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CORNERSTONES
of Managerial Accounting, 5e
CHAPTER 13:
SHORT-RUN DECISION MAKING:
RELEVANT COSTING
Cornerstones of Managerial
Accounting, 5e
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Short-Run Decision Making
 Short-run decision making consists of choosing
among alternatives with an immediate or limited
end in view.
 Also referred to as tactical decisions because
they involve choosing between alternatives with
an immediate or limited time frame in mind.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Short-Run Decision Making (cont.)
 Example: Accepting a special order for less than
the normal selling price to utilize idle capacity and
to increase this year’s profits.
 Some decisions tend to be short run in nature.
 Short-run decisions often have long-run
consequences.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Decision-Making Model
 A decision model, a specific set of procedures
that produces a decision, can be used to
structure the decision maker’s thinking and to
organize the information to make a good
decision.
 The following is an outline of one decisionmaking model:
 Step 1. Recognize and define the problem.
 Step 2. Identify alternatives as possible solutions to the
problem. Eliminate alternatives that clearly are not
feasible.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Decision-Making Model (cont.)
 Step 3. Identify the costs and benefits associated with
each feasible alternative. Classify costs and benefits as
relevant or irrelevant, and eliminate irrelevant ones from
consideration.
 Step 4. Estimate the relevant costs and benefits for
each feasible alternative.
 Step 5. Assess qualitative factors.
 Step 6. Make the decision by selecting the alternative
with the greatest overall net benefit.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Relevant Costs Defined
 The decision-making approach just described
emphasized the importance of identifying and
using relevant costs.
 Relevant costs possess two characteristics:
 they are future costs AND
 they differ across alternatives.
 All pending decisions relate to the future.
 Accordingly, only future costs can be relevant to
decisions.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Opportunity Costs
 Opportunity cost is the benefit sacrificed or
foregone when one alternative is chosen over
another.
 An opportunity cost is relevant because it is both
a future cost and one that differs across
alternatives.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Opportunity Costs (cont.)
 An opportunity cost is never an accounting cost
 Accountants do not record the cost of what might
happen in the future
 (i.e., they do not appear in financial statements)
 It is an important consideration in decision
making.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Sunk Costs
 A sunk cost is a cost that cannot be affected by
any future action.
 It is important to note the psychology behind
managers’ treatment of sunk costs
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Sunk Costs (cont.)
 Although managers should ignore sunk costs for
relevant decisions, it is human nature to allow
sunk costs to affect these decisions.
 Example: Depreciation, a sunk cost, is sometimes
allocated to future periods though the original cost is
unavoidable.
 In choosing between the two alternatives, the original
cost of an asset and its associated depreciation are not
relevant factors.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Cost Behavior and Relevant Costs
 Most short-run decisions require extensive
consideration of cost behavior.
 It is easy to fall into the trap of believing that
variable costs are relevant and fixed costs are
not.
 But this assumption is not true.
 The key point is that changes in supply and
demand for resources must be considered when
assessing relevance.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Cost Behavior and Relevant
Costs (cont.)
 Changes in demand and supply for resources
across alternatives can bring about changes in
spending
 The changes in resource spending are the
relevant costs that should be used in assessing
the relative desirability of the two alternatives.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Some Common
Relevant Cost Applications
 Relevant costing is of value in solving many
different types of problems. Traditionally, these
applications include decisions:
 to make or buy a component.
 to keep or drop a segment or product line.
 to accept a special order at less than the usual price.
 to further process joint products or sell them at the
split-off point.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Some Common
Relevant Cost Applications (cont.)
 Though by no means an exhaustive list, many of
the same decision-making principles apply to a
variety of problems.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Make-or-Buy Decisions
 Managers often face the decision of whether to
make a particular product (or provide a service)
or to purchase it from an outside supplier.
 Make-or-buy decisions are those decisions
involving a choice between internal and external
production.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Make-or-Buy Decisions (cont.)
 One type of relevant cost that is becoming
increasingly large due to globalization and the
green environmental movement concerns the
disposal costs associated with electronic waste
(or e-waste).
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Special Order Decisions
 From time to time, a company may consider
offering a product or service at a price different
from the usual price.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Special Order Decisions (cont.)
 Firms can consider special orders from potential
customers in markets not ordinarily served.
 Special-order decisions focus on whether a specially
priced order should be accepted or rejected.
 These orders often can be attractive, especially when
the firm is operating below its maximum productive
capacity.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Keep-or-Drop Decisions
 A manager needs to determine whether a
segment, such as a product line, should be kept
or dropped.
 Segmented reports prepared on a variablecosting basis provide valuable information for
these keep-or-drop decisions.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Keep-or-Drop Decisions (cont.)
 Both the segment’s contribution margin and its
segment margin are useful in evaluating the
performance of segments.
 Segmented reports provide useful information for
keep-or-drop decisions
 Relevant costing describes how the information
should be used to arrive at a decision.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Keep-or-Drop with Complementary
Effects
 Sometimes dropping one line would lower sales
of another line, as many customers buy both lines
at the same time.
 This information can affect the keep-or-drop
decision.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Further Processing of Joint
Products
 Joint products have common processes and
costs of production up to a split-off point.
 At that point, they become distinguishable as
separately identifiable products.
 The point of separation is called the split-off point.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Further Processing of Joint
Products
 Sometimes it is more profitable to process a joint
product further, beyond the split-off point, prior to
selling it (sell or-process-further decision).
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Product Mix Decisions
 Organizations have wide flexibility in choosing
their product mix.
 Product mix refers to the relative amount of each
product manufactured (or service provided) by a
company.
 Decisions about product mix can have a
significant impact on an organization’s
profitability.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Product Mix Decisions (cont.)
 Every firm faces limited resources and limited
demand for each product.
 These limitations are called constraints.
 A manager must choose the optimal mix given
the constraints found within the firm.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Multiple Constrained Resources
 The presence of only one constrained resource
might not be realistic.
 Organizations often face multiple constraints,
including:
 limitations of raw materials
 limitations of skilled labor
 limited demand for each product
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Multiple Constrained
Resources (cont.)
 The solution of the product mix problem in the
presence of multiple constraints is considerably
more complicated and requires the use of a
specialized mathematical technique known as
linear programming, which is reserved for
advanced cost management courses.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Cost-Based Pricing
 Demand is one side of the pricing equation;
supply is the other side.
 Since revenue must cover all costs for the firm to
make a profit, many companies start with cost to
determine price.
 That is, they calculate product cost and add the
desired profit.
 The mechanics of this approach are
straightforward. Usually, there is a cost base and
a markup.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Cost-Based Pricing (cont.)
 The markup is a percentage applied to the base
cost.
 It includes desired profit and any costs not
included in the base cost.
 Companies that bid for jobs routinely base bid
price on cost.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Target-Costing and Pricing
 Many American and European firms set the price
of a new product as the sum of the costs and the
desired profit. The rationale is that the company
must earn sufficient revenues to cover all costs
and yield a profit.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Target-Costing and Pricing (cont.)
 Target costing is a method of determining the
cost of a product or service based on the price
(target price) that customers are willing to pay.
 The marketing department determines what
characteristics and price for a product are most
acceptable to consumers.
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.