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CFM33B3 2018 Unit 2 Additional Learning Material
CFM33B3 2018 Unit 2 Additional Learning Material
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Contents
1. Learning outcome ............................................................................................................ 3
2. Assessment Criteria ........................................................................................................ 3
3. Resources ......................................................................................................................... 3
4. Introduction: ...................................................................................................................... 3
5. Concepts ........................................................................................................................... 5
i. Relevant cost ................................................................................................................... 5
ii. Opportunity cost.............................................................................................................. 8
iii. Incremental cost/revenue............................................................................................. 8
6. Types of decisions ........................................................................................................... 8
iv. One-time-only special order ........................................................................................ 8
v. Short-term pricing decisions ........................................................................................... 9
vi. Insourcing versus Outsourcing (Make or Buy) ........................................................... 9
vii. Carrying costs of inventory ......................................................................................... 9
viii. Product-mix decision with capacity constraints ........................................................ 10
ix. Customer profitability and relevant costs.................................................................. 10
x. Equipment replacement decisions................................................................................. 11
7. Qualitative factors .......................................................................................................... 11
8. Summary ......................................................................................................................... 11
9. Specific rules .................................................................................................................. 12
10. Example 2.................................................................................................................... 12
11. Class Activities ............................................................................................................ 15
12. Lab Activities ............................................................................................................... 16
13. Tutorial Questions ...................................................................................................... 20
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UNIT 2– Relevant costing and short-term decision-making
1. Learning outcome
2. Assessment Criteria
3. Resources
4. Introduction:
In this unit we will focus on the measuring of costs and benefits for non-routine
decisions. As explained in Chapter 11 in the prescribed textbook the term ‘special
studies’ is sometimes used to refer to decisions that are not routinely made at
frequent intervals. In other words, special studies are undertaken whenever a
decision (that does not usually form part of the business’ activities) needs to be
taken. Examples of these non-routine decisions are:
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Whether to accept an on-time-only special order
Short-term pricing decisions
Outsourcing (making a component within the company or rather buying from an
outside supplier);
Carrying cost of inventory;
Product mix decisions when capacity constraints exist (optimum production to
maximise profit).
Customer profitability and relevant costs
Equipment replacement decisions
These special studies require only those costs and income that are relevant (that
matters) to the specific alternative course of action to be reported. A cost or income
item is relevant when it is different between two different alternative decisions and
when it is a future cost or income. Thus, the term ‘decision-relevant approach’ is used
to describe the specific costs and benefits (income) that should be reported for
special studies. A synonym for relevant costs or revenues is incremental costs or
income (revenues). The objective, when examining alternative courses of action, is to
maximise the present value of future net cash inflows.
Important:
Net cash flow is the difference between additional revenue (that will increase net
cash flow) and additional costs (that will decrease net cash flow).
Alternatively, net cash flow is the difference between cost savings (that will
increase net cash flow) and lost revenue (that will decrease net cash flow).
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Tip:
A decision relevant approach adopts whichever planning time horizon the decision
maker considers appropriate for a given situation. However, it is important not to focus
excessively on the short term, since the objective of any business is to maximise long
term net cash flows.
This unit is the second section in a series of chapters that deal with accumulating costs
for decision-making. The principles laid down in Units 3 (semester 1) and 1 are
fundamental. These form the basis of many advanced questions and therefore it is
essential that you grasp these concepts.
5. Concepts
Explain the meaning of the concepts relevance and irrelevance and applying these
concepts to the different types of decisions that needs to be made.
i. Relevant cost
Relevant costs are those costs that will make a difference in a decision. Relevant costs
are future costs that will differ amongst alternatives – see P447. Past costs (sunk cost)
may be use to predict future cost but the past costs are otherwise irrelevant to the
decision. Differential or incremental cost/income have the same meaning as relevant
cost. Non-cash flow items are usually excluded from relevant cost calculations. The
following example explains relevant and irrelevant costs:
Example 1
A company is deciding whether or not to close a product line. The product line
accounts for approximately 4% of the company’s activities. If the product line is
eliminated, the managers of the product line will be utilised elsewhere in the company
and will continue to receive their salaries of R500 000. The central (head office)
overheads will remain unchanged at R1 000 000. The employees working directly on
the product line, with salaries of R700 000, will be retrenched. The cost related to the
retrenchment of the product line employees amount to R200 000. The contribution of
the product line is R1 050 000. If the product line is closed, the contribution will be lost.
The relevance or irrelevance of the decision to close the product line is:
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How does one determine whether a cost or income item is relevant or irrelevant?
Salaries of managers are irrelevant because the R500 000 will incur whether the
product line is closed or not.
Central overheads of R1 000 000 are irrelevant because it will remain unchanged
whether the product line is closed or not (the total cost will not decline).
The R700 000 salaries of the employees working directly on the product line are
relevant because the cost will be saved if the product line is closed.
The R200 000 related to the retrenchment of the product line employees are
relevant because it will be saved if the product line is kept.
The contribution of R750 000 represents lost income, which is a cash outflow, and
is thus relevant.
The presentation of relevant cost to the decision should be (if product line is
closed):
Item Explanation Amount
Decision:
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The product line should be kept because a net cash outflow of R250 000 is
realised if the company decides to close the product line.
Important:
For those students who still use Drury - An alternative presentation is used in Drury.
You may use Drury’s presentation but the above presentation is in line with the
mark allocation in assessments. This presentation is the same as the last column
in the Drury presentation.
Please note that cash inflows are indicated as positive figures and cash outflow as
negative figures.
If an item is irrelevant, it must be shown as R0 because marks are allocated
if you identify an item as irrelevant.
Always give your decision, and the reason of the decision, after the calculations.
Marks are allocated according to your calculations for the decision made.
Tip:
Sunk costs are irrelevant for decision-making since it is a cost that has been
incurred in the past and cannot change future cash flows.
In general allocated fixed costs are not relevant. The reason being that the
allocated fixed cost is applicable to the entire business and no cost savings will
occur. However, if the company’s activities changes dramatically (i.e. production
move outside the relevant range) the incremental (additional) fixed cost will be
relevant to the decision.
Tip:
Remember that if fixed cost per unit is given at a certain production level, that fixed
cost per unit is only valid for the given production level. You need to multiply the
fixed cost per unit with the given production level to arrive at the total fixed cost.
From there on work with the total fixed cost. For example:
At a production level of 4 820 units, the fixed cost per unit is R7.50. The total fixed
cost is then R36 150. Within the relevant range, the total fixed cost will remain
R36 150 unless specific information is given to you (e.g. rent increased with 10%).
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ii. Opportunity cost
Opportunity cost reveals the economic value in any major choice between two
possibilities; i.e. the contribution to operating income lost by choosing one option
above another. Any choice involve trade-offs and opportunity cost shows you how to
measure these trade-offs. Opportunity costs are not an accounting term but is used in
decision making to determine the best alternative between different options. It is also
not recorded in the accounting system because options that are not taken are not
recorded. The following URL’s can be used as further explanation of opportunity costs:
https://www.youtube.com/watch?v=hR5E7Y4Dxuc
http://www.wikihow.com/Calculate-Opportunity-Cost
http://www.accountingcoach.com/blog/calculate-opportunity-cost
See the general principles for the classification of relevant or irrelevant items on P.
6. Types of decisions
Horngren P450.
Special order decisions are usually a once-off decision and it is important that this (sell
products at a lower sales price than to existing customers) does not influence the sales
to existing customers. This type of decision affect production levels when idle
(excess/spare) capacity and no long-term implication for the company’s normal
customers exist. Fixed costs are usually incurred for normal (full) capacity, is thus
“already covered”, and should not taken into account for the special order (unless
specific costs are incurred in special circumstances). Only consider the costs and
revenues that is relevant to the special order. That is the expected future revenues
and costs that differ as a result of accepting the special order.
Try it P452
Method 2 – show the amounts of relevant revenues and costs and zero for irrelevant
revenues and cost (Horngren P449)
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Tip:
The basic principles of CVP, cost behaviour within and outside the relevant range
and direct and absorption costing (see unit 3 CFM33A3 additional learning
material) is extremely important for the application of this unit.
Only use unit variable cost in your calculation when all fixed costs are not relevant.
When some fixed costs are relevant, use total variable cost and total fixed.
With the special order decision, the sales price were given. Short-term pricing
decisions require a company to bid or tender a sales price to a client. The minimum
sales price is usually the relevant variable cost. See Horngren P453.
Outsourcing to foreign companies bring about another risk namely foreign exchange
risk. See Horngren P457.
When capacity is scarce, you should always consider opportunity cost. Example 3 on
P458 explains this. The solution is presented in two different ways. You may choose
any of the two.
Try it P 460
Horngren P461
How a company decides to invest in inventory, will influence its cash flow because the
cash could also be used alternatively. Work through the example and note the
influence of opportunity cost.
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viii. Product-mix decision with capacity constraints
Horngren P462
This decision involve circumstances when companies do not have enough capacity to
produce all their products for which a market exist. Capacity in this scenario includes
space, machine hours (example machine breakdown), labour hours (labour strikes)
material (temporarily shortage of material) and so forth. The constraint is usually only
short-term. The decision to be made is to determine the product mix that will
yield the highest profit. “Product mix” is the combination of products to be produced
and sold. To determine the most profitable product mix you should calculate the
contribution per product and then contribution per scarce resource (labour hour
/ machine hour / material unit) of that product.
If there is only one constraint, the product with the highest contribution per
constraint should be chosen. Please note that it is not the product with the highest
contribution. When more than one constraint exist and the contribution per limiting
factor (scarce resource) is different between the products, it is necessary to apply
linear programming to determine the optimal mix of the products, taking the
constraints into consideration. Alternatively stated: if the ranking is different, apply
linear programming. For the purpose of CFM33B3/CFM3BB3, limiting factors will not
be more than 2 (e.g. material and machine hours).
Apart from determining the profitability of products, managers also make decisions
about the profitability of customers, branches of a company or product lines. See the
example on page 467. Remember that if there is alternative use for spare capacity
you must always take opportunity cost into account.
A company may analyse profits by department / product / region and so forth. In most
cases the department / product / region will generate their own income and incur their
own costs (fixed and variable costs). However, there may also be general overheads
allocated to this department / product / region to cover the fixed cost of “head office”.
Unless some of the “head office” costs can be saved when a department / product /
region is closed, the “head office” costs are irrelevant.
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Tip:
As long as the department / product / region cover all their own costs (variable and
possibly fixed cost attributed to that department / product / region) and deliver a
positive contribution, the department / product / region should be continued.
Horngren P471
See Example 6 P472. The main point to realise here is that historical or past costs are
irrelevant for the decisions. This topic will be covered extensively in unit 3. The
foundational principles of relevant and irrelevant costs/revenues in terms replacement
of fixed assets are established in this part.
It is extremely important that you work through the paragraph “Decisions and
Performance Evaluation” P473 to assist in interpreting questions and making
recommendations.
7. Qualitative factors
Tip:
8. Summary
There are three general principles used for determining the relevant costs and
revenues relating to a once off decision:
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1. Future. What is past and what is future is determined by reference to the time
at which the decision is made.
2. Incremental. The word incremental refers to financial changes as a result of
the decision at hand.
3. Cash flows. Exclude any non-cash, or notional items from.
9. Specific rules
In support of the three general principles for determining relevant costs, there are a
number of specific rules that should be followed to help accurately determine the
relevant costs and revenues pertaining to a decision:
10. Example 2
Cape Ltd., a steel erector recently tendered for the erection of the sub-structure of a
grain silo. This is a once-off contract that is not expected to be repeated. A summary
of the cost estimates used for the purpose of arriving at the tender price is as follows:
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Cost estimates – Grain Silo Amount
Direct labour – Engineering 3 000 hours at R100 per hour R300 000
Direct labour – Unskilled 10 000 hours at R40 per hour R400 000
Cape Ltd tendered at a price of R2.04 million by adding a mark-up of 20% to the above
costs. It has just been informed that its tender was unsuccessful. Cape Ltd.’s
Managing Director has asked your opinion as to whether the cost estimates, on which
the tender price was based, were correct. You have reviewed the working files and
have discerned that:
Engineering hours were in short supply and earn a contribution of R10 per hour.
6 000 engineering hours are needed to erect the Grain Silo.
Due to the recent cancellation of an order, the company expects to have 6 000
idle unskilled hours available to work on the job. Any additional unskilled labour
required is employed on a casual basis.
The wiring was already in the storeroom for the previous job that was cancelled.
The wiring has no other use and was to be scrapped at a cost of R10 000.
Fixed overheads represent an allocation of Cape Ltd.’s central fixed overhead.
The proposed tender would have incurred specific fixed costs of R20 000.
Steel is in inventory as originally costed R600 000. It is regularly used and
would be replaced at a cost of R250 000.
Variable overheads accurately represent water and electricity.
Cape Ltd does not reduce their labour force on the short-term as a result of idle
capacity available.
Required:
Prepare a revised tender price for Cape Ltd.’s Managing Director if relevant costing
principles were applied. The same mark-up percentage was to be added.
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Solution:
Add 20% mark-up on cost (R900 000 ÷ 100%) x 20% R180 000
The original price quoted was R2.04 million. Cape Ltd probably could have won the
tender if the relevant quotation was used. Decision-making based on accounting
principles will not accurately provide information for decision making as seen in this
example.
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Please note: Different approaches can be used for presenting your answer as
explained in the prescribed text book. Firstly all information (relevant and
irrelevant) can be presented for all the alternatives, secondly only the relevant
information can be presented for all the alternatives and thirdly where there is only
two alternatives only the relevant items can be presented. These different
approaches are evident in the text book examples. The approach used in
Examples 1 and 2 are preferred.
If a cost or revenue is irrelevant indicate the item as R- – you are assessed whether
you can distinguish between relevance and irrelevance. If you write nothing,
nothing can be marked.
Refer to the semester planning document on uLink (‘General Folder’) which questions
will be marked when.
There are many questions in Horngren that will not be discussed formally. Use this as
additional revision. The solution will be available from your lecturer if you have
attempted the question.
11.34; 11.35; 11.39; 11.40; 11.41; 11.26; 11.27; 11.28; 11.30; 11.31; 11.21 & 11.22
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12. Lab Activities
Gear Seal Ltd manufactures bearings and seals for both the automotive as well as
industrial sectors. The company operates in two divisions, the rubber division and the
steel division. Their bearings and seals are used in all makes of motor vehicles, as
well as in industrial equipment and machinery, both locally and internationally. The
bearings are manufactured in the steel division, while the seals are manufactured in
the rubber division. The total cost (at maximum capacity) to produce a bearing is
R4.4444 and the total cost to produce a seal is R2. They are currently producing
60 000 seals and 27 000 bearings for the month, which represents 75% capacity. 70%
of the total costs for the steel division are variable costs.
They have received an order from Nadasen’s auto manufacturers to supply 8 000
bearings for a vintage model Supra at a price of R4.20 per bearing.
Required:
1.1 Based on the above information, should Gear Seal Limited accept the
special order?
1.2 Briefly explain any non-financial factors that should be considered before a
final decision is taken.
Surf Gear manufactures quality beach towels at its highly automated plant in Cape
Town. The plant has a production capacity of 48 000 towels each month. Current
monthly production is 30 000 towels. Expected results for August, with sales of 30 000
towels, are:
Manufacturing costs:
Marketing costs
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As a result of a strike at its existing towel supplier, Azelia, a luxury hotel chain, has
offered to buy 5 000 towels from Surf Gear in August at R11 per towel. No subsequent
sales to Azelia are anticipated. Fixed manufacturing costs are based on the production
capacity of 48 000 towels per month. Fixed marketing costs are based on the sales of
30 000 towels per month. Surf Gear does not carry any inventory.
If Surf Gear accepts the special order, it will use the existing idle capacity to produce
the 5 000 towels. No marketing costs will be necessary for the 5 000 units special
order. Accepting this special order is not expected to affect the selling price or the
quantity of towels sold to regular customers.
Required:
EyeSpy (Pty) Ltd manufactures and sells a surveillance system, consisting of separate
components, which are manufactured in-house and then assembled. The packaging
(for 10 000 units) is currently outsourced to an external supplier at R45 per unit. The
computer component of the surveillance system has a standard manufacturing cost of
R2 300, which is made up as follows:
Component A R250
Component B R450
Component C R250
Component D R150
Assembly R400
The company has spare capacity in the existing factory and is considering
manufacturing their own packaging. The existing employees are paid a fixed salary
per month. A special packaging machine will be leased for R5 000 per month. It is
estimated that this machine will cause additional running costs of R1 000 per month.
The materials required for manufacturing the packaging are as follows:
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Materials Standard Price Standard Quantity
Required:
Question 11.43
Question 5 (Product-mix)
A B C
Material is limited to 60 000 kg per month. The same material is used for all 3
products.
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A B C
The direct labour rate per hour is R20; material costs R100 per kilogram
and variable manufacturing overhead rate is R80 per hour.
Required:
5.1 Calculate the optimal product mix that will maximise profits.
5.2 Assume the enterprise can acquire an extra 5 000 machine hours per
month at an extra cost of R100 000 per month. Would you recommend that
they take it? Support your answer with calculations.
Question 6 (Discontinuation)
Sono Sports manufactures soccer balls and cricket balls. Data on sales and costs for
the past month follows:
Fixed costs:
6.1 Determine if the production and sale of cricket balls should be discontinued.
The company has no other use for the capacity now being used to
manufacture cricket balls.
Question 11.47
Polaris Limited manufactures and sells Jet Ski’s. Polaris’s maximum capacity is 3 000
Jet Ski’s per annum. Costs associated with this level of production and sales are given
below:
The Jet Ski’s normally sell at R20 000 each. The fixed costs are constant at maximum
capacity. Variable selling expenses are commission paid to sales people as a
percentage of sales.
Required:
1.1 The National Credit Act had such an influence on the sales of Jet Ski’s as
fewer people are granted credit. The effect is that that Polaris expects to
sell only 2 500 units next year. One of the sales people contacted an
entrepreneur (who wants to rent out the Jet Ski’s at the Hartbeespoortdam)
to purchase Jet Ski’s which could be manufactured using spare capacity.
The entrepreneur has offered to purchase 250 Jet Ski’s if Polaris is willing
to accept a 20% discount off the regular price. Should this order be
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accepted? Motivate with reasons. Show all calculations (per unit and in
total).
1.2 What is the minimum price that Polaris should charge the entrepreneur to
achieve a total operating income of R3 200 000 per annum. Take the
current operating income (if 2 500 Jet Ski’s are sold) into consideration.
The sales person is willing to settle for R800 commission per Jet Ski for the
special order only. Show all calculations (per unit and in total).
1.3 Name three aspects that should be taken into account when making special
order decisions
The Soho Company manufactures CD player units. The following table show the
current costs for manufacturing 1 000 000 CD player units in 2 500 batches as well as
the expected costs for next year when 1 000 000 units will be produced in 5 000
batches:
- Currently, materials- handling and setup activities occur each time a batch of CD
Players is made. Soho produces 1 000 000 CD players in 2 500 batches, with 400
units in each batch.
- The number of batches is the cost driver for these costs. Total materials handling
costs and setup costs equal fixed costs of R500 000 plus variable costs of R500
per batch (R500 000 + (2 500 batches x R500 per batch) = R1 750 000).
- Soho is considering whether to produce CD players in smaller batch sizes. Soho
anticipates producing the 1 000 000 CD players next year in 5 000 batches of 200
units per batch.
- Through continuous improvement the company expects to reduce variable costs
for materials handling and setup to R300 per batch.
- No other changes in variable costs per unit or fixed costs are anticipated.
Another manufacturer offers to sell Soho 1 000 000 CD players next year for R16 per
unit on whatever delivery schedule Soho wants. Assume that financial factors will be
the basis of this make-or-buy decision.
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Required:
Question 3 (Discontinuation)
The level of operations of Struggle Limited is currently at 40% (40 000 products) and
at this capacity level the operating results are as follows:
Management expects that, because of intensifying competition and rising costs, the
sales volume will fall further but the selling price per unit will remain constant.
Management intends to reorganise the production layout to bring a cheaper product
onto the market. This will take 12 months to complete. The enterprise can save 10%
in fixed costs should it cease its activities.
Required:
3.1 Calculate the sales volume at which point the enterprise must cease its
operations. Verify your answer by preparing an abridged income statement.
Question 4 (Constraints)
Power Recreation assembles two engines – a snowmobile engine and a boat engine
– at its Lexington Kentucky plant.
Snow Boat
Mobiles Engines
Demand 175 80
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Assume that only 600 machine –hours are available daily for assembling the engines.
Additional capacity cannot be obtained in the short term. Power Recreation can sell
as many engines as it produces. The constraining resource then is machine hours. It
takes two machine hours to produce one snowmobile engine and five machine hours
to produce one boat engine.
Required:
Bibliography
Niemand, A.A., Meyer, L., Botes, V.L. & Van Vuuren, S.J. 2004. Fundamentals of Cost
and Management Accounting. LexisNexis Butterworths.
Roos, S., Cairney, C., Savuka, R., Fourie, H., Joubert, D., Haji, A.M. & Pienaar, A.
Principles of Management Accounting a South African perspective. Oxford University
Press.
Van Rensburg, M., Ambe, C.M., Evangelou, O., Govender, B., Koortzen, P.J. &
Ziemerink, J.E.E. 2007. Cost and Management Accounting. Van Schaiks.
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