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Chapter 11: Problem 2

Define relevant costs. Why are historical costs irrelevant?

Short Answer

Expert verified
Relevant costs are future costs that differ between alternatives, while historical costs are irrelevant because they cannot be changed and do not impact future decisions.

Step by step solution

01

Understanding Relevant Costs

Relevant costs are those costs that will be directly affected by a decision in the future. They include costs that will change or differ between alternatives. This means they are used for decision-making purposes because they reflect the financial impact of choosing one option over another.
02

Characteristics of Relevant Costs

Relevant costs must be future-oriented and differ between alternatives. They are typically variable costs, avoidable fixed costs, or opportunity costs. In any decision-making process, only costs that will affect future cash flows and potentially change due to the decisions made are considered relevant.
03

Historical Costs Explained

Historical costs, often referred to as sunk costs, are costs that have already been incurred and cannot be changed or recovered. These costs have occurred in the past and are fixed in terms of their impact on current or future decisions.
04

Why Historical Costs Are Irrelevant

Historical costs are irrelevant in decision-making because they do not change regardless of the outcome or alternatives chosen. They do not impact future cash flows and thus do not affect the costs and benefits analysis associated with a decision.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Historical Costs
When we talk about historical costs, we're referring to expenses that have already been paid. These are often called "sunk costs" because they cannot be recovered. Think of historical costs as the money that was spent in the past. Since this money has already been spent, it doesn't help us decide what to do in the future. Historical costs are fixed. They don鈥檛 change, no matter what new decision you make. If you've paid for something in the past, its cost remains the same whether you decide to keep it, use it differently, or not use it at all.
  • Example: If you bought a piece of equipment last year for $1000, this cost is historical. It won't be recovered no matter what you decide now.
  • Irrelevance for Future Decisions: Since they don't influence or change the future, historical costs aren't considered when making decisions.
Historical costs are useful for accounting but are not influential in future decisions.
Decision-Making
In any decision-making process, it is crucial to focus on the information that affects future choices. Thus, relevant costs come into play. Relevant costs are the expenses that can change based on the decisions you make. The key is they help determine the financial impact between choosing one option over another. Decision-making relies on analyzing these costs to decide the direction to take.
  • Future-Oriented: Decisions should only consider costs that affect future outcomes.
  • Avoid Sunk Costs: As discussed, ignore sunk costs since they鈥檝e already occurred and will not affect new decisions.
To make the most out of your decision-making process, always focus on what changes due to a decision rather than what remains static.
Variable Costs
Variable costs are an essential element of relevant costs. These are costs that change directly with the level of output or activity. Unlike fixed costs, which stay the same regardless of operations' scale, variable costs fluctuate. For example: the more products you produce, the greater your total variable costs are. They are significant because they directly impact the marginal cost of producing one more unit, which is crucial in decision making.
  • Example: Costs like raw materials, direct labor, and utilities increase as production goes up.
  • Importance for Decisions: Knowing how variable costs change with production helps in setting prices and determining the profitability of products.
By focusing on variable costs, businesses can better forecast their expenses and adjust strategies based on predicted changes in production.
Opportunity Costs
Opportunity costs are a type of cost that represent the benefits you could have received by choosing a different option. It's all about weighing what you give up when deciding on a particular course of action. Opportunity costs play a vital role in the decision-making process as they help you see beyond immediate costs to the potential benefits of alternate choices.
  • Example: If you choose to invest in Project A over Project B, the opportunity cost is what you could have gained from choosing Project B instead.
  • Role in Decisions: Opportunity costs emphasize the value of the foregone option, ensuring that all costs are considered in business decisions.
Understanding opportunity costs helps ensure that you are allocating resources in the most effective way, enabling you to maximize potential returns.

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Most popular questions from this chapter

Describe two potential problems that should be avoided in relevant-cost analysis.

(H. Schaefer) The Wild Boar Corporation is working at full production capacity producing 13,000 units of a unique product, Rosebo. Manufacturing cost per unit for Rosebo is as follows: Manufacturing overhead cost per unit is based on variable cost per unit of \(\$ 4\) and fixed costs of \(\$ 39,000\) (at full capacity of 13,000 units). Marketing cost per unit, all variable, is \(\$ 2,\) and the selling price is \(\$ 26\). A customer, the Miami Company, has asked Wild Boar to produce 3,500 units of Orangebo, a modification of Rosebo. Orangebo would require the same manufacturing processes as Rosebo. Miami has offered to pay Wild Boar \(\$ 20\) for a unit of 0 rangebo and share half of the marketing cost per unit. 1\. What is the opportunity cost to Wild Boar of producing the 3,500 units of Orangebo? (Assume that no overtime is worked. 2\. The Buckeye Corporation has offered to produce 3,500 units of Rosebo for Wolverine so that Wild Boar may accept the Miami offer. That is, if Wild Boar accepts the Buckeye offer, Wild Boar would manufacture 9,500 units of Rosebo and 3,500 units of Orangebo and purchase 3,500 units of Rosebo from Buckeye. Buckeye would charge Wild Boar \(\$ 18\) per unit to manufacture Rosebo. 0 n the basis of financial considerations alone, should Wild Boar accept the Buckeye offer? Show your calculations. 3\. Suppose Wild Boar had been working at less than full capacity, producing 9,500 units of Rosebo at the time the Miami offer was made. Calculate the minimum price Wild Boar should accept for Orangebo under these conditions. (lgnore the previous \(\$ 20\) selling price.)

Describe the three steps in solving a linear programming problem.

(A. Atkinson) Oxford Engineering manufactures small engines. The engines are sold to manufacturers who install them in such products as lawn mowers. The company currently manufactures all the parts used in these engines but is considering a proposal from an external supplier who wishes to supply the starter assemblies used in these engines. The starter assemblies are currently manufactured in Division 3 of Oxford Engineering. The costs relating to the starter assemblies for the past 12 months were as follows: Over the past year, Division 3 manufactured 150,000 starter assemblies. The average cost for each starter assembly is \(\$ 5(\$ 750,000 \div 150,000)\) Further analysis of manufacturing overhead revealed the following information. Of the total manufacturing overhead, only \(25 \%\) is considered variable. Of the fixed portion, \(\$ 150,000\) is an allocation of general overhead that will remain unchanged for the company as a whole if production of the starter assemblies is discontinued. A further \(\$ 100,000\) of the fixed overhead is avoidable if production of the starter assemblies is discontinued. The balance of the current fixed overhead, \(\$ 50,000\), is the division manager's salary. If production of the starter assemblies is discontinued, the manager of Division 3 will be transferred to Division 2 at the same salary. This move will allow the company to save the \(\$ 40,000\) salary that would otherwise be paid to attract an outsider to this position. 1\. Tidnish Electronics, a reliable supplier, has offered to supply starter- assembly units at \(\$ 4\) per unit. Because this price is less than the current average cost of \(\$ 5\) per unit, the vice president of manufacturing is eager to accept this offer. 0 n the basis of financial considerations alone, should the outside offer be accepted? Show your calculations. (Hint: Production output in the coming year may be different from production output in the past year. 2\. How, if at all, would your response to requirement 1 change if the company could use the vacated plant space for storage and, in so doing, avoid \(\$ 50,000\) of outside storage charges currently incurred? Why is this information relevant or irrelevant?

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