STRATEGIC COST MANAGEMENT

Short-Term Decision Making (Relevant Costing)

This topic can also be called Short–Term Non-Routine Decisions / Incremental Analysis

Defining Decision Making

• Is the process of choosing a course of action from at least two alternatives.
• As the management accountant, we only give advises
• Management chooses from the alternatives

Short-Term Decision Alternatives

1. Accept or reject a special order
o Non-routine decision making
o Between the customer and the company
o Ex. Some customers order 1,000 units so because this is wholesale, it will be discounted.
▪ We ask the question: Do we accept or reject the special order?
2. Sell or process further a product line
o “Sell as is or Process Further”
o Happens in the Joint and By Product
▪ Split Off Point
▪ Iisang production process pero sa dulo may split off and management will have the option to process
further or sell already
3. Make or buy a part or product line
o Common topic
o Manufacturers need raw materials
o This part asks who will supply these raw materials and where will we save more money?
▪ Outsource suppliers
▪ Manufacture it ourselves
4. Continue or shutdown a business segment
o There are many factors to consider in shutting down business segments like certain unavoidable costs
5. Choosing the best product combination
o Maximization of scarce resources
o With certain constraints

Decision Making Process

1. Defining the problem.
2. Specifying the objective and criteria.
3. Identifying the alternative courses of action.
4. Determining and evaluating the possible consequences of the alternatives.
5. Choosing the best alternative and making the decision.
6. Evaluating the results of the decision.

Types of Costs used in Decision Making

● Relevant Costs – Future cost expected to be different between or among alternatives.

o These costs cannot be incurred from Alternative 1 but can be incurred from Alternative 2
o There is also the presence of differential costs
o If the same cost is present in two different alternatives, that can be considered irrelevant costs
● Differential Costs – Increases (increments) or decreases (decrements) in total costs that result from selecting one
alternative instead of another.
o You will compare the Total Relevant Cost of Alternative 1 (P100K) versus the Total Relevant Cost of
Alternative 2 (P120K)
▪ Choose the lowest one, assuming that the goal is minimization of cost
▪ There is P20,000 differential cost
● If you chose Alternative 1, there is a decremental cost since P100K is lower
● If you chose Alternative 2, there is an incremental cost since P120K is higher
● Avoidable Costs – (Relevant) Costs that will be saved or those that will not be incurred if a certain decision is made.
o Like the Relevant Cost, it is not present for both the alternatives
o You will be able to avoid it if you choose the other alternative
● Sunk Costs – (Irrelevant) Costs incurred already and cannot be avoided regardless of what a manager decides to
do.
o Past Costs / Historical Cost
o Ex. Depreciation of Equipment
o Kahit anong alternative piliin mo, nandiyan na yan
● Out-of-Pocket Costs – (Relevant) Costs that will require expenditure or cash or incurrence of a liability as a
consequence of a management decision.
● Opportunity Costs – (Relevant) Income sacrificed or foregone when a certain alternative is chosen over another
alternative.
o Not part of traditional accounting records
o Nagiging cost lang ito kasi nagsa-sacrifice tayo ng income i.e., nawawalan tayo ng income
o We loss the opportunity to loss additional income
● Joint Costs – (Irrelevant) Costs incurred in simultaneously manufacturing two or more (joint) products that are
difficult to identify individually as separate types of products until the products reach a certain processing stage
known as the split-off point.
o Incurred beforehand i.e. doesn’t really affect the choice of the alternatives
o One example of sunk costs
o One example of indirect cost
● Split-off Point – A point in the manufacturing process where some or all of joint products can be distinctively
recognized as individual products.

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 ● Further Processing Costs – (Relevant) Costs incurred beyond the split-off point if product is to be processed
further.
● Bottleneck Resources – Any resource or operation where the capacity is less than the demand placed upon it.
o Has limited resources
o There are the presence of constraints and these constraints must be maximized

Approaches in solving problems that involve decision-making

● Total approach – The total revenues and costs are determined for each alternative, and the results are compared
to serve as a basis for making decisions.
o Isasama lahat ng costs may it be relevant or irrelevant
▪ Both will be presented
● Differential approach – Only the differences or changes in costs and revenues are considered.
o Pag present sa isa yung cost, wag mo na isama sa kabila

Illustration: Total vs. Differential Approach

Lakers Company has a single product called Jones. The company normally produces and sells 80,000 units each year at a
selling price of P40 per unit. The company’s unit cost at this level of activity is given below:
Direct materials P 9.50 Fixed overhead P 5.00
Direct labor 10.00 Variable selling expense 1.70
Variable overhead 2.80 Fixed selling expense 4.50

Required:
1. Compute Lakers Company’s income.
o Since Production = Sales, there will be problem and the default costing method to be used is Variable
Costing

▪ Remember that Fixed Costs are based on Production, but because Production = Sales, we got
760,000 either way

2. Assume that Lakers Company has sufficient capacity to produce 100,000 rings a year without any increase in fixed
overhead costs. The company could increase sales by 25% if it were to increase the fixed selling expenses by
P120,000. Determine the effect on company profit using:

a. Total analysis

b. Differential analysis

« « Make or Buy a Part for a Product » »

Choose the option that involves the lower cost. In most cases, fixed costs are irrelevant. Consider opportunity costs, if
any.
• Fixed Costs can be:
o Avoidable - Relevant
▪ Present only in one alternative
▪ Ex. In the Make or Buy.
• Kapag ikaw gagawa, you will hire a supervisor, which incurs costs like salary
• Kapag bibili, you won’t have to pay the salary of the supervisor
o Unavoidable - Irrelevant
▪ Fixed cost is present for all the alternatives
o If the problem is silent, Fixed Costs are irrelevant

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Illustration: Make or Buy (the problem is silent regarding the fixed overhead)

The Tiger Company uses 30 units of Part “Kitty” per month in the production of its main product. The manufacturing costs per
unit of Part “Kitty” are as follows:
Materials P 1,000
Handling cost * 100
Direct labor 5,000
Factory overhead (40% fixed) 10,000
Total P 16,100

* Handling cost is applied at 10% of cost of direct materials and/or any purchased parts.

Lion Company, a well-known producer of part “Kitty”, has offered to supply the part for Tiger Company at P12,500 per unit.
Should Tiger Company accept Lion’s offer, the resulting idle facility may be used to produce another product, Product “Ming-
Ming”, which is expected to contribute P75,000 per month.

• Important Notes in Understanding the Problem

o If you accept the offer of the supplier Lion: You will have an idle facility
▪ This allows you to produce “Ming-Ming”
o If you manufacture the part “Kitty”: You won’t have an idle facility
▪ The P75,000 from Ming-Ming becomes an opportunity cost

Should Tiger Company make or buy Part “Kitty” from Lion Company? Why? Buy, P25,500 savings

Illustration: Make or Buy (avoidable & unavoidable fixed costs are specified)

The BMW Motors executive is trying to decide whether the company should continue to produce an engine component or
buy it from Saraw-Philippines at P100 each. Demand for the coming year is 200 units. Data for the current year follow:
Direct materials P 10,000
Direct labor 4,000
Variable factory overhead 2,000
Fixed factory overhead 5,000
Total P 21,000

If BMW makes the components, the unit costs of direct materials will increase by 20%.

If BMW buys the components, 30% of the fixed costs will be avoided. The other 70% will continue regardless of whether the
components are manufactured or purchased. Moreover, the production facility now used to make the components can be
rented out to another firm for P2,500.

Should BMW make or buy the components? Why? Buy, P2,000 savings

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 « « Accept or Reject a Special Order» »

Special Order
• May mga customers na lalapit sa company and manghihingi ng discount
• The selling price are below the regular SP
• The decision to be made here is whether we accept or reject the special order

Accept the order if the additional revenue from the special order exceeds additional cost, provided the regular market will not
be affected. In most cases, fixed costs are irrelevant.

• Additional Revenue > Additional Cost: Accept the Order

o If the regular market will not be affected: Hindi kailangan magsacrifice ng sales for regular customers just
to cater the needs of the special orders
o If the regular market will be affected: There will be a presence of opportunity costs
o Normally, the additional costs being referred to are variable costs

Illustration: Accept or Reject a Special Order (w/ excess capacity or unsold units)

Antonia 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 50,000 units per month is as follows:
Manufacturing costs:
Direct materials P 32.50 per unit
Direct labor 7.20 per unit
Variable overhead 1.30 per unit
Fixed overhead 1,045,000 per month
Selling and administrative costs:
Variable 1.90 per unit
Fixed 365,000 per month

The normal selling price of the product is P75 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 of P65 per unit. 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. The variable selling and administrative expense would be P0.30 less per unit on
this order than on normal sales.

• Important Notes in Understanding the Problem

o Normal Selling Price = P75
o Special Order = 3,000 units
▪ Selling Price = P65
o Order does not affect the company’s normal sales
▪ Regular sales would not be sacrificed
o The Variable Costs would be 1.6 per unit
o If the problem is silent about fixed costs, ignore it

Should Antonia Accept or reject the special order? Why? Accept, P67,200 additional income

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Illustration: Accept or Reject a Special Order (w/o excess capacity or unsold units)

Conrada Company sells Nokia N99 at a price of P27,000 per unit. N99’s costs per unit are:

Direct materials P 7,500

Direct labor 3,900
Variable overhead 4,500
Fixed overhead 6,600
Total P 22,500

A special order for 1,000 units was received from Marcy Wholesalers, Inc., a well-known cellphone dealer based in Cavite.
Additional shipping costs for this sale are P3,000 per unit.

• Important Notes in Understanding the Problem

o If ever, we decide to accept special orders, the regular sales of the company would be affected
▪ Without excess capacity
o Minimum Selling Price means to find the breakeven
▪ Equivalent to the incremental cost
▪ Pinakamababa na pwede mong i-charge sa special order para maiwasan yung loss
o Operating at Full Capacity:
▪ Sa oras na in-accept mo ang special orders, you charge the opportunity to the customers
o

What is the minimum selling price per unit if:

a. Conrada is operating at full capacity? P30,000 b. Conrada has excess capacity? P18,900

a. Full Capacity

▪ Again, since you are operating at full capacity, kung ano yung mawawalang income diyan, you need
to charge it to the special order (as seen in the P11,100)

b. Excess Capacity

▪ You don’t need opportunity cost kasi you don’t sacrifice regular sales when you operate at excess
capacity

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 « « Continue or Shutdown a Business Segment » »

Continue if avoidable revenue of the segment involved is greater than its avoidable costs; otherwise, consider shutting down
the segment. Since allocated fixed cost is usually unavoidable, it is considered irrelevant.
• Nagkakaroon ng ganito kapag napapansin na ng management na parang may net loss sa company
• You cannot shut down a segment without computing its cost, there will be wrong decisions
• Avoidable Revenue Of The Segment Involved > Avoidable Costs: Continue a Business Segment
o Kung ang mawawalang benefit ay P1M tas ang mawawalang cost ay P800K lang, don’t shut it down
• Avoidable Costs
o If you shut down a specific business segment, madadamay na ito
o Hindi na matutuloy ang incurrence nito
o These costs will also be shut down
• Unavoidable Costs
o Can also be called shut down cost
o If a certain segment has been shut down, these costs would be absorbed by another segment
• Here, it is very important to know whether a business is avoidable or not
• Assumption:
o Variable Costs are Avoidable
▪ You cannot incur these costs without operating the company
o Fixed Costs
▪ Indirect / Common / Allocated Fixed Costs are Unavoidable
• 100% unavoidable
o Salary of workers (when the segment has been shut down, pwedeng kunin lang sila ng
ibang segment)
o Property taxes
o Insurance
▪ Direct / Traceable Fixed Costs
• Traceable sa isang segment
• NOT 100% unavoidable
• Can be avoidable but not all
o Salary of a manager (because the segment has been shut down nga)
• When the problem is silent, assume that it is avoidable

Illustration: Continue or Shutdown a Business Segment . . . Always look at the segment margin!

The most recent monthly income statement for Hanamichi Stores is given below:

North Store South Store Total

Sales P 1,200,000 P 800,000 P 2,000,000
Less: Variable expenses 840,000 360,000 1,200,000
Contribution margin P 360,000 P 440,000 P 800,000
Less: Traceable fixed expenses 210,000 180,000 390,000
Segment margin P 150,000 P 260,000 P 410,000
Less: Common fixed expenses 180,000 120,000 300,000
Net operating income (loss) P (30,000) P 140,000 P 110,000

Management of Hanamichi Stores is considering the elimination of the North Store. If the North Store were eliminated, then its
traceable fixed expenses could be avoided. The total common fixed expenses are merely allocated and would be unaffected.

• Important Notes in Understanding the Problem

o Again, Traceable Fixed Expenses = Direct Fixed Costs
o Contribution Margin – Direct Fixed Costs = Segment Margin / Direct Margin
▪ It’s called Direct Margin because Variable Expenses and Traceable Fixed Expenses are considered
Direct Costs
o Traceable Fixed Costs = Avoidable here in the problem
o For the P180,000 Traceable F.C. ni South Store, hindi siya magagalaw
▪ This is because avoidable yung yung Traceable FC ni North. It won’t affect south
o For number 2: Remember that changes in Sales can also be considered changes in CM

1. The elimination of the North Store would result in an overall company net operating income (loss) of: (P40,000)

2. Assume that if North Store is closed, 20% of its traceable fixed expense would continue unchanged. Also, closing of
North Store would result in a 20% decrease in sales of South Store. The overall decrease in operating income will be:
P280,000

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 *There are notes below regarding the problem*
o Avoidable Margin is one of the most important factors to assess whether to continue or shut down a
segment
▪ If it’s positive, it has a positive contribution to the company. Shut it down when it’s negative.
o Pagtinanggal mo si North, mawawala yung Avoidable Margin na P192,000,
o Pagtinanggal mo si North, magkakaroon ng decrease sa total CM ni South

Illustration: Shutdown Point . . . It is still the indifference point!

• Indifference Point = Shutdown Point

• You only must choose whether you would
o Shut Down
▪ How many Number of units / Peso sales na kailangan nating ibenta kung pipiliin natin yung “Continue”
▪ Whatever the result, assuming it is net loss, dapat equal siya kung ico-continue lang
• Net Loss Continue = Net Loss Shut Down
o Continue

The Yusuke Company expects that the volume of sales will drop below the current level of 5,000 units per month. An operating
statement prepared for the monthly sales of 5,000 units show the following:

Sales (5,000 @ P3) P 15,000

Less: Variable costs (5,000 @ P2) P 10,000
Fixed costs 5,000 15,000
Net income P -0-

If plant operations are suspended, a shutdown cost (i.e., plant maintenance, taxes and insurance premiums) of P2,000 per
month will remain as incurred. Since there is no immediate possibility of profit under present conditions, the problem of the
company is just how to minimize the loss.

• Important Notes in Understanding the Problem

o 5,000 units is the Breakeven Point
o Pag shinut down ang isang segment, mawawala ang SALES and also the VARIABLE COST
▪ Fixed Costs are not all avoidable

Required:

1. Compute for the shutdown point in units and in pesos. 3,000 units, P9,000

2. Should the company continue or shut down operations if the company expects demand to be:

a. 4,000 units? Continue, P1,000 loss

▪ Continue because at 4,000 units, it is lower than the Net Loss at Shut Down Point (2,000 from
Number 1)

b. 2,000 units? Shutdown, P3,000 loss

▪ 3,000 is bigger than 2,000

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 « « Sell-as-is or Process Further a Product » »

A product must be processed further if additional revenue from processing further is greater than further processing costs.
Joint costs, since already incurred, are considered sunk costs and irrelevant.

• This would a review on Cost Accounting’s Joint and By Product Costing

o There the problem was how to allocate the Joint Costs
• Here, the problem would be: If we would be selling these products at split off point or if we will process them
further
• Objective of Additional Processing: To increase or to convert the joint product into a more refined or a more
improved product
o Pinatataas yung value ng joint product
• This incurs additional processing costs and sales value will also increase
• ASK: How much will the additional revenue and the additional cost be?
• Additional Revenue from Processing Further > Further Processing Cost: Process Further
o Further Processing Cost = Additional Processing Cost
o If mas mataas si Further Processing Cost, benta mo na agad at Split Off
▪ Selling at Split Off = Sell as Is
• NOTE that it is at the Split Off Point where we decided whether to Sell as Is or Process Further
• At the split off point, Joint Costs have already been incurred
o Therefore, Joint Costs is IRRELEVANT here
o But it’s still part of the computation (as part of the Allocated Cost)

Illustration: Sell-as-is or Process Further a Product

Cloud Company produces four products for a joint cost of P20,000. The products are currently processed beyond the split-off
point, and the final products are sold as follows:
Products Sales Additional Processing Cost
M P 36,000 P 22,000
I 26,400 12,000
L 10,400 8,000
O 2,400 3,000

The firm could sell products M, I and L at the split-off point for P16,000, P7,200 and P2,000, respectively.

• Important Notes in Understanding the Problem

o P16,000, P7,200, and P2,000 are the Sales Value at Split Off Point
▪ Pwede na ibenta here, pero the company still has option to process it further with Additional Processing
Costs
o Understanding the Given:

▪ Question is, which among these should be sold at split off point and which should be processed further
• This depends on the Income / Loss
Required:

1. Determine the product(s) the firm should sell at split-off point. M only

o Additional Profit / Loss = Additional Revenues – Additional Costs

o Product O cannot be sold at Split Off Point because it has no value. It also cannot be Processed Further
because there is a P600 net loss

2. If Choco Company takes the most profitable action, what will be its profit? P12,800

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 « « Optimization of Scarce Resources » »

Identify and measure the constraint on the limited resource(s). Rank the products according to the highest CM per unit of
scarce resources.

• This happens when there is Bottleneck or Constraints

• When the input (materials, labor hours) becomes limited, so the units we can produce is not enough to satisfy the
demand of the customers.
• First, identify where the constraints are
• Instead of computing the CM per unit of finished product, compute for the Contribution Margin per Scarce
Resource
o Pwede kasing magcompute ng CM per unit of finished product pero siya pala yung pinaka-malakas
magconsume nung mga scarce resources, thus magiging kaunti lang yung mapo-produce na product

Illustration: Optimization of Scarce Resources

Bottleneck Co. produces three products: A, B and C. One machine is used to produce the products. The contribution margins,
sales demands, and time on the machine (in hours) are as follows:
Market Limit Selling Price Unit Variable Cost Hours on Machine
A 100 units P 30 P 10 10 per unit
B 80 units P 25 P7 5 per unit
C 150 units P 40 P 15 10 per unit

There are 2,400 hours available on the machine during the week. Total fixed cost is P5,000.

• Important Notes in Understanding the Problem

o Market Limit is hanggang saan lang pwedeng ibenta
o The constraint or the bottleneck is seen in the “2,400 hours available on the machine”
▪ Thus, the production must be maximized based on their Contribution Margin per Machine Hour

1. How many units should be produced and sold to maximize the weekly contribution? A, 50; B, 80; C, 150

o Kung sino yung pinaka-mataas sa Ranking, siya yung dapat i-prioritize

o Because there is the presence of scarce resources, magiging bitin yung utilization for A
▪ This would be alright because A is the last in the rankings
o Summary: We prioritized those that are higher in the rankings. Kung ano yung matira for those na mas
mababa, yun yung mabibitin because of the constraint (in this case, it’s A)

2. How much is the profit associated with the best product combination? P1,190

o This could be called as Maximum Profit / Optimal Profit kasi sinunod yung ranking

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 WRAP-UP EXERCISES (TRUE OR FALSE; MULTIPLE-CHOICE)

1. Variable costs are relevant costs in decision-making, whereas fixed costs are irrelevant. FALSE
• Fixed Costs are not always irrelevant

2. The salary you would otherwise earn by working rather than attending the CPA review is a good example of
a. A sunk cost b. An out-of-pocket cost c. An opportunity cost d. An incremental cost

3. An opportunity cost is usually:

a. Relevant, but is not part of traditional accounting records.
b. Not relevant, but is part of traditional accounting records.
c. Relevant, and is part of traditional accounting records.
d. Not relevant, and is not part of traditional accounting records.

4. A company that has a limited number of labor hours and abundant machine hours should produce first the product that has
the highest
a. Demand in units b. CM per unit c. CM per labor hour d. CM per machine hour

• Per Labor Hour kasi si Labor Hour yung limited/constrained

5. If the margin that will be lost by dropping a product line is more than the fixed costs that will be avoided, then the line should
be dropped. FALSE

• Since avoidable margin is positive, it will only increase the profit. The line should not be dropped but continued.

6. The shutdown point is a point at which loss from continued operation is equal to the costs of shutdown; hence, it is likewise
referred to as the indifference point. TRUE

7. If the level of expected operations falls below the shutdown point, then the company should discontinue the operations. TRUE

8. If there are shutdown costs, a company’s shutdown point is always below the break-even point. TRUE

9. Joint product costs involving the decision to sell or process further are irrelevant and therefore, not to be considered for
product costing purposes. FALSE

• Joint Product Costs must still be considered

10. If there is excess capacity, the minimum acceptable price for a special order must cover
a. Usual fixed manufacturing costs
b. Variable manufacturing costs associated with the special order.
c. Variable and usual fixed manufacturing costs.
d. Variable manufacturing costs plus CM foregone on lost regular units.

11. The opportunity cost of making a component part in a factory with excess capacity for which there is no alternative use is
a. The total manufacturing cost of the component. c. The fixed cost of the component.
b. The variable cost of the component. d. Zero

12. The role of sunk costs in decision-making can be summed up in which of the following sayings?
a. No pain, no gain c. A penny saved is a penny earned
b. Bygones are bygones d. The love of money is the root of all evil

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