SHORT-TERM NON-ROUTINE DECISIONS

CONCEPT OF RELEVANCE

For information to be relevant, it must possess three characteristics, it must (1) be associated with the decision under
consideration (2) be important to the decision maker and (3) have a connection to or bearing on some future
endeavor.

Association with decision

Relevant costing is an approach that focuses managerial attention on a decision’s relevant (or pertinent) facts.

To be relevant, a cost or revenue item must be differential or incremental. An Incremental revenue is the amount
of revenue that differs across decision choices and incremental cost (differential cost) is the amount of cost that
varies across the decision choices.

Incremental cost can be variable or fixed, a general guideline is that most variable costa are relevant and most fixed
cost are not. (The logic of this guideline is that as sales or production volume changes within the relevant range,
variable cost change but fixed costs do not). As with most generalization, some exceptions can occur in the decision
making process.

The difference between the incremental revenue and the incremental cost of a particular alternative is the positive or
negative incremental benefit of course of action. Management can compare the incremental benefits of 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. Such factors cannot be overlooked simply because they may be more difficult to obtain or may
require the use of estimates. For instance, opportunity cost represents the potential benefit foregone because one
course of action is chosen over another. This costs are extremely important in decision making but are not included
in the accounting records.

Importance to Decision maker

The need for specific information depends on how important the information is relative to the objectives that a
manager wants to achieve. Moreover, if all other factors are equal, more precise information is given greater weight
in the decision making process. However, if the information is extremely important, but less precise, the manager
must weight importance against precise.

Bearing on the future

Information can be based on past or present data, but is relevant only if it pertains to a future decision choice. Future
costs are the only cost that can be avoided and longer time horizon equates to more costs that are controllable,
avoidable and relevant. 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 as 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.

RELEVANT COSTS FOR SPECIFIC DECISIONS

1. Make or Buy – Choose the option that involves the lowest cost. In most cases, fixed costs are irrelevant
unless can be avoided. Do not fail to consider opportunity costs of using facilities if there are any.
2. Scare Resources – Identify the constraint or limitation on the scarce resources. Emphasize the product/s
with the greatest contribution margin per unit of scarce resources.

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3. Sales Mix – Relative to quantities of the products that make up the total sales of a company. Priorities the
product with the highest contribution margin (ratio).

4. Accept or Reject a special order – Accept the order when the revenue from the special order exceeds
additional cost, provided the regular market will not be affected. Usually, fixed production costs are
irrelevant.

5. Continue or Discontinue a business segment – Continue if segment margin is positive; Segment margin
represent the excess of revenues over direct variable expenses and avoidable fixed expenses.

6. Sell or Process Further – Process further if additional revenue from processing further is greater than
further processing cost. Ignore joint costs – they are usually irrelevant in this type of alternative choice
problems.

THE ASSUMPTIONS IN RELEVANT COSTING

Some of the assumptions made in relevant costing are as follows:

1. Cost behavior patterns are known, e.g. if a department closes down, the attributable fixed cost savings
would be known.
2. The amount of fixed costs, unit variable costs, sales price and sales demand are known with certainty.
3. The objective of decision making in the short run is to maximize 'satisfaction', which is often known as
'short-term profit'.
4. The information on which a decision is based is complete and reliable.

EXERCISES

1. Exercise 130
Johnson Motors manufactured 4,000 gears are used in its motors and incurred the following costs:

Direct materials P40,000

Direct labor 16,000
Variable manufacturing overhead 20,000
Fixed manufacturing overhead 12,000
P88,000

A supplier has offered to sell the gears to Johnson for P20.00 each. The fixed manufacturing overhead consists
mainly of depreciation on the equipment used to manufacture the part and would not be reduced if the gears were
purchased from the outside firm. If the gears are purchased from the supplier, Johnson has the opportunity to use the
factory equipment to produce another product which is estimated to have a contribution margin of P5,000.

Instructions
Prepare an incremental analysis report for Johnson Motors which can serve as informational input into this make or
buy decision.

Solution Exercise 130

Make Buy Increase (Decrease)
Direct materials P 40,000 P -0- P 40,000
Direct labor 16,000 -0- 16,000
Variable manufacturing overhead 20,000 -0- 20,000
Fixed manufacturing overhead 12,000 12,000 -0-

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Purchase price (4,000 × P20.00) -0- 80,000 (80,000)

Total annual cost 88,000 92,000 (4,000)
Opportunity cost 5,000 -0- 5,000
Total cost P93,000 P92,000 P 1,000

Income is expected to increase by P1,000 if the component part is purchased from the outside supplier if the
company also manufactured its new product.

2. Exercise 124
Anheiser has three divisions: Bud, Wise, and Er. The results of May, 2006 are presented below:
  Bud Wise Er Total
Units sold 3,000 5,000 2,000 10,000
Revenue P70,000 P50,000 P40,000 P160,000
Less variable costs 32,000 26,000 16,000 74,000
Less direct fixed costs 14,000 19,000 12,000 45,000
Less allocated fixed costs 6,000 10,000 4,000 20,000
Net income P18,000 (P5,000) P 8,000 P21,000
All of the allocated costs will continue even if a division is discontinued. Anheiser allocates indirect fixed costs
based on the number of units to be sold. Since the Wise division has a net loss, Anheiser feels that it should be
discontinued. Anheiser feels if the division is closed, that sales at the Bud division will increase by 20%, and that
sales at the Er division will stay the same.
 
Instructions
A. Prepare an analysis showing the effect of discontinuing the Wise division.
B. Should Anheiser close the Wise division? Briefly indicate why or why not.

Solution Exercise 124 (10–12 min.)

A. Bud Er Total
Revenue P84,000 P40,000 P124,000
Less variable costs 38,400 16,000 54,400
Less direct fixed costs 14,000 12,000 26,000
Less allocated fixed costs    12,857 7,143 20,000
Net income P18,743 P 4,857 P23,600
  
Calculations:
Revenue = P70,000 x 120% = P84,000
    Variable costs = P32,000 x 120% = P38,400
    Allocation of total allocated fixed costs of P20,000:
            To Bud: 3,600/(3,600 + 2,000) x P20,000 = P12,857
            To Er: 2,000/(3,600 + 2,000) x P20,000 = P7,143
B. Yes. The profit increases by P2,600 (P23,600 - P21,000) when the division is eliminated. Direct fixed costs and
variable costs for the Wise division were relatively high compared to those for the Bud and Er divisions. The
increase in sales by 20% of the Bud division was enough to offset the loss of the Wise division.   
3. Exercise 127
Paulsen Company produced and sold 8,000 units of product and is operating at 80% of plant capacity. Unit
information about its product is as follows:

Sales Price P35

Variable manufacturing cost P16
Fixed manufacturing cost (P48,000 ÷ 8,000) 6 22
Profit per unit P13

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The company received a proposal from a foreign company to buy 1,000 units of Paulsen Company's product for P20
per unit. This is a one-time only order and acceptance of this proposal will not affect the company's regular sales.
The president of Paulsen Company is reluctant to accept the proposal because he is concerned that the company will
lose money on the special order. All fixed costs are allocated to individual products.

Instructions
Prepare a schedule reflecting an incremental analysis of this proposal. Indicate the effect the acceptance of this order
might have on the company's income.

Solution Exercise 127 (7–9 min.)

Paulsen Company
Incremental Analysis
Proposal to buy 1,000 units at P20

Net Income
Reject Order Accept Order Increase (Decrease)
Revenues (1,000 × P20) P -0- P 20,000 P20,000
Variable costs (1,000 × P16) -0- (16,000) (16,000)
Net Income P 4,000

Paulsen Company would increase its income by P4,000 in accepting the special order.

Activity
Jackson Chemical Corporation produces a water-based pest control chemical which it sells to pest-control
companies to manufacturer as a pesticide. In 2006, the company incurred P140,000 of costs to produce 14,000
gallons of the chemical. The selling price of the chemical is P21.00 per gallon. The costs per unit to manufacture a
gallon of the chemical are presented below:

Direct materials P 3.50

Direct labor 3.00
Variable manufacturing overhead 2.00
Fixed manufacturing overhead 1.50
Total manufacturing costs P10.00

The company is considering manufacturing the pesticide itself. If the company processes the chemical further and
manufactures the pesticide itself, the following additional costs per gallon will be incurred: Direct materials P1.00,
Direct labor P.25, Variable manufacturing overhead, P1.00. No increase in fixed manufacturing overhead is
expected. The company can sell the pesticide at P25.00 per gallon.

Instructions
Determine the incremental per gallon increase in net income and the total increase in net income if the company
manufactures the paint. Should the company sell the chemical as is or process further?

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