Differential Analysis 1 - Compressed

Differential Analysis: The Key to Decision Making 561
CHAPTER 12
T
his chapter discusses what may be a manager’s most important
responsibility—making decisions. Examples of decisions include deciding
FPO what products to sell, whether to make or buy component parts, what prices
to charge, what channels of distribution to use, and whether to accept special
orders at special prices. Making such decisions is often a difficult task that is complicated
by numerous alternatives and massive amounts of data; however, in this chapter you will
learn how to narrow your focus to the information that matters.
Decision Making: Six Key Concepts

Differential Analysis: The Key There are six key concepts that you need to understand to make intelligent decisions.
LO12–1
to Decision Making This section discusses each of those concepts and then concludes by introducing some
additional terminology that was created to help you solve the exercises and problems at
Identify relevant and irrelevant
costs and benefits in a
the end of the chapter. decision.
Understanding the Qualitative Aspects of
Decision Making Key Concept #1
Every decision involves choosing from among at least two alternatives. Therefore, the
first step in decision making is to define the alternatives being considered. For example,
LEARNING OBJECTIVES if a company is deciding whether to make a component part or buy it from an outside sup-
plier, the alternatives are make or buy the component part. Similarly, if a company is con-
BUSINESS FOCUS
After studying Chapter 12, you should be able to: sidering discontinuing a particular product, the alternatives are keep or drop the product.
LO12–1 Identify relevant and irrelevant costs

and benefits in a decision. Key Concept #2
LO12–2 Prepare an analysis showing whether Once you have defined the alternatives, you need to identify the criteria for choosing
a product line or other business among them. The key to choosing among alternatives is distinguishing between relevant
segment should be added or dropped. and irrelevant costs and benefits. Relevant costs and relevant benefits should be consid-
LO12–3 Prepare a make or buy analysis.
ered when making decisions. Irrelevant costs and irrelevant benefits should be ignored
when making decisions. This is an important concept for two reasons. First, being able
LO12–4 Prepare an analysis showing whether to ignore irrelevant data saves decision makers tremendous amounts of time and effort.
a special order should be accepted. Second, bad decisions can easily result from erroneously including irrelevant costs and
LO12–5 Determine the most profitable use benefits when analyzing alternatives.
of a constrained resource.
© Ian Dagnall/Alamy
LO12–6 Determine the value of obtaining
Key Concept #3
SAS is a privately held $2.26 billion company located on a 200-acre cam- more of the constrained resource.
pus in Cary, North Carolina. The company has an on-site medical facility
The key to effective decision making is differential analysis—focusing on the future
LO12–7 Prepare an analysis showing whether
costs and benefits that differ between the alternatives. Everything else is irrelevant and
(including a lab for blood tests) that is staffed by doctors, nurse practi- joint products should be sold at the
tioners, physical therapists, and a nutritionist. The company also has an split-off point or processed further.
should be ignored. A future cost that differs between any two alternatives is known as a
infant day care, a Montessori school, a hair salon, a dry cleaning shop, a
differential cost. Differential costs are always relevant costs. Future revenue that differs
LO12–8 (Appendix 12A) Compute the between any two alternatives is known as differential revenue. Differential revenue is an
fitness center, and jogging and biking trails on campus. Employees that selling price of a product using the
use the day care pay $360 per month per child for the service and SAS
example of a relevant benefit.
absorption costing approach to
covers the remaining $720 per month per child that it costs to retain 120
The terms incremental cost and avoidable cost are often used to describe differential
cost-plus pricing.
teachers and staffers.
costs. An incremental cost is an increase in cost between two alternatives. For example,
LO12–9 (Appendix 12A) Understand how if you are choosing between buying the standard model or the deluxe model of your
Although it may be difficult to quantify the benefits of these invest- customers’ sensitivity to changes
ments, SAS firmly believes that retaining happy and healthy employees
favorite automobile, the costs of the upgrades contained in the deluxe model are incre-
in price should influence pricing mental costs. An avoidable cost is a cost that can be eliminated by choosing one alterna-
is instrumental to its success. Mary Simmons, a SAS software developer decisions.
says, “At lunch I will go out and bike 20 miles. Then I’ll get back and all of
tive over another. For example, assume that you have decided to watch a movie tonight;
LO12–10 (Appendix 12A) Analyze pricing however, you are trying to choose between two alternatives—going to the movie theater
a sudden a thought comes to my brain, and I solve something I was strug-
decisions using value-based pricing. or renting a movie. The cost of the ticket to get into the movie theater is an avoidable cost.
gling with.” ■
LO12–11 (Appendix 12A) Compute the target You would avoid this cost by renting a movie. Similarly, the movie rental fee is an avoid-
Source: Christopher Tkaczk, “Offer Affordable (Awesome) Day Care,” Fortune, August 17, 2009, p. 26. cost for a new product or service. able cost because you could avoid it by going to the movie theater. Avoidable costs (and
incremental costs) are always relevant costs.
560
562 Chapter 12 Differential Analysis: The Key to Decision Making 563
Differential costs and benefits can be qualitative or quantitative in nature. While In all of these various contexts, a financial advantage exists if pursuing an alterna-
qualitative differences between alternatives can have an important impact on decisions, tive, such as closing a store or accepting a special order, passes the cost/benefit test. In
and therefore, should not be ignored; our goal in this chapter is to hone your quantitative other words, it exists if the alternative’s differential benefits (i.e., its future cash inflows)
analysis skills. Therefore, our primary focus will be on analyzing quantitative differential exceed its differential costs (i.e., its future cash outflows). Conversely, a financial (disad-
costs and benefits—those that have readily measurable impacts on future cash flows. vantage) exists when an alternative fails the cost/benefit test—its differential benefits are
less than its differential costs.2
Key Concept #4
Sunk costs are always irrelevant when choosing among alternatives. A sunk cost is a
cost that has already been incurred and cannot be changed regardless of what a manager Identifying Relevant Costs and Benefits: An Example
decides to do. Sunk costs have no impact on future cash flows and they remain the same
no matter what alternatives are being considered; therefore, they are irrelevant and should Cynthia is currently a student in an MBA program in Boston and would like to visit a
be ignored when making decisions. friend in New York City over the weekend. She is trying to decide whether to drive or
For example, suppose a company purchased a five-year-old truck for $12,000. The take the train. Because she is on a tight budget, she wants to carefully consider the costs
amount paid for the truck is a sunk cost because it has already been incurred and the of the two alternatives. If one alternative is far less expensive than the other, that may
transaction cannot be undone. The $12,000 paid for the truck is irrelevant in making be decisive in her choice. By car, the distance between her apartment in Boston and her
decisions such as whether to keep, sell, or replace the truck. Furthermore, any accounting friend’s apartment in New York City is 230 miles. Cynthia has compiled the following
depreciation expense related to the truck is irrelevant in making decisions. This is true list of items to consider:
because accounting depreciation is a noncash expense that has no effect on future cash
flows. It simply spreads the sunk cost of the truck over its useful life.1
Automobile Costs
Cost per Mile
Key Concept #5 Annual (based on
Future costs and benefits that do not differ between alternatives are irrelevant to the deci- Cost of 10,000 miles
sion-making process. So, continuing with the movie example, assume that you plan to Item Fixed Items per year)
buy a Papa John’s pizza after watching a movie. If you are going to buy the same pizza
(a) Annual straight-line depreciation on
regardless of your movie-watching venue, the cost of the pizza is irrelevant when choos- car [($24,000 original cost − $10,000 estimated
ing between the theater and the rental. The cost of the pizza is not a sunk cost because it resale value in 5 years)/5 years] . . . . . . . . . . . . . . . . . . $2,800 $0.280
has not yet been incurred. Nonetheless, the cost of the pizza is irrelevant to the choice of (b) Cost of gasoline ($2.40 per gallon ÷ 24 miles
venue because it is a future cost that does not differ between the alternatives. per gallon). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.100
(c) Annual cost of auto insurance and license . . . . . . . . . $1,380 0.138
Key Concept #6 (d) Maintenance and repairs . . . . . . . . . . . . . . . . . . . . . . . . 0.065
(e) Parking fees at school ($45 per month ×
Opportunity costs also need to be considered when making decisions. An opportunity 8 months) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $360 0.036
cost is the potential benefit that is given up when one alternative is selected over another.
(f) Total average cost per mile . . . . . . . . . . . . . . . . . . . . . . $0.619
For example, if you were considering giving up a high-paying summer job to travel over-
seas, the forgone wages would be an opportunity cost of traveling abroad. Opportunity
Additional Data
costs are not usually found in accounting records, but they are a type of differential cost
that must be explicitly considered in every decision a manager makes. Item
This chapter covers various decision contexts, such as keep or drop decisions, make (g) Reduction in the resale value of car due
or buy decisions, special order decisions, and sell or process further decisions. While solely to wear and tear. . . . . . . . . . . . . . . . . . . . . . . . . . $0.080 per mile
tackling these diverse decision contexts may seem a bit overwhelming, keep in mind that (h) Cost of round-trip train ticket from Boston to
they all share a unifying theme—choosing between alternatives based on their differential New York City. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $114
costs and benefits. To emphasize this common theme, many end-of-chapter exercises and (i) Benefit of relaxing and being able to study during
problems that span a variety of learning objectives will often use the same terminology— the train ride rather than having to drive. . . . . . . . . . . ?
financial advantage (disadvantage)—when asking you to choose between alternatives. ( j) Cost of putting the dog in a kennel while gone . . . . . $80
For example, numerous exercises and problems will ask questions such as: (k) Benefit of having a car available
in New York City . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?
1. What is the financial advantage (disadvantage) of closing the store? (l) Hassle of parking the car in New York City. . . . . . . . . ?
2. What is the financial advantage (disadvantage) of buying the component part from a (m) Cost of parking the car in New York City. . . . . . . . . . . $25 per day
supplier rather than making it?
3. What is the financial advantage (disadvantage) of accepting the special order?
4. What is the financial advantage (disadvantage) of further processing the intermediate 2
Over the life of a company, cumulative net cash flows equal cumulative net income. Therefore, if a
product? decision maximizes future net cash flows, it will also maximize future cumulative net income. However,
because of accruals, in any particular period net income will usually be different from net cash flow. A
1
See Appendix 13C for a discussion of how depreciation expense impacts decisions when tax implica- decision that is based on maximizing future net cash flows might, in the short run, reduce net income,
tions are considered. but in the long run cumulative net income will be higher than it otherwise would have been.
Which costs and benefits are relevant in this decision? Remember, only the differ- Bringing together all of the relevant data, Cynthia would estimate the relevant costs
ential costs and benefits are relevant—everything else is irrelevant and can be ignored. of driving and taking the train as follows:
Start at the top of the list with item (a): the original cost of the car is a sunk cost.
This cost has already been incurred and therefore can never differ between alterna-
tives. Consequently, it is irrelevant and should be ignored. The same is true of the Relevant financial cost of driving to New York City:
accounting depreciation of $2,800 per year, which simply spreads the sunk cost across Gasoline (460 miles × $0.100 per mile) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 46.00
five years. Maintenance and repairs (460 miles × $0.065 per mile) . . . . . . . . . . . . . . . . 29.90
Item (b), the cost of gasoline consumed by driving to New York City, is a relevant Reduction in the resale value of car due solely to wear and tear
cost. If Cynthia takes the train, she would avoid the cost of the gasoline. Hence, the cost (460 miles × $0.080 per mile) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36.80
differs between alternatives and is therefore relevant. Cost of parking the car in New York City (2 days × $25 per day) . . . . . . . . . 50.00
Item (c), the annual cost of auto insurance and license, is not relevant. Whether Cyn- Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 162.70
thia takes the train or drives on this particular trip, her annual auto insurance premium
and her auto license fee will remain the same.3 Relevant financial cost of taking the train to New York City:
Item (d), the cost of maintenance and repairs, is relevant. While maintenance and Cost of round-trip train ticket from Boston to New York City . . . . . . . . . . . . . $ 114.00
repair costs have a large random component, over the long run they should be more or
less proportional to the number of miles the car is driven. Thus, the average cost of $0.065
per mile is a reasonable estimate to use. What should Cynthia do? From a purely financial standpoint, it would be cheaper
Item (e), the monthly fee that Cynthia pays to park at her school during the academic by $48.70 ($162.70 − $114.00) to take the train than to drive. Cynthia has to decide if
year is not relevant. Regardless of which alternative she selects—driving or taking the the convenience of having a car in New York City outweighs the additional cost and the
train—she will still need to pay for parking at school. disadvantages of being unable to relax and study on the train and the hassle of finding
Item (f) is the total average cost of $0.619 per mile. As discussed above, some parking in the city.
elements of this total are relevant, but some are not relevant. Because it contains some
irrelevant costs, it would be incorrect to estimate the cost of driving to New York City
and back by simply multiplying the $0.619 by 460 miles (230 miles each way × 2).
This erroneous approach would yield a cost of driving of $284.74. Unfortunately, such IN BUSINESS
mistakes are often made in both personal life and in business. Because the total cost COMPANIES WRESTLE WITH THE COSTS AND BENEFITS OF
is stated on a per-mile basis, people are easily misled. Often people think that if the CYBERSECURITY
cost is stated as $0.619 per mile, the cost of driving 100 miles is $61.90. But it is not. Quantifying the costs and benefits of alternative cybersecurity investment strategies is difficult
Many of the costs included in the $0.619 cost per mile are sunk and/or fixed and will for companies to do. On the one hand, the costs associated with insufficient spending have
not increase if the car is driven another 100 miles. The $0.619 is an average cost, not the potential to be enormous—Heartland Payment Systems paid fines and legal costs of
a differential cost. Beware of such unitized costs (i.e., costs stated in terms of a dollar $150 million when cyber criminals stole more than 100 million credit and debit card numbers. On
amount per unit, per mile, per direct labor-hour, per machine-hour, and so on)—they the other hand, infinite spending on cybersecurity does not completely eliminate the risk of a
are often misleading. security breach. This troubling reality is highlighted by Richard Bejtlich, Chief Security Strategist
Item (g), the decline in the resale value of the car that occurs as a consequence of at FireEye, Inc., who claims that a mere $1 million in funding would enable him to assemble a
driving more miles, is relevant in the decision. Because she uses the car, its resale value team that could hack into almost any target.
declines, which is a real cost of using the car that should be taken into account. Cynthia So what should companies do to manage the risk of a cyber attack? Perhaps one valuable
estimated this cost by accessing the Kelley Blue Book website at www.kbb.com. The piece of advice comes from Gartner Inc.’s Avivah Litan who estimates that “for every $5.62
reduction in resale value of an asset through use or over time is often called real or eco- businesses spend after a breach, they could spend $1 beforehand on encryption and network
nomic depreciation. This is different from accounting depreciation, which attempts to protection to prevent intrusions and minimize damage.”
match the sunk cost of an asset with the periods that benefit from that cost.
Source: Danny Yadron, “Companies Wrestle with the Cost of Security,” The Wall Street Journal, February 26, 2014, p. B3.
Item (h), the $114 cost of a round-trip ticket on the train, is relevant in this decision.
If she drives, she would avoid the cost of the ticket.
Item (i) is relevant to the decision, even if it is difficult to put a dollar value on relax-
ing and being able to study while on the train. It is relevant because it is a benefit that is
available under one alternative but not under the other.
Item (j), the cost of putting Cynthia’s dog in the kennel while she is gone, is irrel-
evant in this decision. Whether she takes the train or drives to New York City, she will Decision Analysis: The Total Cost and Differential Cost Approaches
still need to put her dog in a kennel.
Like item (i), items (k) and (l) are relevant to the decision even if it is difficult to The example that we just completed focused on identifying the relevant costs and benefits
measure their dollar impacts. of taking the train versus driving—everything else was ignored. This method of deci-
Item (m), the cost of parking in New York City, is relevant to the decision. sion analysis is called the differential approach because it focuses solely on the relevant
costs and benefits. Another method of decision analysis, called the total cost approach,
includes all of the costs and benefits—relevant or not. When done correctly, the two
3
If Cynthia has an accident while driving to New York City or back, this might affect her insurance methods always provide the same correct answer.
premium when the policy is renewed. The increase in the insurance premium would be a relevant cost of To compare and contrast these two methods, let’s consider Oak Harbor Woodworks,
this particular trip, but the normal amount of the insurance premium is not relevant in any case. a company that is contemplating renting a new labor-saving machine for $3,000 per year.
The machine will be used on the company’s butcher block production line. Data concern- If we properly account for the costs and benefits that do not differ between the alterna-
ing the company’s annual sales and costs of butcher blocks with and without the new tives, they will cancel out when we compare the alternatives; hence, they can be ignored.
machine are shown below: Rather than setting up comparative income statements, we could have arrived at
the same solution much more quickly by completely ignoring the irrelevant costs and
benefits.
Situation ∙ The selling price per unit and the number of units sold do not differ between the
Current with the New
alternatives. Therefore, the total sales revenues are exactly the same for the two
Situation Machine
alternatives as shown in Exhibit 12–1. Because the sales revenues are exactly the
Units produced and sold . . . . . . . . . . . . . . . . . . . . 5,000 5,000 same, they have no effect on the difference in net operating income between the two
Selling price per unit. . . . . . . . . . . . . . . . . . . . . . . . $40 $40 alternatives. That is shown in the last column in Exhibit 12–1, which shows a $0 dif-
Direct materials cost per unit . . . . . . . . . . . . . . . . $14 $14 ferential benefit.
Direct labor cost per unit . . . . . . . . . . . . . . . . . . . . $8 $5 ∙ The direct materials cost per unit, the variable overhead cost per unit, and the number
Variable overhead cost per unit . . . . . . . . . . . . . . $2 $2 of units produced and sold do not differ between the alternatives. Consequently, the
Fixed expenses, other . . . . . . . . . . . . . . . . . . . . . . $62,000 $62,000 total direct materials cost and the total variable overhead cost are the same for the
Fixed expenses, rental of new machine . . . . . . . — $3,000 two alternatives and can be ignored.
∙ The “other” fixed expenses do not differ between the alternatives, so they can be
ignored as well.
Given the data above, the net operating income for the product under the two alterna-
Indeed, the only costs that do differ between the alternatives are direct labor costs and
tives can be computed, using the total cost approach, as shown in the first two columns
the fixed rental cost of the new machine. Therefore, the two alternatives can be compared
of Exhibit 12–1. The net operating income in the current situation is $18,000 and the
based only on these relevant costs:
net operating income with the new machine is $30,000. The difference in the net operat-
ing incomes in these two columns indicates a $12,000 (= $30,000 – $18,000) financial
advantage associated with renting the new machine. The irrelevant items (which includes Financial Advantage of Renting the New Machine
sales, direct materials, variable overhead, and fixed expenses, other) appear in both col-
umns, so they cancel each other out when isolating the $12,000 difference in favor of Decrease in direct labor costs (5,000 units at a cost savings
renting the machine. of $3 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,000
Increase in fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,000)
The third column in Exhibit 12–1 uses the differential cost approach to derive the
same financial advantage of $12,000 (= $15,000 + $(3,000)) that is associated with rent- Financial advantage of renting the new machine . . . . . . . . . . . . . . . . . . . . . . $12,000
ing the new machine. A positive number in the Differential Costs and Benefits column
indicates that the difference between the alternatives favors the new machine; a negative
number indicates that the difference favors the current situation. A zero in that column If we focus on just the relevant costs and benefits, we get exactly the same answer
simply means that the total amount for the item is exactly the same for both alternatives. ($12,000 in favor of renting the new machine) as when we listed all of the costs and ben-
efits as shown in Exhibit 12–1—including those that do not differ between the alterna-
tives. We get the same answer because the only costs and benefits that matter in the final
EXHIBIT 12–1 comparison are those items that differ between the two alternatives and, hence, are not
Total and Differential Costs
Situation Differential zero in the last column of Exhibit 12–1.
Current with New Costs and
Situation Machine Benefits
Sales (5,000 units × $40 per unit) . . . . . . . . . $200,000 $200,000 $ 0 Why Isolate Relevant Costs?
Variable expenses: In the preceding example, we used the total cost approach and the differential cost
Direct materials (5,000 units × approach to derive the exact same answer. Thus, it would be natural to ask, “Why bother
$14 per unit) . . . . . . . . . . . . . . . . . . . . . . . 70,000 70,000 0 to isolate relevant costs when total costs will do the job just as well?” Isolating relevant
Direct labor (5,000 units × $8 per unit; costs is desirable for at least two reasons.
5,000 units × $5 per unit) . . . . . . . . . . . . 40,000 25,000 15,000 First, only rarely will enough information be available to prepare a detailed income
Variable overhead (5,000 units ×
statement for both alternatives. Assume, for example, that you are asked to make a deci-
$2 per unit). . . . . . . . . . . . . . . . . . . . . . . . . 10,000 10,000 0
sion relating to a portion of a single business process in a multidepartment, multiprod-
Total variable expenses . . . . . . . . . . . . . . . . . . 120,000 105,000 uct company. Under these circumstances, it would be virtually impossible to prepare
Contribution margin . . . . . . . . . . . . . . . . . . . . . 80,000 95,000 an income statement of any type. You would have to rely on your ability to recognize
Fixed expenses: which costs are relevant and which are not in order to assemble the data necessary to
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,000 62,000 0 make a decision.
Rental of new machine. . . . . . . . . . . . . . . . . 0 3,000 (3,000) Second, mingling irrelevant costs with relevant costs may cause confusion and
Total fixed expenses . . . . . . . . . . . . . . . . . . . . . 62,000 65,000 distract attention from the information that is really critical. Furthermore, the danger
Net operating income. . . . . . . . . . . . . . . . . . . . $ 18,000 $ 30,000 $ 12,000 always exists that an irrelevant piece of data may be used improperly, resulting in an
incorrect decision. The best approach is to ignore irrelevant data and base the decision
entirely on relevant data.
To show how to proceed in a product-line analysis, suppose that Discount Drug

Adding and Dropping Product Lines and Other Segments Company has analyzed the fixed costs being charged to the three product lines and deter-
mined the following:
Decisions relating to whether product lines or other segments of a company should be
LO12–2 1. The salaries expense represents salaries paid to employees working directly on the
dropped and new ones added are among the most difficult that a manager has to make. In
Prepare an analysis showing product. All of the employees working in housewares would be discharged if the
such decisions, many qualitative and quantitative factors must be considered. Ultimately,
whether a product line or product line is dropped.
other business segment however, any final decision to drop a business segment or to add a new one hinges pri-
2. The advertising expense represents advertisements that are specific to each product
should be added or dropped. marily on its financial impact. To assess this impact, costs must be carefully analyzed.
line and are avoidable if the line is dropped.
3. The utilities expense represents utilities costs for the entire company. The amount
An Illustration of Cost Analysis charged to each product line is an allocation based on space occupied and is not
Exhibit 12–2 provides sales and cost information for the preceding month for the Discount avoidable if the product line is dropped.
Drug Company and its three major product lines—drugs, cosmetics, and housewares. 4. The depreciation expense represents depreciation on previously purchased fixtures
A quick review of this exhibit suggests that dropping the housewares segment would that are used to display the various product lines. Although the fixtures are nearly new,
increase the company’s overall net operating income by $8,000. However, this would be they are custom-built and will have no resale value if the housewares line is dropped.
a flawed conclusion because the data in Exhibit 12–2 do not distinguish between fixed 5. The rent expense represents rent on the entire building housing the company; it
expenses that can be avoided if a product line is dropped and common fixed expenses that is allocated to the product lines on the basis of sales dollars. The monthly rent of
cannot be avoided by dropping any particular product line. $20,000 is fixed under a long-term lease agreement.
In this scenario, the two alternatives under consideration are whether to keep the 6. The insurance expense is for insurance carried on inventories within each of the three
housewares product line or drop it. If the housewares line is dropped, then the company product lines. If housewares is dropped, the related inventories will be liquidated and
will lose $20,000 per month in contribution margin because all of this segment’s sales the insurance premiums will decrease proportionately.
and variable expenses will be eliminated. However, by dropping the housewares line it 7. The general administrative expense represents the costs of accounting, purchasing,
may be possible to avoid some fixed costs such as salaries or advertising costs. If drop- and general management, which are allocated to the product lines on the basis of
ping the housewares line enables the company to avoid more in fixed costs than it loses in sales dollars. These costs will not change if the housewares line is dropped.
contribution margin, then it would be financially advantageous to eliminate the product With this information, management can determine that $15,000 of the fixed expenses
line. On the other hand, if the company is not able to avoid as much in fixed costs as it associated with the housewares product line are avoidable and $13,000 are not:
loses in contribution margin, then the housewares line should be kept. Thus, the com-
pany’s managers need to focus their attention on identifying the costs that differ between Total Cost
the two alternatives (i.e., that can be avoided by dropping the housewares product line). Assigned to Not
They should be asking themselves—“What costs can we avoid if we drop this product Fixed Expenses Housewares Avoidable* Avoidable
line?”—while purposely ignoring any costs that do not differ between the alternatives.
Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,000 $ 8,000
As we have seen from our earlier discussion, not all costs are avoidable. For example,
Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,500 6,500
some of the costs associated with a product line may be sunk costs. Other costs may be Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 $ 1,000
allocated fixed costs that will not differ in total regardless of whether the product line is Depreciation—fixtures . . . . . . . . . . . . . . . . . . 2,000 2,000
dropped or retained. Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 4,000
Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 500
General administrative . . . . . . . . . . . . . . . . . . 6,000 6,000
EXHIBIT 12–2 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,000 $ 13,000 $15,000
Discount Drug Company
Product Line
Product Lines *These fixed costs represent either sunk costs or future costs that will not change
House-
whether the housewares line is retained or discontinued.
Total Drugs Cosmetics wares
Sales . . . . . . . . . . . . . . . . . . . . . . . . . $ 250,000 $125,000 $ 75,000 $ 50,000 As stated earlier, if the housewares product line were dropped, the company would lose the
Variable expenses. . . . . . . . . . . . . . 105,000 50,000 25,000 30,000 product’s contribution margin of $20,000, but would save its associated avoidable fixed
Contribution margin . . . . . . . . . . . . 145,000 75,000 50,000 20,000 expenses. We now know that those avoidable fixed expenses total $15,000. Therefore, the
Fixed expenses: financial disadvantage of dropping the housewares product line is $(5,000) as shown below:
Salaries . . . . . . . . . . . . . . . . . . . . . 50,000 29,500 12,500 8,000
Advertising . . . . . . . . . . . . . . . . . . 15,000 1,000 7,500 6,500 Contribution margin lost if the housewares product line is discontinued
Utilities . . . . . . . . . . . . . . . . . . . . . 2,000 500 500 1,000 (see Exhibit 12–2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (20,000)
Depreciation—fixtures . . . . . . . . 5,000 1,000 2,000 2,000 Fixed expenses that can be avoided if the housewares product line is
Rent . . . . . . . . . . . . . . . . . . . . . . . . 20,000 10,000 6,000 4,000 discontinued (see above). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Insurance . . . . . . . . . . . . . . . . . . . 3,000 2,000 500 500 Financial disadvantage of dropping the housewares product line. . . . . . . . . $ (5,000)
General administrative . . . . . . . . 30,000 15,000 9,000 6,000
Total fixed expenses . . . . . . . . . . . . 125,000 59,000 38,000 28,000 In this case, the fixed costs that can be avoided by dropping the housewares product line
Net operating income (loss). . . . . . $ 20,000 $ 16,000 $ 12,000 $ (8,000) ($15,000) are less than the contribution margin that will be lost ($20,000). Therefore,
based on the data given, the housewares line should not be discontinued unless a more
profitable use can be found for the floor and counter space that it is occupying.
EXHIBIT 12–3 EXHIBIT 12–4

A Comparative Format for Product-
Difference: Product Line Discount Drug Company Product
Line Analysis
Net Operating House- Lines—Recast in Contribution
Income Total Drugs Cosmetics wares Format (from Exhibit 12–2)
Keep Drop Increase (or
Housewares Housewares Decrease) Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $250,000 $125,000 $75,000 $ 50,000
Variable expenses. . . . . . . . . . . . . . . . 105,000 50,000 25,000 30,000
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000 $ 0 $ (50,000)
Variable expenses. . . . . . . . . . . . . . . 30,000 0 30,000 Contribution margin . . . . . . . . . . . . . . 145,000 75,000 50,000 20,000
Contribution margin . . . . . . . . . . . . . 20,000 0 (20,000) Traceable fixed expenses:
Salaries . . . . . . . . . . . . . . . . . . . . . . . 50,000 29,500 12,500 8,000
Fixed expenses:
Advertising . . . . . . . . . . . . . . . . . . . . 15,000 1,000 7,500 6,500
Salaries . . . . . . . . . . . . . . . . . . . . . . 8,000 0 8,000
Depreciation—fixtures . . . . . . . . . . 5,000 1,000 2,000 2,000
Advertising . . . . . . . . . . . . . . . . . . . 6,500 0 6,500
Insurance . . . . . . . . . . . . . . . . . . . . . 3,000 2,000 500 500
Utilities . . . . . . . . . . . . . . . . . . . . . . 1,000 1,000 0
Depreciation—fixtures . . . . . . . . . 2,000 2,000 0 Total traceable fixed expenses . . . . . 73,000 33,500 22,500 17,000
Rent . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 4,000 0 Product-line segment margin . . . . . . 72,000 $ 41,500 $27,500 $ 3,000*
Insurance . . . . . . . . . . . . . . . . . . . . 500 0 500
General administrative . . . . . . . . . 6,000 6,000 0 Common fixed expenses:
Utilities . . . . . . . . . . . . . . . . . . . . . . . 2,000
Total fixed expenses . . . . . . . . . . . . . 28,000 13,000 15,000
Rent . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Net operating loss. . . . . . . . . . . . . . . $ (8,000) $ (13,000) $ (5,000) General administrative . . . . . . . . . . 30,000
Total common fixed expenses. . . . . . 52,000
Net operating income. . . . . . . . . . . . . $ 20,000
A Comparative Format *If the housewares line is dropped, the company will lose the $3,000 segment
This decision can also be approached by preparing comparative income statements show- margin generated by this product line. In addition, we have seen that the $2,000
ing the effects of either keeping or dropping the product line. Exhibit 12–3 contains such depreciation on the fixtures is a sunk cost that cannot be avoided. The sum of these
an analysis for the Discount Drug Company. As shown in the last column of the exhibit, if two figures (= $3,000 + $2,000) equals the financial disadvantage of $5,000 associ-
the housewares line is dropped, then overall company net operating income will decrease ated with discontinuing the housewares product line. Of course, the company
by $5,000 each period. This is the same answer, of course, as we obtained when we may later choose to drop the product if circumstances change—such as a pending
decision to replace the fixtures.
focused just on the lost contribution margin and avoidable fixed costs.
Beware of Allocated Fixed Costs

Go back to Exhibit 12–2. Does this exhibit suggest that the housewares product line
should be kept—as we have just concluded? No, it does not. Exhibit 12–2 suggests that
the housewares product line is losing money. Why keep a product line that is showing
IN BUSINESS
DELPHI CLOSES 42 FACTORIES
a loss? The explanation for this apparent inconsistency lies in part with the common More than a decade ago, Delphi Automotive earned revenues of $30 billion per year and
fixed costs that are being allocated to the product lines. One of the great dangers in allo- employed 47,000 people. Now the company’s U. S. work force has dropped to 5,000 employ-
cating common fixed costs is that such allocations can make a product line (or other ees as it has closed 42 of its 47 factories. The company has dropped low margin businesses,
business segment) look less profitable than it really is. In this instance, allocating the such as its heating and cooling segment, to focus its manufacturing efforts on auto safety, navi-
common fixed costs among all product lines makes the housewares product line appear gation systems, fuel economy, and self-driving technologies. It appears that Wall Street inves-
to be unprofitable. However, as we have just shown, there is a $5,000 financial disadvan- tors agree with Delphi’s efforts to trim its product lines given that the company’s stock price has
tage associated with dropping the product line. This point can be seen clearly if we redo more than tripled since it emerged from a four-year bankruptcy.
Exhibit 12–2 by eliminating the allocation of the common fixed costs. Exhibit 12–4 uses
the segmented approach from Chapter 6 to estimate the profitability of the product lines. Source: Jeff Bennett, “Delphi Sale Signals New Era for Car Suppliers,” The Wall Street Journal, February 19, 2015, pp. B1 and B8.
Exhibit 12–4 gives us a much different perspective of the housewares line than does
Exhibit 12–2. As shown in Exhibit 12–4, the housewares line is covering all of its own
traceable fixed costs and generating a $3,000 segment margin toward covering the com-
mon fixed costs of the company. Unless another product line can be found that will gener- Make or Buy Decisions
ate a segment margin greater than $3,000, the company would be better off keeping the
housewares line rather than dropping it. Providing a product or service to a customer involves many steps. For example,
Additionally, managers may choose to retain an unprofitable product line if it helps consider all of the steps that are necessary to develop and sell a product such as a Fitbit LO12–3
Prepare a make or buy
sell other products, or if it serves as a “magnet” to attract customers. Bread, for example, fitness watch. First, engineers need to develop the underlying electronics that provide analysis.
may not be an especially profitable line in some food stores, but customers expect it to be customers with capabilities such as real-time GPS tracking, heart rate monitoring, and
available, and many of them would undoubtedly shift their buying elsewhere if a particu- activity monitoring. In addition, they need to design a wrist watch that not only houses
lar store decided to stop carrying it. the electronic circuitry, but that also meets the customers’ needs in terms of aesthetics,
durability, and functionality. Second, the watches need to be assembled, tested, An outside supplier has offered to sell 8,000 shifters a year to Mountain Goat
individually packaged, and then boxed in larger quantities to enable shipping. Third, Cycles for a price of only $19 each, or a total of $152,000 (= 8,000 shifters × $19 each).
the finished goods need to be transported to retail sales locations and eventually sold to Should the company stop making the shifters internally and buy them from the outside
customers. Finally, the company needs to provide after-sale service such as Internet and supplier? As always, the decision should depend on the relevant costs—those that dif-
phone-based help lines, warranty claims, and product returns. All of these activities, from fer between the alternatives. And the costs that differ between the alternatives consist
development, to production, to after-sales service are called a value chain. of the costs that could be avoided by buying the shifters from the outside supplier. If
Separate companies may carry out each of the activities in the value chain or a single the costs that can be avoided by buying the shifters from the outside supplier total less
company may carry out several. When a company is involved in more than one activ- than $152,000, then the company should continue to make its own shifters and reject the
ity in the entire value chain, it is vertically integrated. Some companies control all of outside supplier’s offer. On the other hand, if the costs that can be avoided by buying the
the activities in the value chain from producing basic raw materials right up to the final shifters from the outside supplier total more than $152,000 the outside supplier’s offer
distribution of finished goods and provision of after-sales service. Other companies are should be accepted.
content to integrate on a smaller scale by purchasing many of the parts and materials that
go into their finished products. 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. Quite often these decisions involve whether to buy a particular part or to make IN BUSINESS
it internally. Make or buy decisions also involve decisions concerning whether to out- ASHLEY FURNITURE MANAGES ITS OWN FLEET OF DELIVERY TRUCKS
source development tasks, after-sales service, or other activities. Many manufacturers choose to outsource truck deliveries in the name of cost savings. How-
ever, Ashley Furniture Industries in Arcadia, Wisconsin, takes a different approach. It owns
Strategic Aspects of the Make or Buy Decision 800 delivery trucks and employs 3,000 people in warehousing and transportation based on the
Vertical integration provides certain advantages. An integrated company is less dependent belief that delivering furniture from its warehouses to the retailers that sell its products improves
on its suppliers and may be able to ensure a smoother flow of parts and materials for pro- customer relations and service. Ashley pays its drivers an average of $70,000 per year and it
duction than a nonintegrated company. For example, a strike against a major parts supplier strives to provide them with predictable delivery schedules that enable them to be home more
can interrupt the operations of a nonintegrated company for many months, whereas an often. Ashley’s vice-president of transportation, Larry Corey, says that he needs to review 100
integrated company that is producing its own parts would be able to continue operations. applications to find one good truck driver. Keith Koenig, who owns furniture stores in southern
© Imaginechina/ AP Images
Also, some companies feel that they can control quality better by producing their own Florida says that Ashley’s delivery times and reliability are unbeatable.
parts and materials, rather than by relying on the quality control standards of outside sup- Source: James R. Hagerty, “A Radical Idea: Own Your Supply Chain,” The Wall Street Journal, April 30, 2015, pp. B1–B2.
pliers. In addition, an integrated company realizes profits from the parts and materials that
it is “making” rather than “buying,” as well as profits from its regular operations.
The advantages of vertical integration are counterbalanced by the advantages of using
external suppliers. By pooling demand from a number of companies, a supplier may be Exhibit 12–5 contains the relevant cost analysis of the make or buy decision related
able to enjoy economies of scale. These economies of scale can result in higher quality to the gear shifters. The direct materials ($48,000), direct labor ($32,000), and variable
and lower costs than would be possible if the company were to attempt to make the parts overhead ($8,000) are all relevant costs because each cost could be avoided by purchas-
or provide the service on its own. A company must be careful, however, to retain con- ing the shifters from the outside supplier. In other words, Mountain Goat Cycles would
trol over activities that are essential to maintaining its competitive position. For example, no longer incur these variable manufacturing costs if it stopped making the shifters. In
Hewlett-Packard controls the software for laser printers that it makes in cooperation with addition, we will assume that the supervisor of the gear shifter manufacturing process
Canon Inc. of Japan. The present trend appears to be toward less vertical integration, would not be retained if the company stops making the shifters; thus, the supervisory
with companies like Oracle and Hewlett-Packard concentrating on hardware and software
design and relying on outside suppliers for almost everything else in the value chain.
An Example of a Make or Buy Decision EXHIBIT 12–5

To provide an illustration of a make or buy decision, consider Mountain Goat Cycles. Total Relevant Mountain Goat Cycles Make or Buy
The company is currently making the heavy-duty gear shifters that it installs on its most Costs—8,000 units Analysis
popular line of mountain bikes. The company’s Accounting Department reports the fol- Make Buy
lowing costs of making 8,000 shifters each year:
Direct materials (8,000 units × $6 per unit) . . . . . . . . . . . . $ 48,000
Per 8,000 Direct labor (8,000 units × $4 per unit) . . . . . . . . . . . . . . . . 32,000
Unit Units Variable overhead (8,000 units × $1 per unit) . . . . . . . . . . 8,000
Supervisor’s salary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6 $ 48,000
Depreciation of special equipment (not relevant)
Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 32,000
Allocated general overhead (not relevant) . . . . . . . . . . . . .
Variable overhead. . . . . . . . . . . . . . . . . . . . . . . . 1 8,000
Outside purchase price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $152,000
Supervisor’s salary . . . . . . . . . . . . . . . . . . . . . . . 3 24,000
Depreciation of special equipment . . . . . . . . . 2 16,000 Total cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 112,000 $152,000
Allocated general overhead . . . . . . . . . . . . . . . 5 40,000 Financial advantage of making the gear shifters . . . . . . . . $40,000
Total cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21 $168,000
salary of $24,000 would be avoided if the company decides to buy the gear shifters Opportunity costs are not recorded in the organization’s general ledger because they
from an outside supplier. 4 do not represent actual dollar outlays. Rather, they represent economic benefits that are
The depreciation of special equipment of $16,000 (as shown in the original data) forgone as a result of pursuing some course of action. The opportunity cost for Mountain
is an irrelevant cost because the equipment has already been purchased; thus, the cost Goat Cycles is sufficiently large in this case to change the decision.
incurred to buy the equipment is a sunk cost. The depreciation charge of $16,000 simply
spreads this sunk cost over the equipment’s useful life. If the equipment could be sold,
its salvage value would be relevant. Or if the equipment could be used to make other
products, this could be relevant as well. However, we will assume that the equipment has
IN BUSINESS
no salvage value and that it has no other use except making the heavy-duty gear shifters. IS THERE SUCH A THING AS A $1 BUS TICKET?
The allocated general overhead of $40,000 (as shown in the original data) is also an When Megabus and Greyhound’s Bolt Bus sell tickets for $1 it begs the question—how can
irrelevant cost in this decision context. We draw this conclusion because we are assuming that be profitable? The answer lies in understanding the concept of opportunity costs. The
that these allocated costs are common to all items produced in the factory and would con- bus companies use computer algorithms to determine how many empty seats ordinarily exist
tinue unchanged even if the shifters were bought from an outside supplier. Throughout this on a given bus route. Since the incremental cost of allowing a customer to occupy a seat
chapter, you should assume that these types of allocated common costs are irrelevant to the that would otherwise be empty is zero, the $1 price provides bus companies with additional
decision unless you are explicitly told otherwise. If you are explicitly told that a portion of contribution margin. Of course, only a few $1 tickets are available for each trip on a given bus
allocated common costs can be avoided by choosing one alternative over another, then by route. Furthermore, these deeply discounted tickets must be purchased well in advance of
all means, treat the explicitly identified avoidable costs as relevant costs. Otherwise, err on the travel date. All other customers pay a higher fare that enables the bus company to earn a
the side of ignoring allocated common costs when choosing between alternatives. profit on its routes. © Kelly Sillaste/Getty Images RF
Because the avoidable costs related to making the shifters is $40,000 less than the
total amount that would be paid to buy them from the outside supplier, Mountain Goat Source: Anne VanderMey, “What’s Up With $1 Bus Tickets?” Fortune, November 7, 2011, p. 27.
Cycles should reject the outside supplier’s offer. However, the company may wish to con-
sider one additional factor before coming to a final decision—the opportunity cost of the
space that it currently uses to produce the shifters.
Opportunity Cost Special Order Decisions

If the space now being used to produce the shifters would otherwise be idle, then Moun-
tain Goat Cycles should continue to make its own shifters and the supplier’s offer should
Managers must often evaluate whether a special order should be accepted, and if the
be rejected, as stated above. Idle space that has no alternative use has an opportunity cost
order is accepted, the price that should be charged. A special order is a one-time order LO12–4
of zero. Prepare an analysis showing
that is not considered part of the company’s normal ongoing business. To illustrate, whether a special order
But what if the space now being used to make shifters could be used for some other
Mountain Goat Cycles has just received a request from the Seattle Police Department to should be accepted.
purpose? In that case, the space would have an opportunity cost equal to the segment
produce 100 specially modified mountain bikes at a price of $558 each. The bikes would
margin that could be derived from the best alternative use of the space.
be used to patrol some of the more densely populated residential sections of the city.
To illustrate, assume that the space now being used to make shifters could be used
Mountain Goat Cycles can easily modify its City Cruiser model to fit the specifications
to produce a new cross-country bike that would generate a segment margin of $60,000
of the Seattle Police. The normal selling price of the City Cruiser bike is $698, and its
per year. Under these conditions, Mountain Goat Cycles would be $20,000 better off by
unit product cost is $564 as shown below:
choosing to buy the shifters from the outside supplier (rather than making them) and
using the newly available space to produce the cross-country bike:
Direct materials . . . . . . . . . . . . . . . . . . . . . . $372
Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . . 90
Make Buy Manufacturing overhead . . . . . . . . . . . . . . 102
Total annual cost (see Exhibit 12–5) . . . . . . . . . . . . . . . . . . . . $ 112,000 $ 152,000 Unit product cost . . . . . . . . . . . . . . . . . . . . . $564
Opportunity cost—segment margin forgone
on a potential new product line . . . . . . . . . . . . . . . . . . . . . . 60,000
The variable portion of the above manufacturing overhead is $12 per unit. The order
Total cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 172,000 $ 152,000 would have no effect on the company’s total fixed manufacturing overhead costs.
The modifications requested by the Seattle Police Department consist of welded
Financial advantage of buying the gear shifters from
brackets to hold radios, nightsticks, and other gear. These modifications would require
the outside supplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000
$34 in incremental variable costs. In addition, the company would have to pay a graph-
ics design studio $2,400 to design and cut stencils that would be used for spray paint-
4 ing the Seattle Police Department’s logo and other identifying marks on the bikes. The
Many companies adhere to a “no layoffs” policy because they believe it improves employee morale,
organizational learning, customer satisfaction, and financial results. Furthermore, in some countries,
company’s managers believe that this order will have no effect on the company’s other
such as France, Germany, and Japan, labor regulations and cultural norms may limit management’s sales and it can be produced without disrupting any of the company’s regular sched-
ability to reduce the size of the labor force. In these contexts, it would be incorrect to assume that direct uled production.
labor and supervision are automatically avoidable costs in make or buy decisions. Nonetheless, for the To quantify the financial advantage (disadvantage) of accepting the Seattle Police
sake of consistency, within this chapter you should assume that direct labor and supervisory salaries are Department’s order, Mountain Goat Cycles should focus its attention on the incremental
avoidable costs when analyzing make or buy decisions unless you are explicitly told otherwise. costs and benefits associated with the order. Because the existing fixed manufacturing
overhead costs would not be affected by the order, they are not relevant. The financial EXHIBIT 12–6
advantage (disadvantage) of the special order would be computed as follows: Processing Surgery Patients at an NHS Facility (simplified)*
Per Total Add to

General
Unit 100 Bikes Appointment Outpatient surgery Follow-up
practitioner Surgery Discharge
made visit waiting visit
Incremental revenue (a) . . . . . . . . . . . . . . . . . . . . . . . $ 558 $ 55,800 referral
list
Less incremental costs:
100 patients 100 patients 50 patients 150 patients 15 patients 60 patients 140 patients
Variable costs:
per day per day per day per day per day per day per day
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . 372 37,200
Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 9,000
Variable manufacturing overhead . . . . . . . . . . . 12 1,200 *This diagram originally appeared in the February 1999 issue of the U.K. magazine Health Management.
Special modifications . . . . . . . . . . . . . . . . . . . . . . 34 3,400
Total variable cost . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 508 50,800
Fixed cost: As an example, long waiting periods for surgery are a chronic problem in the
Purchase of stencils . . . . . . . . . . . . . . . . . . . . . . . 2,400 National Health Service (NHS), the government-funded provider of health care in
Total incremental cost (b) . . . . . . . . . . . . . . . . . . . . . . 53,200 the United Kingdom. The diagram in Exhibit 12–6 illustrates a simplified version of
Financial advantage of accepting the order (a) − (b). . . $ 2,600 the steps followed by a surgery patient. The number of patients who can be processed
through each step in a day is indicated in the exhibit. For example, appointments for
outpatient visits can be made for as many as 100 referrals from general practitioners
Therefore, even though the $558 price on the special order is below the normal $564 in a day.
unit product cost and the order would require additional costs, the company is still better The constraint, or bottleneck, in the system is determined by the step that limits
off accepting the order. In general, a special order should be accepted if the incremental total output because it has the smallest capacity—in this case surgery. The total number
revenue from the special order exceeds the incremental costs of the order. However, it of patients processed through the entire system cannot exceed 15 per day—the maxi-
is important to make sure that there is indeed idle capacity and that the special order mum number of patients who can be treated in surgery. No matter how hard managers,
does not cut into normal unit sales or undercut prices on normal sales. For example, if doctors, and nurses try to improve the processing rate elsewhere in the system, they
the company was operating at capacity, opportunity costs would have to be taken into will never succeed in driving down wait lists until the capacity of surgery is increased.
account, as well as the incremental costs that have already been detailed above. In fact, improvements elsewhere in the system—particularly before the constraint—are
likely to result in even longer waiting times and more frustrated patients and health care
providers. Thus, to be effective, improvement efforts must be focused on the constraint.
Volume Trade-Off Decisions A business process, such as the process for serving surgery patients, is like a chain. If
you want to increase the strength of a chain, what is the most effective way to do this?
Companies are forced to make volume trade-off decisions when they do not have enough Should you concentrate your efforts on strengthening the strongest link, all the links,
capacity to produce all of the products and sales volumes demanded by their customers. or the weakest link? Clearly, focusing your effort on the weakest link will bring the
In these situations, companies must trade off, or sacrifice production of some products in biggest benefit.
favor of others in an effort to maximize profits. The key questions become: how should The procedure to follow to strengthen the chain is clear. First, identify the weakest
companies manage those trade-offs? Which products should they produce and sell and link, which is the constraint. In the case of the NHS, the constraint is surgery. Sec-
which sales opportunities should they intentionally bypass? ond, do not place a greater strain on the system than the weakest link can handle—if
To answer these questions, our discussion of volume trade-off decisions will proceed you do, the chain will break. In the case of the NHS, more referrals than surgery can
in three steps. First, we’ll define the meaning of a constraint. Second, we’ll explain how accommodate lead to unacceptably long waiting lists. Third, concentrate improvement
to determine the most profitable use of a constrained resource. Third, we’ll discuss how efforts on strengthening the weakest link. In the case of the NHS, this means finding
to determine the value of obtaining more of a constrained resource and how to manage ways to increase the number of surgeries that can be performed in a day. Fourth, if the
constraints to increase profits. improvement efforts are successful, eventually the weakest link will improve to the
point where it is no longer the weakest link. At that point, the new weakest link (i.e.,
What Is a Constraint? the new constraint) must be identified, and improvement efforts must be shifted over
A constraint is anything that prevents you from getting more of what you want. Every to that link. This simple sequential process provides a powerful strategy for optimizing
individual and every organization faces at least one constraint, so it is not difficult to find business processes.
examples of constraints.5 You may not have enough time to study thoroughly for every
subject and to go out with your friends on the weekend, so time is your constraint. United
Airlines has only a limited number of loading gates available at its busy Chicago O’Hare Utilizing a Constrained Resource to Maximize Profits
hub, so its constraint is loading gates. Vail Resorts has only a limited amount of land to Managers routinely face the challenge of managing constrained resources in a manner
develop as homesites and commercial lots at its ski areas, so its constraint is land. that maximizes profits. A department store, for example, has a limited amount of floor LO12–5
Determine the most profitable
space and therefore cannot stock every product that may be available. A manufacturer
use of a constrained resource.
5
In this chapter, we always assume that the company has only one constraint. When companies have has a limited number of machine-hours and a limited number of direct labor-hours at its
more than one constraint, the optimal production mix can be found using a quantitative method known disposal. When companies face these types of constraints their managers must decide
as linear programming, which is covered in more advanced courses. which products or services make the most profitable use of those limited resources.
Because fixed costs remain the same regardless of how a constrained resource is used, This figure is computed by dividing a product’s contribution margin per unit by the
managers should ignore them when making volume trade-off decisions and instead amount of the constrained resource required to make a unit of that product. These calcu-
focus their attention on identifying the mix of products that maximizes the total contri- lations are carried out below for the mountain and touring panniers:
bution margin.
Given that some products must be cut back when a constraint exists, the key to
maximizing the total contribution margin may seem obvious—favor the products with Mountain Touring
the highest unit contribution margins. Unfortunately, that is not quite correct. Rather, the Pannier Pannier
correct solution is to favor the products that provide the highest contribution margin per Contribution margin per unit (a) . . . . . . . . . . . $15.00 $12.00
unit of the constrained resource. To illustrate, in addition to its other products, Mountain Stitching machine time required to
Goat Cycles makes saddlebags for bicycles called panniers. These panniers come in produce one unit (b) . . . . . . . . . . . . . . . . . . . 2 minutes 1 minute
two models—a touring model and a mountain model. Cost and revenue data for the two Contribution margin per unit of the
models of panniers follow: constrained resource, (a) ÷ (b). . . . . . . . . . . $7.50 per minute $12.00 per minute
Mountain Touring It is now easy to decide which product is less profitable and should be deempha-
Pannier Pannier sized. Each minute on the stitching machine that is devoted to the touring pannier results
in an increase of $12.00 in contribution margin and profits. The comparable figure for
Selling price per unit. . . . . . . . . . . . . . . . . . . . . $ 25 $ 30
the mountain pannier is only $7.50 per minute. Therefore, the touring model should be
Variable cost per unit . . . . . . . . . . . . . . . . . . . . 10 18
emphasized. Even though the mountain model has the larger contribution margin per unit
Contribution margin per unit . . . . . . . . . . . . . . $ 15 $ 12 and the larger CM ratio, the touring model provides the larger contribution margin in
Contribution margin (CM) ratio . . . . . . . . . . . . 60% 40% relation to the constrained resource.
To verify that the touring model is indeed the more profitable product, suppose
an hour of additional stitching time is available and that unfilled orders exist for both
The mountain pannier appears to be much more profitable than the touring pannier. products. The additional hour on the stitching machine could be used to make either
It has a $15 per unit contribution margin as compared to only $12 per unit for the touring 30 mountain panniers (60 minutes ÷ 2 minutes per mountain pannier) or 60 touring panniers
model, and it has a 60% CM ratio as compared to only 40% for the touring model. (60 minutes ÷ 1 minute per touring pannier), with the following profit implications:
But now let us add one more piece of information—the plant that makes the pan-
niers is operating at capacity. This does not mean that every machine and every person
in the plant is working at the maximum possible rate. Because machines have different Mountain Touring
capacities, some machines will be operating at less than 100% of capacity. However, if Pannier Pannier
the plant as a whole cannot produce any more units, some machine or process must be Contribution margin per unit (a) . . . . . . . . . . . . . . . . . . . . . . . . . . $ 15 $ 12
operating at capacity. The machine or process that is limiting overall output is called the Additional units that can be
bottleneck—it is the constraint. processed in one hour (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 60
At Mountain Goat Cycles, the bottleneck (i.e., constraint) is a stitching machine. The Additional contribution margin (a) × (b) . . . . . . . . . . . . . . . . . . . . $450 $720
mountain pannier requires two minutes of stitching time per unit, and the touring pan-
nier requires one minute of stitching time per unit. The stitching machine is available for
12,000 minutes per month, and the company can sell up to 4,000 mountain panniers and Because the additional contribution margin would be $720 for the touring panniers and
7,000 touring panniers per month. Producing up to this demand for both products would only $450 for the mountain panniers, the touring panniers make the most profitable use
require 15,000 minutes, as shown below: of the company’s constrained resource—the stitching machine.
The stitching machine is available for 12,000 minutes per month, and producing
the touring panniers is the most profitable use of the stitching machine. Therefore, to
Mountain Touring maximize profits, the company should produce all of the touring panniers the market
Pannier Pannier Total will demand (7,000 units) and use any remaining capacity to produce mountain pan-
Monthly demand (a) . . . . . . . . . . . . 4,000 units 7,000 units niers. The computations to determine how many mountain panniers can be produced are
Stitching machine time required as follows:
to produce one unit (b). . . . . . . . 2 minutes 1 minute
Total stitching time required
(a) × (b) . . . . . . . . . . . . . . . . . . . . . 8,000 minutes 7,000 minutes 15,000 minutes Monthly demand for touring panniers (a) . . . . . . . . . . . . . . . . . . . . . . . . 7,000 units
Stitching machine time required to produce one touring
pannier (b). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 minute
Producing up to demand would require 15,000 minutes, but only 12,000 minutes Total stitching time required to produce touring panniers
are available. This simply confirms that the stitching machine is the bottleneck. By def- (a) × (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 minutes
inition, because the stitching machine is a bottleneck, the stitching machine does not Remaining stitching time available
have enough capacity to satisfy the existing demand for mountain panniers and touring (12,000 minutes − 7,000 minutes) (c) . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 minutes
panniers Therefore, some orders for the products will have to be turned down. Natu- Stitching machine time required to produce one mountain
pannier (d). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 minutes
rally, managers will want to know which product is less profitable. To answer this ques-
Production of mountain panniers (c) ÷ (d) . . . . . . . . . . . . . . . . . . . . . . . . 2,500 units
tion, they should focus on the contribution margin per unit of the constrained resource.
Therefore, profit would be maximized by producing 7,000 touring panniers and then So what is the value of relaxing the constraint—the time on the stitching machine?
using the remaining capacity to produce 2,500 mountain panniers. With this product mix The manager should first ask, “What would I do with additional capacity at the bottle-
the company can earn a total contribution margin of $121,500 computed as follows: neck if it were available?” If the time were to be used to make additional mountain pan-
niers, it would be worth $450 per hour. If the time were to be used to make additional
Mountain Touring touring panniers, it would be worth $720 per hour. In this latter case, the company should
Pannier Pannier Total be willing to pay an overtime premium to the stitching machine operator of up to $720
per hour! Suppose, for example, that the stitching machine operator is paid $20 per hour
Contribution margin per unit (a) . . . . . . . . . . . . . . $15 $12 during normal working hours and time-and-a-half, or $30 per hour, for overtime. In this
Number of units produced (b) . . . . . . . . . . . . . . . . 2,500 7,000
case, the premium for overtime is only $10 per hour, whereas in principle, the company
Contribution margin (a) × (b) . . . . . . . . . . . . . . . . . $37,500 $84,000 $121,500
should be willing to pay a premium of up to $720 per hour. The difference between what
the company should be willing to pay as a premium, $720 per hour, and what it would
This example clearly shows that looking at each product’s unit contribution margin actually have to pay, $10 per hour, is pure profit of $710 per hour.
alone is not enough; the contribution margin must be viewed in relation to the amount of To reinforce this concept, suppose that there are only unfilled orders for the moun-
the constrained resource each product requires. tain pannier. How much would it be worth to the company to run the stitching machine
overtime in this situation? Because the additional capacity would be used to make the
mountain pannier, the value of that additional capacity would drop to $7.50 per minute or
IN BUSINESS $450 per hour. Nevertheless, the value of relaxing the constraint would still be quite high
SUBARU RESPONDS TO A PRODUCTION CONSTRAINT and the company should be willing to pay an overtime premium of up to $450 per hour.
When demand for Subaru’s vehicles jumped unexpectedly the automaker missed many sales These calculations indicate that managers should pay great attention to the bottleneck
opportunities because of insufficient production capacity. The company responded by expand- operation. If a bottleneck machine breaks down or is ineffectively utilized, the losses to
ing its Japanese production capacity by 15% and investing $400 million to increase the output the company can be quite large. In our example, for every minute the stitching machine is
of its U.S. plant in Lafayette, Indiana, by 76%. Subaru is contemplating building a new plant that down due to breakdowns or setups, the company loses between $7.50 and $12.00.6 The
could produce 200,000 more vehicles; however, because this volume represents more than losses on an hourly basis are between $450 and $720! In contrast, there is no such loss of
25% of Subaru’s global output, it presents some risks. If sales take a downturn, Subaru could be contribution margin if time is lost on a machine that is not a bottleneck—such machines
left with a large amount of unused capacity costs. have excess capacity anyway.
Source: Yoshio Takahashi and Yoree Koh, “Subaru’s Got a Big Problem: It’s Selling Too Many Cars,” The Wall Street Journal,
The implications are clear. Managers should focus much of their attention on managing
© Kristoffer Tripplaar/Alamy
August 21, 2013, pp. B1 and B2. the bottleneck. As we have discussed, managers should emphasize products that make the
most profitable use of the constrained resource. They should also make sure that products
are processed smoothly through the bottleneck, with minimal lost time due to breakdowns
and setups. And they should try to find ways to increase the capacity at the bottleneck.
Managing Constraints The capacity of a bottleneck can be effectively increased in a number of ways, including:
Effectively managing an organization’s constraints is a key to increasing profits. As dis-
LO12–6 cussed above, when a constraint exists in the production process, managers can increase ∙ Working overtime on the bottleneck.
Determine the value of profits by producing the products with the highest contribution margin per unit of the ∙ Subcontracting some of the processing that would ordinarily be done at the bottleneck.
obtaining more of the constrained resource. However, they can also increase profits by increasing the capacity ∙ Investing in additional machines at the bottleneck.
constrained resource. ∙ Shifting workers from processes that are not bottlenecks to the process that is the
of the bottleneck operation.
When a manager increases the capacity of the bottleneck, it is called relaxing bottleneck.
(or elevating) the constraint. In the case of Mountain Goat Cycles, the company is ∙ Focusing business process improvement efforts on the bottleneck.
currently working one eight-hour shift. To relax the constraint, the stitching machine ∙ Reducing defective units. Each defective unit that is processed through the bottleneck
operator could be asked to work overtime. No one else would have to work overtime. and subsequently scrapped takes the place of a good unit that could have been sold.
Because all of the other operations involved in producing panniers have excess capacity, The last three methods of increasing the capacity of the bottleneck are particularly attrac-
up to a point, the additional panniers processed through the stitching machine during tive because they are essentially free and may even yield additional cost savings.
overtime could be finished during normal working hours in the other operations.
The benefits from relaxing the constraint are often enormous and can be easily
quantified—the key is the contribution margin per unit of the constrained resource that
we have already computed. This number, which was originally stated in terms of min- Joint Product Costs and Sell or Process Further Decisions
utes in the Mountain Goat Cycles example, is restated below in terms of hours for easier
interpretation: In some industries, two or more products, known as joint products, are produced from a
single raw material input. For example, in the petroleum refining industry a large number LO12–7
Prepare an analysis showing
Mountain Touring of joint products are extracted from crude oil, including gasoline, jet fuel, home heating whether joint products should
Pannier Pannier be sold at the split-off point or
6
Setups are required when production switches from one product to another. For example, consider a com- processed further.
Contribution margin per minute of the
constrained resource (a) . . . . . . . . . . . . . . . $7.50 per minute $12.00 per minute pany that makes automobile side panels. The panels are painted before shipping them to an automobile
Minutes per hour (b) . . . . . . . . . . . . . . . . . . . . . 60 minutes 60 minutes manufacturer for final assembly. The customer might require 100 blue panels, 50 black panels, and 20 yellow
panels. Each time the color is changed, the painting equipment must be purged of the old paint color, cleaned
Contribution margin per hour of the
with solvents, and refilled with the new paint color. This takes time. In fact, some equipment may require
constrained resource (a) × (b) . . . . . . . . . . . $450 per hour $720 per hour
such lengthy and frequent setups that it is unavailable for actual production more often than not.
oil, lubricants, asphalt, and various organic chemicals. The point in a manufacturing pro- EXHIBIT 12–7
cess where joint products (such as gasoline and jet fuel) can be recognized as separate Santa Maria Wool Cooperative
Wool
products is referred to as the split-off point. Joint cost
Quite often joint products can be sold at the split-off point or they can be processed (Cost: $200,000)
further and sold for a higher price. A decision as to whether a joint product should be sold
at the split-off point or processed further is known as a sell or process further decision.
To make these decisions, managers need to follow a three step process. First, they should
always ignore all joint costs, which include all costs incurred up to the split-off point. These
costs should be ignored because they remain the same under both alternatives—whether the Separation Process
Joint cost
manager chooses to sell a joint product at the split-off point or process it further. (Cost: $40,000)
The second step is to determine the incremental revenue that is earned by further
processing the joint product. This computation is performed by taking the revenue earned
after further processing the joint product and subtracting the revenue that could be earned
by selling the joint product at the split-off point.
The third step is to take the incremental revenue from step two and subtract the incre-
mental costs associated with processing the joint product beyond the split-off point. If the
resulting answer is positive, then the joint product should be processed further and sold Undyed Undyed Undyed
for a higher price. If the answer is negative, then the joint product should be sold at the Coarse Wool Fine Wool Superfine Wool
split-off point without any further processing. Intermediate
(Sales value (Sales value (Sales value
products
at this point: at this point: at this point:
Santa Maria Wool Cooperative: An Example $120,000) $150,000) $60,000)
Santa Maria Wool Cooperative buys raw wool from local sheepherders, separates the
wool into three grades—coarse, fine, and superfine—and then dyes the wool using tra-
ditional methods that rely on pigments from local materials. Exhibit 12–7 contains a
diagram of the company’s production process.
The company’s joint costs include $200,000 for the raw wool and $40,000 for sepa- Dyeing Dyeing Dyeing Separate product
rating the raw wool into three intermediate products. The three types of undyed wool are (Cost: $50,000) (Cost: $60,000) (Cost: $10,000) costs
called intermediate products because they are not finished at this point. Nevertheless, a
market does exist for undyed wool—although at a significantly lower price than finished,
dyed wool. More specifically and as shown in Exhibit 12–7, the undyed course wool,
undyed fine wool, and undyed superfine wool each can be sold at the split-off point for
$120,000, $150,000, and $60,000 respectively. Dyed Dyed Dyed
Exhibit 12–7 also shows that the cost of further processing the undyed coarse wool, End products
Coarse Wool Fine Wool Superfine Wool
undyed fine wool, and undyed superfine wool is $50,000, $60,000, and $10,000 respec-
tively. Furthermore, the sales values of dyed coarse wool, dyed fine wool, and dyed
superfine wool are $160,000, $240,000, and $90,000, respectively.
If Santa Maria Wool Cooperative chooses to further process all three of its interme-
Final Sale Final Sale Final Sale
diate products, it will earn a profit of $130,000 as shown below:
$160,000 $240,000 $90,000
Analysis of the profitability of the overall operation:
Combined final sales value
($160,000 + $240,000 + $90,000) . . . . . . . . . . . . . . . . $490,000
Less costs of producing the end products:
The appropriate way to answer these sell-or-process-further questions is to compare
Cost of wool . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200,000
the incremental revenues and incremental costs for each of the joint products as follows:
Cost of separating wool . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000
Combined costs of dyeing
($50,000 + $60,000 + $10,000). . . . . . . . . . . . . . . . . 120,000 360,000 Analysis of sell or process further:
Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $130,000 Coarse Fine Superfine
Wool Wool Wool
Note that the joint costs of buying the wool ($200,000) and separating the wool Final sales value after further processing . . . . . . . . $ 160,000 $ 240,000 $90,000
($40,000) are relevant when considering the profitability of the entire operation. This is Less sales value at the split-off point . . . . . . . . . . . . 120,000 150,000 60,000
because these joint costs could be avoided if the entire operation were shut down. Incremental revenue from further processing . . . . 40,000 90,000 30,000
While Santa Maria can make a profit of $130,000 if it further processes all three Less cost of further processing (dyeing) . . . . . . . . . 50,000 60,000 10,000
products, the questions we want to explore further are: should the company further pro- Financial advantage (disadvantage)
cess all three products? Could the company be financially better off by selling one or of further processing . . . . . . . . . . . . . . . . . . . . . . . $ (10,000) $ 30,000 $20,000
more of the three products at the split-off point?
As this analysis shows, the company would be better off selling the undyed coarse
wool at the split-off point rather than processing it further. The other two products should Activity-Based Costing and Relevant Costs
be processed further and dyed before selling them.
Note that the joint costs of the wool ($200,000) and of the wool separation process As discussed in an earlier chapter, activity-based costing can be used to help identify poten-
($40,000) play no role in the decision to sell or further process the intermediate products. tially relevant costs for decision-making purposes. Activity-based costing improves the trace-
These joint costs are relevant in a decision of whether to buy wool and to run the wool ability of costs by focusing on the activities caused by a product or other segment. However,
separation process, but they are not relevant in decisions about what to do with the inter- managers should exercise caution against reading more into this “traceability” than really
mediate products once they have been separated. exists. People have a tendency to assume that if a cost is traceable to a segment, then the
Finally, we can recompute Santa Maria’s overall profitability if it chooses to sell the cost is automatically an avoidable cost. That is not true because the costs provided by a well-
undyed coarse wool at the split-off point and to further process the dyed fine wool and the designed activity-based costing system are only potentially relevant. Before making a deci-
dyed superfine wool as follows: sion, managers must still decide which of the potentially relevant costs are actually avoidable.
Only those costs that are avoidable are relevant and the others should be ignored.
To illustrate, refer again to the data relating to the housewares line in Exhibit 12–4.
Analysis of the profitability of the overall operation: The $2,000 fixtures depreciation is a traceable cost of the housewares lines because it
Combined final sales value directly relates to activities in that department. We found, however, that the $2,000 is not
($120,000 + $240,000 + $90,000) . . . . . . . . . . . . . . . . . $450,000 avoidable if the housewares line is dropped. The key lesson here is that the method used to
Less costs of producing the end products: assign a cost to a product or other segment does not change the basic nature of the cost. A
Cost of wool . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200,000 sunk cost such as depreciation of old equipment is still a sunk cost regardless of whether it
Cost of separating wool . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 is traced directly to a particular segment on an activity basis, allocated to all segments on
Combined costs of dyeing the basis of labor-hours, or treated in some other way in the costing process. Regardless
($60,000 + $10,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 310,000 of the method used to assign costs to products or other segments, the principles discussed
Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000 in this chapter must be applied to determine the costs that are avoidable in each situation.
Notice that the revised profit of $140,000 is $10,000 higher than the profit of
$130,000 that was computed earlier when the company further processes all three prod- Summary
ucts. This $10,000 increase in profit equals the $10,000 financial disadvantage of further
processing coarse wool that was computed earlier. Everything in this chapter consists of applications of one simple but powerful idea—only those
costs and benefits that differ between alternatives are relevant in a decision. All other costs and
benefits are irrelevant and should be ignored. In particular, sunk costs are irrelevant as are future
costs that do not differ between alternatives.
IN BUSINESS This simple idea was applied in a variety of situations including decisions that involve adding or
GETTING IT ALL WRONG dropping a product line, making or buying a component, accepting or rejecting a special order, using
a constrained resource, and further processing joint products. This list includes only a small sample of
A company located on the Gulf of Mexico produces soap products. Its six main soap product
the possible applications of the differential cost concept. Indeed, any decision involving costs hinges
lines are produced from common inputs. Joint product costs up to the split-off point constitute on the proper identification and analysis of the differential costs. We will continue to focus on the con-
the bulk of the production costs for all six product lines. These joint product costs are allocated cept of differential costs in the following chapter where long-term investment decisions are considered.
to the six product lines on the basis of the relative sales value of each line at the split-off point.
A waste product results from the production of the six main product lines. The company
loaded the waste onto barges and dumped it into the Gulf of Mexico because the waste was Review Problem: Differential Analysis
thought to have no commercial value. The dumping was stopped, however, when the com-
pany’s research division discovered that with some further processing the waste could be sold Charter Sports Equipment manufactures round, rectangular, and octagonal trampolines. Sales and
expense data for the past month follow:
as a fertilizer ingredient. The further processing costs $175,000 per year. The waste was then
sold to fertilizer manufacturers for $300,000. Trampoline
The accountants responsible for allocating manufacturing costs included the sales value
Total Round Rectangular Octagonal
of the waste product along with the sales value of the six main product lines in their allocation
of the joint product costs at the split-off point. This allocation resulted in the waste product Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000 $ 140,000 $500,000 $ 360,000
being allocated $150,000 in joint product cost. This $150,000 allocation, when added to the Variable expenses. . . . . . . . . . . . . . . . . . . . 410,000 60,000 200,000 150,000
further processing costs of $175,000 for the waste, made it appear that the waste product was Contribution margin . . . . . . . . . . . . . . . . . . 590,000 80,000 300,000 210,000
unprofitable—as shown in the table below. When presented with this analysis, the company’s Fixed expenses:
management decided that further processing of the waste should be stopped. The company Advertising—traceable . . . . . . . . . . . . . . 216,000 41,000 110,000 65,000
went back to dumping the waste in the Gulf. Depreciation of special equipment . . . 95,000 20,000 40,000 35,000
Line supervisors’ salaries . . . . . . . . . . . . 19,000 6,000 7,000 6,000
General factory overhead*. . . . . . . . . . . 200,000 28,000 100,000 72,000
Sales value of the waste product after further processing. . . . . . $300,000
Total fixed expenses . . . . . . . . . . . . . . . . . . 530,000 95,000 257,000 178,000
Less costs assigned to the waste product . . . . . . . . . . . . . . . . . . . 325,000
Net operating income (loss). . . . . . . . . . . . $ 60,000 $ (15,000) $ 43,000 $ 32,000
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (25,000)
*A common fixed cost that is allocated on the basis of sales dollars.
Management is concerned about the continued losses shown by the round trampolines Joint products Two or more products that are produced from a common input. (p. 581)
and wants a recommendation as to whether or not the line should be discontinued. The special Make or buy decision A decision concerning whether an item should be produced internally or
equipment used to produce the trampolines has no resale value. If the round trampoline model is purchased from an outside supplier. (p. 572)
dropped, the two line supervisors assigned to the model would be discharged. Opportunity cost The potential benefit that is given up when one alternative is selected over
Required: another. (p. 562)
1. What is the financial advantage (disadvantage) of discontinuing the round trampolines? The Relaxing (or elevating) the constraint An action that increases the amount of a constrained
company has no other use for the capacity now being used to produce the round trampolines. resource. Equivalently, an action that increases the capacity of the bottleneck. (p. 580)
Show computations to support your answer. Relevant benefit A benefit that should be considered when making decisions. (p. 561)
2. Recast the above data in a format that would be more useful to management in assessing the Relevant cost A cost that should be considered when making decisions. (p. 561)
profitability of the various product lines. Sell or process further decision A decision as to whether a joint product should be sold at the
split-off point or sold after further processing. (p. 582)
Solution to Review Problem Special order A one-time order that is not considered part of the company’s normal ongoing
1. No, production and sale of the round trampolines should not be discontinued. Computations business. (p. 575)
to support this answer follow: Split-off point That point in the manufacturing process where some or all of the joint products
can be recognized as individual products. (p. 582)
Sunk cost A cost that has already been incurred and that cannot be changed by any decision made
Contribution margin lost if the round trampolines are discontinued . . . . . . $(80,000)
now or in the future. (p. 562)
Less fixed expenses that can be avoided:
Vertical integration The involvement by a company in more than one of the activities in the
Advertising—traceable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $41,000
entire value chain from development through production, distribution, sales, and after-sales
Line supervisors’ salaries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 47,000
service. (p. 572)
Financial (disadvantage) of discontinuing the round trampolines. . . . . . . . . $(33,000)
The depreciation of the special equipment is a sunk cost, and therefore, it is not relevant to
the decision. The general factory overhead is allocated and will presumably continue regardless of
whether or not the round trampolines are discontinued; thus, it is not relevant. Questions
2. If management wants a clearer picture of the profitability of the segments, the general factory
overhead should not be allocated. It is a common cost and, therefore, should be deducted from the 12–1 What is a relevant cost?
total product-line segment margin. A more useful income statement format would be as follows: 12–2 Define the following terms: incremental cost, opportunity cost, and sunk cost.
12–3 Are variable costs always relevant costs? Explain.
Trampoline 12–4 “Sunk costs are easy to spot—they’re the fixed costs associated with a decision.” Do you
agree? Explain.
Total Round Rectangular Octagonal 12–5 “Variable costs and differential costs mean the same thing.” Do you agree? Explain.
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,000,000 $140,000 $ 500,000 $ 360,000 12–6 “All future costs are relevant in decision making.” Do you agree? Why?
Variable expenses. . . . . . . . . . . . . . . . . . . . 410,000 60,000 200,000 150,000 12–7 Prentice Company is considering dropping one of its product lines. What costs of the
product line would be relevant to this decision? What costs would be irrelevant?
Contribution margin . . . . . . . . . . . . . . . . . . 590,000 80,000 300,000 210,000
12–8 “If a product is generating a loss, then it should be discontinued.” Do you agree?
Traceable fixed expenses: Explain.
Advertising—traceable . . . . . . . . . . . . . . 216,000 41,000 110,000 65,000 12–9 What is the danger in allocating common fixed costs among products or other segments
Depreciation of special equipment . . . 95,000 20,000 40,000 35,000 of an organization?
Line supervisors salaries . . . . . . . . . . . . 19,000 6,000 7,000 6,000 12–10 How does opportunity cost enter into a make or buy decision?
Total traceable fixed expenses . . . . . . . . . 330,000 67,000 157,000 106,000 12–11 Give at least four examples of possible constraints.
Product-line segment margin . . . . . . . . . . 260,000 $ 13,000 $ 143,000 $ 104,000 12–12 How will relating product contribution margins to the amount of the constrained
Common fixed expenses . . . . . . . . . . . . . . 200,000 resource they consume help a company maximize its profits?
12–13 Define the following terms: joint products, joint costs, and split-off point.
Net operating income. . . . . . . . . . . . . . . . . $ 60,000
12–14 From a decision-making point of view, should joint costs be allocated among joint
products?
12–15 What guideline should be used in determining whether a joint product should be sold at
Glossary the split-off point or processed further?
12–16 Airlines sometimes offer reduced rates during certain times of the week to members of a
Avoidable cost A cost that can be eliminated by choosing one alternative over another in a deci- businessperson’s family if they accompany him or her on trips. How does the concept of
sion. This term is synonymous with differential cost and relevant cost. (p. 561) relevant costs enter into the decision by the airline to offer reduced rates of this type?
Bottleneck A machine or some other part of a process that limits the total output of the entire
system. (p. 577)
Constraint A limitation under which a company must operate, such as limited available machine
time or raw materials, that restricts the company’s ability to satisfy demand. (p. 576)
Differential cost A future cost that differs between any two alternatives. (p. 561) Applying Excel
Differential revenue Future revenue that differs between any two alternatives. (p. 561)
Incremental cost An increase in cost between two alternatives. (p. 561) The Excel worksheet form that appears below is to be used to recreate the example in the text LO12–7
Joint costs Costs that are incurred up to the split-off point in a process that produces joint prod- related to Santa Maria Wool Cooperative. Download the workbook containing this form from Con-
ucts. (p. 582) nect, where you will also receive instructions about how to use this worksheet form.

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Differential Analysis: The Key to Decision Making 561

Decision Making: Six Key Concepts

LO12–1 Identify relevant and irrelevant costs

To show how to proceed in a product-line analysis, suppose that Discount Drug

EXHIBIT 12–3 EXHIBIT 12–4

Beware of Allocated Fixed Costs

An Example of a Make or Buy Decision EXHIBIT 12–5

Opportunity Cost Special Order Decisions

Per Total Add to

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