Differential Analysis – The

Key to Decision Making

CHAPTER 13

Managerial
Accounting
Seventeenth edition
13-2

Learning Objective 1

Identify relevant and

irrelevant costs and
benefits in a
decision.
Decision Making – Six Key
13-3

Concepts – Concepts 1 and 2

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.
Key Concept
#2
Once you have defined the alternatives, you
need to identify the criteria for choosing
among them.
• Relevant costs and relevant benefits
should be considered when making decisions.
• Irrelevant costs and irrelevant benefits
should be ignored when making decisions.
Decision Making – Six Key
13-4

Concepts – Concept 3
Key Concept
#3
The key to effective decision making is
differential analysis—focusing on the future
costs and benefits that differ between the
alternatives. Everything else is irrelevant and
should be ignored.
• A future cost that differs between any two
alternatives is known as a differential cost.
• Future revenue that differs between any two
alternatives is known as differential revenue.
• An incremental cost is an increase in cost
between two alternatives.
• An avoidable cost is a cost that can be
eliminated by choosing one alternative over
Decision Making – Six Key
13-5

Concepts – Concepts 4 and 5

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 decides to do.

Key Concept
#5
Future costs and benefits that do not
differ between alternatives are irrelevant
to the decision-making process.
13-6

Decision Making – Six Key Concepts –

Concept 6
Key Concept
#6
Opportunity costs also need to be
considered when making decisions.
• An opportunity cost is the potential benefit
that is given up when one alternative is
selected over another.
Identifying Relevant Costs – An
13-7

Example
Cynthia, a Boston student, is considering visiting her friend in New York. She
can drive or take the train. By car, it is 230 miles to her friend’s apartment. She
is trying to decide which alternative is less expensive and has gathered the
following information.

Automobile Costs (based on 10,000 miles driven per year)

Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

$45 per month × 8 months $2.70 per gallon ÷ 27 MPG

$24,000 cost – $10,000 salvage value ÷ 5 years

Identifying Relevant Costs –
13-8

Additional Information
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

Additional Information
7 Reduction in resale value of car per mile of wear $ 0.026
8 Round-tip train fare $ 104
9 Benefits of relaxing on train trip ????
10 Cost of putting dog in kennel while gone $ 40
11 Benefit of having car in New York ????
12 Hassle of parking car in New York ????
13 Per day cost of parking car in New York $ 25
Identifying Relevant Costs – 13-9

Part 1
Which costs and benefits are relevant in
Cynthia’s decision?

The cost of The annual cost of

the car is a insurance is not
sunk cost and relevant. It will
is not relevant remain the same if
to the current she drives or takes
decision. the train.
However, the cost of gasoline is clearly
relevant if she decides to drive. If she takes
the train, she would avoid the cost of the
gasoline, so the cost differs between the
alternatives.
Identifying Relevant Costs – 13-10

Part 2
Which costs and benefits are relevant in Cynthia’s
decision?

The cost of The monthly school

maintenance and parking fee is not
repairs is relevant. In relevant because it
the long-run, these must be paid if Cynthia
costs depend upon drives or takes the
miles driven. train.

At this point, we can see that some of the average cost of

$0.619 per mile are relevant and others are not.
Identifying Relevant Costs – 13-11

Part 3
Which costs and benefits are relevant in Cynthia’s
decision?

The decline in resale The round-trip train fare

value due to additional is clearly relevant. If she
miles is a relevant cost. drives the cost can be
avoided.

Relaxing on the train is The kennel cost is not

relevant even though it relevant because Cynthia
is difficult to assign a will incur the cost if she
dollar value to the drives or takes the train.
benefit.
Identifying Relevant Costs – 13-12

Part 4
Which costs and benefits are relevant in Cynthia’s
decision?

The cost of parking in

New York is relevant
because it can be
avoided if she takes
the train.

The benefits of having a car in New York and

the problems of finding a parking space are
both relevant but are difficult to assign a
dollar amount.
Identifying Relevant Costs – 13-13

Part 5
From a financial standpoint, Cynthia would be better off
taking the train to visit her friend. Some of the non-
financial factors may influence her final decision.

Relevant Financial Cost of Driving

Gasoline (460 @ $0.100 per mile) $ 46.00
Maintenance (460 @ $0.065 per mile) 29.90
Reduction in resale (460 @ $0.026 per mile) 11.96
Parking in New York (2 days @ $25 per day) 50.00
Total $ 137.86

Relevant Financial Cost of Taking the Train

Round-trip ticket $ 104.00
13-14

Total and Differential Cost

Approaches – Total Cost Approach
The management of a company is considering a new
labor saving machine that rents for $3,000 per year. Data
about the company’s annual sales and costs with and
without the new machine are: Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000
13-15

Total and Differential Cost Approaches –

Differential Cost Approach
As you can see, the only costs that differ
between the alternatives are the direct labor
costs savings and the increase in fixed rental
Situation Differential
Current With New Costs and
costs. Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000
We can efficiently analyze the decision by
looking at the different costs and revenues
and arrive at the same solution.

Finanical Advantage of Renting the New Machine

Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Increase in fixed rental expenses (3,000)
Financial advantage of renting the new machine $ 12,000
Total and Differential Cost
13-16

Approaches

Using the differential approach is

desirable for two reasons:
1. Only rarely will enough information
be available to prepare detailed
income statements for both
alternatives.
2. Mingling irrelevant costs with
relevant costs may cause confusion
and distract attention away from the
information that is really critical.
13-17

Learning Objective 2

Prepare an analysis
showing whether a
product line or other
business segment
should be added or
dropped.
Adding/Dropping Segments – 13-18

Part 1

One of the most important

decisions managers make is
whether to add or drop a
business segment. Ultimately, a
decision to drop an old segment
or add a new one is going to To assess this impact, it
hinge primarily on its financial is necessary to carefully
impact. analyze the costs.
Adding/Dropping Segments – 13-19

Part 2

Due to the declining popularity of digital

watches, Lovell Company’s digital watch line
has not reported a profit for several years.
Lovell is considering whether to keep this
product line or drop it.
A Contribution Margin 13-20

Approach
DECISION RULE
Lovell should drop the digital watch segment
only if its profit would increase.
Lovell will compare the contribution margin
that would be lost if the digital watch line was
discontinued to the fixed expenses that would
be avoided if the line was discontinued.
Adding/Dropping Segments –
13-21

Example – Part 1
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
Adding/Dropping Segments –
13-22

Example – Part 2
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
12-24

An investigation has revealed that the fixed

general factory overhead and fixed general
administrative expenses will not be affected by
dropping the digital watch line. The fixed general
factory overhead and general administrative
expenses assigned to this product would be
reallocated to other product lines.

©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or
further distribution permitted without the prior written consent of McGraw-Hill Education.
Adding/Dropping Segments –
13-23

Example – Part 3
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
12-26

The equipment used to manufacture

digital watches has no resale
value or alternative use.

Should Lovell retain or drop

the digital watch segment?

©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or
further distribution permitted without the prior written consent of McGraw-Hill Education.
Contribution Margin Approach
13-24

Solution
Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped $ (300,000)

Less fixed costs that can be avoided

Salary of the line manager $ 90,000
Advertising - direct 100,000
Rent - factory space 70,000 260,000
Financial disadvantage of dropping
the digital wataches product line $ (40,000)
Comparative Income Approach
13-25

– Part 1

The Lovell solution can also be obtained by

preparing comparative income statements
showing results with and without the digital
watch segment.

Let’s look at this second approach.

Comparative Income Approach
13-26

– Part 2

If the digital watch line is

dropped, the company loses
$300,000 in contribution

margin .
Comparative Income Approach 13-27

– Part 3

On the other hand, the general factory

overhead would be the same under both
alternatives, so it is irrelevant.
Comparative Income Approach
– Part 4 13-28

The salary of the

product line
manager would
disappear, so it is
relevant to the
decision.
Comparative Income Approach 13-29

– Part 5

The depreciation is a sunk cost. Also,

remember that the equipment has no resale
value or alternative use, so the equipment and
the depreciation expense associated with it ar

irrelevant to the decision .

Comparative Income Approach
– Part 6 13-30

The complete comparative income statements reveal that Lovell

would earn $40,000 of additional profit by retaining the digital
watch line.
13-31

Beware of Allocated Fixed Costs –

Part 1

Be aware that allocated fixed costs can distort the

keep/drop decision.

Lovell’s managers may ask: “Why

should we keep the digital watch
segment when it’s showing a
$100,000 loss?”
13-32

Beware of Allocated Fixed Costs –

Part 2

The answer lies in the way we allocate

common fixed costs to our products.
13-33

Beware of Allocated Fixed Costs –

Part 3

Including unavoidable common

fixed costs makes the product
line appear to be unprofitable,
when in fact dropping the
product line would decrease the
company’s overall net operating
income.
13-34

Learning Objective 3

Prepare a make or
buy analysis.
13-35

The Make or Buy Decision

When a company is involved in more than one activity
in the entire value chain, it is vertically integrated. 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.
Vertical Integration – 13-36

Advantages

Smoother flow of
parts and materials

Better quality
control

Realize profits
Vertical Integration – 13-37

Disadvantages
Companies may fail to take advantage of
suppliers who can create economies of scale
advantage by pooling demand from numerous
companies.

While the economics of scale factor can be

appealing, a company must be careful to retain
control over activities that are essential to
maintaining its competitive position.
The Make or Buy Decision – An
13-38

Example

Essex Company manufactures part 4A that is used in one of its

products. The unit product cost of this part is:

Direct materials $ 9
Direct labor 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary 2
General factory overhead 10
Unit product cost $ 30
The Make or Buy Decision – 13-39

Part 1
The special equipment used to manufacture part 4A has no
resale value.
The total amount of general factory overhead, which is
allocated on the basis of direct labor hours, would be unaffected
by this decision.
The $30 unit product cost is based on 20,000 parts produced
each year.
An outside supplier has offered to provide the 20,000 parts at a
cost of $25 per part.
Should the company stop making part 4A and buy it from an
outside supplier?
The Make or Buy Decision – 13-40

Part 2
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
Allocated gen. fact. overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The avoidable costs associated with making part 4A include direct materials,
direct labor, variable overhead, and the supervisor’s salary.
The Make or Buy Decision – 13-41

Part 3
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
Allocated gen. fact. overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The cost incurred to buy the equipment is a sunk cost; the

depreciation simply spreads this sunk cost over the
equipment’s useful life.
The Make or Buy Decision – 13-42

Part 4
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
Allocated gen. fact. overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The allocated general factory overhead represents allocated costs

common to all items produced in the factory and would continue
unchanged. Thus, it is irrelevant to the decision.
The Make or Buy Decision – 13-43

Part 5
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
Allocated gen. fact. overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000
Financial advantage of making part 4A $160,000
Should we make or buy part 4A? Given that the total avoidable
costs are less than the cost of buying the part, Essex should
continue to make the part.
13-44

Opportunity Cost

Opportunity costs are not actual cash outlays and are not
recorded in the formal accounts of an organization.
An opportunity cost is the benefit that is foregone as a
result of pursuing some course of action.
If the space to make Part 4A had an alternative use, the
opportunity cost would have been equal to the segment
margin that could have been derived from the best
alternative use of the space.
13-45

Learning Objective 4

Prepare an analysis
showing whether a
special order should
be accepted.
13-46

Special Orders
A special order is a one-time order that is not
considered part of the company’s normal
ongoing business.

When analyzing a special order, only the

incremental costs and benefits are relevant.
Since the existing fixed manufacturing
overhead costs would not be affected by the
order, they are not relevant.
13-47

Special Orders – Example

 Jet Inc. makes a single product whose normal selling price is
$20 per unit.
 A foreign distributor offers to purchase 3,000 units for $10
per unit.
 This is a one-time order that would not affect the company’s
regular business.
 Annual capacity is 10,000 units, but Jet Inc. is currently
producing and selling only 5,000 units.

Should Jet accept the offer?

13-48

Special Orders – Part 1

Jet Inc.
Contribution Inc. Stmt, before considering special order
Revenue (5,000 × $20) $ 100,000
Variable costs:
Direct materials $ 20,000
Direct labor 5,000
Manufacturing overhead 10,000 $8 variable cost
Marketing costs 5,000
Total variable costs 40,000
Contribution margin 60,000
Fixed costs:
Manufacturing overhead $ 28,000
Marketing costs 20,000
Total fixed costs 48,000
Net operating income $ 12,000
13-49

Special Orders – Part 2

If Jet accepts the special order, the incremental revenue will exceed
the incremental costs. In other words, net operating income will
increase by $6,000. This suggests that Jet should accept the order.

Incremental revenue (3,000 × $10) $ 30,000

Incremental cost (3,000 × $8 variable cost) 24,000
Financial advantage of accepting the order $ 6,000

Note: This answer assumes that the fixed costs are

unavoidable and that variable marketing costs must be
incurred on the special order.
13-50

Quick Check 1
Northern Optical ordinarily sells the X-lens for $50. The
variable production cost is $10, the fixed production cost is
$18 per unit, and the variable selling cost is $1. A
customer has requested a special order for 10,000 units of
the X-lens to be imprinted with the customer’s logo. This
special order would not involve any selling costs, but
Northern Optical would have to purchase an imprinting
machine for $50,000.
(see the next page)
13-51

Quick Check 1a
What is the rock bottom minimum price below which Northern
Optical should not go in its negotiations with the customer? In
other words, below what price would Northern Optical actually
be losing money on the sale? There is ample idle capacity to
fulfill the order and the imprinting machine has no further use
after this order.
a. $50
b. $10
c. $15
d. $29
13-52

Quick Check 1b
What is the rock bottom minimum price below which Northern
Optical should not go in its negotiations with the customer? In
other words, below what price would Northern Optical actually
be losing money on the sale? There is ample idle capacity to
fulfill the order and the imprinting machine has no further use
after this order.
a. $50
Variable production cost $100,000
b. $10 Additional fixed cost + 50,000
c. $15 Total relevant cost $150,000
d. $29 Number of units 10,000
Average cost per unit = $15
13-53

Learning Objective 5

Determine the most

profitable use of a
constrained
resource.
13-54

Volume Trade-Off Decisions

Companies are forced to make volume trade-off decisions

when they do not have enough capacity to produce all of
the products and sales volumes demanded by their
customers.
• In these situations, companies must trade off, or
sacrifice production of some products in favor of others
in an effort to maximize profits.
13-55

Key Terms and Concepts

When a limited resource of

some type restricts the
company’s ability to satisfy
demand, the company is
said to have a constraint.
The machine or
process that is
limiting overall output
is called the
bottleneck – it is the
constraint.
Utilization of a Constrained 13-56

Resource
Fixed costs are usually unaffected in these situations, so the
product mix that maximizes the company’s total contribution
margin should ordinarily be selected.
A company should not necessarily promote those products
that have the highest unit contribution margins.
Rather, total contribution margin will be maximized by
promoting those products or accepting those orders that
provide the highest contribution margin in relation to the
constraining resource.
Utilization of a Constrained
13-57

Resource – An Example – Part 1

Ensign Company produces two products and selected data are
shown below:
Product
1 2
Selling price per unit $ 60 $ 50
Less variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.
Utilization of a Constrained
13-58

Resource – An Example – Part 2

Machine A1 is the constrained resource and is being used at

100% of its capacity.
There is excess capacity on all other machines.
Machine A1 has a capacity of 2,400 minutes per week.

Should Ensign focus its efforts on Product 1 or

Product 2?
13-59

Quick Check 2
How many units of each product can be processed
through Machine A1 in one minute?
Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2.0 units
c. 2 units 1.0 unit
d. 2 units 0.5 unit
13-60

Quick Check 2a
How many units of each product can be processed
through Machine A1 in one minute?
Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2.0 units
c. 2 units 1.0 unit
d. 2 units 0.5 unit
13-61

Quick Check 2b
What generates more profit for the company, using one
minute of machine A1 to process Product 1 or using
one minute of machine A1 to process Product 2?
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.
13-62

Quick Check 2c
What generates more profit for the company, using one
minute of machine A1 to process Product 1 or using
one minute of machine A1 to process Product 2?
a. Product 1
b. Product 2
c. They
With both
one wouldofgenerate
minute machine the same
A1, profit.
Ensign could make
d.1Cannot
unit ofbe determined.
Product 1, with a contribution margin of
$24, or 2 units of Product 2, each with a contribution
margin of $15 per unit.
2 × $15 = $30 > $24
Utilization of a Constrained
13-63

Resource – Part 1
The key is the contribution margin per unit of the
constrained resource.
P roduct
1 2
Contri buti on m a rgi n pe r uni t $ 24 $ 15
Ti m e re qui re d to produce one uni t ÷ 1. 00 m i n. ÷ 0. 50 m i n.
Contri buti on m a rgi n pe r m i nute $ 24 $ 30

Ensign should emphasize Product 2 because it

generates a contribution margin of $30 per minute
of the constrained resource relative to $24 per
minute for Product 1.
Utilization of a Constrained
13-64

Resource – Part 2
The key is the contribution margin per unit of the
constrained resource.
P roduct
1 2
Contri buti on m a rgi n pe r uni t $ 24 $ 15
Ti m e re qui re d to produce one uni t ÷ 1. 00 m i n. ÷ 0. 50 m i n.
Contri buti on m a rgi n pe r m i nute $ 24 $ 30

Ensign can maximize its contribution margin by first

producing Product 2 to meet customer demand and then
using any remaining capacity to produce Product 1. The
calculations would be performed as follows.
Utilization of a Constrained
13-65

Resource – Part 3
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.
Utilization of a Constrained
13-66

Resource – Part 4
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.
Utilization of a Constrained
13-67

Resource – Part 5
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.
Time required per unit ÷ 1.00 min.
Production of Product 1 1,300 units
Utilization of a Constrained
13-68

Resource – Part 6
According to the plan, we will produce 2,200
units of Product 2 and 1,300 of Product 1. Our
contribution margin looks like this.

Product 1 Product 2
Production and sales (units) 1,300 2,200
Contribution margin per unit $ 24 $ 15
Total contribution margin $ 31,200 $ 33,000

The total contribution margin for Ensign is $64,200.

13-69

Learning Objective 6

Determine the value

of obtaining more of
the constrained
resource.
Value of a Constrained
13-70

Resource – Example

Increasing the capacity

of a constrained
resource should lead to
increased production
and sales.

How much should

Ensign be willing to pay
for an additional minute
of Machine A1 time?
Value of a Constrained
13-71

Resource – Solution
The additional machine time would be used to
make more units of Product 1, which had a
contribution margin per minute of $24.

Ensign should be willing to pay up to $24

per minute. This amount equals the
contribution margin per minute of machine
time that would be earned producing more
units of Product 1.
13-72

Quick Check 3
Colonial Heritage makes reproduction colonial
furniture from select hardwoods.
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only be

able to supply 2,000 board feet this month. Is this
enough hardwood to satisfy demand?
a. Yes
b. No
13-73

Quick Check 3a
Colonial Heritage makes reproduction colonial
furniture from select hardwoods.
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only be

able to supply 2,000 board feet this month. Is this
enough hardwood to satisfy demand?
a. Yes
(2  600) + (10  100 ) = 2,200 > 2,000
b. No
13-74

Quick Check 3b
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only be able

to supply 2,000 board feet this month. What plan would
maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
13-75

Quick Check 3c
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only be able to

supply 2,000 board feet this month. What plan would
maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
12-79

Chairs Tables
Selling price $ 80 $ 400
Variable cost 30 200
Contribution margin $ 50 $ 200
Board feet 2 10
CM per board foot $ 25 $ 20

Production of chairs 600

Board feet required 1,200
Board feet remaining 800
Board feet per table 10
Production of tables 80

©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or
further distribution permitted without the prior written consent of McGraw-Hill Education.
13-76

Quick Check 4
As before, Colonial Heritage’s supplier of hardwood will
only be able to supply 2,000 board feet this month.
Assume the company follows the plan we have
proposed. Up to how much should Colonial Heritage be
willing to pay above the usual price to obtain more
hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero
13-77

Quick Check 4a
As before, Colonial Heritage’s supplier of hardwood will
only be able to supply 2,000 board feet this month.
Assume the company follows the plan we have
proposed. Up to how much should Colonial Heritage be
willing to pay above the usual price to obtain more
hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero
The additional wood would be used to make tables. In this
case, each board foot of additional wood will allow the
company to earn an additional $20 of contribution margin
and profit.
13-78

Managing Constraints
It is often possible for a manager to increase the capacity of a
bottleneck, which is called relaxing (or elevating) the
constraint, in numerous ways such as:
1. Working overtime on the bottleneck.
2. Subcontracting some of the processing that would be done
at the bottleneck.
3. Investing in additional machines at the bottleneck.
4. Shifting workers from non-bottleneck processes to the
bottleneck.
5. Focusing business process improvement efforts on the
bottleneck.
6. Reducing defective units processed through the bottleneck.
13-79

Learning Objective 7

Prepare an analysis
showing whether
joint products
should be sold at the
split-off point or
processed further.
13-80

Joint Product Costs

In some industries, two or more products,
known as joint products are produced from a
single raw material input.
The point in the manufacturing process where
joint products can be recognized as a separate
product is called the split-off point.
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.
13-81

Joint Products
For example, in the
Oil petroleum refining
industry, a large
number of products
Common
Joint are extracted from
Production Gasoline
Input crude oil, including
Process
gasoline, jet fuel,
home heating oil,
Chemicals lubricants, asphalt,
and various organic
chemicals.
Split-Off
Point
Joint Products – Additional
13-82

Processing
Joint costs
are incurred
up to the
Oil
Separate Final
split-off point Processing Sale

Common
Joint Production Final
Gasoline
Input Process
Sale

Separate Final
Chemicals
Processing
Sale

Split-Off Separate
Point Product
Costs
13-83

The Pitfalls of Allocation

Joint costs are traditionally allocated among
different products at the split-off point. A
typical approach is to allocate joint costs
according to the relative sales value of the end
products.

Although allocation is needed for some

purposes such as balance sheet inventory
valuation, allocations of this kind are very
dangerous for decision making.
13-84

Sell or Process Further

Joint costs are irrelevant in decisions regarding
what to do with a product from the split-off point
forward. Therefore, these costs should not be
allocated to end products for decision-making
purposes.

With respect to sell or process further decisions, it is

profitable to continue processing a joint product
after the split-off point so long as the incremental
revenue from such processing exceeds the
incremental processing costs incurred after the
split-off point.
Sell or Process Further – An 13-85

Example
Sawmill, Inc. cuts logs from which unfinished lumber and
sawdust are the immediate joint products.
Unfinished lumber is sold “as is” or processed further into
finished lumber.
Sawdust can also be sold “as is” to gardening wholesalers
or processed further into “presto-logs.”
Sell or Process Further –
13-86

Additional Data
Data about Sawmill’s joint products includes:
Per Log
Lumber Sawdust
Sales value at the split-off point $ 140 $ 40

Sales value after further processing 270 50

Allocated joint product costs 176 24
Cost of further processing 50 20
Sell or Process Further – Part 13-87

1
Analysis of Sell or Process Further
Per Log
Lumber Sawdust
Final sales value after further
processing $ 270 $ 50
Sales value at the split-off point 140 40
Incremental revenue from further
processing 130 10
Cost of further processing
Financial advantage (disadvantage)
of further processing
Sell or Process Further – Part 13-88

2
Analysis of Sell or Process Further
Per Log
Lumber Sawdust
Final sales value after further
processing $ 270 $ 50
Sales value at the split-off point 140 40
Incremental revenue from further
processing 130 10
Cost of further processing 50 20
Financial advantage (disadvantage)
of further processing $ 80 $ (10)
Sell or Process Further – Part 13-89

3
Analysis of Sell or Process Further
Per Log
Lumber Sawdust
Final sales value after further
processing $ 270 $ 50
Sales value at the split-off point 140 40
Incremental revenue from further
processing 130 10
Cost of further processing 50 20
Financial advantage (disadvantage)
of further processing $ 80 $ (10)

The lumber should be processed

further and the sawdust should be
sold at the split-off point.
Activity-Based Costing and
13-90

Relevant Costs
ABC can be used to help identify potentially relevant
costs for decision-making purposes.

However, managers should exercise

caution against reading more into this
“traceability” than really exists.

People have a tendency to assume that if a cost is

traceable to a segment, then the cost is automatically
avoidable, which is untrue. Before making a decision,
managers must decide which of the potentially relevant
costs are actually avoidable.