Potential Problems in Relevant-Cost Analysis

Managers should avoid two potential problems in relevant-cost analysis. First, they must watch for incorrect general assumptions, such as all variable costs are relevant and all fixed costs are irrelevant. In the Surf Gear example, the variable marketing cost of $5 per unit is irrelevant because Surf Gear will incur no extra marketing costs by accepting the special order. But fixed manufacturing costs could be relevant. The extra production of 5,000 towels per month from 30,000 towels to 35,000 towels does not affect fixed manufacturing costs because we assumed that the existing level of fixed manufacturing cost can support any level of production in the relevant range from 30,000 to 45,000 towels per month. In some cases, however, producing the extra 5,000 towels might increase fixed manufacturing costs (and also increase variable manufacturing cost per unit). Suppose Surf Gear would need to run three shifts of 15,000 towels per shift to achieve full capacity of 45,000 towels per month. Increasing monthly production from 30,000 to 35,000 would require a partial third shift (or overtime payments) because two shifts could produce only 30,000 towels. The partial shift would increase fixed manufacturing costs, thereby making these additional fixed manufacturing costs relevant for this decision.

Second, unit-fixed-cost data can potentially mislead managers in two ways:

1. WHEN IRRELEVANT COSTS ARE INCLUDED. Consider the $4.50 of fixed manufacturing cost per unit (direct manufacturing labor, $1.50 per unit, plus manufacturing overhead, $3.00 per unit) included in the $12-per-unit manufacturing cost in the one-time-only special-order decision (see Exhibits 12-4 and 12-5). This $4.50-per-unit cost is irrelevant because this cost will not change if the one-time-only special order is accepted, and so managers should not consider it.
2. WHEN THE SAME UNIT FIXED COSTS ARE USED AT DIFFERENT OUTPUT LEVELS. Generally, managers should use total fixed costs rather than unit fixed costs because total fixed costs are easier to work with and reduce the chance for erroneous conclusions. Then, if desired, the total fixed costs can be unitized. In the Surf Gear example, total fixed manufacturing costs remain at $135,000 even if the company accepts the special order and produces 35,000 towels. Including the fixed manufacturing cost per unit of $4.50 as a cost of the special order would lead managers to the erroneous conclusion that total fixed manufacturing costs would increase to $157,500 $(\mathrm{\$}4.50\text{per towel}\times \text{35,000}\text{towels})\mathrm{.}$

The best way for managers to avoid these two potential problems is to keep focusing on (1) total fixed costs (rather than unit fixed cost) and (2) the relevance concept. Managers should always require all items included in an analysis to be expected total future revenues and expected total future costs that differ among the alternatives.