
machine will
will have
have zero
zero salvage
salvage value
value
Repairs
Repairs to
to old
old machine
machine would
would be
be $3,500
$3,500 and
and would
would
allow
allow one
one more
more year
year of
of productivity
productivity
Power
Power for
for either
either machine
machine is
is expected
expected to
to be
be
$2.50/hour
$2.50/hour
New
New machine
machine will
will reduce
reduce labor
labor costs
costs by
by $0.50/hour
$0.50/hour
Expected
Expected level
level of
of output
output for
for next
next year
year is
is 2,000
2,000 units
units

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Equipment Replacement
Decision (continued)
The
The relevant
relevant costs
costs are....
are....

Original
Original cost
cost of
of old
old machine,
machine, $4,200
$4,200
Current
Current book
book value
value of
of old
old machine,
machine, $2,100
$2,100
Purchase
Purchase price
price of
of aa new
new machine,
machine, $7,000
$7,000
New
New machine
machine will
will have
have zero
zero salvage
salvage value
value
Repairs
Repairs to
to old
old machine
machine would
would be
be $3,500
$3,500 and
and
would
would allow
allow one
one more
more year
year of
of productivity
productivity
Power
Power for
for either
either machine
machine is
is expected
expected to
to be
be
$2.50/hour
$2.50/hour
New
New machine
machine will
will reduce
reduce labor
labor costs
costs by
by
$0.50/hour
$0.50/hour

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Relevant Cost Analysis:

Additional Considerations
Batch-level cost drivers should be considered in
relevant cost analysis
For example, if setup on one machine takes longer and
requires more skilled labor than the other machine,
these factors should be included in the analysis

Opportunity costs, the benefit lost when one

chosen option precludes the benefits from an
alternative option, should also be considered in
the analysis of alternative options
For example, addition of a new product could cause
reduction, delay, or lost sales in other product areas
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Relevant Cost Analysis: Additional

Considerations (continued)
Depreciation is not included in relevant cost
analysis except when considering tax implications
Time-value of money is relevant when deciding
among alternatives with cash flows over two or
more years
Importance of qualitative factors:

Differences in quality
Functionality
Timeliness of delivery
Reliability in shipping
After-sale service level

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Strategic Cost Analysis

Strategic information keeps the decision makers
attention focused on the firms crucial strategic goal
By identifying only relevant costs, the decision maker might
fail to link the decision to the firms strategy
For example, while it may be advantageous to outsource
production of a part based on cost figures, this decision
might be a poor strategic move if the firms competitive
position depends on product reliability that can be
maintained only by manufacturing that part internally

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Relevant Cost Analysis vs.

Strategic Cost Analysis

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Relevant and Strategic Cost Analysis

in Decision Making
This decision framework can be used to address
common management decisions such as:
The special-order decision
The make-lease-or-buy decision
The decision to sell before or after additional
processing
The short-term product-mix decision
Profitability analysis (e.g., short-term product-mix
decisions)
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13

Example: the Special-Order

Decision
A special-order decision occurs when a firm has a
one-time opportunity to sell a specified quantity of its
product or service; these orders are generally nonrecurring
The first step in the decision process is to consider
the relevant costs (an example follows):
TTS,
TTS, Inc.
Inc. normally
normally charges
charges $9.00
$9.00 per
per T-shirt,
T-shirt, but
but
Alpha
Alpha Beta
Beta Gamma
Gamma has
has offered
offered to
to pay
pay $6.50
$6.50 for
for
1,000
1,000 T-shirts.
T-shirts. What
What are
are the
the relevant
relevant costs
costs in
in
determining
determining ifif the
the offer
offer should
should be
be accepted?
accepted?
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The Special-Order Decision (continued)

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The Special-Order Decision (continued)

The costs that are
not relevant total
$450,000

Therefore.....
Total Cost = $5.05 per unit + $200 per batch + $450,000
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The Special-Order Decision (continued)

Analysis of the net contribution looks favorable

If TTS has excess capacity, the offer should be

accepted because it will add $1,250 to pre-tax
income (1,000 T-shirts $1.25/shirt)
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The Special-Order Decision (continued)

BUT...to make an informed decision, TTS must also
consider the strategic factors in this decision
Is TTS producing at or near full capacity?
In this case, the answer is no
If TTS were producing at or near capacity, it would have to
consider opportunity costs
Is this order really a one-time special order?
Special-order decisions are meant for infrequent situations,
and if done on a regular basis, can erode profitability
The credit history of the buyer, any potential complexities in
the design that might cause problems

How might the special-order price affect the long-term price

structure of the firm?
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18

Example: Make-or-Buy Decision

Decision context: which parts to make internally and
which parts to purchase from an outside supplier?
The relevant cost analysis proceeds much like that of
a special-order decision (an example follows):

Blue
Blue Tone
Tone is
is currently
currently manufacturing
manufacturing the
the
mouthpiece
mouthpiece for
for its
its clarinet,
clarinet, but
but has
has the
the option
option to
to buy
buy
this
this item
item from
from aa supplier.
supplier. Short-term
Short-term fixed
fixed overhead
overhead
costs
costs will
will not
not change
change whether
whether or
or not
not Blue
Blue Tone
Tone
chooses
chooses to
to make
make or
or to
to buy
buy the
the mouthpiece.
mouthpiece.
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19

Make-or-Buy Example (continued)

The relevant cost analysis indicates that manufacturing the part is

more cost effective, but Blue Tone must also consider strategic
factors, such as the quality of the part, reliability of the supplier,
and potential alternative uses of plant capacity, before making a
final decision.
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20

Lease-or-Buy Example
Lets say the decision is not whether to make or buy
an item for the firm, but whether to lease or buy that
item (an example follows):
Quick Copy is considering an upgrade to the latest model
copier that is not available for lease but must be purchased
for $160,000. The purchased copier is useful for one year,
after which it could be sold back to the manufacturer for
$40,000. In addition, the new machine has a required annual
service contract of $20,000. Should Quick Copy purchase the
new copier or renew its lease on its old copier?
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21

Lease-or-Buy
Example (continued)
Quick Copy Lease or Buy Information
Annual lease
Charge per copy
Purchase cost
Annual service contract
Value at end of period
Expected number of copies per year

Lease
$ 40,000
0.02
N/A
N/A
N/A
6,000,000

Purchase
N/A
N/A
$ 160,000
20,000
40,000
6,000,000

The first step in this analysis is to use CVP

analysis to calculate the indifference point . . .
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22

Lease-or-Buy
Example (continued)
Lease cost = Purchase cost
Annual fee
$40,000 + ($0.02 Q)
Q

=
=
=
=

Net purchase cost + Service contract

($160,000 - $40,000) + $20,000
$100,000 $0.02
5,000,000 copies

The
The indifference
indifference point,
point, 5,000,000
5,000,000 copies,
copies, is
is lower
lower than
than the
the
expected
expected annual
annual machine
machine usage
usage of
of 6,000,000
6,000,000 copies.
copies. So,
So, Quick
Quick
Copy
Copy should
should purchase
purchase the
the machine
machine ifif strategic
strategic factors,
factors, such
such as
as
quality
quality of
of the
the copy,
copy, reliability
reliability of
of the
the machine,
machine, and
and benefits
benefits and
and
features
features of
of the
the service
service contract,
contract, are
are favorable
favorable
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Lease-or-Buy Example (continued)

Cost

Cost to Lease Copier

$140,000
Net cost to Purchase Copier

$40,000

Q = 5,000,000
Number of Copies per Year
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24

Sell-or-Process Further Example

Decision: whether to sell a product or service before
an intermediate processing step or to add further
processing and then sell the product or service for a
higher price?

TTS
TTS has
has suffered
suffered an
an equipment
equipment malfunction
malfunction causing
causing
400
400 T-shirts
T-shirts not
not to
to be
be acceptable.
acceptable. The
The shirts
shirts can
can be
be
sold
sold as-is
as-is for
for $4.50
$4.50 each
each or
or run
run through
through the
the printing
printing
process
process again.
again. The
The cost
cost of
of running
running the
the T-shirts
T-shirts through
through
the
the printer
printer aa second
second time
time is
is variable
variable cost
cost of
of $1.80
$1.80 per
per
shirt
shirt and
and the
the cost
cost of
of one
one setup.
setup.
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Sell-or-Process Further Example

(continued)

25

The net advantage to reprinting the T-shirts is $880 ($2,680 $1,800). TTS would need to consider the effect of selling to discount
stores were the cost analysis in favor of that option.
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Profitability Analysis
Profitability analysis addresses issues such as:
Which product lines are most profitable?
Are the products priced properly?
Which products should be promoted and advertised more
aggressively?
Which product-line managers should be rewarded?

An example follows:
Windbreakers, Inc. manufactures three jackets.
Management is concerned about the low profitability of the
Gale jacket and is thinking about dropping the product. If
the jacket is dropped, there will be no change in total fixed
costs for the coming year.
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Profitability Analysis (continued)

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Profitability Analysis
(continued)
The company is $15,000 ($147,000 $132,000) better off retaining rather
than deleting the Gale jacket.
Windbreakers, Inc. should also
consider strategic factors in this
decision, such as whether dropping one
product line would affect sales of
another and whether employee morale
would be affected by the decision.
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Profitability Analysis in Service and

Not-for-Profit (NFP) Organizations
Relevant cost analysis is often used by service and
NFP firms to determine the desirability of new
services: example, Triangle Womens Center:

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30

Short-Term Product Mix Decision

How to make best use out of existing resources? That
is, how to choose the best short-term product mix?
Continuing with the Windbreakers Inc. example
assume one production constraint:
The Windy and Gale jackets are manufactured in the
same plantboth require an automated sewing
machine for assembly. There are 3 machines that can
be run up to 20 hours per day, 5 days per week (1,200
hours per month). The demand for both jackets exceeds
the capacity of the 3 machines (i.e., there is one
production constraint or limiting resource).
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Short-Term Product Mix Decision:

One Production Constraint

31

The goal is to maximize contribution margin, subject to

the production resource constraint. For this, we need to
determine each products contribution margin per unit of
the scare resource:

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Short-term Product Mix Decision:

One Production Constraint

36,000

Slope = -36,000 24,000 = -3/2

Intercept = 36,000
Blocher,Stout,Cokins,Chen, Cost Management 4e

Production constraint for

sewing machine. All
possible sales mixes are
represented on this line.

24,000

Units of
Sales
for Gale

Units of Sales
for Windy
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33

Short-term Product-Mix Decision:

One Production Constraint

Production of Windy is favored over production of Gale

($192,000 - $144,000). When there is one constraint, one of
the products will be favored over the others.
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Short-term Product-Mix Decision:

Two Production Constraints
In the presence of two or more production constraints,
determining the best sales mix becomes more
complicated, but the principle is the same.
Continuing with the Windbreakers Inc. example assume:
The
Thecompleted
completedjackets
jacketsare
areinspected
inspectedand
andlabels
labelsare
areadded
added
before
beforepackaging.
packaging.Forty
Fortyworkers
workersare
arerequired
requiredfor
for this
this
operation.
operation.Each
Eachof
ofthe
the40
40 workers
workersworks
works35
35productive
productive hours
hours
per
perweek...thus,
week...thus,5,600
5,600 hours
hoursare
are available
availableper
per month
month for
for
inspecting
inspectingand
andpackaging.
packaging.
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35

Short-term Product-Mix Decision:

Two Production Constraints
With two constraints, the results are as follows:

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Short-term Product-Mix Decision:

Two Production Constraints
67,200
Production constraint for Inspection and Packaging
Maximum contribution margin

Corner Point Analysis

Blocher,Stout,Cokins,Chen, Cost Management 4e

Production constraint for

sewing machine

Units of
Sales
for Gale

20,800 units of Windy and

4,800 units of Gale

22,400
24,000

36,000

Units of
Sales for
Windy
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Behavioral and
Implementation Issues
Managers must be sure to keep the firms strategic
objectives in the forefront in any decision situation to
avoid focusing solely on short-term gains
Predatory pricing occurs when a company has set
prices below average variable cost with a plan to raise
prices later to recover losses from these lower prices
Courts have found in favor of the defendants time after
time in cases involving predatory pricing
U.S. congressional leaders are considering revising the
laws related to predatory pricing to promote competition
in previously uncompetitive industries
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38

Behavioral and Implementation

Issues (continued)
Managements goal should be to maximize contribution
margin while minimizing fixed costs
Relevant cost analysis focuses on variable costs,
appearing to ignore fixed costs
If upper-level management focuses too heavily on variable
costs, lower-level management may feel pressure to
replace variable costs with fixed costs at the firms expense

Managers must be careful not to include irrelevant,

including sunk, costs in their decision making
When fixed costs are shown as cost per unit, many
managers tend to improperly classify them as relevant
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39

Chapter Summary
A relevant cost is a future cost that differs between
decision alternatives
It is important to consider strategic factors when
performing a relevant cost analysis
Focusing solely on short-term profits could potentially
lead to long-term losses
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40

Chapter Summary (continued)

This decision framework in this chapter was applied to
four common management decisions:

The special-order decision

The make, lease, or buy decision
The decision to sell or process further decision
Profitability analysis (i.e., product profitability, productmix, pricing, promotion, and reward-related issues)

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41

Chapter Summary (continued)

Relevant cost analysis changes significantly with two or
more products and limited resources
Under conditions of one or more production constraints,
the goal is to find the most profitable sales mix
For decision-making purposes, product profitability must
be expressed in terms of contribution margin per unit of
the scare resource

Managers must be careful to encourage maximization

of contribution margin and reduction of fixed costs
Irrelevant, including sunk, costs must not be included in
relevant cost analysis
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