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Relevant Costing and Short-Run Decision Making

Management accounting looks at how to provide the most appropriate financial information to managers for decision-making. One key part of this task is to identify relevant costs and benefits to a decision. Common decisions made in organizations that require relevant cost information are “make or buy decisions,” “adding or dropping a product line,” “special orders,” and “sell or process further” decisions.

Relevant Costs: In management accounting, we use the terms “avoidable cost” and “differential cost” to mean this same thing. Avoidable costs are costs that can be eliminated (in whole or in part) by choosing one alternative over another. Sunk costs and future costs that do not differ between alternatives are irrelevant costs.

Sunk Costs: Past costs that have already been incurred and cannot be changed. As a result, they are no longer relevant in decision-making. For example, imagine a company invested $10,000 in a project, which they intended to sell for $10,000 when completed, but it has gone over cost. In fact, the project will still take an additional $5,000 to complete. If we include the original $10,000 in determining whether we should abandon the project, we would conclude, incorrectly, that we would have to spend $15,000 and only get $10,000 back. However, we only have to spend $5,000 more to make $10,000, so we should not abandon the project.

Opportunity Costs: Costs that are not directly incurred, however, they represent forgone benefits if an alternative is chosen. For example, when you go to college or university, you not only pay tuition and buy books, but you also forgo the money you could have made if you were working. This forgone income is considered an opportunity cost of getting an education.

Categories within Relevant Costing and Short-Run Decision Making

Adding and Dropping a Product Line

Postings: 2

Decisions to add or drop product lines are based on the impact that products have on operating income. When managers consider dropping a product line, they look to determine what costs they can avoid by doing so.

Make or Buy Decisions

Postings: 12

Most companies do not carry out every activity along the value chain. Deciding whether to make or buy an input to the manufacturing process or to sell is based on a comparison of costs.

Special Orders

Postings: 2

Special orders are one-time orders that businesses have the opportunity to fulfill outside of their normal business operations. Deciding whether a special order should be accepted or not, and at what price, is an important decision for managers.

Sell or Process Further Decisions

Postings: 4

When a single input or raw material creates multiple products, these products are known as joint products. Deciding what to do with a product from the split-off point forward is known as a sell or process further decision.

sunk costs, opportunity costs, Goldratt's Theory of Constraints

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Relevant Costs: Reduced Selling Price

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Differential analysis involves knowing which costs are relevant.

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Relevant Costing

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Relevant Costing Problem: Westcost Air Company

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