Teaching Notes for Chapter 5
Relevant Information for Special Decisions
Some managerial accounting textbooks imply that whether a cost is relevant to a special
decision depends on whether the cost exhibits fixed or variable behavior. Whether a cost
is fixed or variable does not determine its relevance. Consider a production supervisor’s
salary that is fixed relative to the number of units of product produced. A traditional
approach might suggest that the salary is not relevant to a special order decision because
it is fixed and therefore will remain unchanged regardless of whether the special order is
accepted or rejected. Later, students may be confused to learn that the same cost (a
production supervisor’s salary) may be relevant with respect to deciding whether to make
or buy the product. If the company buys the product, it avoids the costs of producing it,
including the supervisor’s salary. The salary cost is still fixed, but now it is a relevant
cost.
Clearly, a fixed cost can be relevant or not relevant. Likewise, a variable cost can be
relevant or not relevant. Consider the cost of direct labor. Direct labor cost is relevant to
a special order decision because it can be avoided by rejecting the special order. Now
change the decision context. Suppose a company is deciding whether to make red or
green chairs. Either color chairs (red or green) require the same amount of direct labor.
Here, the labor cost is variable but not relevant. As these examples show, there is no
connection between cost behavior and relevance. A cost is relevant to a special decision
if it satisfies two criteria: (1) it is future-oriented, and (2) it differs between the
alternatives available to the decision-maker. These criteria apply regardless of whether
the cost is fixed or variable.
To avoid the confusion associated with using fixed and variable terminology when
identifying costs relevant to special decisions, Chapter 5 uses terminology from the
activity-based costing (ABC) literature to describe the costs involved. We classify costs
into one of four hierarchical categories: (1) unit-level, (2) batch-level, (3) product-level,
and (4) facility-level costs. These cost categories are logically associated with relevance.
For example, because unit-level costs are incurred each time a unit of product is made,
they are relevant to a special order decision regarding whether additional units should be
made and sold. However, because the number of units of product made and sold does not
affect product-level and facility-level costs, those costs are not relevant to a special order
decision. The hierarchical classification scheme still requires exercising judgment. For
example, whether a batch-level cost is relevant to a special order decision depends upon
whether the additional units would be produced as part of an existing batch or as a
separate batch. Even so, the hierarchical classification scheme is clearer than the cost
behavior approach. We encourage you to experiment with the hierarchical classification.
By this point in the course, most students are ready to begin the first class on Chapter
5 with a problem-based learning exercise. Demonstration Problem 5-1 provides an
entertaining introduction to the topic of special decisions. It does not require use of the
hierarchical scheme discussed above. While you may find the solution obvious, repeated
use in our classes suggests that students find the answer elusive enough to stimulate
enthusiastic class participation.
5-1
Detailed Outline of a Lesson Plan for Chapter 5
I. Use Demonstration Problem 5-1 as a problem-based learning exercise.
Briefly explain how DDI established the $350 price. Clarify the facts of the
problem, but do not provide instruction regarding the meaning of relevance. This
is a problem-based learning experience. Providing the answer too early removes
the opportunity for students to discover concepts for themselves. Have students
work in their groups to complete the problem requirement.
II. Engage students in a discussion regarding their groups’ decisions. The
problem calls for the group members to select a spokesperson. This is an
effective, non-threatening way to encourage group members to take the exercise
seriously. Knowing that the group’s answer may have to be defended publicly
motivates students to develop a serious response. Allowing the group to select the
spokesperson reduces anxiety. Most groups include at least one person who does
not mind acting as a spokesperson. Consequently, group members are motivated
but not threatened.
A. After allowing ample time (usually 10 to 15 minutes) for groups to formulate
answers, ask the spokespersons to raise their hands to indicate whether they
would accept or reject the special order for 200 driveways. Begin with a
spokesperson from a group that rejects the offer. Ask the spokesperson to
explain why the group rejected the offer. When you ask an open-ended
question such as this be prepared for unexpected responses. Be respectful of
all answers.
The answer most frequently encountered in our classes centers on the
mistaken belief that the cost of paving the driveways is greater than the sales
price. Students draw this conclusion because they include the overhead cost
in the cost of pouring the additional 200 driveways. The way different groups
measure the overhead cost can vary. Some groups simply include the $80 per
driveway overhead cost mentioned in the problem. Because the resulting total
cost of $300 exceeds the offer price of $250, they reject the offer. Other
groups recalculate the per-unit cost based on a revised volume of 1,200
driveways. ($80,000 / 1,200 = $67 per driveway). The total cost is then $287
($100 materials + $120 labor + $67 overhead). The cost of $287 again is
greater than the offer price of $250, and students reject the offer.
At this point, you should not correct the answer. Doing so would end the
discussion. Instead, ask a spokesperson from a group that decided to accept
the order to explain their reasoning. Here also, you may get a variety of
answers. Keep searching until you find a group that recognized the overhead
cost is not relevant. DDI incurs this cost regardless of whether the special
order is accepted or rejected (the overhead cost does not differ between the
alternatives).
5-2
When getting answers from your students, look for the right logic rather than
the right terms. Remember this is a problem-based learning exercise.
Students have not yet been exposed (unless they read ahead!) to such terms as
relevant, differential, incremental, or avoidable. Even so, some students are
able to tap into the logic. In a problem-based learning experience, the
instructor’s job is to provide names for concepts the students discover. This
teaching strategy is different from the traditional approach wherein the
instructor provides definitions for terms.
B. After emphasizing that the overhead cost is not relevant, try playing devil’s
advocate. Tell the students that you are one of DDI’s regular customers who
just happens to run into Rachel Rodgers, the new builder, at a local Chamber
of Commerce meeting. You discover that Rachel is paying $250 per driveway
while you are paying $350. Engage a spokesperson from a group that decided
to accept the offer, and complain about the excessive charge you are paying
compared to what Ms. Rodgers is paying. Permit other members of the class
to respond to your complaint. This approach provides a natural preface to a
discussion of the qualitative features that decision-makers must consider.
C. Now it is time to define relevance.
III. Introduce the concept of relevance. Explain that the overhead cost in the DDI
problem is not relevant to the special order decision because DDI will incur it
regardless of whether the order is accepted or rejected. In other words, DDI
cannot avoid the overhead cost by rejecting the special order. Explain that, to be
relevant, a cost must (1) differ between the alternatives, and (2) be futureoriented.
Reinforce the two criteria for relevance with an example that contrasts relevant
costs with a sunk cost. Ask your students to suppose their friend paid $20,000 to
purchase an investment in a company’s stock. The market price of the stock
immediately dropped to $15,000. The friend wants to buy a car. However, your
friend does not have the money to buy the car and does not want to sell the stock
because she will lose $5,000 ($20,000 cost  $15,000 current market value). Is
the friend exercising good or poor judgment? Give your students time to ponder
the question. If you have time let a few of them share their ideas with the class.
Conclude with the observation that whether to sell the stock is their friend’s
personal choice, but they should make sure the friend’s decision is not influenced
by the loss in market value of the stock. The $20,000 stock cost is irrelevant. The
relevant question to the friend is, “if you had $15,000 today would you buy the
stock or a car?” If the answer is “buy the car,” then she should sell the stock and
purchase the car. The original cost of the stock ($20,000) is not relevant because
it is a sunk cost and not oriented to the future.
5-3
IV. Distinguish between product costing, cost behavior, and relevance.
Students who understand concepts can distinguish among them. Thus far in the
course, we have introduced three key concepts: (1) product costing, (2) cost
behavior, and (3) relevance. Demonstration Problem 5-2 is designed to
compare and contrast these three concepts. Also, we integrate all three concepts
in one problem to alert students to the interrelationships among underlying
concepts. They must develop a foundation that enables them to fuse isolated
concepts from different parts of the course into an integrated whole.
Demonstration Problem 5-2 provides a cumulative learning experience. Cover
this problem in class and then assign Exercises 5-1A and 5-3A as homework
assignments.
V. Introduce the concept of opportunity cost and explain why opportunity costs
are relevant in decision making.
We suggest the following example. Brown Manufacturing Company (BMC) is
currently using a building as a manufacturing facility. The building cost $6
million when new, and depreciation on the building is $200,000 per year. The
building is in a location that is experiencing significant growth in retail shopping.
A retail company has offered to rent the manufacturing facility from BMC at a
price of $180,000 per year. What cost is relevant in deciding whether to move the
manufacturing facility to a different location?
Answer: The $180,000 opportunity cost is the relevant cost. It represents the
amount BMC will sacrifice if it chooses to remain in the same location. The
depreciation is a sunk cost that is not relevant.
VI. Introduce the cost classification hierarchy. While this classification scheme
may be unfamiliar at first, you will find it a superior tool for identifying the costs
relevant to a given decision. The four cost categories are:
A. Unit-level: costs incurred to make or sell one unit of a product or service.
Examples include direct materials and direct labor costs.
B. Batch-level: costs incurred to make or distribute a batch (group) of units of a
product. Examples include setup and inspection costs.
C. Product-level: costs incurred to create or support a product or product line.
Examples include legal costs incurred each time a publishing company files
for a new book copyright and engineering costs incurred when an automobile
manufacturer adds a new model to its line. The distinguishing feature is
between new products or more units of existing products.
D. Facility-level: costs incurred to establish and maintain a business facility.
Examples include factory depreciation, maintenance, utilities, and
administrative salaries.
5-4
VII. Discuss the relationships between different types of special decisions and the
above cost classifications.
A. Special order decisions require identifying the relevant costs of making and
selling additional units of an existing product and then comparing these costs
with the incremental sales revenue the company will earn if it accepts the
special order. The quantitative aspect of a special order decision involves
three steps. First, determine the amount of revenue the company will earn by
selling the additional units of product. Next, determine the relevant costs of
making the additional units. Third, compare the incremental revenues to the
additional costs. If the incremental revenues exceed the additional costs, the
quantitative analysis suggests accepting the special order.
What costs must a company consider when deciding whether to sell
additional units of an existing product at a price below the company’s normal
sales price? If the company makes and sells additional units of a product, the
total amount of unit-level costs will differ from what they would be if the
company rejected the special order. Consequently, unit-level costs are
relevant for special order decisions. Batch-level costs may or may not be
relevant to special order decisions. Batch-level costs are not relevant if
expanding production of an existing batch can fill the special order. However,
if the company must produce a separate batch to satisfy the special order,
batch-level costs are relevant because they could be avoided if the special
order were rejected. Because product-level and facility-level costs remain
unchanged regardless of whether a special order is accepted or rejected, they
are not avoidable and therefore are not relevant.
B. Outsourcing decisions require identifying the relevant costs of making a
product internally and then comparing those costs to the cost of outsourcing—
buying the product from an outside supplier. Outsourcing decisions are
frequently called make or buy decisions. Unit-level, batch-level, and productlevel costs are all relevant to outsourcing decisions. In general, these costs are
avoidable if products are outsourced instead of produced internally. Some
product-level costs, however, may not be relevant to an outsourcing decision.
For example, product sales commissions are incurred regardless of whether
the product is manufactured internally or purchased from a third party before
it is sold. Because facility-level costs remain unchanged, they are not
avoidable and therefore are not relevant.
C. Segment elimination decisions require identifying the relevant costs of
operating a business segment and comparing these costs to the revenue
generated by the segment. Unit-level, batch-level, product-level, and facilitylevel costs usually are relevant to a segment elimination decision. Some
facility-level costs, however, may not be relevant. For example, certain
corporate-level facility costs may be incurred even if a segment of a company
is eliminated. Such facility-level costs are not avoidable and are therefore not
relevant.
5-5
D. Asset replacement decisions require identifying the relevant costs of
operating existing assets and comparing these costs to the costs of operating
new, replacement assets. A company should choose the lowest cost option.
VIII. Work an example of each type of special decision problem.
A. Recall that Demonstration Problem 5-1 involved a special order decision.
Exercise 5-6A in the textbook provides a good follow-up problem. You
should be able to assign this exercise without providing any introduction.
You could have the students compare their answers with members of their
group. If you are short of time, you may simply provide the answer.
B. Provide a brief explanation of a make or buy decision. Explain that unit-level,
batch-level, and some product-level costs are relevant to outsourcing
decisions. Use Exercise 5-12A as an example. This exercise includes the
effect of an opportunity cost. You may choose to work the exercise as a
demonstration problem or let students attempt it on their own as you circulate
through the room. By seeking help from you or their group members most
students are able to complete this problem. While letting students discover
concepts themselves is a highly effective teaching approach, it does require
considerable class time. The extent to which you choose to intervene is a
matter of personal style.
C. Provide a brief explanation of a segment elimination decision. Use Exercise
5-15A as a demonstration problem.
D. Provide a brief explanation of an asset replacement decision. Use Exercise 518A as a demonstration problem.
5-6
Summary Outline of a Lesson Plan for Chapter 5
I. Use Demonstration Problem 5-1 as a problem-based learning exercise. Have
students work in their groups to complete the problem requirement.
II. Engage students in a discussion regarding their groups’ decision.
III. Introduce the concept of relevance. To be relevant a cost must (1) differ
between the alternatives and (2) be future-oriented.
IV. Distinguish between product costing, cost behavior, and relevance.
The text has thus far introduced three key concepts: (1) product costing, (2) cost
behavior, and (3) relevance. Demonstration Problem 5-2 is designed to directly
compare and contrast these three concepts. Exercises 5-1A and 5-3A may be
assigned as homework.
V. Introduce the concept of opportunity cost and explain why opportunity costs
are relevant.
VI. Introduce the cost classification hierarchy. The four cost categories are:
A. Unit-level: costs incurred to make or sell one unit of a product or service.
B. Batch-level: costs incurred to make or distribute a batch (group) of units of a
product.
C. Product-level: costs incurred to create, sustain, or sell a product or product
line. The distinguishing feature here is between new products or more units of
existing products.
D. Facility-level: costs incurred to establish and maintain a business facility.
VII. Discuss the relationships between different types of special decisions and the
above cost classifications.
VIII. Work an example of each type of special decision problem.
A. Use Exercise 5-6A as an example of a special order decision.
B. Use Exercise 5-12A as an example of an outsourcing decision.
C. Use Exercise 5-15A as an example of a segment elimination decision.
D. Use Exercise 5-18A as an example of an asset replacement decision.
5-7
Quiz Questions for Chapter 5
Use the following information to answer the next three questions.
Harker Manufacturing (HM) has the capacity to produce 10,000 fax machines per year.
HM currently produces and sells 7,000 units per year. The fax machines normally sell
for $100 each. Modem Products has offered to buy 2,000 fax machines from HM for $60
each. Unit-level costs associated with manufacturing the fax machines are $15 each for
direct labor and $40 each for direct materials. Product-level and facility-sustaining costs
are $50,000 and $65,000, respectively.
1.
What is HM's current profit (net income)?
a. $115,000
b. $120,000
c. $200,000
d. $315,000
2.
How much would profit increase (decrease) if HM accepted this special order?
a. $10,000
b. $112,000
c. ($10,000)
d. ($112,000)
3.
Should HM accept the special offer?
a. yes, unequivocally
b. no, unless there are qualitative factors that favor accepting the offer.
c. yes, if qualitative factors are favorable.
d. no, because GAAP requires all costs to be included in the product
Use the following information to answer the next two questions.
Based on the segment income statement below, Gourmet Sorbet is considering
eliminating its Mango Tango line.
Revenue from Mango Tango sales
Salaries for Mango Tango workers
Direct material
Sunk costs (equipment depreciation)
Allocated company-wide facility-sustaining
costs
Net loss
4.
$500,000
(100,000)
(300,000)
(75,000)
(50,000)
$ (25,000)
The amount of relevant costs in this decision situation are
a. $400,000.
b. $475,000.
c. $525,000.
d. $550,000.
5-8
5.
If Mango Tango were eliminated, profitability would
a. increase by $25,000.
b. increase by $525,000.
c. decrease by $25,000.
d. decrease by $100,000.
6.
To be relevant in decision making, information must
a. differ among the alternatives.
b. make a difference in a decision.
c. be future oriented.
d. all of the above.
7.
GOGO Golf carts currently produces its own electric motors. Electrico has offered
to sell the electric motors to GOGO at a price of $300 each.
Current production information follows:
Unit-level material and labor
Facility-level depreciation of manufacturing equip.
Product-level supervisor's salary
Annual facility-level utilities
$175
$1,000/month
$2,000/month
$1,500
GOGO is currently operating profitably producing 2,000 motors a year using 83%
of its manufacturing capacity. If GOGO stops producing the motors, the productline supervisor would continue to be employed by the company. Which of the
following is true?
a. GOGO should buy the motors for cost savings of $113 per unit.
b. GOGO should continue producing the motors.
c. GOGO has relevant costs of greater than $300 a unit and should buy.
d. GOGO will save $226,000 by producing the motors.
8.
A cost that is not affected by later decisions is called a(n)
a. replacement cost.
b. historical cost.
c. opportunity cost.
d. sunk cost.
9.
A condensed income statement for Tramco follows: (amounts are shown in
thousands)
Products
Sales (total)
Unit-level Variable Cost
(total)
Contribution Margin
Facility-Level Fixed Cost
Income (Loss)
F
$200
(120)
G
$180
(160)
H
$320
(200)
Total
$700
(480)
80
(25)
$ 55
20
(30)
$(10)
120
(40)
$ 80
220
(95)
$125
5-9
Tramco’s management is considering whether to discontinue manufacturing
product G at the beginning of the next year. Doing so will have no effect on
total fixed costs and no effect on the sales or variable costs of products F and H.
The change in income that would result from discontinuing product G is
a. $10,000 increase
b. $10,000 decrease
c. $20,000 decrease
d. $30,000 increase
10. Jason Company is considering replacing equipment that originally cost $600,000.
The new equipment costs $500,000, and the old equipment can be sold for
$220,000. What is the sunk cost in this situation?
a. $600,000
b. $380,000
c. $220,000
d. $500,000
11. Tom's Toolery is operating at 80% of its productive capacity. It is currently
purchasing for $20 each a part used in its manufacturing operation. Tom's estimates
it could make the part internally for a total cost of $24 per unit, consisting of $18 of
unit-level production costs and $6 of facility-level costs that are currently attributed
to other products. Tom’s usually purchases 50,000 units of the part each year.
These units could be manufactured using Tom’s excess capacity. What is the
differential increase or decrease in costs derived from making the part rather than
purchasing it?
a. $100,000 cost decrease in costs
b. $100,000 cost increase in costs
c. $200,000 cost increase in costs
d. $1,000,000 cost increase in costs
5-10
Solutions to Quiz Questions
Question
Answer
1
2
3
4
5
6
7
8
9
10
11
C
A
C
A
D
D
B
D
C
A
A
5-11
Demonstration Problems for Chapter 5
Demonstration Problem 5-1 Special Order
Davis Driveways, Inc. (DDI) pours concrete driveways for single family homes. DDI uses a cost-plus
pricing approach. The company’s accountant prepared the following report showing how DDI
established the price per driveway at $350.
Davis Driveways, Inc.
Cost Plus Pricing Policy
Materials
Labor
Overhead*
Total
Desired Profit
Price
$100
120
80
$300
50
$350
*Annual overhead cost for rent on the corporate office and supervisory
salaries is $80,000. Normal volume is 1,000 driveways per year.
Overhead cost per unit is determined as $80,000 / 1,000 units = $80 per
unit. The relevant range is from 800 to 1,500 units.
A new builder in town, Rachel Rodgers, has acquired a large tract of land upon which
she intends to build 200 single family homes. Ms. Rodgers offers to purchase all 200
driveways from DDI. However, she is willing to pay only $250 per driveway.
Required
Assume your group is a management team responsible for deciding whether to accept or
reject Ms. Rodgers’ offer. Develop a response, support your decision with appropriate
computations, and choose a spokesperson to explain your answer.
5-12
Demonstration Problem 5-2 Contrast Relevance, Cost Behavior,
and Cost Type
Pass Fast, Inc. is considering two alternative locations in which to conduct its CPA
review course. One alternative is an exclusive hotel; the other is a moderately priced
training facility. The hotel is in a central location easily accessible to potential students.
The training facility is in a less desirable location. Pass Fast has gathered the following
cost data regarding the two locations.
Cost Items
Rental Fee for Classroom
Twenty Advertising Brochures Distributed to
each Student for Referrals
Cost of Instruction
Books (per student)
Refreshments (per student)
Depreciation on Instructional Equipment
Training
Cost
Product
Hotel Facility Relevant? Behavior or GS&A
$2,000 $1,500
250
5,000
100
5
400
250
5,000
100
4
400
Required
a. In the column titled “Relevant?” indicate whether each cost is relevant (Yes) or not
relevant (No) to deciding which facility to rent for the course.
b. In the column titled “Cost Behavior” indicate whether each cost is fixed, variable, or
mixed relative to the number of students attending the course.
c. In the column titled “Product or GS&A” indicate whether each cost would be
classified as a product cost or a general, selling, and administrative (GS&A) cost.
5-13
Demonstration Problem 5-1 Solution
From a quantitative standpoint, DDI should accept the offer. By
not accepting, DDI would avoid the $220 per driveway cost of
materials and labor ($100 materials + $120 labor). The overhead
cost is not relevant to the decision because it cannot be
avoided. It will be incurred whether the offer is accepted or
rejected. The avoidable cost of $220 is less than the incremental
revenue of $250. Accepting the offer will contribute $6,000
[($250  $220) x 200 driveways)] to DDI’s profit. This conclusion
is based solely on quantitative considerations. DDI must also
consider qualitative issues before making a final decision.
Demonstration Problem 5-2 Solution
Product
Training
Cost
or
Cost Items
Hotel Facility Relevant? Behavior GS&A
Rental Fee for Classroom $2,000 $1,500
Yes
Fixed Product
Twenty Advertising
Brochures Distributed to
250
250
No
Variable GS&A
each Student for
Referrals
Cost of Instruction
5,000
5,000
No
Fixed Product
Books (per student)
100
100
No
Variable Product
Refreshments
5
4
Yes
Variable Product
(per student)
Depreciation on
No
Instructional
400
400
Fixed Product
(Sunk)
Equipment
5-14
Demonstration Problem 5-1 Work Paper
Demonstration Problem 5-2 Work Paper
Cost Items
Hotel
Rental Fee for Classroom $2,000
Twenty Advertising
Brochures Distributed to
250
each Student for
Referrals
Cost of Instruction
5,000
Books (per student)
100
Refreshments
5
(per student)
Depreciation on
Instructional
400
Equipment
Allocated Portion of
Accounts Receivable
450
Collection Costs
5-15
Product
Training
Cost
or
Facility Relevant? Behavior GS&A
$1,500
250
5,000
100
4
400
500