Question

Relevant Costs in Short-Term Decision Making

Your friend is also in this same class. He says, “The topic on relevant costs is easy……..all you have to know is that variable costs are always relevant, and fixed costs are always irrelevant.”

REQUIRED:

Is his statement about variable costs correct? (Answer Yes or No)

Is his statement about fixed costs correct? (Answer Yes or No)

Provide one example to support your answer concerning variable costs in #1

Provide one example to support your answer concerning fixed costs in #2.

Answer 1

True ... Future costs that do not differ between the alternatives in a decision are avoidable costs. Sunk costs and future costs that do not differ between the alternatives may or may not be relevant in a decision. Variable costs are always relevant costs in decisions.

Fixed costs are irrelevant! (to pricing)

Your price should be determined by how much your customers are willing to pay. Their willingness to pay is driven by the amount of value they get for your product. That value is determined by what else they would do with their money and the incremental benefit your product or service provides. Their willingness to pay does not change if you have higher R&D costs. Your fixed costs don’t matter.

Variable costs do matter. What if a prospect’s willingness to pay is less than your variable costs? Then don’t sell to him or her. Sometimes, especially in a retail setting, you only get to set one price for many prospects with different willingnesses to pay. In this case variable costs matter because you are trading off additional marginal profit per unit sold against the marginal profit of lost sales. Marginal profit is price minus variable cost. (OK, I’ve re-read and re-written this paragraph many times and still can’t make it easy to understand. Trust me that variable costs are relevant when setting prices.)

Fixed costs DO matter, just not to pricing. Fixed costs matter when you decide whether or not to get into a business. This may be easiest to understand by looking at a video game company. EA spends millions of dollars to develop a new video game. Those millions of dollars are fixed costs. Should they spend that money on developing a new video game? It all depends on how much profit they expect that game to generate. They estimate the price they can get, the expected demand, and their variable costs. Using simple math, they estimate how many profit dollars they can generate and compare that to the amount of the fixed costs. Then they decide whether or not to invest the dollars into fixed costs.

Example

ABC Company is currently using a machine it purchased for $50,000 two years ago. It is depreciated using the straight-line depreciation over its useful life of 10 years. The company is contemplating on buying a machine worth $80,000. The new machine will have a useful life of 8 years. Though units produced will stay the same, the company expects a significant decrease in variable costs from $68,000 to $50,000, annually. Fixed costs other than depreciation expense will remain at $40,000.

Analysis:

a.) The depreciation of the old machine, $5,000, is irrelevant since the company will continue to depreciate the machine until the end of its useful life. Whether the company purchases the new equipment or not, it will still incur the $5,000 depreciation. Take note that the company has already paid for the old machine (a sunk cost).

b.) The depreciation of the new machine, $10,000, is relevant since the company will incur such cost only when it decides to buy the new machine.

c.) The variable costs are relevant since the total variable cost will be different if the company chooses to replace the machine. The company will save $18,000.

d.) The other fixed costs of $40,000 are irrelevant since it will not differ under the two choices.

e.) After analyzing the relevant costs, the company will have net annual savings of $8,000. The company will be able to decrease its variable costs by $18,000 but will incur in incremental costs of $10,000 due to increase in depreciation.