Relevant Costs for Decision Making
Solutions to Questions
A relevant cost is a cost that differs in total between the alternatives in a decision.
An incremental cost (or benefit) is the change in cost (or benefit) that will result from some proposed action. An opportunity cost is the benefit that is lost or sacrificed when rejecting some course of action. A sunk cost is a cost that has already been incurred and that cannot be changed by any future decision.
No. Variable costs are relevant costs only if they differ in total between the alternatives under consideration.
No. Not all fixed costs are sunk—only those for which the cost has already been irrevocably incurred. A variable cost can be a sunk cost, if it has already been incurred.
No. A variable cost is a cost that varies in total amount in direct proportion to changes in the level of activity. A differential cost is the difference in cost between two alternatives. If the level of activity is the same for the two alternatives, a variable cost will not be affected and it will be irrelevant.
No. Only those future costs that differ between the alternatives under consideration are relevant.
Only those costs that would be avoided as a result of dropping the product line are relevant in the decision. Costs that will not differ regardless of whether the product line is retained or discontinued are irrelevant.
Not necessarily. An apparent loss may be the result of allocated common costs or of sunk costs that cannot be avoided if the product line is dropped. A product line should be discontinued only if the contribution margin that will be lost as a result of dropping the line is less than the fixed costs that would be avoided. Even in that situation the product line may be retained if its presence promotes the sale of other products.
Allocations of common fixed costs can make a product line (or other segment) appear to be unprofitable, whereas in fact it may be profitable.
If a company decides to make a part internally rather than to buy it from an outside supplier, then a portion of the company’s facilities have to be used to make the part. The company’s opportunity cost is measured by the benefits that could be derived from the best alternative use of the facilities.
Any resource that is required to make products and get them into the hands of customers could be a constraint. Some examples are machine time, direct labor time, floor space, raw materials, investment capital, supervisory time, and storage space. While not covered in the text, constraints can also be intangible and often take the form of a formal or informal policy that prevents the organization from furthering its goals.
Assuming that fixed costs are not affected, profits are maximized when the total contribution margin is maximized. A company can maximize its contribution margin by focusing on the products with the greatest amount of contribution margin per unit of the constrained resource.
Joint products are two or more products that are produced from a common input. Joint costs are the costs that are incurred up to the split-off point. The split-off point is the point in the manufacturing process where joint products can be recognized as individual products.
Joint costs should not be allocated among joint products. If joint costs are allocated among the joint products, then managers may think they are avoidable costs of the end products. However, the joint costs will continue to be incurred as long as the process is run regardless of what is done with one of the end products. Thus, when making decisions about the end products, the joint costs are not avoidable and are irrelevant.
As long as the incremental revenue from further processing exceeds the incremental costs of further processing, the product should be processed further.
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