Chapter 12: Relevant Costs for Decision Making

Relaxing (or elevating) the Constraint

An action that increases the amount of a constrained resource. Equivalently, an action that increases the capacity of the bottleneck.

Differential Cost

Any cost that differs between alternatives in a decision-making situation. This term is synonymous with avoidable cost and relevant cost.

Sunk Cost

Any cost that has already been incurred and that cannot be changed by any decision made now or in the future.

Relevant Cost

A cost that differs between alternatives in a decision. This term is synonymous with avoidable cost and differential cost.

Relevant Cost Analysis Application

1. Adding or dropping a product line or segment 2. Deciding whether to make or buy a product 3. Accepting a special order from a customer 4. Maximizing the utilization of a constrained resource

What are the relevant costs (and benefits) to consider when making a decision?

1. Avoidable costs can be eliminated, at least in part, by selecting one alternative over another 2. Benefits that are difficult to monetize are still relevant to the decision if they differ among alternatives 3. Beware of average cost estimates--you are only concerned with the incremental costs and benefits associated with the decision

Why are irrelevant costs hard to ignore?

1. Escalating Commitment 2. Prospect Theory

What are some ways that capacity can be increased at a bottleneck?

1. Overtime 2. Subcontracting procesing 3. Adding machinery and/or workers 4. Shifting workers and/or equipment from low to high utilization 5. Six Sigma process improvements 6. Reducing defects and rework

What are irrelevant costs that can be ignored when making a decision?

1. Sunk Costs have already been incurred and cannot be avoided regardless of the alternative chosen 2. Future Costs (and benefits) that do not differ between the alternatives can be safely ignored 3. Common Fixed Costs should be ignored since they will be incurred even if a segment is dropped

What factors should be considered when deciding to drop a product or segment?

1. The contribution margin and segment margin of the product/segment 2. The effect of the product/segment on the profits of other segments (ex. is it a loss leader?) 3. Ignore allocated fixed costs and sunk costs

What factors should managers consider when deciding whether to accept a special order?

1. What are the relevant costs and benefits of the order? 2. What are the opportunity costs associated with foregone sales (if any?) 3. Will the special order have a negative effect on future sales (precedent setting concerns?) 4. Are there any non-financial factors (ex. reputational concerns) to consider?

Avoidable Cost

A cost that can be eliminated (in whole or in part) by choosing one alternative over another in a decision. This term is synonymous with relevant cost and differential cost.

Make or Buy Decision

A decision concerning whether an item should be produced internally or purchased from an outside supplier. Companies "make" when they decide to carry out a value chain activity themselves. Factors to consider include costs and benefits, risk, control, focus, and economies of scale

Constraint

A limitation under which a company must operate, such as limited available machine time or raw materials, that restricts the company's ability to satisfy demand.

Bottleneck

A machine or some other part of a process that limits the total output of the entire system.

Special Order

A one-time order that is not considered part of the company's normal ongoing business.

Vertical Integration

Companies that choose to make rather than buy a value chain activity. The involvement by a company in more than one of the activities in the entire value chain from development through production, distribution, sales, and after sales service.

What should managers do when they are facing constrained resources?

Managers should prioritize the products that have the highest contribution margin per unit of the constrained resource (usually time or space)

Prospect Theory

Managers tend to be risk-averse when they are in a position of gains (profitable) and risk-seeking when they are in a loss position (unprofitable). We have an irrational tendency to be less willing to gamble with profits than with losses.

Escalating Commitment

Tendency to invest additional resources in an apparently losing proposition, influenced by effort, money, and time already invested

Opportunity Costs

They are the potential benefits that are given up when one alternative is selected over another such as when a firm gives up the sales of one product line in order to divert its capacity to making and selling another. *these are not recorded in financial statements, but are relevant to decision making