University:
California State University, Northridge
Course:
MGT 360 | Management and Organizational Behavior
Academic year:

2024
Views:

466

Pages:

16
Author:

Elaine Burgess

Chapter 11 Relevant Costs for Decision Making 11-2 Learning Objective 1 Identify relevant and irrelevant costs and benefits in a decision. 11-3 Cost Concepts for Decision Making A relevant cost is a cost that differs between alternatives. 11-4 Identifying Relevant Costs and Benefits 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 which have already been incurred and cannot be avoided regardless of what a manager decides to do. Future costs that do not differ between the alternatives. 11-5 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. 11-6 Different Costs for Different Purposes Costs that are relevant in one decision situation may not be relevant in another context. 11-7 Identifying Relevant Costs Cynthia, a Boston student, is considering visiting her friend in New York. She can drive or take the train. By car it is 230 miles to her friend’s apartment. She is trying to decide which alternative is less expensive and has gathered the following information: Automobile Costs (based on 10,000 miles driven per year) 1 2 3 4 5 6 Annual straight-line depreciation on car Cost of gasoline Annual cost of auto insurance and license Maintenance and repairs Parking fees at school Total average cost $45 per month × 8 months Annual Cost of Fixed Items $ 2,800 1,380 360 Cost per Mile $ 0.280 0.050 0.138 0.065 0.036 $ 0.569 $1.60 per gallon ÷ 32 MPG $18,000 cost – $4,000 salvage value ÷ 5 years 11-8 Identifying Relevant Costs Automobile Costs (based on 10,000 miles driven per year) 1 2 3 4 5 6 Annual straight-line depreciation on car Cost of gasoline Annual cost of auto insurance and license Maintenance and repairs Parking fees at school Total average cost 7 8 9 10 11 12 13 Annual Cost of Fixed Items $ 2,800 1,380 360 Cost per Mile $ 0.280 0.050 0.138 0.065 0.036 $ 0.569 Some Additional Information Reduction in resale value of car per mile of wear Round-trip train fare Benefits of relaxing on train trip Cost of putting dog in kennel while gone Benefit of having car in New York Hassle of parking car in New York Per day cost of parking car in New York $ 0.026 $ 104 ???? $ 40 ???? ???? $ 25 11-9 Identifying Relevant Costs Which costs are relevant in Cynthia’s decision? The cost of the car is a sunk cost and is not relevant to the current decision. The annual cost of insurance is not relevant. It will remain the same if she drives or takes the train. However, the cost of gasoline is clearly relevant if she decides to drive. If she chooses to drive, the gasoline cost would be incurred, so it varies, depending on the decision. 11-10 Identifying Relevant Costs Which costs are relevant in Cynthia’s decision? The cost of maintenance and repairs is relevant. In the long-run, these costs depend upon miles driven. The monthly school parking fee is not relevant because it must be paid if Cynthia drives or takes the train. At this point, we can see that some of the average cost of $0.569 per mile are relevant, while others are not. 11-11 Identifying Relevant Costs Which costs and benefits are relevant in Cynthia’s decision? The decline in resale value due to additional miles is a relevant cost. The round-trip train fare is clearly relevant. If she drives, the cost can be avoided. Relaxing on the train is relevant even though it is difficult to assign a dollar value to the benefit. The kennel cost is not relevant because Cynthia will incur the cost if she drives or takes the train. 11-12 Identifying Relevant Costs Which costs and benefits are relevant in Cynthia’s decision? The cost of parking is relevant because it can be avoided if she takes the train. The benefits of having a car in New York and the problems of finding a parking space are both relevant but are difficult to assign a dollar amount. 11-13 Identifying Relevant Costs From a financial standpoint, Cynthia would be better off taking the train to visit her friend. Some of the nonfinancial factors may influence her final decision. Relevant Financial Cost of Driving Gasoline (460 @ $0.050 per mile) Maintenance (460 @ $0.065 per mile) Reduction in resale (460 @ $0.026 per mile) Parking in New York (2 days @ $25 per day) Total $ 23.00 29.90 11.96 50.00 $ 114.86 Relevant Financial Cost of Taking the Train Round-trip ticket $ 104.00 11-14 Total and Differential Cost Approaches The management of a company is considering a new labor-saving machine that rents for $3,000 per year. Data about the company’s annual sales and costs with and without the new machine are: Sales (5,000 units @ $40 per unit) Less variable expenses: Direct materials (5,000 units @ $14 per unit) Direct labor (5,000 units @ $8 and $5 per unit) Variable overhead (5,000 units @ $2 per unit) Total variable expenses Contribution margin Less fixed expense: Other Rent on new machine Total fixed expenses Net operating income Current Situation $ 200,000 Situation With New Machine $ 200,000 Differential Costs and Benefits - 70,000 40,000 10,000 120,000 80,000 70,000 25,000 10,000 105,000 95,000 $15,000 15,000 62,000 62,000 18,000 62,000 3,000 65,000 30,000 (3,000) (3,000) $12,000 $ $ 11-15 Total and Differential Cost Approaches As you can see, the only costs that differ between the alternatives are the direct labor costs savings and the increase in fixed rental costs. Sales (5,000 units @ $40 per unit) Less variable expenses: Direct materials (5,000 units @ $14 per unit) Direct labor (5,000 units @ $8 and $5 per unit) Variable overhead (5,000 units @ $2 per unit) Total variable expenses Contribution margin Less fixed expense: Other Rent on new machine Total fixed expenses Net operating income Current Situation $ 200,000 Situation With New Machine $ 200,000 Differential Costs and Benefits - 70,000 40,000 10,000 120,000 80,000 70,000 25,000 10,000 105,000 95,000 $15,000 15,000 62,000 3,000 65,000 30,000 (3,000) (3,000) $12,000 We can efficiently analyze the decision by62,000 62,000 looking at the different costs and revenues and $ 18,000 arrive at the same solution. Net Advantage to Renting the New Machine Decrease in direct labor costs (5,000 units @ $3 per unit) Increase in fixed rental expenses Net annual cost saving from renting the new machine $ $ 15,000 (3,000) 12,000 $ 11-16 Total and Differential Cost Approaches Using the differential approach is desirable for two reasons: 1. Only rarely will enough information be available to prepare detailed income statements for both alternatives. 2. Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical.