Summary of

Chapter 8

RELEVANT COSTING OR DIFFERENTIAL

ANALYSIS
Relevant and Irrelevant Cost/Benefits
Keys to Successful Decision-
Making

Focus only on relevant costs and

relevant benefits

Ignore everything else including

sunk costs and future costs and
benefits that do not differ
between the alternatives.
Different Costs for
Different Purposes

• Costs that are relevant in one decision

situation may not be relevant in another
context. Thus, in each decision situation,
the manager must examine the data at
hand and isolate the relevant costs.
Relevant Cost and Benefits

Avoidable Cost
Differential Cost
Differential Benefits
Incremental Cost
Opportunity Cost
Irrelevant Cost

A future cost
that does not
Sunk Cost
differ between
the alternatives
Quick Check 

The relevance of a particular cost to a decision is determined by

A. Amount of the cost.
B. Potential effect on the decision.
C. Number of decision variables.
D. Riskiness of the decision.
Quick Check 

The relevance of a particular cost to a decision is determined by

A. Amount of the cost.
B. Potential effect on the decision.
C. Number of decision variables.
D. Riskiness of the decision.
Quick Check 
Wenig Inc. has some material that originally cost
$73,500. The material has a scrap value of
$45,600 as is, but if reworked at a cost of $6,600,
it could be sold for $58,100. What would be the
incremental effect on the company's overall profit
of reworking and selling the material rather than
selling it as is as scrap?

A. decrease of $22,000
B. decrease of $67,600
C. increase of $51,500
D. increase of $5,900
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)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

$2.70 per gallon ÷ 27 MPG

$45 per month × 8 months
$24,000 cost – $10,000 salvage value ÷ 5 years
Identifying Relevant Costs
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

Additional Information
7 Reduction in resale value of car per mile of wear $ 0.026
8 Round-tip train fare $ 104
9 Benefits of relaxing on train trip ????
10 Cost of putting dog in kennel while gone $ 40
11 Benefit of having car in New York ????
12 Hassle of parking car in New York ????
13 Per day cost of parking car in New York $ 25
 Identifying Relevant Costs

Which costs and benefits are relevant in Cynthia’s

decision?

(1) The cost of the car (3) The annual cost of

is a sunk cost and is insurance is not relevant.
It will remain the same if
not relevant to the
she drives or takes the
current decision. train.

(2) However, the cost of gasoline is clearly relevant if she

decides to drive. If she takes the train, the cost would not
be incurred, so it varies depending on the decision.
Identifying Relevant Costs

Which costs and benefits are relevant in Cynthia’s

decision?

(4) The cost of (5)The monthly school

maintenance and parking fee is not relevant
repairs is relevant. In because it must be paid if
the long-run these costs Cynthia drives or takes the
depend upon miles train.
driven.
Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?
(7) The decline in resale (8) The round-trip train
value due to additional fare is clearly relevant.
miles is a relevant cost. If she drives the cost
can be avoided.
(9) Relaxing on the
train is relevant even (10) The kennel cost is
though it is difficult to not relevant because
assign a dollar value to Cynthia will incur the
the benefit. cost if she drives or
takes the train.
Identifying Relevant Costs

Which costs and benefits are relevant in Cynthia’s

decision?

(13) The cost of

parking in New York is
relevant because it can
be avoided if she takes
the train.
(11-12) 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.
 Identifying Relevant Costs
From a financial standpoint, Cynthia would be better off taking
the train to visit her friend. Some of the non-financial factors
may influence her final decision.

Relevant Financial Cost of Driving

Gasoline (460 @ $0.100 per mile) $ 46.00
Maintenance (460 @ $0.065 per mile) 29.90
Reduction in resale (460 @ $0.026 per mile) 11.96
Parking in New York (2 days @ $25 per day) 50.00
Total $ 137.86

Relevant Financial Cost of Taking the Train

Round-trip ticket $ 104.00
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:

Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000
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.
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
We(5,000
Direct materials canunits
efficiently analyze the
@ $14 per unit) decision70,000
70,000 by -
Direct labor looking
(5,000 unitsat
@ $8the
anddifferent
$5 per unit) costs 40,000
and revenues 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses and arrive at the same solution
120,000 . 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:Net Advantage to Renting the New Machine
Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Other 62,000 62,000 -
Increase in fixed rental expenses (3,000)
Rent on newNet machine
annual cost saving from renting the new machine
- $
3,000
12,000
(3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000
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.
 Adding/
Dropping
Segments
Adding/Dropping
Segments
• One of the most important decisions
managers make is whether to add or
drop a business segment. Ultimately, a
decision to drop an old segment or add
a new one is going to hinge primarily on
the impact the decision will have on net
operating income.
• To assess this impact, it is necessary to
carefully analyze the costs.
Padilla Company expects the following results in 2003. Fixed
costs, all unavoidable, are allocated based on relative peso sales.
Product A Product B Total
Sales P450 P400 P850
Variable Cost 200 100 300
Contribution margin P250 P300 P550
Fixed costs 110 180 290
Profit P140 P120 P260

The managers are considering increasing advertising for product A by P40.

They expect to achieve a 30% increase in volume for product A with no change
in selling price, but some of that increase will be the expense of product B.
Sales of B are expected to decline by 5%. What will total profit be if the
managers approve the proposed action?
Padilla Company expects the following results in 2003. Fixed
costs, all unavoidable, are allocated based on relative peso sales.
Product A Product B Total
Sales P450 P400 P850
Variable Cost 200 100 300
Contribution margin P250 P300 P550
Fixed costs 110 180 290
Profit P140 P120 P260

The managers are considering dropping product A and replacing it with product
C. Introducing product C would increase total fixed costs by P75. C’s
contribution margin percentage is 40%. What peso sales of product C are
needed to maintain the original profit of P260?
Quick Check 
Lusk Corporation produces and sells 20,000 units
of Product X each month. The selling price of
Product X is $30 per unit, and variable expenses
are $21 per unit. A study has been made
concerning whether Product X should be
discontinued. The study shows that $50,000 of the
$250,000 in fixed expenses charged to Product X
would not be avoidable even if the product was
discontinued. If Product X is discontinued, the
company's overall net operating income would:
Approach

• Contribution Margin Approach

• Comparative Income Approach (Total Approach)

Note: Beware of Allocated Fixed Cost (Common Fixed Cost)

Alternatively,
Contribution Margin PXX
Less: Avoidable Fixed Costs and Expense (XX)
Controllable Segment Margin PXX

• If the Controllable Segment Margin is negative,

Discontinue/Drop Segment, because if the
Segment/Division is dropped, the loss is eliminated,
and the overall profit of the enterprise will increase by
the same amount.
Make or
Buy
Decision
Quick Check 
• Barrus Corporation makes 30,000 motors to be used in the
productions of its power lawn mowers. The average cost per motor at
this level of activity is as follows:
Direct materials ₱9.50
Direct labor ₱8.60
Variable manufacturing overhead ₱3.75
Fixed manufacturing overhead ₱4.35

This motor has recently become available from an outside supplier for ₱25 per
motor. If Barrus decides not to make the motors, none of the fixed
manufacturing overhead would be avoidable and there would be no other use
for the facilities. If Barrus decides to continue making the motor, how much
higher or lower will the company's net operating income be than if the motors
are purchased from the outside supplier? Assume that direct labor is a variable
cost in this company.
Opportunity Cost

An opportunity cost is the benefit that is

foregone as a result of pursuing some
course of action.

Opportunity costs are not actual cash

outlays and are not recorded in the formal
accounts of an organization.
Accept or Reject
Special Order
Accept or Reject Special Order
With idle capacity No Alternative use of With Alternative use
Capacity of Capacity
No Idle Capacity No Alternative use of With Alternative use
Capacity of Capacity

When analyzing a special order, only the incremental costs and

benefits are relevant.
Since the existing fixed manufacturing overhead costs would
not be affected by the order, they are not relevant.
 With idle capacity
No Alternative use of With Alternative use of Capacity
Capacity Incremental Sales PX
Incremental Sales PX Incremental Costs (X)
Incremental Costs (X) Incremental profit(loss) X
Incremental profit(loss) PX Opportunity cost (benefit) from the
alternative use of capacity (X)
Advantage (Disadvantage) of
Accepting the special sales PX

The opportunity cost here refers to the net benefit that could
have been derived from another alternative had the special
sales order not accepted.

If the order is not accepted, the idle capacity may be

• Rented out to others, or
• Use to produce another product and give additional
contribution margin.
 No Idle Capacity
No Alternative use of Capacity With Alternative use of Capacity
Incremental Sales PX Incremental Sales PX
Incremental Costs (X) Incremental Costs (X)
Incremental profit(loss) PX Incremental profit(loss) X
Opportunity cost, net of best benefit foregone
From alternative use of capacity (X)
Advantage (Disadvantage) of
Accepting the special sales PX

Opportunity cost here refers to the lost contribution

margin form regular sales or from the best use of the
sacrificed capacity.
 Quick Check 
• A customer has requested that Gamba Corporation fill a special order for 3,000 units
of product Q41 for ₱25.00 a unit. While the product would be modified slightly for the
special order, product Q41's normal unit product cost is ₱21.40:
Direct materials ₱5.70
Direct labor 3.40
Variable manufacturing overhead 5.80
Fixed manufacturing overhead 6.50
Unit product cost ₱21.40

Direct labor is a variable cost. The special order would have no effect on the company's total
fixed manufacturing overhead costs. The customer would like modifications made to
product Q41 that would increase the variable costs by ₱7.00 per unit and that would require
an investment of ₱15,000 in special molds that would have no salvage value.

This special order would have no effect on the company's other sales. The company has
ample spare capacity for producing the special order. If the special order is accepted, the
company's overall net operating income would increase (decrease) by:
Optimization
of Scarce
Resources
• Wherever and whoever you are, resources will always be
limited. We live in a world of scarcity. Businesses are sadled
with the reality that operations are to be done in an
environment of scarce resources. Although, the level of
resource scarcity varies from one organization to another. Still,
the challenge to management is to produce extraordinary
results from scarce resources. Money, machine hours, direct
labor hours, supply of materials and technology are subject to
scarcity.
• When a limited resource of some type restricts the company’s
ability to satisfy demand, the company is said to have a constraint.
• The machine or process that is limiting overall output is called the
bottleneck – it is the constraint.
 Quick Check 
• Oruro Chemical Corporation manufactures a variety of household cleaners, solvents,
and beverages. Because of a recent shortage of Mytron, a key ingredient needed for
three of its products, the corporation must decide what amount of each product
would be most advantageous to produce. Information related to the three products
that use Mytron are shown below:
Hand Soap Paint Remover Root Beer
Contribution margin per case ₱24 ₱20 ₱12
Contribution margin ratio 50% 70% 60%
Mytron required per case (in ounces) 3 5 2
Maximum monthly demand (in cases) 500 200 2,000

Assume that Oruro only has 3,000 ounces of Mytron available next month.
What is the maximum amount of contribution margin that Oruro can generate
next month from the three products above given the shortage of Mytron?
Managing Constraints

• It is often possible for a manager to increase the capacity of

a bottleneck, which is called relaxing (or elevating) the
constraint, in numerous ways such as:
• Working overtime on the bottleneck.
• Subcontracting some of the processing that would be
done at the bottleneck.
• Investing in additional machines at the bottleneck.
• Shifting workers from non-bottleneck processes to the
bottleneck.
• Focusing business process improvement efforts on the
bottleneck.
• Reducing defective units processed through the
bottleneck.
Other Relevant Costing /
Differential Analysis
• Sell or Process Further Joint Products
• Continue operations or Shut Down Temporarily
• Determining Indifference Point.

Note: for Discussion, please refer to the other Power point for
Module/Chapter 5.
Thank you
by: ProfJ