BULLET NOTES ON DIFFERENTIAL ANALYSIS / RELEVANT COSTING
Decision Making is the process of choosing from at least two alternatives. For business entities, management must choose in favor of the option that maximizes the company profits.
Short-term decisions: Accept or reject a special order. Sell or process further. Make or buy. Retain or replace equipment. Continue or shut down a business segment. Choosing the best product combination. Utilization of scarce resources. Selecting a change in profit factors.
DEFINITIONS Relevant Costs – future costs that are expected to be different under each alternative course of action. Differential Costs – increases (increments) or decreases (decrements) in total costs that result from selecting one alternative instead of another. Avoidable Costs – costs that will be saved or those that will not be incurred if a certain decision is made. Opportunity Costs – the benefit lost by taking one action as opposed to another. Sunk Costs – refer to the non-recoverable costs incurred in the past. Joint Costs – costs incurred in simultaneously processing or manufacturing two or more products which are difficult to identify individually as separate types of products until a certain processing stage known as the point of separation or split-off point. Further Processing Costs – Costs incurred beyond the split off point as separated joint products are to be processed further. Split-Off Point – The earliest stage in the production where joint products can be recognized as distinct and separate products. Shutdown Costs – usual costs that a company will continue even if it decides to discontinue or shutdown the operation of a company segment.
DECISION CRITERIA
Nature of Alternatives Decision Criteria
Make or Buy a Choose the option that has the lower cost. In most cases, fixed part/product costs are irrelevant. Consider opportunity costs, if any. Accept or Reject a special Accept the order when the additional revenue from the order special order exceeds additional cost, provided the regular market will not be affected. In most cases, fixed costs are irrelevant. Continue or Shutdown a Continue if segment’s avoidable revenue is greater than the business segment avoidable costs; otherwise consider shutting down the segment since allocated fixed cost is usually unavoidable, it is considered irrelevant. Sell or Process further a Process further if additional revenue from processing further product is greater than further processing costs.
Joint costs, since already incurred prior to the split-off point,
are considered sunk costs and irrelevant. Best Product Combination Identify and measure the constraint on the limited resources(s). (Optimization of Scarce Rank the product(s) according to the highest contribution Resources) margin per unit of limited resources. Change in Profit Factors Identify the factor to change and the amount of contemplated (related with CVP Analysis) change. Change the profit factor if it will cause an improvement on the company’s overall profit position. BULLET NOTES – RELEVANT COSTING Compiled by Vhin
Management’s Decision-Making Process
The steps are: o Identify the problem and assign responsibility. o Determine and evaluate possible courses of action. o Make a decision. o Review the results of the decision. Accounting’s contribution to the decision-making process occurs primarily in steps (b) and (d) – evaluating possible courses of action and reviewing results.
Incremental Analysis The process used to identify the financial data that change under alternative courses of action is called incremental analysis. These data are relevant to the decision because they will vary in the future among the possible alternatives. Incremental analysis sometimes involves changes that might seem contrary to your intuition. For example, sometimes: o Variable costs do not change under the alternative courses of action. o Fixed costs do change.
a. Accept an order at a special price
o The relevant information is the difference between the variable manufacturing costs to produce the special order and expected revenues. o If other sales are affected, then the company would have to consider the lost sales in making the decision. o If the company is operating at full capacity, it is likely that the special order would be rejected.
b. Make or buy o In a make or buy decision, the relevant costs are: The variable manufacturing costs that will be saved. The fixed manufacturing costs that can be eliminated. The purchase price. Opportunity costs: The potential benefit that may be obtained by following an alternative course of action.
c. Sell or process further
o Many manufacturers have the option of selling products at a given point in the production cycle or continuing to process with the expectation of selling them at a later point at a higher price. o The basic decision rule is: Process further as long as the incremental revenue from such processing exceeds the incremental processing costs. o In many industries, a number of end-products are produced from a single raw material and a common production process. These multiple end-products are referred to as joint products. o All costs incurred prior to the point at which the two products are separately identifiable (the split-off point) are called joint costs. o Joint product costs must be allocated to individual products, frequently done based on the relative sales value of the joint products. o The allocation of joint product costs is important for the determination of product cost but is irrelevant for any sell-or-process-further decisions since these joint costs are sunk costs. They have already been incurred and cannot be avoided by any subsequent decision.
d. Retain or replace equipment
o Management often has to decide whether to continue using an asset or replace it. o The relevant items to be considered are: The effects on variable costs The cost of the new equipment Any disposal value of the existing asset must also be considered. BULLET NOTES – RELEVANT COSTING Compiled by Vhin
o The book value of the old asset does not affect the decision. Book value is a sunk cost, which is a cost that cannot be changed by any present or future decision.
e. Eliminate an unprofitable segment
o In deciding whether to eliminate an unprofitable segment, the relevant information is the contribution margin produced by the segment and the disposition of the segment’s fixed expenses. o In deciding on the future status of an unprofitable segment, management should consider the effect of elimination on related segments. o Management should also consider the effect of eliminating the segment on employees who may have to be discharged or retained.
