CHAPTER 16: RELEVANT COSTING Other items to consider

● Sometimes involves changes that seem contrary to

Decision-Making intuition
LEARNING OBJECTIVE 1 ● Variable costs sometimes do not change under alternatives
Describe management’s decision-making process and incremental ● Fixed costs sometimes change between alternatives
analysis.
Types of Incremental Analysis
Making decisions is an important management function. Common types of decisions involving incremental analysis:
● Does not always follow a set pattern 1. Accept an order at a special price
● Decisions vary in scope, urgency, and importance 2. Make or buy component parts or finished products
● Steps usually involved in process include: 3. Sell products or process them further
4. Repair, retain, or replace equipment
5. Eliminate an unprofitable business segment or product

DO IT! 1: Incremental Analysis

Owen T Corporation is comparing two different options. The
company currently operates under Option 1, with revenues of
$80,000 per year, maintenance expenses of $5,000 per year, and
operating expenses of $38,000 per year. Option 2 provides revenues
Decision-Making Process of $80,000 per year, maintenance expenses of $12,000 per year, and
In making business decisions, operating expenses of $32,000 per year. Option 1 employs a piece of
● Considers financial and non-financial information equipment that was upgraded 2 years ago at a cost of $22,000. If
● Financial information Option 2 is chosen, it will free up resources that will increase
○ Revenues and costs, and revenues by $3,000.
○ Effect on overall profitability
Complete the following table to show the change in income from
● Nonfinancial information choosing Option 2 versus Option 1. Designate any sunk costs with an
○ Effect on employee turnover “S.”
○ The environment
○ Overall company image Solution:

Incremental Analysis Approach

● Decisions involve a choice among alternative actions
● Process used to identify the financial data that change
under alternative courses of action
○ Both costs and revenues may vary or
○ Only revenues may vary or
○ Only costs may vary
Special Orders
How Incremental Analysis Works LEARNING OBJECTIVE 2
Basic approach in incremental analysis Analyze the relevant costs in accepting an order at a special price.

● To obtain additional business by making a major price

concession to a specific customer
● Assumes that sales of products in other markets are not
affected by special order
● Assumes that company is not operating at full capacity

Special Orders
● Incremental revenue is $15,000 less under Alternative B Sunbelt Company produces 100,000 Smoothie blenders per month,
● Incremental cost savings of $20,000 is realized which is 80% of factory capacity. Variable manufacturing costs are $8
● Alternative B produces $5,000 more net income per unit. Fixed manufacturing costs are $400,000, or $4 per unit. The
Smoothie blenders are normally sold directly to retailers at $20 each.
Important concepts used in incremental analysis Kensington Co. (a foreign wholesaler) has offered to purchase an
● Relevant costs and revenues additional 2,000 blenders from Sunbelt at $11 per unit. Management
● Opportunity cost
● Sunk cost
has determined that acceptance of the offer would not affect normal Opportunity Cost
sales of the product, and the additional units can be manufactured The lost potential benefit that could have been obtained from
without increasing factory capacity. What should management do? following an alternative course of action.

Solution: If there is an opportunity to use this productive capacity in some

other manner, then this opportunity cost must be considered.

Illustration
Assume that through buying the switches, Baron Company can use
the released productive capacity to generate additional income of
$38,000 from producing a different product. This lost income is an
additional cost of continuing to make the switches in the
make-or-buy decision.
● Fixed costs do not change since within existing capacity –
thus fixed costs are not relevant
● Variable manufacturing costs and expected revenues
change – thus both are relevant to the decision

Make or Buy
LEARNING OBJECTIVE 3
Analyze the relevant costs in a make-or-buy decision.

Illustration: Baron Company incurs the following annual costs in Sell or Process Further
producing 25,000 ignition switches for motorcycles. LEARNING OBJECTIVE 4
Analyze the relevant costs and revenues in determining whether to
sell or process materials further.

May have option to sell product at a given point in production or

continuing to process and sell later at a higher price.

Decision Rule:
● Process further as long as the incremental revenue from
such processing exceeds the incremental processing costs.

Instead of making switches, Baron might purchase ignition switches

at a price of $8 per unit. If they do this, all variable costs and $10,000 Multiple-Product Case
of fixed costs will be eliminated. What should Baron do? Joint production process-Creamery
Cream and skim milk are products that result from the processing of
raw milk.

Joint product costs are sunk costs and thus not relevant to the
sell-or-process-further decision.

● Manufacturing cost is $1 higher per unit than purchase

price
● Must absorb at least $50,000 of fixed costs under either
option
Cost and revenue data per day for cream useful life of four years. The company is considering replacing this
machine with a new machine.

A new machine is available that costs $120,000. It is expected to

have zero salvage value at the end of its four-year useful life. If the
new machine is acquired, variable manufacturing costs are expected
to decrease from $160,000 to $125,000 annually, and the old unit
could be sold for $5,000.

Prepare the incremental analysis for the four-year period.

Determine whether the company should simply sell the cream or
process it further into cottage cheese. Incremental analysis-retain or replace equipment
Prepare the incremental analysis for the four-year period.
Analysis of whether to sell cream or process further

Marais should or begin underline should not end underline process

the cream further? Marais should not process the cream further.
Jeffcoat Company should replace the machine.
Cost and revenue data per day for skim milk
Additional Considerations
● Suppose that the manager spent $90,000 repairing a
machine two months ago
○ The amount spent to repair the machine is
irrelevant to the current decision
○ Costs which cannot be changed by future
decisions (sunk cost) are not relevant in
incremental analysis
Determine whether the company should sell the skim milk or ● Any trade-in allowance or cash disposal value of the
process further into condensed milk. existing asset is relevant

Sell skim milk or process into condensed milk? Eliminate Unprofitable Segment or Product
LEARNING OBJECTIVE 6
Analyze the relevant costs in deciding whether to eliminate an
unprofitable segment or product.

● Key: Focus on Relevant Costs

● Consider effect on related product lines
● Fixed costs allocated to the unprofitable segment must be
absorbed by the other segments
Marais should or should not process the skim milk further? Marais ● Net income may decrease when an unprofitable segment
should process the skim milk further. is eliminated
● Decision Rule: Retain the segment unless fixed costs
Repair, Retain, or Replace Equipment eliminated exceed contribution margin lost
LEARNING OBJECTIVE 5
Analyze the relevant costs to be considered in repairing, retaining,
or replacing equipment.

Illustration: Jeffcoat Company has a factory machine that originally

cost $110,000. It has a balance in Accumulated Depreciation of
$70,000, so the machine’s book value is $40,000. It has a remaining
Eliminate Unprofitable Segment
Segment income data
Illustration: Venus Company manufactures three models of tennis
rackets:

Income data after eliminating Champ

Prepare income data after eliminating Champ product line. Assume
fixed costs are allocated 2/3 to Pro and 1/3 to Master.

Incremental analysis-no reduction in fixed costs

Incremental analysis of Champ provided the same results:
Do Not Eliminate Champ

Assume that $22,000 of the fixed costs attributed to the Champ line
can be eliminated if the line is discontinued.
Eliminate Champ