Chapter 10 of “Managerial Accounting: An Introduction to Concepts, Methods, and Uses” focuses on identifying relevant costs for decision-making. Relevant costs are crucial in short-term business decisions, as they directly affect the financial outcomes of various strategic choices.

Key Topics in Chapter 10

1. Understanding Relevant Costs:

• Relevant costs are costs that will change as a result of a decision. They are future costs that differ between alternatives. Only these costs should be considered when making decisions.
• Irrelevant costs are costs that do not change between alternatives or are sunk costs (costs already incurred and cannot be recovered).

1. Types of Relevant Costs:

• Avoidable Costs: Costs that can be eliminated if a particular decision is made.
• Incremental Costs: Additional costs that occur if a specific action is taken.
• Opportunity Costs: The benefits foregone by choosing one alternative over another.

1. Common Decision-Making Scenarios:

• Make or Buy Decisions: Involves deciding whether to produce a component in-house or purchase it from an external supplier.
• Special Order Decisions: Determining whether to accept an order at a price lower than the normal selling price, typically to utilize excess capacity.
• Product Line Decisions: Deciding whether to add or drop a product line or business segment based on profitability.
• Sell or Process Further Decisions: Determining whether to sell a product as is or process it further to enhance its value.
• Resource Allocation Decisions: Choosing how to allocate limited resources among different products or services to maximize profitability.

1. Make or Buy Analysis:

• This analysis involves comparing the relevant costs of making a product internally versus buying it from an external supplier. Relevant costs typically include direct materials, direct labor, variable overhead, and any avoidable fixed costs.

Math Problem and Solution from Chapter 10

To illustrate Make or Buy Decisions, consider the following problem:

Problem:
XYZ Company is currently producing a component internally at the following costs for 10,000 units per year:

• Direct Materials: $2 per unit
• Direct Labor: $4 per unit
• Variable Overhead: $1 per unit
• Fixed Overhead: $3 per unit (of which $2 per unit is avoidable if production is outsourced)

An external supplier offers to provide the component at $8 per unit. Should XYZ Company continue to make the component or buy it from the external supplier?

Solution:

1. Calculate the Relevant Costs of Making the Component: Relevant costs include all variable costs and avoidable fixed costs:

• Direct Materials Cost: $$
  \text{Direct Materials Cost} = 2 \times 10,000 = 20,000
  $$
• Direct Labor Cost: $$
  \text{Direct Labor Cost} = 4 \times 10,000 = 40,000
  $$
• Variable Overhead Cost: $$
  \text{Variable Overhead Cost} = 1 \times 10,000 = 10,000
  $$
• Avoidable Fixed Overhead Cost: $$
  \text{Avoidable Fixed Overhead Cost} = 2 \times 10,000 = 20,000
  $$ Total Relevant Costs of Making: $$
  \text{Total Relevant Cost (Make)} = 20,000 + 40,000 + 10,000 + 20,000 = 90,000
  $$

1. Calculate the Cost of Buying the Component: If the company buys the component, the cost will be: $$
   \text{Total Cost (Buy)} = 8 \times 10,000 = 80,000
   $$
2. Compare the Costs:

• Cost of Making: $90,000
• Cost of Buying: $80,000 Since the cost of buying ($80,000) is less than the cost of making ($90,000), XYZ Company should buy the component from the external supplier.

1. Opportunity Cost Consideration: If there are no opportunity costs associated with using the company’s facilities for another purpose, the decision to buy is clear. However, if the facilities can be used for a more profitable purpose, that opportunity cost should be included in the decision analysis.

Conclusion

Chapter 10 emphasizes the importance of understanding relevant costs when making managerial decisions. By focusing only on costs that will change as a result of a decision, managers can make more informed choices that align with the company’s strategic objectives. Whether it’s deciding to make or buy a product, accept a special order, or allocate resources, identifying relevant costs is key to maximizing profitability and operational efficiency.