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AE11 Man Econ Module 3-4
AE11 Man Econ Module 3-4
Explain the three behavior of cost namely fixed, variable and semi-fixed or semi-variable cost.
Describe the importance of CVP analysis as a managerial accounting technique
Explain the Contribution Margin (CM) Ratio and variable cost ratio, Break-even point (in pesos or
units), Margin of safety, Changes in net income, and the Degree of operating leverage
Explain the basic cost-volume-profit assumptions and limitations
Analyze business decision using cost-volume-profit analysis
WARM-UP (PRE-ACTIVITY)
After performing the Warm-up Section, evaluate yourself by placing a check mark on the column that
best describes your ability to describe your visual understanding. There are no wrong answers in this
section.
3 2 1 0
TOTAL
5-6 Proficient
1-2 Developing
0 Beginning
LECTURE NOTES (INPUT)
CHAPTER 3
In this chapter, we will discuss in detail the behavior of cost for you understand better the CVP analysis.
Fixed costs remain constant (in total) over some relevant range of output. Depreciation, insurance, property
taxes, and administrative salaries are examples of fixed costs. Recall that so-called fixed costs are fixed in the
short run but not necessarily in the long run.
For example, a local high-tech company did not lay off employees during a recent decrease in business volume
because the management did not want to hire and train new people when business picked up again.
Management treated direct labor as a fixed cost in this situation. Although volume decreased, direct labor costs
remained fixed.
Variable costs vary (in total) directly with changes in volume of production or sales. In particular, total variable
costs change as total volume changes. If pizza production increases from 100 10-inch pizzas to 200 10-inch
pizzas per day, the amount of dough required per day to make 10-inch pizzas would double. The dough is a
variable cost of pizza production. Direct materials and sales commissions are variable costs.
Direct labor is a variable cost in many cases. If the total direct labor cost increases as the volume of output
increases and decreases as volume decreases, direct labor is a variable cost. Piecework pay is an excellent
example of direct labor as a variable cost. In addition, direct labor is frequently a variable cost for workers paid
on an hourly basis, as the volume of output increases, more workers are hired. However, sometimes the nature
of the work or management policy does not allow direct labor to change as volume changes and direct labor can
be a fixed cost.
Mixed costs have both fixed and variable characteristics. A mixed cost contains a fixed portion of cost incurred
even when the facility is idle, and a variable portion that increases directly with volume. Electricity is an
example of a mixed cost. A company must incur a certain cost for basic electrical service. As the company
increases its volume of activity, it runs more machines and runs them longer. The firm also may extend its hours
of operation. As activity increases, so does the cost of electricity.
Managers usually separate mixed costs into their fixed and variable components for decision-making purposes.
They include the fixed portion of mixed costs with other fixed costs, while assuming the variable part changes
with volume. (See Chapter 2)
Cost-Volume-Profit Analysis (CVP analysis), also commonly referred to as Break-Even Analysis, is a way for
companies to determine how changes in costs (both variable and fixed) and sales volume affect a
company’s profit. With this information, companies can better understand overall performance by looking at
how many units must be sold to break even or to reach a certain profit threshold or the margin of safety.
Components of CVP Analysis
There are several different components that together make up CVP analysis. These components involve various
calculations and ratios, which are broken down below:
Consider the following example in order to calculate the five important components listed above.
CM ratios and variable expense ratios are numbers that companies generally want to see to get an idea of how
significant variable costs are.
A high CM ratio and a low variable expense ratio indicate low levels of variable costs incurred.
The break-even point (BEP), in units, is the number of products the company must sell to cover all production
costs. Similarly, the break-even point in pesos is the number of sales the company must generate to cover all
production costs.
It is quite common for companies to want to estimate how their net income will change with changes in sales
behavior. For example, companies can use sales performance targets or net income targets to determine their
effect on each other.
In this example, if management wants to earn a profit of at least Php100,000, how many units must the
company sell?
( = P240,000 +P100,000}/15
Therefore, to earn at least Php100,000 in net income, the company must sell at least 22,666 units.
In addition, companies may also want to calculate the margin of safety. This is commonly referred to as the
company’s “wiggle room” and shows by how much sales can drop and yet still break even.
This margin can also be calculated as a percentage in relation to actual sales: 240,000/1,200,000 = 20%.
Therefore, sales can drop by $240,000, or 20%, and the company is still not losing any money.
Finally, the degree of operating leverage (DOL) can be calculated using the following formula:
The DOL number is an important number because it tells companies how net income changes in relation to
changes in sales numbers. More specifically, the number 5 means that a 1% change in sales will cause a
magnified 5% change in net income.
Many might think that the higher the DOL, the better for companies. However, the higher the number, the
higher the risk, because a higher DOL also means that a 1% decrease in sales will cause a magnified, larger
decrease in net income, ultimately decreasing its profitability.
Other Methods used to determine BEP
Break-even Chart
A break-even chart is a graph which plots total sales and total cost curves of a company and shows that the
firm’s breakeven point lies where these two curves intersect. The break-even point is defined as the
output/revenue level at which a company is neither making profit nor incurring loss. For a company to make
zero profit, its total sales must equal its total costs. When sales are higher than total costs, it earns a profit but
when total costs are higher than total sales, it loses money. A break-even chart visualizes the whole relationship
and makes it easier to follow the break-even point.
A break-even chart is constructed such that units are plotted on the x-axis and revenue/cost on y-axis. It is
useful only when the production is inside the relevant range i.e. output bracket in which fixed costs do not
change.
Example:
Let’s consider a cab company which charges Php5 per kilometer. Its fixed costs are Php200,000 per cab per
annum and its variable operating costs are Php3 per kilometer. Let’s find the minimum number of kilometers
which the cabs must be plied or the company will suffer a loss.
Using the data above, we can write the following equations for total revenue and total costs:
TR= Php5 x Q = 5Q
TC=FC+VC
TC=Php200,000+Php3xQ
TC=Php200,000+3Q
By plugging different Q values, we can create a table of total revenue and total costs, which may be bifurcated
into total variable costs and total fixed costs.
1 5 200,003 3 200,000
Php
p
The break-even point is this example is 100,000 units because it is the output level at which the total revenue
and total cost curves intersect.
At any point below the break-even point, the company is incurring losses equal to the red-shaded area and at
any point above 100,000 units, the company is making profit as represented by the blue-shaded area.
ALTERNATIVE APPROACHES TO BEP AND SALES WITH DESIRED PROFIT: (SINGLE PRODUCT)
Formulae:
SDPBT = Sales with Desired Profit Before Tax
SDPAT = Sales with Desired Profit After Tax
Illustrations:
A - Single product
MHO Corporation, which produces product Y, has the following data for 200C:
REQUIRED: Compute:
Solutions:
1. BEP Sales = FC (P500,000)
CM% (25%)
= P2,000,000
2. SDPBT = FC + DPBT
CM%
= P500,000 + P1,000,000
25%
= P6,000,000
SDPBT Units = FC + DPBT
CMU
= P1,500,000
P50
= 30,000 units
3. SDPAT = FC + DPAT
(1-TR)
CM%
= P500,000 + P680,000
(1-32%)
25%
= P6,000,000
Proof:
Sales (30,000 units @ P200) P6,000,000
Less: Variable costs: (30,000 units @ P150) 4,500,000
Contribution margin (30,000 units @ P50) P1,500,000
Less: Fixed cost 500,000
Profit before tax P1,000,000
Less: Income tax, 32% 320,000
Net profit after tax P 680,000
Although you are likely to use cost-volume-profit analysis for a single product, you will more frequently use it
in multi-product situations. The easiest way to use cost-volume-profit analysis for a multi-product company is
to use dollars of sales as the volume measure. For CVP purposes, a multi-product company must assume a
given product mix or sales mix. Product (or sales) mix refers to the proportion of the company’s total sales for
each type of product sold.
To illustrate the computation of the break-even point for COB Company, a multi-product company that makes
three types of cereal, assume the following historical data (percent is a percentage of sale, for each product, take
the amount / sales and multiply by 100 to get the percentage):
We use the data in the total columns to compute the break-even point. The contribution margin ratio is 40%
(total contribution margin Php40,000/total sales Php100,000). Assuming the product mix remains constant and
fixed costs for the company are Php50,000, break-even sales are Php125,000, computed as follows:
Since what we found in our example for COB Company is a total, we need to determine how much sales
would be needed by each product to break even. To find the three product sales totals, we multiply total sales
dollars by the percent of product (or sales) mix for each of the three products. The product mix for products 1,
2, and 3 is 60:30:10, respectively. That is, out of the Php100,000 total sales, there were sales of Php60,000 for
product 1, Php30,000 for product 2, and Php10,000 for product 3. An easy way to calculate product or sales
mix is to divide each product’s sales by total sales like in the following table:
We can calculate the amount each product needs to sell by multiplying the total break even sales required x the
sales mix for each product. This is calculated as:
Illustration:
NYC, Inc. manufactures and sells products A, B, and C with unit selling prices of P20, P20, and P10,
and with unit variable costs of P13, P9, and P6, respectively. They are sold in the ratio of 3:1:4. Total fixed cost
amounted to P480,000.
The computation of sales mix would be:
A B C Total
Proof:
Product
Total
A B C
Sales P600,000 P200,000 P400,000 P1,200,000
Variable cost 390,000* 90,000** 240,000*** 720,000
Contribution marginP210,000 P110,000 P160,000 P 480,000
Fixed costs 480,000
Net Income P -0- 0
Computations of
Variable Costs:
JFMC, Inc. manufactures and sells products M, N, and O. Other information is presented below:
Products______________
M ___ N ____ O____
Unit selling price P 300 P 100 P 600
Unit variable cost 200 50 450
Fixed cost P500,000 P300,000 P600,000
Sales mix 2 1 3
REQUIRED: Determine:
Proof:
Product
Total
M N O
Sales P3,600,000 P600,000 P10,800,000 P15,000,000
Variable cost 2,400,000* 300,000** 8,100,000*** 10,800,000
Contribution margin P1,200,000 P300,000 P2,700,000 4,200,000
Fixed costs 1,400,000
Profit before tax P2,800,000
Income tax, 32% 896,000
Net Profit after tax P1,904,000
SUMMARY:
By tracking variable, fixed, step, and mixed costs, you get a clear picture of how your costs typically behave,
which helps you when it comes to figuring out per-unit pricing. Because you measure these costs internally and
log them as expenses, you build cost behaviour into your pricing standards behind the scenes. This ensures you
know how much you need to make per unit to break even and make a profit. Having this information on hand
especially helps when you wish to expand your operations.
To measure cost behaviour patterns, you first need to track and categorize your expenses into classifications and
then look for your relevant range, or the spot where revenue and expenses balance exactly as you expect.
Fixed costs include things such as rent, insurance, salaries, and property taxes, which stay constant in your
relative range. In some instances, though, expanding your inventory can drive up these costs. For example, say
your crochet company has one warehouse to store its finished blankets and the rent on the warehouse costs
Php500 per month. By paying a fixed cost of Php500 per month, you have the space to store a set number of
blankets. If you need greater space, your fixed cost of rent may increase.
Variable costs change as the number of products you produce changes. Imagine your small business crochets
blankets. If you need to make more blankets, you must purchase more yarn. In this instance, yarn represents a
variable cost because its final total cost fluctuates depending on many blankets you produce. Because you can
easily control variable coasts, you can slow or stop blanket production to reduce expenses when you reach the
end of your relevant range or the amount of blankets you typically make. In some cases, though, making
products beyond the relevant range drives your price per unit down. For example, this might occur if suppliers
offer you yarn discounts when you purchase larger quantities.
Key calculations when using CVP analysis are the contribution margin and the contribution margin ratio.
The contribution margin represents the amount of income or profit the company made before deducting its fixed
costs. Said another way, it is the amount of sales pesos available to cover (or contribute to) fixed costs. When
calculated as a ratio, it is the percent of sales pesos available to cover fixed costs. Once fixed costs are covered,
the next peso of sales results in the company having income.
CVP analysis is only reliable if costs are fixed within a specified production level. All units produced are
assumed to be sold, and all fixed costs must be stable in a CVP analysis. Our discussion of CVP analysis has
focused on the sales necessary to break even or to reach a desired profit, but two other concepts are useful
regarding our break-even sales. Those concepts are margin of safety and operating leverage.
A company’s margin of safety is the difference between its current sales and its break-even sales. The margin of
safety tells the company how much they could lose in sales before the company begins to lose money, or, in
other words, before the company falls below the break-even point. The higher the margin of safety is, the lower
the risk is of not breaking even or incurring a loss. In order to calculate margin of safety, we use the following
formula:
In much the same way that managers control the risk of incurring a net loss by watching their margin of
safety, being aware of the company’s operating leverage is critical to the financial well-being of the
firm. Operating leverage is a measurement of how sensitive net operating income is to a percentage change
in sales pesos. Typically, the higher the level of fixed costs, the higher the level of risk. However, as sales
volumes increase, the payoff is typically greater with higher fixed costs than with higher variable costs. In
other words, the higher the risk the greater the payoff.
______________________________________________________________________________
The assumptions imposed by accountants in calculating the C VP ratios also serve as the possible limitations of
the technique. Most CVP analyses are based on the concept of static cost.
1. All costs can be classified into two categories: fixed costs and variable costs. This assumption is not
always true because certain costs like depreciation cannot be determined exactly. Different depreciation
methods may yield different results. There is a third category of costs known as ‘semi-variable’ costs.
These costs are also called mixed costs, because part of the cost is fixed and part is variable (for
example, Telephone expenses).
2. All functions-that is, sales, variable costs, and fixed costs-are linear.
3. Fixed costs will not change at all levels of sales within the assumed relevant range of activity.
4. Selling price per unit remains constant.
5. Variable costs vary in direct proportion to changes in activity i.e. as a percentage of sales revenue. They
remain constant.
6. The sales mix is assumed to remain constant if more than one product is sold.
7. The beginning and ending inventory levels are not significantly different.
8. There are no significant fluctuations in the efficiency of the firm’s operations.
9. The projections are over a short period of time only.
The limitations and assumptions of CVP analysis mentioned above impair but do not destroy the usefulness of
the technique for managers as a useful profit planning tool.
CVP Analysis and Decision Making
Putting all the pieces together and conducting the CVP analysis, companies can then make decisions on whether
to invest in certain technologies that will alter their cost structures, and determine the effects on sales and
profitability much quicker.
For example, let’s say that XYZ Company from the previous example was considering investing in new
equipment that would increase variable costs by Php 3 per unit but could decrease fixed costs by Php30,000. In
this decision-making scenario, companies can easily use the numbers from the CVP analysis to determine the
best answer.
The hardest part in these situations involves determining how these changes will affect sales patterns – will
sales remain relatively similar, will they go up, or will they go down? Once sales estimates become somewhat
reasonable, it then becomes just a matter of number crunching and optimizing the company’s profitability.
A) BSBA-FM, Inc. manufactures and sells products A, B, and C with unit selling prices of P20, P40,
and P40, and with unit variable costs of P12, P18, and P26, respectively. They are sold in the ratio of 4:1:3.
Total fixed cost amounted to P960,000. Compute the breakeven point in pesos and in units.
REQUIRED: Determine:
a. Sales in units and pesos to earn a profit before tax of P312,000.
b. Sales un units and pesos to earn a net profit after tax of P424,320. Income
tax rate is 32%. Prove your answer.
MAIN TASK QUESTIONS
QUESTION 1
What are the 3 classification of costs according to behavior? Explain each using your own
understanding.
QUESTION 2
QUESTION 3
What is CVP analysis? Describe the relationship between the cost-volume and profit.
What are the advantages and disadvantages of using CVP analysis as a managerial accounting technique?
QUESTION 4
Explain:
a) Contribution Margin (CM) Ratio
b) Variable cost ratio
c) Break-even point (in pesos or units)
d) Margin of safety ratio
e) What causes changes in net income
f) The Degree of operating leverage
g) Explain the basic cost-volume-profit assumptions and limitations
QUESTION 5
Write a paragraph that explains why pension and health benefits are classified as product costs and not period
costs. Also explain why these benefits are classified as manufacturing overhead costs rather than direct labor.
QUESTION 6
Assume that you are preparing a seminar on cost-volume-profit analysis for non-accountants. Several potential
attendees have approached you and have asked why they should be interested in learning about your topic. The
individuals include:
a. A factory worker who serves as her company labor union representative in charge of contract
negotiations.
b. A purchasing agent in charge of ordering raw materials for a large manufacturing company.
c. A vice president of sales for a large automobile company.
d. A dean of BSU Graduate program.
Instructions: What unique reasons would you give each of these individuals to motivate them to come to your
seminar?
QUESTION 7
Why do French fries from Mcdonald’s taste different than those from Burger King? Somebody explains that
much of the taste difference has to do with the design of the deep fryer. A raw material for a new job enter the
manufacturing process, production machines communicate with central computer via an Ethernet cable to
automatically download a set of specifications tailored specifically for the customer order being filled. When a
job is finished, the computer downloads a new set of instructions for the next order in the queue. The
technology that enables companies to efficiently and effectively change design specifications without delay is
called machine-to-machine communications (M2M) as manufacturing companies look to reduce overhead costs,
M2M is certain to play a growing role in many industries.
Instructions: Discuss how M2M can help a manufacturing company reduce manufacturing
overhead and increase profitability.
REFLECT UPON (REFLECTION ACTIVITY)
1. What are the difficulties that you encountered in studying the CVP/BEP analysis?
2. How can you apply CVP/BEP analysis in your own family business/livelihood, i.e. salaries, farm, retail store,
furniture business, buy and sell, etc?
EXTEND YOUR KNOWLEDGE:
(REINFORCEMENT ACTIVITY)
1. https://corporatefinanceinstitute.com/resources/knowledge/finance/cvp-analysis-guide/
2. https://psu.pb.unizin.org/hmd329/chapter/cvp/
3. https://www.wallstreetmojo.com/cost-volume-profit-analysis/
4. https://xplaind.com/612533/cvp-analysis
5. https://www.wallstreetmojo.com/break-even-formula/
6. https://www.thebalancesmb.com/how-to-calculate-breakeven-point-393469
7. Accounting software such as QuickBooks Online makes it simple to track and record cost behaviour
classifications along with every aspect of your small business’s financial life. More than 4.3 million
customers use QuickBooks to manage their finances. Join them today to help your business thrive for
free.
MODULE 4
Explain the role of incremental analysis (analysis of incremental costs and revenues) in
management decisions.
WARM-UP (PRE-ACTIVITY)
Example:
SELF-EVALUATION
After performing the word puzzle in the Warm-up Section, evaluate yourself by placing a check mark on the
column that best describes your ability to familiarize the cost terms. There are no wrong answers in this section,
so answer as objectively as possible.
Usually Sometimes Seldom Never
3 2 1 0
TOTAL
5-6 Proficient
1-2 Developing
0 Beginning
LECTURE NOTES (INPUT)
All decisions involve a choice among alternative courses of action. In Chapter 1, we learned that the solution to
all business problems involves incremental analysis—the analysis of the incremental revenue and the
incremental costs incurred when one decision alternative is chosen over another. Incremental revenue is the
additional revenue received as a result of selecting one decision alternative over another. Incremental cost is the
additional cost incurred as a result of selecting one decision alternative over another. If an alternative yields an
incremental profit (the difference between incremental revenue and incremental cost), then it should be selected.
Incremental costs sometimes are referred to as relevant costs, because they are the only costs that are relevant to
consider when analyzing decision alternatives. They are also referred to as differential costs, because they are
the costs that differ between decision alternatives.
Q : The focus on incremental analysis makes it seem like decisions are pretty cut and dry and based just on
“running the numbers.” I’ve talked to business people who say that “gut feel” plays a very important role in the
major decisions they make.
A : When making an important business decision, it’s always a good idea to perform incremental analysis. But
often there are important incremental benefits and incremental costs that are difficult, if not impossible, to
quantify. Managers shouldn’t ignore them, and that’s where “gut feel” plays a role. We’ll discuss this in a bit
more detail at the end of the chapter, in the section Qualitative Considerations in Decision Analysis.
When Your Boss Asks, “What Does This Product (Service) Cost?” You Should Say, “Why Do You Want
to Know?”
If you’re ever in a situation where your boss asks you how much a product or service costs, you should reply:
“Why do you want to know?” While that reply may seem a bit rude, it makes an important point about
incremental analysis. There is no single cost number that is relevant for all decisions. Thus, you need to know
what decision your boss is planning to make so you can identify the incremental cost information that is
applicable to the decision. Suppose your boss is trying to decide whether to accept a special order for a
particular product. In this case, your boss wants to know whether the incremental cost of producing the order
will exceed the incremental revenue from accepting it. Some costs, such as the salary of a production
supervisor, will not change as a result of accepting the order and should not be considered as an incremental
cost.
However, your boss may be considering dropping the product. If the product is dropped, the supervisor may be
laid off, and the cost savings related to the supervisor’s salary are incremental. Thus, whether supervisory salary
is an incremental cost and relevant to a decision depends on the decision being made. So, whenever, you’re
asked what a product or service costs, you need to respond: “Why do you want to know?”
Decisions are the determination of future actions from a given set of alternatives. Decisions pertain to the future
and most of the time, in some aspect, will depend on predicting how future events will occur. However,
predicting future events are usually based on data retrieved from historical events and how these historical
events is expected to be constant or altered. Making decisions is something that cannot be taken lightly for it
can make or break a business. One erroneous decision can make a financially healthy company bankrupt in just
a flick of a finger. In business, managerial activities always require decision making. During the planning phase,
the selection of an objective, strategy and plan of actions needs decision making. Under the execution phase, to
whom a particular task will be assigned and how the employees will be motivated, the same with the controlling
phase, deciding whether a particular variance is worth analyzing and the corrective action related to such
variance requires decision making. All managerial activities require decisions and this is the reason why they
are called managers, they manage by determining the courses of actions to be taken.
There are two types of decision for managers, routine and non-routine. Routine decisions are made under a
specific process and certainty. Decisions are recurring and there are already sets of programmed responses.
Valuable time and resources should not be expended each time routine decisions are to be made. Thus, usually,
companies create a manual of procedure to guide managers on how to deal with routine decisions. Examples of
Routine Decisions includes replenishment of inventory, sending delinquency notes to customers, and giving
employees raised among others. Generally, routine decisions are activities that are part of the normal operating
cycle or the day-to-day activities in business. Non-Routine Decisions are made using the discretion of the
decision maker in addressing situations that are uncommon and isolated. It is quite risky wherein bad decision
is irrevocable and causes material damages. Usually, when critical non-routine decisions are made, the normal
operating cycle of the company is being altered. For example, when a company is contemplating whether to
make or buy a particular product or materials, it is actually deciding whether to be a manufacturer or a
merchandiser which has a different operating cycle. Another will be, if management is evaluating whether to
drop or to maintain a segment of the company might increase or decrease the number of business unit that is
being managed.
One of the critical steps in the scientific approach is the gathering of data, for the data acquired can be used in
order to support or contradict a propose alternative course of action, hence, an erroneous information caused by
irrelevant and unreliable data can result to wrong decisions. The key to prevent providing erroneous information
from happening is classifying costs as relevant and irrelevant costs. Relevant Costs are any expected future cost
which will differ among alternative courses of actions while irrelevant costs are either future costs that will not
change or past cost that was already incurred. There are two types of relevant cost, differential costs and
opportunity costs while irrelevant costs can be classified as committed (unavoidable) fixed cost and sunk costs.
Differential Costs
These are costs that differ among alternative courses of actions. It can also be called as incremental or avoidable
costs depending on the perspective of the decision to be made.
Incremental costs are costs that will be incurred or will increase if a decision is made while an avoidable cost
are cost that will be prevented from being incurred if a decision is made. In a decision whether to buy a car or
not, the fare being incurred from jeepneys, taxis, and other means of transportation can either be an incremental
or avoidable cost. If you are on the perspective of buying a car, the fare will be considered as an avoidable cost
since if a person bought a car and use it, he does not have to pay for any fare. However, if you are on the
perspective on not buying a car, the fare is an incremental cost since not having a car will require a person to
commute, hence the need to pay for the different fare. As a rule of thumb, whatever costs that were classified as
incremental in one perspective will be classified as avoidable in the other perspective.
Opportunity Costs
These are benefits foregone when a particular alternative courses of action is not chosen. For an item to be
considered as an opportunity costs it has to be a possible benefit in an alternative. A benefit in accounting
literature is anything that increases cash either through additional revenue or cost savings. In a decision whether
to get a job or continue studying, under the alternative of getting a job, possible benefits exist like the salary that
can be earned, and the amount of tuition fee and allowances that can be saved. Cost savings is no different from
avoidable costs. However, tuition fees and allowances will be classified as incremental costs under the
alternative of continue studying while the salaries that can be earned will be classified as opportunity cost.
Committed Fixed Costs
These are on-going fixed costs which cannot be altered or affected by a particular decision because a company
will continue to incur the fixed cost that is committed regardless of which decision alternative is selected. For
example, the amount of monthly rental payment to be made in a decision whether to accept or reject a special
order from a one-time customer especially if the company has enough excess idle capacity. The rental payment
is a committed fixed cost since it will remain to be the same amount, due and outstanding regardless whether
the order was accepted or rejected.
Sunk Costs
These are cost which was incurred in the past and cannot be altered or affected by a particular decision. Sunk
costs, like committed costs, will continue to have been incurred by the company regardless of which of the
available courses of action the company may choose to take in the future. In relation to the special order
decision in the previous section, the amount spent by the company in researching and developing its product is a
sunk cost since it has already been incurred and the company will not be able to avoid or incur additional
research and development costs.
Before solving or rendering any decision, it is very important that a solid foundation on identifying relevant and
irrelevant cost has been attained. The different cost classification will be used alternately in analyzing and
solving the different problems. Generally, management’s non-routine decisions fall into, but not limited to, the
following categories:
1. Make or Buy decision or Outsourcing decision
2. Accept or Reject Decision of Special Orders
3. Dropping or Maintaining a Business Segment which can also include temporary shut-down decisions
4. Sell or Process Further after the joint processing
5. Addressing Limited Capacity Problems
6. Retain or Replace old equipment
This kind of decision present a situation in which a company must decide whether it should manufacture a
component part for its own use or purchase this part from an outside supplier. It also include decision pertaining
to setting up service departments like security, maintenance, accounting, etc. or contracting external business
processing companies to perform such services for the company. Thus, make or buy decision it is also called as
Outsourcing Decision. The key in solving these problems is to exclude all committed fixed costs as being
irrelevant to the analysis and then compare the alternatives presented based on the incremental revenues and
incremental costs of each alternative. Remember the general objective in this kind of decision is to select the
alternative that will result to a lower cost. The following table shows how cost can generally be considered in
the decision analysis.
Cost to Make Cost to Buy
Direct Materials xx Purchase Price xx
Direct Labor xx Other directly
Variable Overhead xx attributable cost of
Incremental Fixed Overhead (if xx buying the material (i.e.
any) Freight, Inspection,
Opportunity Cost (if any – Ordering Cost, etc.) xx
alternative usage of the space) xx
TOTAL xx TOTAL xx
ILLUSTRATION NO. 1:
Plainfield Company manufactures part G for use in its production cycle. The cost per unit for 10,000 units of
part G are as follows: Direct materials P 3 Direct labor 15 Variable overhead 6 Fixed overhead 8 Total P 32
Verona Company has offered to sell Plainfield 10,000 units of part G for P30 per unit. If Plainfield accepts
Verona’ offer, the released facilities could be used to save P45,000 in relevant costs in the manufacture of part
H. In addition, P5 per unit of the fixed overhead applied to part G would be totally eliminated. What alternative
is more desirable and by what amount is it more desirable?
SOLUTION:
An excellent way of determining which alternative is more desirable is by comparing each alternatives relevant
costs. The total unit variable production costs is P24 (i.e., P3 + P15 + P6). Fixed costs are generally invariable
and are constant, except for avoidable fixed costs and expenses which change from an alternative to another and
is therefore relevant. An analysis of the relevant costs of the alternatives, make or buy, is shown as follows:
Make Buy
ILLUSTRATION NO. 2:
Great Electronics is operating at 70% capacity. The plant manager is considering making component 501 now
being purchased for P110 each, a price that is projected to increase in the near future. The plant has the
equipment and labor force required to manufacture the component. The design engineer estimates that each
component requires P40 of direct materials and P30 of direct labor. The plant overhead is 200% of direct labor
peso cost, and 40% of the overhead is fixed cost. a decision to manufacture component 501 will result in a gain
or (loss) for each component of?
The gain(loss) for each component if component 501 is manufactured by the company.
It is a case of make or buy decision. The alternative that gives the lower relevant cost will be selected. A
relevant costs analysis is shown below:
Cost to make Cost to buy
Syanton manufactures a particular computer component. Manufacturing cost per units are as follows: Direct
materials P 50 Direct labor 500 Variable overhead 250 Fixed overhead 400 Total manufacturing costs P1,200
Fredix, Inc. has contracted Syanton with an offer to sell 10,000 of the component for P1,100 per unit. If Syanton
accepts the proposals, P2,500,000 of the fixed overhead will be eliminated. Should Syanton make or buy the
component and why?
The following standard costs pertain to a component part manufactured by Atoy Company: Direct materials P 2
Direct labor 5 Factory overhead 20 Standard cost per unit P 27 Factory overhead is applied at P1 per standard
machine hour. Fixed capacity cost is 60% of applied factory overhead, and is not affected by any “make or buy”
decision. It would cost P25 per unit to buy the part from an outside supplier. In the decision to “make or buy”,
what is the total relevant unit manufacturing cost to be considered?
Essence Producers, Inc., manufactures various scents out of Philippine flowers and plants. It also manufactures
exotic oils that it subsequently uses in the scents production. The cost per unit of measure for 15,000 units of
exotic oils are as follows:
Direct materials P 20
Direct labor 34
Variable factory overhead 24
Unavoidable fixed factory overhead 32
Total P110
Xtra Oils, Inc. offered Essence to supply 15,000 units of measure of the exotic oil for P1,260,000. Assuming the
facilities for exotic oils have no alternative use, Essence Producers, Inc., should make or buy?
The ABC Company manufactures components for use in producing one of its finished products. When 12,000
units are produced, the full cost per unit is P35, separated as follows:
Direct materials P5
Direct Labor 15
Variable overhead 10
Fixed overhead 5
The XYZ Company has offered to sell 12,000 components to ABC for P37 each. If ABC accepts the offer,
some of the facilities currently being used to manufacture the components can be rented as warehouse space for
P40,000. However, P3 of the fixed overhead currently applied to each component would have to be covered by
ABC’s other products. What is the differential cost to the ABC Company of purchasing the components from
the XYZ Company?
Accept or Reject a Special Order
This kind of decision often arises when a company receives from a potential customer a special one-time order
at a selling price which is below the company’s regular selling price. A special order is a one-time order that is
not considered part of the company’s normal ongoing business and is not expected to recur and be part of the
normal operating cycle.
To address this kind of situation, the key usually is to exclude any committed cost as being irrelevant in the
analysis and then compare the available courses of action based on the additional or incremental revenues and
costs that will result under each alternative. When analyzing a special order, only the incremental costs and
benefits are relevant. Since the existing fixed manufacturing overhead costs would generally not be affected by
the decision to accept or reject the order, they are considered to irrelevant. In analyzing the situation, the general
objective is to determine whether the incremental revenue (Special offer price) would be higher than the
incremental cost to be incurred. The following table shows how cost can generally be considered in the
decision analysis.
ILLUSTRATION NO. 1
Angeles Corporation sells its product for P35 per unit. The company’s unit product cost based on the full
capacity of 400,000 units is as follows:
Direct materials P 8
Direct labor 10
Variable manufacturing overhead 4
Fixed Manufacturing overhead 8
Unit product cost P 30
A special order offering to buy 40,000 units has been received from a foreign customer for P30 per unit. The
only selling costs that would be incurred on this order would be P6 per unit for shipping. The company has
sufficient idle capacity to manufacture the additional units.
Should Angeles accept the order? Just like in the make or buy decision, one of the key factor in solving this
problem is to identify the relevant cost, however, this time, we will focus more on the incremental cost rather
than the avoidable cost. In the given problem, direct materials, direct labor, variable overhead and variable
selling cost will be considered as incremental cost, thus relevant, while fixed manufacturing overhead will be
disregarded since this will be considered as a committed cost that will remain to be incurred regardless whether
the special order is accepted or rejected. The complete solution will be as follows:
Supposing that the order of the foreign customer will be needing a unique labeling that will require a special
engraving tool equipment that cost P 60,000 and will have no other use for Angeles after it has serve the special
order, should Angeles still accept the special order?
The incremental cost, that is, the purchase price of the additional machine that will be specifically acquire for
this order will be spread out to the number of units to be ordered and will be added as part of incremental cost to
make and sell. The revised solution for this special order problem follows:
Alternatively, the Total advantage of P 20,000 can be determined by simply deducting the P 60,000
purchase price to the original advantage of P 80,000.
ILLUSTRATION NO. 2
ADRITSJIFFJOBLIN Company produces a single product. The cost of producing and selling a single unit of
this product at the company's normal activity level of 40,000 units per month is as follows:
Direct materials ............................................... P 38.80
Direct labor ...................................................... P 9.70
Variable manufacturing overhead ................... P 2.30
Fixed manufacturing overhead ........................ P 18.10
Variable selling & administrative expense ...... P 1.70
Fixed selling & administrative expense .......... P 8.80
The normal selling price of the product is P81.10 per unit. An order has been received from an overseas
customer for 3,000 units to be delivered this month at a special discounted price.
This order would have no effect on the company's normal sales and would not change the total amount of the
company's fixed costs. Direct labor is a variable cost in this company.
Required:
a. Suppose the company has ample idle capacity to produce the units required by the overseas customer and the
special discounted price on the special order is P75.30 per unit. By how much would this special order increase
(decrease) the company's net operating income for the month?
Therefore:
Variable cost per unit on special order:
Normal variable cost per unit ........................... P52.50
Variable cost per unit on special order ............ P52.50
ILLUSTRATION NO. 3
Adamyan Co. manufactures and sells medals for winners of athletic and other events. Its manufacturing plant
has the capacity to produce 15,000 medals each month; current monthly production is 12,750 medals. The
company normally charges P120 per medal. Cost data for the current level of production are shown below:
Variable costs:
Direct materials ...................................... P624,750
Direct labor ............................................. P306,000
Selling and administrative ...................... P15,300
Fixed costs:
Manufacturing ........................................ P506,175
Selling and administrative ...................... P123,675
The company has just received a special one-time order for 700 medals at P83 each. For this particular order, no
variable selling and administrative costs would be incurred. This order would also have no effect on fixed costs.
Required: Should the company accept this special order? Why?
SOLUTION:
Only the direct materials and direct labor costs are relevant in this decision. To make the decision, we must
compute the average direct materials and direct labor cost per unit.
Since price on the special order is P83 per medal and the relevant cost is only P73, the company would earn a
profit of P10 per medal. Therefore, the special order should be accepted.
Albertine Co. manufactures and sells trophies for winners of athletic and other events. Its manufacturing plant
has the capacity to produce 16,000 trophies each month; current monthly production is 12,800 trophies. The
company normally charges P113 per trophy. Cost data for the current level of production are shown below:
Variable costs:
Direct materials .......................... P614,400
Direct labor ................................. P256,000
Selling and administrative .......... P35,840
Fixed costs:
Manufacturing ............................ P294,400
Selling and administrative .......... P94,720
The company has just received a special one-time order for 1,200 trophies at P61 each. For this particular order,
no variable selling and administrative costs would be incurred. This order would also have no effect on fixed
costs.
Nore Milling Co. has a plant capacity of 40,000 units per month. Unit cost capacity are: Direct materials P100
Direct labor 150 Variable overhead 75 Fixed overhead 75 Marketing fixed cost 175 Marketing variable costs 90
Present monthly sales are 39,000 units at P630 each. Josh Corporation contacted Nore about purchasing 1,000
units at P600 each. The present sales would not be affected by the special order. Nore should accept or reject the
special order.
ILLUSTRATION NO. 1
Traditional Approach
In analyzing this type of decision, the key is to exclude committed fixed costs as being irrelevant and
then compare the alternatives presented based on the incremental revenue and incremental cost of each
available alternative.
To illustrate, Pampanga Corporation sells two (2) different product lines in its retail store. Pampanga’s
operating income results last year were as follows:
Sales P 100,000
Variable Costs 60,000
Contribution Margin 40,000
Avoidable Fixed Costs 35,000
Decrease in profit if Product A is eliminated P 5,000
Alternatively, the P 5,000 opportunity cost (since it is a profit that will be foregone if Product A is
dropped) can be computed as follows:
Hence, Pampanga should not drop product A since it will result to a decrease in profit by P5,000.
ILLUSTRATION NO. 2
When deciding to keep or drop a part of the company, the first thing to do is to create an income statement
broken into segments. For example, if a product is unprofitable, create a product line income statement. If there
is a location that is not profitable, create an income statement for that location. Use a contribution margin
income statement to separate variable costs from fixed costs.
This is the kind of income statement that would make a company think about dropping a product. Overall, the
company has a loss of P4,000 and it appears that Product A has a P38,000 loss. On the surface, it might look
like dropping Product A and only producing Product B would result in a profit of P34,000. But is that correct?
Here are some things to consider when evaluating if a company should keep or drop a segment (product,
department, or location):
If we look at Product A, it does have a positive contribution margin. This is important because the product is
covering all of it’s variable costs and it is contributing toward foxed costs. While the contribution margin is not
high enough to cover all of the fixed costs, increasing sales of Product A would increase contribution margin
and lower the loss.
2. Can any of the fixed costs be avoided if the segment was discontinued?
There are two types of fixed costs that should be considered, direct fixed costs and common fixed costs.
Direct fixed costs are fixed costs that can be directly traced to the segment. Just because a fixed cost is direct
does not mean that it is avoidable. There may be depreciation, contractual obligations, and other costs that the
company will not be able to cut even if the segment is discontinued. If the fixed costs cannot be avoided, losses
will increase if the segment is discontinued because the segment will no longer be contributing to the total
contribution margin.
Common fixed costs are organization sustaining fixed costs that are allocated to the segment. These fixed costs
will continue even if the segment has been eliminated; they will just be allocated to the remaining segments.
Let’s say, in our example, that none of the direct fixed costs are avoidable. What happens to the loss if Product
A is discontinued?
Since there are no longer sales from Product A, we eliminate the revenue and the variable costs from Product A.
We also lose P85,000 in contribution margin that was helping to offset some of the fixed costs. The loss
increased by P85,000 (the amount of contribution margin that was eliminated). What would happen if we could
eliminate all of the direct fixed expenses?
If all of the direct fixed costs could be eliminated, now we see positive results. Notice that the common fixed
cost is still P99,000.
Make sure to carefully examine fixed costs to see which, if any, could be cut.
If the segment was discontinued, could the company use the machinery and employees for another purpose?
Could the company make additional units of another product or make a new product? Assessing these
alternatives helps the company decide if there is something more profitable it could do instead. Idle capacity
makes it less likely that fixed costs could be eliminated.
4. Will discontinuing a segment have adverse effects on the sale of other products?
Imagine that Product A is a cereal bowl and Product B is a matching plate. Do you think that discontinuing
Product A would hurt the sales of Product B? I think it would. Before discontinuing a product make sure that
sales of remaining products would not be adversely affected.
Let’s say that we could eliminate all the direct fixed costs from Product A but sales of Product B would fall
15%. Should we drop Product A? If we remove Product A and it’s direct fixed costs but lower the sales and
variable costs of Product B by 15%, the results are not good.
The loss is larger now than it was when the company was making Product A. The negative impact on sales of
Product B outweighs the savings from discontinuing Product A.
Make sure to look at the adverse effects on other segments of the company before deciding to drop a segment.
Final Thoughts
When deciding if a company should drop an unprofitable segment, the company should create a segment
contribution margin income statement. If the contribution margin is positive, the company should consider
direct and common fixed costs, what to do with freed capacity, and the effect on sales of other products.
C J F
Sales P200,000 P150,000 P125,000
Separate (product) fixed costs 60,000.00 35,000.00 40,000.00
Allocated fixed costs 35,000.00 40,000.00 25,000.00
Variable costs 95,000.00 75,000.00 50,000.00
The company lost its lease and must move to smaller facility. As a result, total allocated fixed costs will be
reduced by 40%. However, one product must be discontinued. The expected net income (loss) after the
appropriate product has been discontinued is? (Support your answer)
A. P10,000 C. P20,000
B. P(15,000) D. P25,000
Joint Production
The key in addressing this kind of situation is to segregate sunk cost and consider only incremental revenue and
incremental cost. Joint costs incurred prior to split-off are not relevant when making the sell-at-split-off or-
process-further decision, since such cost is assumed to have already been incurred before the need for the
decision arises. Remember, it is only after the joint production process was finished that the need to make the
decision arises. The correct decision is made by comparing the separable cost incurred against the amount of
increased sales revenue.
The pro-forma solution guide in solving this kind of situation follows:
Sales after further processing xx
Sales at Split-off point (xx)
Incremental Revenue xx
Cost to be incurred when process further (Incremental Cost) (xx)
Net Incremental Profit (if positive) xx
ILLUSTRATION NO. 1
To illustrate, Laguna Company produces donuts. The production phase begins with a joint process that cost P
7,000 and each product can be sold at split-off or processed further. Details of producing the three donut
flavors from a standard batch are as follows:
Strawberry Bavarian
Choco Nut
Filled Crumble
Joint Production costs allocated to
each product up to split-off P 4,000 P 1,000 P 2,000
Sales value at split off 2,000 6,000 8,000
Sales value if processed further 4,800 9,000 14,000
Processing cost beyond split-off 1,600 3,500 5,000
As already been discussed, the joint production cost will be disregarded since it is a type of sunk cost in as far
as this type of decision is concern. The first step is to determine the incremental revenue by simply comparing
the sales value at split off and after further processing.
Strawberry Bavarian
Choco Nut
Filled Crumble
Sales value if processed further 4,800 9,000 14,000
Sales value at split off (2,000) (6,000) (8,000)
Incremental Revenue 2,800 3,000 6,000
The second step is to compare the incremental revenue computed to the incremental cost which is the
processing cost to be incurred for processing the products further to determine the total advantage or
disadvantage of further processing the products.
Strawberry Bavarian
Choco Nut
Filled Crumble
Incremental Revenue 2,800 3,000 6,000
Incremental Cost (1,600) (3,500) (5,000)
Advantage/(Disadvantage) 1,200 ( 500) 1,000
As we can see, processing Choco Nut and Bavarian Crumble further will provide an advantage of 1,200 and
1,000 respectively while Strawberry Filled will have a 500 disadvantage if process further, hence, it will be wise
for Laguna not to further process strawberry filled donut.
ILLUSTRATION NO. 2
Iden Company makes two products from a common input. Joint processing costs up to the split-off point total
$64,800 a year. The company allocates these costs to the joint products on the basis of their total sales values at
the split-off point. Each product may be sold at the split-off point or processed further. Data concerning these
products appear below:
Product X Product Y Total
Allocated joint processing costs 32,400 32,400 64,800
Sales value at split-off point 36,000 36,000 72,000
Costs of further processing 20,300 14,300 34,600
Sales value after further processing 55,400 53,000 108,400
Required:
a. What is the net monetary advantage (disadvantage) of processing Product X beyond the split-off point?
b. What is the net monetary advantage (disadvantage) of processing Product Y beyond the split-off point?
c. What is the minimum amount the company should accept for Product X if it is to be sold at the split-off
point?
d. What is the minimum amount the company should accept for Product Y if it is to be sold at the split-off
point?
SOLUTION:
Required a and b:
Product X Product Y
Sales value after further processing ........... P55,400 P53,000
Costs of further processing ........................ 20,300 14,300
Benefit of further processing ..................... 35,100 38,700
Less: Sales value at split-off point ............ 36,000 36,000
Net advantage (disadvantage) ................... (900) 2,700
Required c and d:
Benjamin Company produces products C, J, and R from a joint production process. Each product may be sold at
the split-off point or processed further. Joint production costs of $95,000 per year are allocated to the products
based on the relative number of units produced. Data for Benjamin's operations for last year follow:
The main decision criterion in this type of problem is that when only one limited resource is present, a company
should focus on products that would be maximizing the profit in relation to the given scarce/limited resource.
ILLUSTRATION 1
To illustrate, Leyte Company produces wooden plaques and trophies, the following limited information about the two
products follows:
Plaques Trophies
Selling Price Per Unit P 36 P 30
Variable Cost Per Unit 24 15
Contribution Margin Per Unit P 12 P 15
The company only has one sander that is being used to sand the wood which is the main component for both the
plaques and the trophies. Generally, the wood required for each plaque takes 2 hours to sand, while the wood
required for each trophy takes 3 hours to sand. Currently, the sander can only be used for a total of 900 hours,
which of the two products should Leyte prioritize?
If the contribution margin per unit will be the basis, then it will be Trophies that will be prioritize since a unit of
Trophy will yield P15 as compared to a unit of Plaques which only earns P12. However, the constraint here is
not the units but rather the machine time of the sander, and knowing that a unit of Plaque and Trophy requires 2
and 3 hours, respectively, in the sanding machine, we have to determine which of the two products will be
providing the highest contribution margin in relation to the constraint. We can do this by simply assuming that
the total machine time will be devoted to one product and computing the total number of units that can be
produced and multiplying it to the contribution margin per unit to determine the total contribution margin.
Plaques Trophies
Total Sanding Hours Available 900 900
Divided by: Hours required per unit 2 3
Maximum number of units that can be produced 450 300
Multiplied by: Contribution Margin Per Unit P 12 P 15
Total Contribution Margin P 5,400 P 4,500
As we can see, assuming that all the available sanding time will be devoted to plaques, the maximum earnings
that the company will earn is P 5,400 while, if it will be devoted to Trophies, the company will only earn P
4,500. Another way of looking at it is the amount of contribution margin earned per available sanding time, for
plaques, it will be P6 or (P 5,400/900) while it will be P5 (P 4,500/900) for Trophies. This means that a plaque
will contribute more than a trophy on per sanding hour basis. This means that Leyte should prioritize Plaques
rather than Trophies in order for the company to maximize profit. An alternative and easier way of determining
the contribution margin per hour is simply dividing the contribution margin per unit by the hours required per
unit.
Plaques Trophies
Contribution Margin Per Unit P 12 P 15
Divided by: Hours required per unit 2 3
Contribution Margin per Constrained Resource P 6 P 5
Total Sanding Hours Available 900 900
Total Contribution Margin P 5,400 P 4,500
If the product line with the highest contribution margin per constrained resource has a maximum market
demand limit, the remaining limited resources still left may be devoted to the other product line. Assuming that
Leyte can only sell 150 plaques and 300 trophies, how many of each product should Leyte produce and sell?
Since plaques has a higher contribution margin per constrained resources, it will be prioritize, the only problem
is that although Leyte can produce as many as 450 plaques, it can only sell 150 plaques, hence, there is no sense
of producing all 450 plaques. Some of the available sanding time should also be given to Trophies. The
allocation will be as follows:
As the solution shows, Leyte will be producing 150 plaques and 200 trophies.
ILLUSTRATION 2
Wright, Inc. produces three products. Data concerning the selling prices and unit costs of the three products appear below:
PRODUCT
C D E
Selling price P90 P30 P60
Variable costs P35 P10 P20
Fixed costs P45 P10 P30
Tapping machine time (minutes) 5 4 2
Fixed costs are applied to the products on the basis of direct labor hours. Demand for the three products exceeds
the company's productive capacity. The tapping machine is the constraint, with only 2,400 minutes of tapping
machine time available this week.
Required:
a. Given the tapping machine constraint, which product should be emphasized? Support your answer with
appropriate calculations.
b. Assuming that there is still unfilled demand for the product that the company should emphasize in part (a)
above, up to how much should the company be willing to pay for an additional hour of tapping machine time?
SOLUTION:
a. The product to emphasize can be determined by computing the contribution margin per unit of the scarce
resource, which in this case is tapping machine time.
PRODUCT
C D E
Selling price P90 P30 P60
Variable costs P35 P10 P20
Contribution margin P55 P20 P40
Tapping machine time (minutes) 5 4 2
Contribution margin per minute P11 P5 P20
Product E should be emphasized because it has the greatest contribution margin per unit of the scarce resource.
b. If additional tapping machine time would be used to produce more of Product E, the time would be worth 60
× $20 = P1,200 per hour.
Product A has a contribution margin of P80 per unit, a contribution margin ratio of 50 percent, and requires 4
machine hours to produce. Product B has a contribution margin of P120 per unit, a contribution margin ratio of
40 percent, and requires 5 machine hours to produce. If the company has limited machine hours available, then
it should produce and sell?
Data regarding four different products manufactured by an organization are presented below. Direct materials
and direct labor are readily available from their respective resource markets. However, the manufacturer is
limited to a maximum of 3,000 machine hours per month.
Product A B C D
Selling price/unit P15 P18 P20 P25
Variable cost/unit P17 P11 P10 P16
Units produced per machine hour 3 4 2 3
The product that is the most profitable for the manufacturer in this situation is
A. Product A. C. Product C.
B. Product B. D. Product D.
ILLUSTRATION NO. 1
Ysabelle Industries, Inc. has an opportunity to acquire a new equipment to replace one of its existing equipment.
The new equipment would cost P900,000 and has a five-year useful life, with a zero terminal disposal price.
Variable operating cost would be P1 million per year. The present equipment has a book value of P500,000 and
a remaining life of five years. Its disposal price now is P50,000 but would be zero after five years. Variable
operating costs would be P1,250,000 per year. Considering the five years in total, but ignoring the time value of
money and income taxes, Ysabelle should?
The old equipment shall be replaced if the savings or income derived from the new equipment will be enough to
absorb the cost of buying it. The data analysis on the short-term decision of “replace” or “retain” an old
equipment is shown below:
SOLUTION:
Retain Replace
Therefore:
Savings in 5 years (P250,000 x 5 yrs.) P1,250,000
Salvage value of old equipment 50,000
Total cash inflows 1,300,000
Purchase price (900,000)
Net advantage of replacing the old equipment P 400,000
The book value of the old asset is irrelevant. It is a sunk cost and cannot be changed regardless of the decision
to be made. This analysis does not consider the time value of money and tax effects.
Summary
1. Describe the nature of decision making and the related process as applied into business
Decision making is necessary for managerial activities. There are two types of decision, routine and
non-routine. Routine decisions are those that are recurring and already have programmed set of
responses which is usually included in a company’s procedures manual. Non-Routine Decisions are
results of uncommon situation and may materially affect how a business operates. Non-routine
decisions must be sold using the scientific approach.
Association with Decision: Information must be associated with the decision or question under
consideration in order for the information to be relevant.
Relevant costing is an approach that focuses managerial attention on a decision’s relevant (or pertinent)
facts.
A differential cost is a cost that differs between or among the various decision alternatives. A cost must
be differential to be relevant.
Incremental cost is the additional cost of producing or selling a contemplated quantity of output.
Incremental costs can be either variable or fixed. Most variable costs are relevant while most fixed costs are not
relevant.
Incremental revenue is the additional revenue resulting from a contemplated sale or provision of a
service.
The difference between the incremental revenue and incremental costs of a particular alternative is the
positive or negative incremental benefit of that course of action.
Management can compare the incremental benefits of various alternatives to decide on the most
profitable or least costly alternative or set of alternatives.
Some relevant factors, such as prime product costs, are easily identified and quantified, and are integral
parts of the accounting system.
Other factors, such as opportunity costs, may be relevant and quantifiable, but are not part of the
accounting system.
An opportunity cost represents the potential benefit foregone because one course of action is chosen
over another.
Importance to Decision Maker: The need for specific information depends on how important the
information is relative to management objectives.
Bearing on the future.
a. Information can be based on past or present data, but it can only be relevant if it pertains to a future
decision.
b. The future may be the short run or the long run; future costs are the only costs that can be avoided;
and the longer into the future a decision’s time horizon is, the more costs are controllable, avoidable, and
relevant.
c. Only information that has a bearing on future events is relevant in decision making.
Sunk Costs
A sunk cost is a cost incurred in the past that is not relevant to any future courses of action.
Such a cost is the historical or past cost associated with the acquisition of an asset or a resource.
Sunk costs are not relevant to future decisions.
TRUE/FALSE QUESTIONS
1. Fixed costs are sunk costs and are therefore irrelevant in decisions.
2. Future costs that do not differ between the alternatives in a decision are avoidable costs.
3. The book value of an old machine is always considered a sunk cost in a decision.
4. In a special order situation that involves using existing idle capacity, opportunity costs are zero.
5. When a company has a production constraint, the product with the highest contribution margin per unit of the
constrained resource should be given highest priority.
6. Lumber produced in a lumber mill results in several different products being produced from each log; such
products are called joint products.
7. In a sell or process further decision, an avoidable fixed production cost incurred after the split-off point is
relevant to the decision.
8. Joint processing after the split-off point is profitable if the incremental revenue from such processing exceeds
the incremental processing costs.
9. A differential cost is a cost that differs between or among the various decision alternatives. A cost must be
differential to be relevant.
10. Incremental cost is the additional cost of producing or selling a contemplated quantity of output.
Incremental costs can be either variable or fixed. Most variable costs are relevant while most fixed costs are not
relevant.
MULTIPLE CHOICE QUESTIONS:
1. Hal Etoesus currently works as the fry guy at Burger Breath Drive Thru but is thinking of quitting his job to
attend college full time next semester. Which of the following would be considered an opportunity cost in this
decision?
A) the cost of the textbooks
B) the cost of the cola that Hal will consume during class
C) Hal's lost wages at Burger Breath
D) both A and B above Answer: C Level: Easy LO: 1
3. When a multi-product factory operates at full capacity, decisions must be made about what products to
emphasize. In making such decisions, products should be ranked based on:
A) selling price per unit B) contribution margin per unit
C) contribution margin per unit of the constraining resource D) unit sales volume
5. Product X-547 is one of the joint products in a joint manufacturing process. Management is studying whether
to sell X-547 at the split-off point or to process X547 further into Xylene. The following data have been
gathered:
I. Selling price of X-547
II. Variable cost of processing X-547 into Xylene.
III. The avoidable fixed costs of processing X-547 into Xylene.
IV. The selling price of Xylene.
V. The joint cost of the process from which X-547 is produced.
Which of the above items are relevant in a decision of whether to sell the X-547 as is or process it further into
Xylene?
A) I, II, and IV. B) I, II, III, and IV.
C) II, III, and V. D) I, II, III, and V.
6. The term relevant cost applies to all of the following decision situations except the
A. Acceptance of special product order. B. Determination of product price.
C. Manufacture of purchase of a component part. D. Replacement of equipment.
8. Among the costs relevant to a make-or-buy decision, include variable manufacturing costs as well as
A. Unavoidable costs. C. Avoidable fixed cost.
B. Plant depreciation. D. Real estate taxes.
9. In determining whether to manufacture a part or buy it from an outside vendor, a cost that is irrelevant to the
short-run decision is
A. Direct labor.
B. Variable overhead.
C. Fixed overhead that will be avoided if the part is bought from an outside vendor.
D. Fixed overhead that will continue even if the part is bought from an outside vendor. (Unavoidable costs)
10. What is the opportunity cost of making a component part in factory given no alternative use of the capacity?
A. The total manufacturing cost of the component.
B. Zero.
C. The fixed manufacturing cost of the component.
D. The variable manufacturing cost of the component.
11. Cost relevant to an insourcing vs. outsourcing decision include variable manufacturing costs as well as
A. Avoidable fixed costs. C. Property taxes.
B. Factory depreciation. D. Factory management costs
12. In considering a special order situation that will enable a company to make use of presently idle capacity,
which of the following costs would be irrelevant?
A. Depreciation. C. Materials.
B. Variable overhead. D. Direct labor.
13. When only differential manufacturing costs are taken into account for special-order pricing, an essential
assumption is that
A. Manufacturing fixed and variable costs are linear.
B. Selling and administrative fixed and variable costs are linear.
C. Acceptance of the order will not affect regular sales.
D. Acceptance of the order will not cause unit selling and administrative variable costs to increase.
14. Production of a special order will increase gross profit when the additional revenue from the special order is
greater than
A. The direct materials and labor cost in producing the order.
B. The fixed costs incurred in producing the order.
C. The indirect costs of producing the order.
D. The marginal cost of producing the order
15. When considering a special order that will enable a company to make use of currently idle capacity, which
of the following cost is irrelevant?
A. Materials. C. Direct Labor.
B. Depreciation. D. Variable overhead.
16. When a multi-product plant operates at full capacity, quite often decisions must be made as to which
products to emphasize. These decisions are frequently made with a short-run focus. In making such decisions,
manager should select products with the
A. Highest sales price per unit.
B. Highest individual unit contribution margin.
C. Highest volume potential.
D. Highest contribution margin per unit of the constraining resource.
17. In the manufacturing process of Drigo Company, an output called substance “pooz” is disposed of as waste.
Recently, the Research Department has discovered a process to convert this waste to detergent. The following
data are available:
1. Cost of disposal is P20.00 per liter.
2. Additional processing cost will be P6.00 per liter.
3. Selling price of the new detergent is P14.00 per liter.
4. Joint costs to manufacture all products is P1.5 billion, of which P250,000 can be allocated to “pooz”.
Which of the amounts are relevant in the decision to dispose or sell “pooz” as detergent?
A. P20, P6, P14, P250,000. C. P1.5 billion, P250,000
B. P20, P6, P14. D. P20, P14, P1.5 billion, P250,000
18. Buff Corp. is considering replacing an old machine with a new machine. Which of the following items is
relevant to Buff's decision? (Ignore income tax considerations.)
Book value Disposal value
of old machine of new machine
A) Yes No
B) No Yes
C) No No
D) Yes Yes
19. Which one of the following is most relevant to a manufacturing equipmentreplacement decision?
A. Original cost of the old equipment.
B. Disposal price of the old equipment.
C. Gain or loss on the disposal of the old equipment.
D. A lump-sum write-off amount from the disposal of the old equipment.
ESSAY QUESTIONS
2. Enumerate and briefly describe at least five (5) types of decision making cases commonly encountered by
managers.
4. Determine the important decision rule/criteria to be follow in making the following decisions:
1. Make or Buy decision or Outsourcing decision
2. Accept or Reject Decision of Special Orders
3. Dropping or Maintaining a Business Segment which can also include temporary shut-down decisions
4. Sell or Process Further after the joint processing
5. Addressing Limited Capacity Problems
6. Retain or replace the old equipment
RUBRIC FOR ESSAY QUESTIONS
Needs improvement Approaching standards Good Excellent
1 pts 2 pts 3 pts 4 pts
Needs improvement Approaching standards Good Excellent
1. What are the difficulties that you encountered in studying the “Relevant Costing or Differential Costing”?
2. How can you apply your learnings in “Relevant Costing or Differential Costing” in your everyday life
experiences (you may include your future plan)?
(REINFORCEMENT ACTIVITY)
Learn more about the “Relevant Costing or Differential Costing” in these Web sites:
1. https://www.investopedia.com/terms/r/relevantcost.asp
2. https://accounting-simplified.com/management/relevant-costing/
3. https://corporatefinanceinstitute.com/resources/knowledge/accounting/differential-cost/
4. https://courses.lumenlearning.com/sac-managacct/chapter/differential-analysis-and-its-application-to-
managerial-decision-making/
5. https://www.accountingnotes.net/cost-accounting/differential-cost/differential-cost-meaning-features-and-
applications/7736