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ACCTG 312 Relevant
Costs for
decision making
Chapter 11
Relevant costs and revenues
• The relevant financial inputs for decision-making are future cash flows that will differ between the various alternatives being considered.
• Therefore only relevant (incremental/differential) cash flows should be considered.
• Relevant costs and revenues are required for special decision makings.
Not every cost is relevant (e.g. joint costs are not relevant for further
process decision-making).
Examples of decisions using relevant
costs and revenues
1. Special selling price decisions (e.g. less than your regular
price).
2. Decisions on replacement of equipment.
3. Outsourcing (Make or buy)decisions.
4. Discontinuation decisions.
5. Product-mix decisions when capacity constraints exist.
• Decisions should not be based only on items that can be expressed in quantitative terms — qualitative factors must also be considered.
(e.g. reputation, satisfaction, etc.)
Relevant cost of direct materials
• Generally, the relevant cost of direct materials is
replacement cost (e.g. when you have them in stock).
• If direct materials are already owned but would not
be replaced, then the relevant cost is the higher of
current resale value or the value of putting the direct
materials to an alternative use (e.g. making a
different product).
• If direct materials are owned and would not be
replaced and have no resale value or other possible
use, then the relevant cost =0
Direct materials – decision tree
Do you own the
direct materials?
Relevant cost =
purchase price Are the DMs
going to be
replaced?
Do the DMs have an
alternative use?
Relevant cost
= purchase price
Relevant cost
= scrap value
Relevant cost = higher of
alternative use value
or scrap value
Yes
No Yes
No Yes
No
Special pricing decisions
Special pricing decisions are typically one-time only orders and/or orders below the prevailing market price.
Example 1 (A short-term order) Monthly capacity for a department within a company = 50,000 units Expected monthly production and sales for next quarter at normal selling
price of $40 for 35,000 units are as follows: $ (total) $ (unit) Labour (fixed in short-term) 420,000 12 Variable costs 350,000 10 Manufacturing non-variable overheads 280,000 8 Marketing and distribution costs 105,000 3 Total costs 1,155,000 33 Sales 1,400,000 40 Profit 245,000 7 The excess capacity is temporary and a company has offered
to buy 3,000 units each month for the next three months at a price of $20 per unit. Extra selling costs for the order would be $1 per unit.
Example 1 cont.
• Evaluation of the order ($’s monthly costs and revenues)
(1) (2) (3)
Do not Accept Difference
accept order order (Relevant
costs)
Labour 420,000 420,000
Variable costs 350,000 380,000 30,000
Manufacturing non-
variable overheads 280,000 280,000
Extra selling costs 3,000 3,000
Marketing /dist. costs 105,000 105,000 ______
Total costs 1,155,000 1,188,000 33,000
Sales 1,400,000 1,460,000 60,000
Profit 245,000 272,000 27,000
Total additional profit for three months: $81,000 ($27,000*3)
Relevant costing
Only variable costs, the extra selling costs and sales revenues differ between alternatives and are the only relevant costs/revenues.
Two approaches to presenting relevant costs — Present only columns 1 and 2 or just column 3.
Since relevant revenues exceed relevant costs the order is acceptable subject to the following assumptions:
1. Normal selling price of $40 will not be affected.
2. No better opportunities will be available during the period.
3. The resources have no alternative uses.
4. The fixed costs are unavoidable for the period under consideration.
• Note that the identification of relevant costs depends on the circumstances (e.g. in this question labour costs was fixed and not relevant)
Longer-term decisions
Example 1 (A longer-term order)
• Assume now spare capacity in the foreseeable
future (Capacity = 50,000 units and demand = 35,000
units) and that an opportunity for a contract of
15,000 units per month at $25 SP emerges involving
$1 per unit special selling costs.
• No other opportunities exist so if the contract is not
accepted labour will be reduced by 30%,
manufacturing non-variable costs by $70,000 per
month and marketing by $20,000. Unutilised
facilities can be rented out at $25,000 per month.
Example 1 – longer term
• Evaluation of the order ($’s monthly costs and revenues): (1) (2) (3) Do not accept Accept the Difference orders orders (Relevant
costs) Units sold 35,000 50,000 15,000 $ $ $ Labour 294,000 420,000 126,000 (30%) Variable costs 350,000 500,000 150,000 Manufacturing non- variable overheads 210,000 280,000 70,000 Extra selling costs 15,000 15,000 Marketing/dist.costs 85,000 105,000 20,000 Total costs 939,000 1,320,000 381,000 Revenues-facilities rental 25,000 (25,000) Sales revenues 1,400,000 1,775,000 375,000 Profit 486,000 455,000 (31,000)
Example 1 – longer term
• Company will be better off by $31,000 per month if it
reduces capacity (assuming there are no qualitative
factors).
• In the longer-term all of the above costs and
revenues are relevant.
• Look at important difference between short-term and
long-term decisions: We accepted $20 price for
short-term but didn’t accept $25 price for long-term
Decisions on replacement of equipment The original purchase cost of the old machine, its written down
value (RDW) and depreciation are irrelevant for decision-
making.
Example
WDV of existing machine (remaining life of 3 years) £90,000
Cost of new machine
(expected life of 3 years and zero scrap value) £70,000
Operating costs (£3 per unit old machine)
(£2 per unit new machine)
Output of both machines is 20,000 units per annum
Disposal value of old machine now £40,000
Disposal value of new and old machines
(3 years time) Zero
© 2000 Colin Drury
• Total costs over a 3 year period are as follows:
(1) (2) (3)
Retain Buy Difference
£ £ £
Variable operating costs:
20,000 units at £3
per unit (3 yrs) 180,000
20,000 units at £2
per unit (3 yrs) 120,000 (60,000)
Old machine disposal value (40,000) (40,000)
Initial purchase price
of new machine _______ 70,000 70,000
Total cost 180,000 150,000 30,000
• Note that the depreciation charge is not a relevant cost.
• Columns 1 and 2 or just column 3 can be presented but it
is more meaningful to restate column 3 as follows:
Savings on variable operating costs (3 years) 60,000
Sale proceeds of existing machine 40,000
100,000
Less purchase cost of replacement machine 70,000
Savings on purchasing replacement machine 30,000
Outsourcing (make or buy decisions)
Involves obtaining goods or services from outside
suppliers instead of from within the organization.
Example: A division currently manufactures 10,000 components per annum.
The costs are as follows:
Total (£) Per unit (£)
Direct materials 120,000 12
Direct labour 100,000 10
Variable manufacturing
overhead costs 10,000 1
Fixed manufacturing
overhead costs 80,000 8
Share of non-manufacturing
overheads 50,000 5
Total costs 360,000 36
A supplier has offered to supply 10,000 components per
annum at a price of £30 per unit for a minimum of three
years.
If the components are outsourced the direct labour will be
made redundant.
Direct materials and variable overheads are avoidable and
fixed manufacturing overhead would be reduced by
£10,000 per annum but non-manufacturing costs would
remain unchanged.
The capacity has no alternative uses.
Assuming there is no alternative use of the released
internal capacity arising from outsourcing,
annual costs will be as follows:
(1) (2) (3)
Make Buy Difference
(£) (£) (£)
Direct materials 120,000 120,000
Direct labour 100,000 100,000
Variable manufacturing
overhead 10,000 10,000
Fixed manufacturing
overheads 80 000 70,000 10,000
Non-manufacturing
costs 50,000 50,000
Outside purchase cost incurred/
saved _______300,000 (300,000)
Total costs incurred/
saved 360 000 420 000 (60 000)
Columns 1 and 2 can be presented or just column 3
which shows that the relevant costs of making are
£240,000 (120,000 +100,000 + 10,000 + 10,000)
compared with £300,000 from outsourcing/buying).
Where the released internal capacity arising from
outsourcing can be used to generate rental income
or a profit contribution, the lost income or profit
contribution represents an opportunity cost
associated with making the components.
Assume that the released capacity from outsourcing
enables a profit contribution of £90,000 to be generated.
The relevant costs of making will now be:
Relevant costs (described above) £240,000
Opportunity cost (Lost profit contribution) 90,000
Total relevant costs of making 330,000
Outsourcing is now the cheaper alternative.
330,000 – 300,000 = 30,000 saving
Discontinuation decisions
•Routine periodic profitability analysis by cost objects provides
attention-directing information that highlights those potential
unprofitable activities that require more detailed (special studies).
•Assume the periodic profitability analysis of sales territories reports the
following:
Southern Northern Central Total
£000 £000 £000 £000
Sales 900 1,000 900 2,800
Variable costs (466) (528) (598) (1,592)
Fixed costs (266) (318) (358) (942)
Profit/(Loss) 168 154 (56) 266
• Assume that special study indicates that £250,000 of Central fixed
costs and all variable costs are avoidable and £108,000 fixed costs
are unavoidable if the territory is discontinued. (you may think
closing Central division improves your total profit by 56000 but you
need to look at relevant information for such a decision as follows):
• The relevant financial information is as follows:
Keep Central Discontinue Difference
open Central
£000 £000 £000
Variable costs 1,592 994 598
Fixed costs 942 692 250
Total costs to be assigned 2,534 1,686 848
Reported profit 266 214 52
Sales 2,800 1,900 900
Columns 1 and 2 can be presented or just column 3 which
shows that the relevant revenues arising from keeping the
territory open are £900,000 and the relevant (incremental)
costs are £848,000. Therefore Central provides a
contribution of £52,000 towards fixed costs and profits.
Workshop 1
Q1: Foster Industries manufactures 20,000 components per year. The manufacturing
cost of the components was determined as follows:
Direct materials $150,000
Direct labour 240,000
Variable manufacturing overhead 90,000
Fixed manufacturing overhead _120,000
Total $600,000
An outside supplier has offered to sell the component for $25.50
per unit.
Required:
A: What is the effect on income if Foster Industries purchases
the component from the outside supplier?
B: Assuming that Foster Industries is able to rent out its
manufacturing facilities for $45,000, what is the effect on
income if Foster purchases the component from the outside
supplier?
Workshop 2 Q2: Miller Company produces speakers for home stereo units. The
speakers are sold to retail stores for $30. Manufacturing and other
costs are as follows:
Variable costs per
unit:
Fixed costs per month:
Direct materials $ 9.00 Factory overhead $120,000
Direct labour 4.50 Selling and admin. __60,000
Factory overhead 3.00 Total $180,000
Distribution __1.50
Total $18.00
The variable distribution costs are for transportation to the retail
stores. The current production and sales volume is 20,000 per year.
Capacity is 25,000 units per year.
Workshop 2
Required:
• A: Tennessee manufacturing firm has offered a one-year contract to supply speaker parts at a cost of $6.00 per unit. If Miller Company accepts the offer, it will be able to reduce variable costs by 30 percent and rent unused space to an outside firm for $18,000 per year. All other information remains the same as the original data. What is the effect on profits if Miller Company buys from the Tennessee firm?
• B: San Diego wholesaler has proposed to place a special one-time order of 10,000 units at a reduced price of $24 per unit. The wholesaler would pay all distribution costs, but there would be additional fixed selling and administrative costs of $3,000. All other information remains the same as the original data. What is the effect on profits if the special order is accepted?
Workshop 2
Required:
• C: An Atlanta wholesaler has proposed to place a special
one-time order for 7,000 units at a special price of $25.20 per
unit. The wholesaler would pay all distribution costs, but
there would be additional fixed selling and administrative
costs of $6,000. In addition, assume that overtime
production is not possible and that all other information
remains the same as the original data. What is the effect on
profits if the special order is accepted?
• D: The speakers are currently unpackaged. Packaging them
individually would increase costs by $1.20 per unit.
However, the units could then be sold for $33.00. All other
information remains the same as the original data. What is
the effect on profits if Miller Company packages the
speakers?
Workshop 3
Q3: The operations of Smits Ltd. are divided into the Childs Division and
the Jackson Division. Projections for the next year are as follows:
Childs Jackson
Division Division Total
Sales $250,000 $180,000 $430,000
Variable costs __90,000 _100,000 _190,000
Contribution margin $160,000 $ 80,000 $240,000
Direct fixed costs __75,000 __62,500 _137,500
Segment margin $ 85,000 $17,500 $102,500
Allocated common costs __35,000 __27,500 __62,500
Operating income (loss) $ 50,000 $(10,000) $ 40,000
A: What is the operating income for Smits Ltd. as a whole if the Jackson
Division were dropped (assuming that direct fixed costs for the division
can be avoided)?
Workshop 4
Q4: The operations of Knickers Ltd. are divided into the Pacific Division and
the Bulls Division. Projections for the next year are as follows:
Pacific Bulls
Division Division Total
Sales $420,000 $252,000 $672,000
Variable costs _147,000 _115,500 _262,500
Contribution margin $273,000 $136,500 $409,500
Direct fixed costs _126,000 _105,000 _231,000
Segment margin $147,000 $ 31,500 $178,500
Allocated common costs __63,000 __47,250 _110,250
Operating income (loss) $ 84,000 $(15,750) $ 68,250
What is the operating income for Knickers Ltd. as a whole if the Bulls
Division were dropped (assuming that direct fixed costs for the division can
be avoided)?
Workshop 5
Q5: The following information relates to Ewing Company's three products:
D E F
Unit sales per month 900 1,400 800
Selling price per unit $6.00 $11.25 $ 7.50
Variable costs per unit _3.00 __9.00 __7.80
Unit contribution margin $3.00 $ 2.25 $(0.30)
Required:
A: Assume that product F is discontinued and the space used to produce product
F is rented for $600 per month. What is the impact on monthly profits?
B: Assume that product F is discontinued and the space is used to produce E.
Product E's production is increased to 2,200 units per month, but E's selling
price of all units of E is reduced to $10.20. What is the impact on monthly
profits?
C: Assume that the selling price of product F is increased to $8.25 with a
reduction in monthly sales to 400 units. What is the impact on monthly profits?
Workshop 6
Q6: Reggie Ltd. manufactures a single product with the following unit costs for
1,000 units:
Direct materials $2,400
Direct labour 960
Factory overhead (30% variable) 1,800
Advertising expenses (50% variable) 900
Administrative expenses (10% variable) ____840
Total per unit $6,900
Recently, a company approached Reggie Ltd. about buying 100 units for $5,100
each. Currently, the models are sold to dealers for $7,800. Reggie Ltd.'s capacity
is sufficient to produce the extra 100 units. No additional selling expenses would
be incurred on the special order.
A: What is the profit earned by Reggie Ltd. on the original 1,000 units?
B: How much will income change if the special order is accepted?
C: If Reggie Ltd. wants to increase its profit only by $18,000 on the special
order, what is the minimum price it should charge per unit?
Workshop 7
1. Junior Company currently buys 30,000 units of a part used to manufacture its
product at $40 per unit. Recently the supplier informed Junior Company that a
20 percent increase will take effect next year. Junior has some additional space
and could produce the units for the following per-unit costs (based on 30,000
units):
Direct materials $16
Direct labour 12
Variable overhead 12
Fixed overhead 10
Total $50
If the units are purchased from the supplier, $200,000 of fixed costs will continue to
be incurred. In addition, the plant can be rented out for $20,000 per year if the
parts are purchased externally.
Required:
• Should Junior Company buy the part externally or make it internally?