Relevant Revenues and Costs

4572 Words Feb 4th, 2013 19 Pages
CHAPTER 2:
RELEVANT REVENUES AND COSTS

The primary goal of a firm is to maximize profits. This implies, of course, that each decision a manager makes is consistent with that goal. Although managers are expected to rely on internally-produced reports, such as balance sheets and income statements, to help them make decisions, most of the information that appears on these statements is period-based rather than decision-based. A balance sheet shows the sum total of a firm’s assets and liabilities at a given point in time. If the firm sold off all of its assets at book value and used the proceeds to pay its liabilities, what remains is owner’s equity: the amount that is owed to shareholders. An income statement is the difference
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If the decision is implemented, revenues will rise from $3,000 to $3,200, or by $200. The $200 increase in revenue is the relevant revenue. Note that the relevant revenue is not simply the revenues generated by the additional 100 boxes. If that were true, revenues would rise by $8 x 100 boxes, or $800. Instead, the relevant revenues incorporate the fact that the 300 boxes that could have been sold for $10 will also be sold for $8. In other words, to sell the additional 100 boxes for $800, the group sacrificed $600 on the first 300 boxes. Hence, the decision caused the group’s revenue to rise by $800 - $600, or $200.
The relevant cost in this example is the change in the group’s cost if the decision to lower the price is implemented. Because each box costs the group $3, if it lowers the price to $8, it will sell 100 additional boxes at a cost of $3, causing costs to rise by $300.
If we compare the relevant revenues with the relevant costs, we can see that the group should not lower its price. If it does, its revenues will rise by $200 whereas its cost will increase by $300. It will be $100 worse off by lowering its price.
This can also be seen by examining total revenues and costs. At a price of $10, the group’s revenue is $10 x 300, or $3,000 and its costs are $3 x 300, or $900, leaving a profit of $2,100. If it charges $8, its revenues will be $3,200 ($8 x 400) and its costs will be equal to $1,200 ($3 x 400), for a
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