Managerial Accounting Chapter 13

Relevant Costs and Benefits

A relevant cost is a cost that differs between alternatives. A relevant benefit is a benefit that differs between alternatives.

Identifying Relevant Costs

An avoidable cost is a cost that can be eliminated, in whole or in part, by choosing one alternative over another. Avoidable costs are relevant costs. Unavoidable costs are irrelevant costs. Two broad categories of costs are never relevant in any decision: 1. A sunk cost is a cost that has already been incurred and cannot be avoided regardless of what a manager decides to do. 2. A future cost that does not differ between alternatives is never relevant in a decision.

ferent 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.

Beware of Allocated Fixed Costs

Lovell's allocated fixed costs can distort the keep/drop decision. Lovell's managers may ask "why keep the digital watch segment when its segmented income statement shows a $100,000 loss?" The answer lies in the way common fixed costs are allocated to products.

Comparative Income Approach

The Lovell solution can also be obtained by preparing comparative income statements showing results with and without the digital watch segment.

Decision Making: A Two-Step Process

The first step is to eliminate costs and benefits that do not differ between alternatives. These irrelevant costs consist of sunk costs and future costs that do not differ between alternatives. The second step is to use the remaining costs and benefits that do differ between alternatives in making the decision. The costs that remain are the differential, or avoidable, costs.

Total and Differential Cost Approaches

The total approach requires constructing two contribution format income statements - one for each alternative. The difference between the two income statements of $12,000 equals the differential benefits shown at the bottom of the right-hand column. KNOW INCOME STATEMENT

Differential Analysis

focusing on the costs and benefits that differ between the alternatives

A Contribution Margin Approach

To determine how dropping this line will affect the overall profits of the company, Lovell will compare the contribution margin that would be lost to the costs that would be avoided if the line was to be dropped. Lovell should drop the digital watch segment only if its profit would increase. This would only happen if the fixed cost savings exceed the lost contribution margin.

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.

The Make or Buy Decision

When a company is involved in more than one activity in the entire value chain, it is vertically integrated. A decision to carry out one of the activities in the value chain internally, rather than to buy externally from a supplier is called a "make or buy" decision.

Opportunity Cost

An opportunity cost is the benefit that is foregone as a result of pursuing a course of action. These costs do not represent actual cash outlays and they are not recorded in the formal accounts of an organization. In the Essex Company example that we just completed, if Essex had an alternative use for the capacity that it used to make part 4A, there would have been an opportunity cost to factor into the analysis. The opportunity cost would have been equal to the segment margin that could have been derived from the best alternative use of the space.

Vertical Integration- Disadvantage

The primary disadvantage of vertical integration is that a company may fail to take advantage of suppliers who can create an economies of scale advantage by pooling demand from numerous companies. While the economies of scale factor can be appealing, a company must be careful to retain control over activities that are essential to maintaining its competitive position.

Vertical Integration- Advantages

An integrated company may be able to ensure a smoother flow of parts and materials for production than a nonintegrated company. Some companies feel that they can control quality better by producing their own parts and materials. Integrated companies realize profits from the parts and materials that they choose to make instead of buy.

Differential Analysis Intro

Making decisions is one of the basic functions of a manager. To be successful in decision making, managers must be able to tell the difference between relevant and irrelevant data and must be able to correctly use the relevant data in analyzing alternatives. The purpose of this chapter is to develop these skills by illustrating their use in a wide range of decision-making situations.

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.

Part I Assume the following information with respect to Cynthia, a Boston student who is considering visiting her friend in New York. Cynthia is trying to decide whether it would be less expensive to drive or take the train to New York. She has compiled the following information with respect to her automobile.

Part II The straight-line depreciation is calculated as cost minus salvage value divided by useful life. Part III Gasoline per mile is calculated by taking the price per gallon of gasoline and dividing it by the number of miles per gallon of the car. The annual cost of insurance and license and maintenance and repairs are also included to arrive at the average cost per mile. Part IV The parking fee at school is $45 a month. Cynthia attends school only eight months out of the year.