Relevant Revenues and Costs

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CHAPTER 2:
RELEVANT REVENUES AND COSTS

The primary goal of a firm is to maximize profits. This implies, of course, that each decision a manager makes is consistent with that goal. Although managers are expected to rely on internally-produced reports, such as balance sheets and income statements, to help them make decisions, most of the information that appears on these statements is period-based rather than decision-based. A balance sheet shows the sum total of a firm’s assets and liabilities at a given point in time. If the firm sold off all of its assets at book value and used the proceeds to pay its liabilities, what remains is owner’s equity: the amount that is owed to shareholders. An income statement is the difference between revenues and expenses between two points in time.

A myriad of useful pieces of information can be gleaned from these statements: the current ratio, inventory ratio, and liabilities ratio may be determined from balance sheets. Net sales to inventory and net profits to net sales are obtained from income statements. But as useful as this information can be to managers, the critical element is that the balance sheet and income statement represent the results of previous decisions. The balance sheet indicates where the firm stands as a result of all past decisions. The income statement reports the revenues received and expenses incurred between two distinct dates. Some of the revenues may flow from decisions made in previous periods. Some of the expenses that are incurred may not generate revenue until a future time period. There is nothing in the statement that reports the results of a specific decision.

But managers need to know how to make profitable decisions. This is the primary focus of this book: to merge economic theory with accounting practices to help managers make better decisions. The target market for this book is business managers more than accountants. Although the theoretical background will be useful to accountants, most accountants are already schooled in the cost accounting procedures we will discuss. Rather, the book is geared for business managers who wish to make proper decisions based on available information. Economic theory can be very useful in determining factors associated with consumer demand and revenue generation. Theory is also useful in describing factors that generate costs. As we will learn, much of the information decision-makers need to know on the cost side is unavailable. Few persons know how much each individual unit will cost to produce. Unit cost estimates are not accurate representations of unit cost: rather, they represent best estimates of unit cost. Different cost accounting methods report different unit costs, each with its own bias. Yet this requires managers to make decisions based on information that is not necessarily accurate. Biased estimates may mislead managers into making bad decisions: decisions that may cause them to over- or underproduce, or to over- or underprice their goods. It may cause them to give the “go-ahead” to an unprofitable capital budgeting project, or to say “no” to a project that might have been profitable.

Economists and accountants assert that managers should compare the relevant revenues and relevant costs associated with a decision. Relevant revenues refer to any revenues that will change if the decision is implemented. Any revenue that will remain unchanged is irrelevant and should be disregarded in evaluating a course of action. Relevant costs refer to any costs that will change if the decision is implemented. Any costs that remain unchanged should not be factored into the firm’s decision. Let’s use several contrasting examples. A local group decides to hold a fundraiser by selling boxes of chocolate chip cookies. Each box costs the group $3. Historically, it charged a price of $10/box and sold 300 boxes. This year, the group is considering lowering its price to sell more...
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