Cost Analysis and Contribution Margin Quiz

Chapter 12: Relevant Costs for Decision Making

• Relevant cost is a cost that differs between alternatives.
• Avoidable cost can be eliminated, wholly or partly, when choosing one alternative over another.
• Avoidable costs are relevant; Unavoidable costs are irrelevant.
• Sunk costs and future costs that don't vary between alternatives are never relevant.
• Relevant cost analysis is a two-step process.
  • Eliminate costs and benefits that don't differ between alternatives.
  • Use the remaining costs and benefits to make the decision.

Learning Objectives

• Distinguish between relevant and irrelevant costs in decision making.
• Prepare analyses for various decision situations.
• Determine the most profitable use of a constrained resource and the value of obtaining more of the constrained resource.
• Compute selling prices based on costs using absorption and variable costing approaches.
• Understand how customer sensitivity to pricing changes should influence pricing decisions.
• Analyze pricing decisions using value-based pricing.
• Compute target costs based on selling prices.

Identifying Relevant Costs and Benefits

• A relevant cost differs between alternatives.
• An avoidable cost can be eliminated by choosing one alternative over another.
• Avoidable costs are relevant; unavoidable costs are irrelevant.
• Two types of costs never relevant:
  • Sunk costs
  • Future costs that do not vary between alternatives.

Relevant Cost Analysis: A Two-Step Process

• Identify costs and benefits relevant to each decision situation.
• Eliminate costs and benefits that do not vary between alternatives.
• Use the remaining costs and benefits to make the decision; these are the avoidable (differential) costs.

Different Costs for Different Purposes

• Costs relevant in one decision may not be relevant for another.

Identifying Relevant Costs

• Cost of the car is a sunk cost (irrelevant to a current decision).
• Annual insurance cost is irrelevant: it remains the same whether driving or taking the train.
• Gasoline cost is relevant if driving, not incurred if taking the train.
• Car maintenance is relevant, dependent on driven kilometers.
• Monthly school parking is irrelevant, incurred in either case.
• Round-trip train fare is relevant as it can be avoided if driving.
• Benefits of relaxing on the train, hassles of parking, and cost of putting the dog in a kennel are relevant but cannot be assigned dollar values.

Identifying Relevant Costs (Continued)

• Costs of parking in Moncton are relevant since avoiding them leads to more money.

Identifying Financial Costs of Driving vs. Taking the Train

• Calculations are shown for the cost of driving; for train travel.

Total and Differential Cost Approaches

• Data is presented for a situation where managers are considering renting a new machine.
• Calculations are shown for the cost savings of renting the machine compared to the current situation.
• Differential approach is effective in situations with detailed income statements.

Adding/Dropping Segments

• Managers face crucial decisions about adding or dropping business segments (e.g., products or stores).
• Differential revenues and costs are key to these decisions.

Adding/Dropping Segments (Continued)

• Specific example presented using Lovell Company's declining digital watch line.

A Contribution Margin Approach

• Decision rule: Drop the digital watch segment only if profit increases.
  • Profit only increases if fixed cost savings exceed lost contribution margins.

Adding/Dropping Segments (Segment Income Statement example)

• Show the segment income statement from the example for Digital Watches

Adding/Dropping Segments (Continued)

• Discussion of which costs/expenses will be carried forward if segment is dropped

Adding/Dropping Segments (Continued)

Specific examples show if the segment should be kept or dropped.

A Comparative Format

• Comparative income statement approach - showing results for the company with and without the segment.

Beware of Allocated Fixed Costs

• In decisions regarding segments, common fixed costs are often allocated to products, causing a segment to seem less profitable than it truly is.

The Make or Buy Decision

• When a company performs multiple value-chain activities, it is vertically integrated, including decisions about "make or buy."
• Advantages and disadvantages of making parts internally are presented.
• An Example of Part 4A, made internally, compares cost of making to cost of buying from an outside source.

The Make or Buy Decision (example)

• Calculations provided for the company to make Part 4A

The Make or Buy Decision (example)

• The cost to make Part 4A is compared to the cost of buying from an outside company.

Opportunity Cost

• Opportunity cost is the benefit forfeited as a consequence of choosing a particular course of action.
• For example, if you choose one course, you lose the chance of another one.

Special Orders

• Special orders are one-time orders not included in a company's regular business.
• Only incremental costs and benefits are relevant in evaluating special orders.

Special Orders (Example)

• A foreign distributor offers to purchase 3,000 units of a given product at a lower-than-normal price from an example company.

Special Orders (Example)

• An example calculation shows how to determine if the order should be accepted based on contribution margin and capacity.

Quick Check

• Various examples for situations requiring pricing decisions; and explanations.
• Calculate the lowest price to accept to avoid losing money.
• Examples regarding making or buying products and materials, and other situational examples are shown.

Joint Product Costs

• In many industries, several end products are created from a singular raw material input.
  • Two or more products produced from a singular input are called joint products
• The split-off point in the production process means multiple goods can be created.

Joint Products (diagrammatic representation)

Diagrams to conceptualize the split-off process in the creation of multiple products from one starting material.

Joint Products (Example)

• An example calculation shows the manufacturing costs and sales associated with different products.

The Pitfalls of Allocation

• Joint costs should not be allocated to individual products for making decisions.

Sell or Process Further

• Joint costs are irrelevant to decisions made after split-off
• Processing further is profitable if incremental revenue exceeds increased costs.

Data about Sawmill’s Joint Products

• Data about the sales value at the split-off point, sales value after further processing, and allocated joint costs for products lumber and sawdust are shown

Analysis of Sell or Process Further

• Incremental revenue and Cost of further processing.
• Calculations are provided to evaluate whether to sell products as is or to process them further

Utilization of a Constrained Resource

• A limited resource restricts the company's ability to meet demand.
• A key theory of constraints (TOC) effectively manages constraints.
• The challenge is to best utilize a constrained resource to enhance profits.

Contribution Margin in Relation to a Constrained Resource

• Product mix optimization maximizes total contribution margin while remaining fixed.
• Products yielding the highest contribution margin per unit of constrained resource should be prioritized.
• Example calculation of contribution margin and time required per unit given for two products.

Example: Contribution Margin in Relation to a Constrained Resource (Continued)

• The concept, utilizing the constrained resource; and maximizing profit is demonstrated; as well as examples of product mixes.

Quick Check

• How many units of each product can be processed through the constrained resource (Machine A1) in one minute?
• What generates greater profit to the business: Utilizing one minute of Machine A1 for Product 1, or utilizing one minute of Machine A1 for Product 2?

CM in Relation to a Constrained Resource (Example)

• Calculations are shown providing the best possible product mix to maximize profit when facing a constrained resource.

Setting a Target Selling Price - Absorption Costing

• Absorption costing approach sets the cost base based on the absorption costing unit product cost rather than the variable cost.
• Relevant data (variable and fixed manufacturing costs and SG&A data) to determine the target selling price is presented.

Setting a Target Selling Price - Absorption Costing (Example)

• Example calculation to determine price, incorporating a specified markup percentage given a specified production volume.

Determining the Markup Percentage

• Markup percentage can be based on industry norms, company tradition or explicitly calculated.
• Equation to explicitly calculate the markup percentage in absorption costing.

Determining the Markup Percentage (Example)

• An example to calculate the markup percentage given a required return on investment and sales volume.

Problems with the Absorption Costing Approaches

• Assumptions in absorption costing may differ greatly from reality.
• Customers have choices to impact results.

Problems with the Absorption Costing (Example)

• Examples demonstrated where the absorption costing approach may lead to inappropriate decisions or incorrect conclusions.

Setting a Target Selling Price - Variable Costing

• Variable costing approach is consistent with CVP analysis and doesn't arbitrarily allocate common fixed costs to specific products.

Setting a Target Selling Price for Service Companies Using Time and Materials Pricing

• Service companies frequently use a time and materials pricing model, employing two pricing rates: one based on direct labor time, and the other on the direct material used in completing a project.

Pricing and Customer Latitude

• Customers appreciate choice in purchase decisions.
• Customers can make alternate purchases from competitors, impacting pricing decisions.

Value-Based Pricing

• Value-based pricing uses the economic value of benefits delivered to customers as its basis for fixing prices.
• Economic value to the customer (EVC) estimates customers' perceived value of a product or service.

Economic Value to the Customer

• A product's economic value to the customer equals the reference value plus the differentiation value.
• Reference value is the price of the best alternative, whereas differentiation value is the value of how a product improves on the best alternative.

Differentiation Value

• Differentiation value is created either by facilitating greater customer sales with a product or by promoting greater cost savings.

Economic Value to the Customer (EVC)

• The EVC is the sum of the reference value and the differentiation value.
• Pricing should fall within the range of the reference value and the EVC.

Target Costing

• Target costing determines the maximum allowable cost for a new product and then constructs a prototype to meet that cost limitation.
• Target cost = anticipated selling price - desired profit.

Reasons for Using Target Costing

• Target costing incorporates market supply and demand into the design stage.
• Target pricing reflects market values and sets cost targets to maximize profitability.

Reasons for Using Target Costing (Continued)

• Target costing departs significantly from traditional design-costing-pricing models by first establishing the target cost, then designing the product to conform to that cost.

Target Costing (Example)

• Example to calculate target cost given a desired profit, projected sales volume and investment figures.