CHAPTER 3
Using Costs in Decision Making
Cost Classification
 Costs can be classified by:
 Financial reporting: product VS period
costs
 Traceability: direct VS indirect costs
 Behavior: variable/fixed /mixed/step
costs
 Other terms: incremental costs, sunk
costs, opportunity costs, avoidable
costs etc
Cost Categories Used in Financial
Reporting
Common Cost Behavior Patterns
Variable Costs: total costs changes in proportion to
changes in quantity or activity.

E.g. DM, DL, & sales commissions.
Fixed Costs: total costs do not change in response to
changes in quantity or activity.
•
E.g. depreciation by straight line method, rent, and insurance etc.
Mixed Costs: costs that have both variable and fixed
elements.

E.g. a salesperson’s salary where he receives a base salary (fixed) plus
commissions (variable).
Step Costs: fixed for a range of output, but increase when
upper bound of range is exceeded.

E.g. company adds second or third production shift, fixed costs related to
supervisory salary, heat, light etc are expected to increase.
Practice
 How does the cost of your cell phone
plan behavior?




$0.50 per minute
$10 monthly fee, $0.10 per minute
$60 per month unlimited minutes
$20 monthly fee up to 200 minutes;
$40 monthly fee if 201 to 500 minutes;
and $50 monthly fee if 501-1000
minutes.
Practice
 Matching questions #1
Other Useful Cost Definitions
 Incremental Cost—the cost of the
next unit of production, sometimes
referred to as the Marginal Cost
 Sunk costs—these are costs that have
occurred and no current action or
decision can change them
Other Useful Cost Definitions
 Relevant Costs—a cost that will
change as a result of a decision
 Opportunity Costs—the maximum
value forgone when a course of
action is chosen
 Avoidable Costs—costs that can be
avoided by taking a specific course
of action
Summary of Cost Concepts
 Sunk costs are never incremental or relevant
i.e. Do not differ between alternatives
 Avoidable costs are always incremental and
relevant
 Opportunity costs are also incremental and
relevant
Which of the following is often not an
incremental cost?
a. Material
b. Labor
c. Variable overhead
d. Fixed overhead
Opportunity costs are:
a.
b.
c.
d.
Never incremental costs
Always incremental costs
Sometimes sunk costs
Never avoidable costs
Slide 7-11
Learning objective 2: Define sunk cost, avoidable cost, and
opportunity cost, and understand how to use these concepts in
Which of the following costs should not be
taken into consideration when making a
decision?
a. Opportunity costs
b. Sunk costs
c. Relevant costs
d. Differential costs
“What Does This Product Cost?”
Answer: Why do you want to know?
 No single cost number is relevant for
all decisions
 Must find incremental information
that is applicable to the decision
- Some costs will change due to the
decision, some will not
- Only costs that change are relevant
Cost-Volume-Profit Analysis
 The Profit Equation
Profit (NI) = SP(x) – VC(x) – TFC
Where:
x = Quantity of units produced and sold
SP = Selling price per unit
VC = Variable cost per unit
TFC = Total fixed cost
 Fundamental to CVP analysis
Cost-Volume-Profit Analysis
 Break-Even Point
• # of units sold that allow the company
cover its total costs, with a profit of zero.
• NI= SP(x) – VC(x) – TFC = 0
• Break Even Unit (x0)=TFC/(SP-VC)
• Break-Even Sales= SP*x0
• Units to realize target profit:
• Target Profit = SP(xt) – VC(xt) – TFC
• xt= (Target Profit + TFC)/(SP-VC)
• Target Sales= SP*xt
Gabby’s Wedding Cakes creates elaborate
wedding cakes. Each cake sells for $500.
The variable cost of baking the cakes is $200
and the fixed cost per month is $6,000
1. Calculate the break-even point in units
2. How many cakes must be sold to earn a profit
of $9,000?
At Winford Corp., the selling price per lawn
mower is $120, variable cost per lawn mower
is $55. Fixed costs are $130,000. Break-Even
Point in units is?
a. 1,000 units
b. 1,083 units
c. 2,000 units
d. None of these
Break-Even Point
Practice
 Matching questions #2
Contribution Margin
Difference between revenue and
variable costs
 Contribution margin (CM):
 CM=Sales-TVC = SP(x) – VC(x)
 Unit contribution margin (Unit CM):
 Unit CM= SP– VC
 CM=Unit CM * x
 Unit CM measures the amount of
incremental profit generated by selling an
additional unit
At Winford Corp., the selling price per
lawn mower is $120, variable cost per
lawn mower is $55. Fixed costs are
$130,000. Contribution Margin per unit is?
a. $65
b. $75
c. $175
d. $30
Contribution Margin Ratio
The contribution margin ratio measures
the amount of incremental profit
generated by an additional dollar of sales
 Two methods to calculate the
contribution margin ratio
1. Contribution margin divided by sales
revenue (Sales – TVC) / Sales
2. Unit contribution margin divided by
selling price (SP – VC) / SP
Rhetorix, Inc. produces stereo speakers. The
selling price per pair of speakers is $800.
The variable cost of production is $300 and
the fixed cost per month is $50,000.
1. Calculate the unit contribution margin
associated with a pair of speakers
2.Calculate the contribution margin ratio for
Rhetorix associated with a pair of speakers
Rhetorix, Inc. produces stereo speakers. The
selling price per pair of speakers is $800. The
variable cost of production is $300 and the fixed
cost per month is $50,000.
1. If the company sells five more speakers than
planned, what is the expected effect on profit
of selling the additional speakers?
2.If the company has sales that are $5,000
higher than expected, what is the expected
effect on profit?
Variations in CVP Analysis
 Pg 68-71
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Profit in percent
Impact of income tax
what-if analysis
Multiproduct firm
Analysis of Decisions Faced
by Managers
Four types of decisions that managers
frequently face:
1.Make or buy (outsourcing)
2.Short-term product mix with
constraints
3.Drop a product or not (death spiral)
4.Costing order (the floor price)
Save 3&4 for later chapters
Make or Buy Decisions
 A Case
 Picture this: you are new at the job and you
are eager to succeed. You go out and buy (after
convincing your boss) a new machine for $1
million. It’s a highly specialized machine, built
especially for your firm, with no resale value.
 You plan to use this machine to produce a part
that is used in every product the firm makes.
 It will cost you, thanks to this new machine,
only $4 per unit in variable costs and $1 in
depreciation (fixed cost) to make the part.
Make or Buy Decisions
 Case continued
 Great!!...until a salesman from a very
reputable firm comes to your office and offers
to sell you the same part you are making, same
quality, reliable delivery, etc. for $4.50 a part.
Her company is willing to sign a long-term
contract so the price is firm.
 Questions:
 Should you accept her offer (i.e., buy the part)
or continue to make the part yourself?
 Would your decision change if the fixed costs
could be avoided by selling the machine at
cost?
Make or Buy Decisions
 Decision involves no incremental
revenues; Analysis concentrates solely
on incremental costs.
 How much cost can be saved?
Make or Buy Decisions
 Cost savings (avoidable cost)
 Not all fixed cost are irrelevant. If they are
avoidable, then they should be factored into
the decision just like variable costs;
 Labor costs, even for direct labor (variable)
costs, could be unavoidable if workers cannot
be laid off because existing labor contract.
 An opportunity cost (benefit forgone by
selecting one decision alternative over
another) must also be considered in decision
making.
Examples
 Chaps Company pg79-80
 Anjlee’s Catering Services pg80-81
 Practice 3-40 pg102
Short –Term Product Mix
Decisions with Constraints
 Constraining factor
 Fred’s wood products pg87-89
 Harris Chemical pg89-93
 Group Case: Excel Solver
 3-67 pg114