Chapter 10: Relevant Costs & Benefits

Question 1

what can’t you do in terms of revenue and cost analysis

Answer 1

Can’t just compare all revenues and costs from one option against the revenues and costs of another and deciding

Question 2

what needs to be done in terms of cost and revenue analysis

Answer 2

Need to conduct a relevant cost and benefit analysis

Question 3

what is relevant cost and benefit analysis

Answer 3

its considering what revenues and costs that will change if one alternative is chosen over the other

Question 3

what is incremental revenue

Answer 3

Additional revenue one alternative generates over the other (relevant benefit)

Question 4

what is relevant cost

Answer 4

Revenue lost; the decrease in revenue of one alternative compared to the other (Also considered an opportunity cost)

Question 4

what happens if two alternatives generate the same revenue

Answer 4

then the revenue is not relevant to the analysis

Question 5

what is relevant benefit

Answer 5

Cost saving; the reduction in cost of one alternative compared to the other (avoidable cost)

Question 5

what is incremental cost

Answer 5

Additional cost one alternative incurs over the other (relevant cost)

Question 6

what are unavoidable costs

Answer 6

If two alternatives incur the same costs; they are not relevant to the analysis

Question 7

if revenues decrease compared to its alternative what is it considered

Answer 7

Relevant Cost / Opportunity Cost

Question 7

if revenues increase compared to its alternative what is it considered

Answer 7

Relevant Benefit / Incremental Revenue

Question 8

what is differential revenue

Answer 8

Difference in revenues between the two alternatives

Question 9

if there are no changes to revenues compared to its alternative what is it considered

Answer 9

Irrelevant

Question 9

Example: ESI is considering to offer luxury women’s accessories but didn’t know if they should do high-end watches or high-end rings
Based on estimates from the sales and FP&A teams:
Revenue of watches = $3M
Revenue of rings = $2.5
Both options requires secure storage costing $50k annually
Watches requires additional $5k annual maintenance cost to ensure batteries are at 100% charge when sold
ESI has display cases that can be used to store both watches or rings

from the watches perspective, what would be the incremental revenue

Answer 9

an incremental revenue of $0.5M (more than the rings)

Question 10

if costs increase compared to its alternative what is it considered

Answer 10

Relevant Cost / Incremental Cost

Question 10

if costs decrease compared to its alternative what is it considered

Answer 10

Relevant Benefit / Avoidable Cost

Question 10

if there are no changes to costs compared to its alternative what is it considered

Answer 10

Irrelevant / Unavoidable Cost

Question 10

Example: ESI is considering to offer luxury women’s accessories but didn’t know if they should do high-end watches or high-end rings
Based on estimates from the sales and FP&A teams:
Revenue of watches = $3M
Revenue of rings = $2.5
Both options requires secure storage costing $50k annually
Watches requires additional $5k annual maintenance cost to ensure batteries are at 100% charge when sold
ESI has display cases that can be used to store both watches or rings

what is a relevant benefit between the 2 options

Answer 10

Watches have a relevant benefit because they have an incremental revenue of $0.5M more than rings

Question 11

Example: ESI is considering to offer luxury women’s accessories but didn’t know if they should do high-end watches or high-end rings
Based on estimates from the sales and FP&A teams:
Revenue of watches = $3M
Revenue of rings = $2.5
Both options requires secure storage costing $50k annually
Watches requires additional $5k annual maintenance cost to ensure batteries are at 100% charge when sold
ESI has display cases that can be used to store both watches or rings

what is a irrelevant cost?

Answer 11

Secure storage is irrelevant/unavoidable cost since it’s required and costs the same for both options

Question 11

Example: ESI is considering to offer luxury women’s accessories but didn’t know if they should do high-end watches or high-end rings
Based on estimates from the sales and FP&A teams:
Revenue of watches = $3M
Revenue of rings = $2.5
Both options requires secure storage costing $50k annually
Watches requires additional $5k annual maintenance cost to ensure batteries are at 100% charge when sold
ESI has display cases that can be used to store both watches or rings

what is a relevant cost?

Answer 11

Watches have a relevant/incremental cost, having $5k more compared to the rings due to maintenance

Question 11

when would revenues be irrelevant to the analysis

Answer 11

If the revenues for both options were the same

Question 12

what is differential cost

Answer 12

Difference in costs between the two alternatives

Question 12

when is differential costs irrelevant to the analysis

Answer 12

if they were the same under both options

Question 12

what are sunk costs

Answer 12

• Costs that have already been incurred and wouldn’t affect any decision now or in the future
• are irrelevant to the analysis

Question 12

Example: ESI is considering to offer luxury women’s accessories but didn’t know if they should do high-end watches or high-end rings Based on estimates from the sales and FP&A teams: Revenue of watches = $3M Revenue of rings = $2.5 Both options requires secure storage costing $50k annually Watches requires additional $5k annual maintenance cost to ensure batteries are at 100% charge when sold ESI has display cases that can be used to store both watches or rings what is a sunk cost?

Answer 12

- The display cases are sunk costs, and irrelevant to the analysis - If new display cases needed to be bought, they would be relevant or not based on if the cost of the display cases would differ between the two options

Question 12

Example: ESI is considering to offer luxury women’s accessories but didn’t know if they should do high-end watches or high-end rings Based on estimates from the sales and FP&A teams: Revenue of watches = $3M Revenue of rings = $2.5 Both options requires secure storage costing $50k annually Watches requires additional $5k annual maintenance cost to ensure batteries are at 100% charge when sold ESI has display cases that can be used to store both watches or rings from the rings perspective, what would an opportunity cost

Answer 12

it would be an opportunity cost of $0.5M (less than the watches)

Question 13

what are the steps to identify what is relevant and not

Answer 13

1. Eliminate irrelevant costs (unavoidable and sunk costs), and those costs and benefits that are the same across all alternatives 2. Make the decision based on an analysis of the relevant costs and benefits remaining

Question 13

Example: After graduating from university, you bought a small condo Mortgage = $2k per month Want to go on a month-long vacation to Croatia and want to know if $5k in savings is enough to fund the trip Decide you will only go on the trip if you can pay for it in full with the savings Monthly income = $5k ($1,250 would be unpaid; only have 3 weeks of paid vacation) monthly expenses: utilities = $100 (only $60 if going) groceries = $1k gasoline = $250 (based on regular usage) trip expenses: flight + transportation = $1.5k accommodations = $1.5k food & entertainment = $1k souvenirs = $500 perform the second step of a relevant cost and benefit analysis: what are the avoidable costs

Answer 13

2. Make the decision based on an analysis of the relevant costs and benefits remaining - Utilities of $40 - Would only incur $60 instead of $100 if you go on vacation - So you would be avoiding/saving $40 - Groceries of $1,000 - Wouldn’t need to pay for these at all since you wouldn’t be home - Gasoline of $250 - Won’t be driving while on vacation, so no gas expenses

Question 13

Example: After graduating from university, you bought a small condo Down payment = $100k Want to go on a month-long vacation to Croatia and want to know if $5k in savings is enough to fund the trip Decide you will only go on the trip if you can pay for it in full with the savings Monthly income = $5k ($1,250 would be unpaid; only have 3 weeks of paid vacation) monthly expenses: mortgage = $2k utilities = $100 (only $60 if going) groceries = $1k insurance = $300 gasoline = $250 (based on regular usage) car parking = $100 trip expenses: flight + transportation = $1.5k accommodations = $1.5k food & entertainment = $1k souvenirs = $500 perform the first step of a relevant cost and benefit analysis

Answer 13

1. eliminate irrelevant costs (unavoidable and sunk costs), and those costs and benefits that are the same across all alternatives Unavoidable costs: Costs that don’t change regardless if you take the trip or not - Mortgage - Insurance - Car parking Sunk Costs: Costs made before the decision and won’t affect the vacation decision - Condo down payment

Question 13

Example: After graduating from university, you bought a small condo Mortgage = $2k per month Want to go on a month-long vacation to Croatia and want to know if $5k in savings is enough to fund the trip Decide you will only go on the trip if you can pay for it in full with the savings Monthly income = $5k ($1,250 would be unpaid; only have 3 weeks of paid vacation) monthly expenses: utilities = $100 (only $60 if going) groceries = $1k gasoline = $250 (based on regular usage) trip expenses: flight + transportation = $1.5k accommodations = $1.5k food & entertainment = $1k souvenirs = $500 perform the second step of a relevant cost and benefit analysis: what are the incremental costs

Answer 13

2. Make the decision based on an analysis of the relevant costs and benefits remaining Incremental costs: costs that increase if you take the vacation - Lost of income of $1,250 - Cost of a week of unpaid vacation - Would’ve earned this amount if you don’t go on the trip - Trip expenses of $4,500 - All trip expenses are incremental, since they won’t exist if you don’t go

Question 13

Example: After graduating from university, you bought a small condo Down payment = $100k Want to go on a month-long vacation to Croatia and want to know if $5k in savings is enough to fund the trip Decide you will only go on the trip if you can pay for it in full with the savings Monthly income = $5k ($1,250 would be unpaid; only have 3 weeks of paid vacation) monthly expenses: mortgage = $2k utilities = $100 (only $60 if going) groceries = $1k insurance = $300 gasoline = $250 (based on regular usage) car parking = $100 trip expenses: flight + transportation = $1.5k accommodations = $1.5k food & entertainment = $1k souvenirs = $500 arrange the costs and benefits to compare

Question 13

Example: After graduating from university, you bought a small condo Down payment = $100k Mortgage = $2k per month Want to go on a month-long vacation to Croatia and want to know if $5k in savings is enough to fund the trip Decide you will only go on the trip if you can pay for it in full with the savings Monthly income = $5k ($1,250 would be unpaid; only have 3 weeks of paid vacation) will you go on the trip?

Answer 13

- Based on the relevant cost and benefit analysis, the total relevant cost of taking the vacation is $4,460 - Since you have $5,000 in savings, you have enough to fund the entire vacation

Question 13

what are the different ways relevant and cost benefit analysis is used for (for a company)

Answer 13

- deciding to keep or drop a product or business segment - choosing office locations - accepting or rejecting a special order

Question 13

what is the formula for deciding to continue or discontinue a product or business segment

Answer 13

Continue/(Discontinue) = CM Lost - (Fixed Costs Avoided + CM gained elsewhere) - If CM lost > fixed costs + CM gained from other products/segments, the product/segment should be kept - If CM lost < fixed costs + CM gained from other products/segments, the product/segment should be discontinued

Question 14

when doing a relevant cost and benefit analysis, what would be irrelevant costs that are included when deciding whether to keep a product or business segment

Answer 14

irrelevant costs can include those that would be incurred regardless of whether a product continued to be sold or sunk costs that have already been incurred to open a store, even if it ends up being closed

Question 14

what are relevant benefits that exists for when doing analysis for choosing office locations

Answer 14

- Incremental revenue: from new sales in the geographical territory of the new location - Variable and fixed costs avoided: if status quo location is closed/lease terminated

Question 14

what is something choosing office locations might not always include

Answer 14

- relevant benefits - incremental revenues and/or no cost savings to be compared to the pre-decision position

Question 14

what are some examples relevant benefits when deciding to keep or drop a product or business segment

Answer 14

- Fixed costs avoided if a product is discontinued or a store closed - CM gained on other products/segments from repurposing the space previously used for the discontinued product/segment

Question 14

when you are analyzing a keep or drop question what is the perspective you should always approach it from

Answer 14

you always approach it from the perspective of the impact of the discontinuation

Question 14

what are relevant costs that exists for when doing analysis for choosing office locations

Answer 14

- Incremental costs: variable and fixed costs based on each location - Opportunity costs: any potential foregone sales from relocating

Question 14

what are some examples relevant costs when deciding to keep or drop a product or business segment

Answer 14

- CM lost on a discontinued product or segment - Includes lost revenue and savings of variable costs related to the product/segment

Question 15

since making decisions around changing office location won't always include relevant benefits, what is the decision made based on?

Answer 15

- The decision made is based on which option has the lowest costs - If there are benefits that outweigh the relevant costs, that's even better

Question 15

what is a special order

Answer 15

An order that is not within the parameters of what the company would consider normal business operations and is not recurring

Question 16

what are relevant benefits to consider when deciding to accept or reject a special order

Answer 16

Incremental revenue from the order

Question 16

what are relevant costs to consider when deciding to accept or reject a special order

Answer 16

- Incremental costs; variable and fixed costs of accepting the order - Opportunity costs of accepting the order; potentially foregone sales of other products to accommodate the special order

Question 16

what is the formula used to help determine if a special order should be accepted or rejected

Answer 16

Incremental Revenue - Total Relevant Costs = Accept/(Reject) Special Order - If incremental revenue > total relevant costs associated with the order, the special order should be accepted - If incremental revenue < total relevant costs associated with the order, the special order should not be accepted