Chapter 13 Notes Page 1 Please send comments and corrections to me at [email protected] Relevant Costing In making decisions, the following steps are taken: • Define the problem; • Identify the feasible alternatives; • Identify the costs of each feasible alternative; • Compare the relevant costs and benefits; and • Select the alternative with the greatest net benefit. The key part of this analysis is to consider only the information that is relevant to the decision being made. Relevant Costs & Benefits Relevant costs and benefits are costs and benefits that are different between the alternatives being considered. Costs that are the same, regardless of which alternative is chosen, have no impact on the decision making process. How can they? Their impact on each alternative is exactly the same. For example, assume that you rent a boat for $1,000 a month. Also assume that you can operate either a harbor tour business or a fishing business using that boat. The following revenues and costs would be generated from the alternative uses of the boat: Fishing Tour Difference Revenue $8,000 $10,000 -$2,000 Expenses -1,000 -4,000 3,000 Rent -1,000 -1,000 ____0 Profit $6,000 $5,000 $1,000 You will generate $1,000 more profit if you choose the Fishing Business alternative. Your decision to operate a Fishing business would remain unchanged if you had not considered the rent: Fishing Tour Difference Revenue $8,000 $10,000 -$2,000 Expenses -1,000 -4,000 3,000 Profit $7,000 $6,000 $1,000 With either calculation, the Fishing business produces a profit that is $1,000 higher than the Tour business. If a particular cost is the same under both alternatives (e.g., rent), that cost is not relevant to the decision of which alternative to choose. Including such a cost in your analysis might cause you to make the wrong decision. The purpose of this analysis is to make a decision as to which alternative to choose. The bottom line profit/cost that appears in the table is not important to our analysis, and it does not haveChapter 13 Notes Page 2 Please send comments and corrections to me at [email protected] to reflect all of the revenues and costs associated with each alternative. The difference between the two columns is the key to this analysis (e.g., Fishing produces $1,000 more in Operating Profits). Another term used for relevant costs is differential costs, and this subject matter is often referred to as Relevant Costing or Differential Costing. Relevant costs do not include sunk or historical costs. Sunk costs are costs that we have already spent, and that we cannot recover. Because they are already spent, sunk costs are the same (not different) for each alternative. In order to be relevant, costs and benefits must be future costs and benefits. For example, assume that you bought an original oil painting by Leroy Neiman for your home. The painting is huge, and filled an entire wall of your living room. At the time, you paid $10,000 for the painting. You are now downsizing your lifestyle (and living accommodations), and the painting is too large to be appropriately displayed in your new trailer park accommodations. You have decided to sell the painting, but the only offer that you have received is $8,000. The fact that you originally paid $10,000 for the painting is not relevant to whether you should accept or reject this offer. The original price that you paid for the painting is a sunk cost. Although, you may not like the idea of selling the painting for less than you paid for it, you should be attempting to liquidate your investment in the painting in a manner that will produce the highest net benefit to you. This could involve selling the painting at a loss, if that is the best deal that you can obtain. Other revenue generating operations that are available if only one of the alternatives is selected is relevant to your decision. These are Opportunity Costs. For example, assume that you have rented retail space, and you are trying to decide whether to use it to operate a CD store or a Comic Book store. Assume that if you elect to operate a Comic Book store, then you will also be able to sublease part of your space to vending machine operators for an additional $200 a month. There is not sufficient space to permit such a sublease if you choose to operate a CD store. The lost revenue from the vending machines ($200) is viewed as an Opportunity Cost if the CD store alternative is chosen, and it is added to the other costs of the CD store. Sunk CostChapter 13 Notes Page 3 Please send comments and corrections to me at [email protected] CD Store Comic Book Store Difference Revenue $10,000 $7,000 -$3,000 Expenses -5,000 -2,000 -3,000 Sublease -200 _____0 ____-200 Profit $4,800 $5,000 -$200 In this chapter we will focus on a quantitative analysis, but qualitative factors are also relevant. For example, assume you are trying to decide whether you should produce a product internally, or outsource its production. While we will focus on which alternative provides you with the maximum economic net benefit; in real life, qualitative factors would play an important role in your decision. For example, you would be concerned with such qualitative factors as the reliability of the supplier; your ability to control the quality of the outsourced products; the impact on the morale of your workforce if you downsize your manufacturing operations; whether you decision would change with a change in circumstances, and the ability for you to resume production of the product if circumstances change. Another factor that is very relevant to decision making is the time-value of money. For simplicity, we will not consider it in this chapter. Relevant Cost Example Assume that Titanic, Inc. owns a ship that takes passengers on day-long cruises from Long Beach to Catalina and back again. The ship was purchased for $4,000,000, and has a 20-year life. The ship is depreciated using the straight-line method over its useful life with no salvage value. This produces a depreciation expense of $200,000 a year. Only half of the ship is used for the Catalina cruises. Titanic is
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