Marginal Analysis

Defining Relevant Costs
I. What Costs Are Relevant?
A. Relevant costs are defined as the costs affected by the decision about to
be made. Variable costs are almost always considered to be relevant, but
be careful. If for any reason a variable cost will take place whether or not
the decision facing the manager does take place, then that variable cost is
not relevant to the decision.
B. Irrelevant costs are not affected by the decision. Often, fixed costs are
unaffected and irrelevant to the decision. However, remember that
fixed costs are defined as costs that do not change based on volume of
production or sales. A fixed cost that is relevant to the decision goes
away or takes place only if management determines to move forward
with the decision, even though the fixed cost may not get incrementally
larger or smaller depending on the scale of the decision.
II. Sunk Costs
A. Sunk costs are unchanged by the decision, and are never relevant.
Typically, these are past costs made prior to the decision.
B. Sunk costs are not always in the past. Future costs can also be “sunk” if
these costs are unavoidable and unchanged by the decision. For
example, costs committed to be paid due to a contract signed for some
old equipment are sunk costs, even if the old equipment is replaced by
new equipment.
III. Opportunity Costs
A. Be careful with opportunity costs. These costs don't actually represent
money paid or received by the organization. Opportunity costs represent
money that might have been paid or received.
B. The economic definition of opportunity cost is “the value of the next best
opportunity given up to make the current decision.” Opportunity cost is
the result of an incremental analysis on other options.
1. Value given up in the next best opportunity is a cost of the current
decision. For example, in the decision to move forward to produce
and sell a particular product (Product A), the profit given up by
not producing and selling the next best alternative product
(Product B) is a cost of the decision to sell Product A.
2. Alternatively, costs that would have been paid in the next best
opportunity are actually a value of the current decision. For
example, in a decision to spend money to satisfy an environmental
 regulation requirement (Solution A), the costs that would have
been spent to satisfy the regulation requirement using a different
solution (Solution B) are actually an economic savings that offsets
Solution A.
Practice Question
Management at Tough Trucking is considering the purchase of a new delivery truck
for P86,000. If they purchase the new truck, they will sell their current truck,
which cost them P61,000 two years ago, for P48,000. General maintenance and
insurance on the current truck is approximately P3,100 annually. The current truck is
also due for a major overhaul that will cost P5,500. Straight-line depreciation on the
current truck is P10,000 per year. General maintenance and insurance for the new
truck will be approximately the same as for the current truck. If the new truck is
purchased, depreciation on it will be P12,000 per year.
Which costs are relevant and irrelevant, and why?
Answer:
It is crucial to focus on the decision at hand, which is whether to purchase the new
truck. Relevant costs are the costs affected if the decision to purchase the new truck is
made.
Relevant Costs:
 The P86,000 purchase price of the new truck is obviously relevant, and is offset
by the P48,000 opportunity cost (value) of selling the old truck.
 The overhaul cost of P5,500 is also relevant and offsets the purchase price of
the new truck.
Irrelevant Costs:
 The old purchase price of the current truck (P61,000) is unchanged whether or
not the new truck is purchased. This is a sunk cost.
 Because annual maintenance and insurance costs of both trucks are the same
(P3,100), these are irrelevant costs. If the costs were different from each other,
then the difference between the costs would be relevant.
 Even though the annual depreciation expense for each truck is different,
these costs are irrelevant because they are non-cash expenses represented
already by the purchase prices. However, if taxes were involved in this
decision, then the tax savings created by depreciation expense would
be relevant.

Sunk Costs, Opportunity Costs, and Capacity

I. The Irrelevance of Sunk Costs!
A. Remember that sunk costs are defined as costs that are unchanged by the
decision. Typically, these are past costs made prior to the decision, and
are never relevant.
B. Sunk costs can also take place in the future. If future costs are
committed, and cannot be avoided by making the decision at hand, these
future costs are considered “sunk” and are not relevant to the decision.
C. With practice, you can learn to identify and disregard sunk costs when
doing relevant decision analysis.
Practice Question
Amazing.com is an e-commerce company that designs “business-ready”
websites for small retail companies. The company committed to a P3 million
contract to build and support 300 individual retail websites as part of a larger
service provided by a specialized industry association. To support this project,
Amazing.com hired 30 additional programmers and invested in additional
office space. The programming labor costs will be P1.5 million, which is based
on expected wages of P50,000 for each programmer. Office equipment costs
were P200,000 and an office rental contract was signed for P300,000.
After spending P1.2 million in production costs (P800,000 in programming,
P200,000 in equipment, and P200,000 for rent), an economic recession pushed
the specialized industry association into bankruptcy. At that point, 100 of the
merchant websites had been fully developed, with the remaining 200 websites
still in production.
Amazing.com individually contacted each of the retailers to determine their
willingness to continue with the website build-and-support service. Not
surprisingly, many of the merchants were unable or unwilling to individually
contract with Amazing.com to have a retail website completed for P10,000
(based on the original P3 million ÷ 300 merchants). But 120 merchants did
express interest in receiving their website at a P3,000 price, for a total of
P360,000 in revenue.
Amazing.com will only need 10 programmers to finish the work. However,
regardless of whether any more programing work is done, the company is
contractually obligated to pay wages equal to the equivalent of 15 programmers
(15 × P50,000 = P750,000). The office equipment not needed can be scrapped
for P30,000. The equipment needed to complete the 120 merchant websites has
a scrap value of P10,000. Fortunately, the office rental contract can be canceled
at this point, saving P100,000. The 10 programmers can be squeezed into
Amazing.com's own office space without additional space costs.
Which costs are sunk and irrelevant, and which costs are relevant, to this
decision to individually contract with 120 merchants for a total revenue of
P360,000?
Answer:
 Remember that sunk costs are defined as costs that are unaffected by the
decision at hand. The decision for Amazing.com is whether to take on the work
to complete 120 retail websites. Otherwise, Amazing.com will effectively walk
away from this programming work and scrap the investment made thus far.
Sunk Costs:
o The P1.2 million spent thus far in programming, equipment, and rental
space are certainly sunk costs.
o It will require 10 programmers to complete the websites. However,
Amazing.com is obligated to pay salaries equal to 15 programmers.
Because Amazing.com can't avoid paying these programmers, whether
or not these retail websites are actually built, the P750,000 in
programming costs used for these 120 websites are sunk costs.
o Total scrap value of equipment is P40,000 (P30,000 + P10,000). The
P30,000 that can be scrapped right now would be scrapped whether or
not the retail websites will be built and delivered. Hence, this P30,000 is
irrelevant to the decision.
o Because the office rental contract will be canceled regardless of whether
or not the retail websites are delivered, the P100,000 saved is irrelevant
to the decision.
Relevant costs:
o The only relevant cost to making the decision to complete and deliver
120 retail websites for P360,000 is the scrap value of the equipment
needed to complete the work, which is P10,000. Based on this one
relevant cost, Amazing.com should make the decision to build these
“cheap” retail websites.
II. The Relevance of Opportunity Costs!
A. Opportunity costs, if present, are always relevant to a business decision.
The challenge, though, with opportunity costs is that there isn't a
recorded transaction in the accounting records to indicate and put a
dollar value on the cost.
B. Opportunity costs represent the value the organization could have
received if resources to make the current decision were used instead for
the next best opportunity given up. Typically, the opportunity cost is
measured by the revenue less variable costs less any direct fixed costs
that represent the next best opportunity.
C. One key characteristic to watch for in the current decision is “capacity.”
When the organization is running out of capacity, it has more
opportunities than it has the capability to pursue. In those situations, the
organization needs to make choices about how to best optimize the
capacity. It is those situations with limited capacity where opportunity
costs clearly occur.
 D. Evaluating the profitability of a decision with opportunity costs often fits
the following framework:
Revenues
 −Variable costs
 −Direct Fixed costs
 −Opportunity costs
Practice Question
Kreature Komforts, Inc. makes high-quality portable stadium seats that fans can attach
to bleachers. The company facilities can make 30,000 seats a year. A summary of
operating results for last year follows:
Sales (18,000 seats at a sales price of P1,800,000
P100)
Variable costs 990,000
Contribution margin P 810,000
Fixed costs 495,000
Net operating income P 315,000
A foreign distributor has offered to buy 15,000 seats at P90 per seat next year. This is
an all-or-nothing offer; that is, if Kreature Komforts accepts the offer, it must fill the
entire order. Kreature Komforts expects its regular sales next year to be 18,000 units.
If Kreature Komforts accepts the offer, what would be the impact on its operating
income next year? (Assume that the total fixed costs would be the same no matter
how many seats are produced and sold.)
Answer:
Kreature Komforts is currently planning to produce 18,000 seats. Taking on the
15,000 seat order would push the company past its 30,000 seat production capacity. In
order to accept the new order, Kreature Komforts would have to forgo 3,000 seats of
normal sales. The value, measured by the contribution margin, of these 3,000 seats is
an opportunity cost of the new order. Note that variable cost per seat is 990,000 ÷
18,000 = P55.
Additional Revenue = 15,000 × P90   P1,350,000
Additional Variable Cost = 15,000 × P55   (825,000)
Additional Contribution Margin   P 525,000
Opportunity Cost = 3,000 × (P100 – P55)   (135,000)
Additional Operating Income   P 390,000
Total Operating Income for Kreature Komforts with this additional order = P315,000
+ P390,000 = P705,000
Marginal Analysis and Product Line Decisions
I. Defining Marginal Costs and Marginal Revenues
A. Identifying marginal costs is tied directly to a fundamental concept in
relevant decision making, which is that only the costs that will change if
the decision is made are relevant to the decision. Further, the
term marginal cost is essentially synonymous with the term incremental
cost.
1. We basically follow a two-step process in analyzing relevant
costs. First, we identify the cost affected by the decision as the
relevant cost.
2. With the relevant cost identified, the second step is to determine
the amount by which the relevant cost affects the decision—that
is, how much additional (incremental) cost is created by the
relevant cost. This is what is known as the marginal cost.
B. Marginal revenue is identified much the same way that we
identify marginal costs. It is the incremental revenue that is directly
associated with making the decision at hand.
II. Decisions to Process a Product Further
A. The concept of marginal cost and marginal revenue describes exactly the
approach taken with decisions involving products or services that have
multiple stages of development with a sales point available at each stage.
The decision is about whether to continue processing the product further
by adding more cost in order to sell at a higher (premium) price.
B. The math is straightforward. Compute the change in cost (i.e.,
the marginal cost) and compare to the change in revenue (i.e.,
the marginal revenue). If the marginal revenue exceeds
the marginal cost, then process the product further to the next sales point.
C. Note that the incremental analysis of marginal costs
and marginal revenues can be conducted using total costs and total
revenues, or using cost per unit and price per unit.
D. When multiple products are involved, there is typically a joint
production process or shared service that all the products or services will
move through. However, the cost of the joint process or shared
service cannot be directly tied to individual products. There are several
methods available that can be used to allocate these joint costs.
However, it is important to understand that the allocation of joint costs
does not affect the decision to sell now or process further individual
products or services.
 Practice Question
A company manufactures three products using the same production
process. The costs incurred up to the split-off point are P200,000. These
costs are allocated to the products on the basis of their sales value at the
split-off point. The number of units produced, the selling prices per unit
of the three products at the split-off point and after further processing,
and the additional processing costs are as follows.
Number of Units Selling Price at Selling Price after Additional
Product Produced Split-Off Processing Processing Costs
D 3,000 P11.00 P15.00 P14,000
E 6,000 P12.00 P16.20 P16,000
F 2,000 P19.40 P24.00 P 9,000
Which product(s) should be processed further and which should be sold
at the split-off point?
Answer:
Incremental Incremental Incremental
Product Incremental Price Revenue Costs Profit
D P15.00 – P11.00 = P4.00 × 3,000 = P14,000 (P2,000)
P4.00 P12,000
E P16.20 – P12.00 = P4.20 × 6,000 = P16,000 P9,200
P4.20 P25,200
F P24.00 – P19.40 = P4.60 × 2,000 = P 9,000 P 200
P4.60 P9,200
Products E and F should be processed further. Product D should be sold
at the split-off point.
Note that this decision can also be analyzed using per-unit incremental
costs, and comparing the per-unit costs to the incremental price per unit.
III. Decisions to Add or Drop a Product Line
A. Another term that can be used to describe relevant costs is avoidable
costs. Similarly, irrelevant costs can be described as unavoidable costs.
This terminology, of course, captures well the concept that only relevant
costs are affected by the decision being considered.
B. When managers are considering a decision to add or drop a division or
product line based on a desire to increase profits, it's very important that
unavoidable costs are not included in the analysis of the division.
Unavoidable costs are often allocated to divisions or product lines
despite the fact that these business units don't actually create the costs.
C. When assessing the “true profitability” of a business unit, a
contribution margin approach in the analysis is best. Variable costs
 belonging to a division or product line are almost always avoidable if the
business unit is discontinued or dropped. And if the business unit has
any direct fixed costs, (i.e., fixed costs that are directly caused by the
business unit), those costs should also be included in the analysis.
D. A good template to use to assess the relevant revenues and costs of a
division, product line, customer group, or another for-profit business unit
is shown below.
Revenues−Variable Costs=Contribution Margin−Direct Fixed Costs=Business Unit Profit

Practice Question
You received a report on the operating performance of Wasson
Company's six divisions. With the report came a recommendation that if
the Ortiz Division were to be eliminated, total profits would increase by
P23,870.
  Ortiz Division The Other Five Divisions Total
Sales P96,200 P1,664,200 P1,760,400
Cost of Goods Sold 76,470 978,520 1,054,990
Gross Profit 19,730 685,680 705,410
Operating Expenses 43,600 527,940 571,540
Operating Income P(23,870) P 157,440 P 133,870
With a little more research, you learn that in the Ortiz Division cost of
goods sold is P70,000 variable and P6,470 fixed, and its operating expenses
are P15,000 variable and P28,600 fixed. None of the Ortiz Division's fixed
costs will be eliminated if the division is discontinued.
What will be the effect on total profits if the Ortiz Division is eliminated?
Answer:
If Wasson Company's profit analysis on the Ortiz Division was organized to
separate the variable and fixed costs, it would demonstrate the
contribution margin of this division, which in this case is the incremental
value provided by the Ortiz Division. As shown below, if this division were
eliminated, Wasson Company profits would not increase by P23,870.
Instead, it will decrease by P11,200. For this division, all fixed costs are
unavoidable and, therefore, irrelevant to the analysis.
  Ortiz Division
Sales   P 96,200
Variable Costs    
(avoidable)
   Ortiz Division
Sales   P 96,200
 Cost of Goods Sold P70,000  
 Operating Expenses 15,000 85,000
Contribution Margin 19,730 P 11,200
Fixed Costs (unavoidable)    
 Cost of Goods Sold P 6,470  
 Operating Expenses 28,600 35,070
Operating Income   P(23,870)
IV. Decisions to Prioritize Products with Constraints
A. It is important to pay attention to constraints in the organization when
analyzing relevant costs and revenues in decision making. When the
organization's resources are constrained, limited, or bottle-necked, then
choices need to be made to prioritize products or services in order to
optimize profit for the organization.
B. The key focus is contribution margin. But the analysis should not be
based on the units of output for the organization. Instead, identify the
resource creating the constraint on total output, and compute
contribution margin based on the units of input. Input for the constraint
is defined in terms of whatever measure is used to identify how the
constraint is consumed by the products or services.
C. The analysis process is done using two steps.
1. First, compute contribution margin per unit of output for each
product or service using the constraint.
2. Then multiply contribution margin per unit of output by the
number of outputs generated based on each unit of input.
D. The contribution margin per unit of input determines the priority of
products or services using the constrained resource.
Practice Question
The Good Health Baking Company produces a salt-free whole-grain bread and a
carob-chip cookie. The demand for these products is exceeding Good Health's
production capacity. The company has only 80,000 direct labor hours available. A
case of bread requires one direct labor hour while a case of cookies requires half a
direct labor hour. The company estimates that it can sell 100,000 cases of bread and
50,000 cases of cookies in the next year. The following financial information is
available:
   Bread Cookies
Selling price per case P60 P30
Variable costs per case    
 Direct materials P13 P4
 Direct labor 8 4
 Variable production overhead 2 1
 Variable marketing costs 2 1
Total Variable costs P25 P10
How should Good Health allocate its production capacity between bread and cookies?
That is, how many cases of bread and how many cases of cookies should Good Health
produce in order to maximize total profits?
Answer:
Direct labor hours represent the constrained resource for Good Health. Determine the
priority of production by computing contribution margin per direct labor hour (the
unit of input for the constrained resource).
  Bread Cookies
Selling price per case P60 P30
Variable cost per case (25) (10)
Contribution margin per case P35 P20
Cases per direct labor hour 1 ×2
Contribution margin per direct labor P35 P40
hour
Good Health should prioritize cookies first in order to most profitably use its limited
direct labor hours. Hence, it should produce and sell all the cookies possible to the
market (50,000 cases). Then it should use the remaining direct labor hours to produce
bread.
Direct Labor Hours Needed:
 50,000 cases of cookies × 0.5 direct labor hour = 25,000 direct labor hours used
 80,000 available hours – 25,000 hours = 55,000 hours remaining to produce
bread
 55,000 direct labor hours × 1 case per hour = 55,000 cases of bread
  Bread Cookies
Cases Produced 55,000 50,000
Contribution Margin per Case × P35 × P20
Total Contribution Margin P1,925,00 P1,000,000
   Bread Cookies
0
This works out to total contribution margin for Good Health of P2,925,000. No other
combination of production will generate more profit than this combination.