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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. This simple idea was applied in a variety of situations including decisions that involve making or buying a component, adding or dropping a product line, accepting or rejecting a special order, processing a joint product further, and using a constrained resource. This list includes only a small sample of the possible applications of the relevant cost concept. Indeed, any decision involving costs hinges on the proper identification and analysis of the costs that are relevant. We will continue to focus on the concept of relevant costs in the following chapter where long-run investment decisions are considered. In this chapter, the following learning objectives will be covered: Identify relevant and irrelevant costs and benefits in a decision. Prepare an analysis showing whether a product line or other business segment should be dropped or retained. Prepare a make or buy analysis. Prepare an analysis showing whether a special order should be accepted. Determine the most profitable use of a constrained resource and the value of obtaining more of the constrained resource. Prepare an analysis showing whether joint products should be sold at the split-off point or processed further.
Key Terms:
Avoidable cost
A cost that can be eliminated (in whole or in part) by choosing one alternative over another in a decision. This term is synonymous with relevant cost and differential cost. A machine or some other part of a process that limits the total output of the entire system. 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. Any cost that differs between alternatives in a decision-making situation. This term is synonymous with avoidable cost and relevant cost. Costs that are incurred up to the split-off point in a process that produces joint products. Two or more products that are produced from a common input. A decision concerning whether an item should be produced internally or purchased from an outside supplier. An action that increases the amount of a constrained resource. Equivalently, an action that increases the capacity of the bottleneck. A cost that differs between alternatives in a decision. This term is synonymous with avoidable cost and differential cost. A decision as to whether a joint product should be sold at the splitoff point or sold after further processing. A one-time order that is not considered part of the company's normal ongoing business. That point in the manufacturing process where some or all of the joint products can be recognized as individual products. Any cost that has already been incurred and that cannot be changed by any decision made now or in the future. The involvement by a company in more than one of the activities in the entire value chain from development through production, distribution, sales, and after-sales service.
Bottleneck Constraint
Differential cost Joint costs Joint products Make or buy decision Relaxing (or elevating) the constraint Relevant cost Sell or process further decision Special order Split-off point Sunk cost Vertical integration