Managerial Accounting

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Relevant Costing

Module 008: Relevant Costing

Course Learning Outcomes:

At the end of this module, the student will be able to:
1. Define decision making and other terminologies used in short-term
decision making.
2. Know the short-term decision alternatives.
3. Present relevant cost and quantitative analysis in different situations
involving short-term decisions.

Decision Making
Decision making is the process of choosing from at least two alternatives. For business
entities, management must choose in favor of the option that maximizes the company
profit.

Short-Term Decision Alternatives

1. Make or buy a part or a product line
2. Accept or reject a special order
3. Sell or process further a product line
4. Continue or shutdown a business segment
5. Choosing the best product combination
6. Selecting a change in profit factors

Typical Decision Making Process

1. Defining the problem
2. Specifying the objective and criteria
3. Identifying the alternative courses of action
4. Evaluating the possible consequences of the alternatives
5. Collecting the data needed to make decision
6. Choosing the best alternative and making the decision
7. Evaluating the results of the decision

Factors Considered in Decision Making

 Qualitative factors – factors that cannot be expressed in monetary terms.
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  Quantitative factors – factors that can be expressed in monetary or other
numerical units.
Quantitative approaches in decision making:
1) TOTAL approach – the total revenues and costs are determined for each
alternative and the results are compared to serve as a basis for the decision
to make.
2) DIFFERENTIAL approach – only the differences or changes in costs and
revenues are considered.
In most decision-making cases that involve a conflict between qualitative and
quantitative factors, quality usually prevails over quantity.
Cost standards indicate what the cost of the quantity standards (materials quantity
and labor time) should be.

Terminologies Used in Short-Term Decision Making

Relevant costs Future costs that are different among alternatives. They are
considered as the avoidable costs of a particular decision.
Differential costs Increases (increments) or decreases (decrements) in total costs
that result from selecting one alternative instead of another.
[Relevant]
Avoidable costs Costs that will be saved or those that will not be incurred if a
certain decision is made. [Relevant]
Opportunity costs Income sacrificed or benefit foregone when a certain alternative
is chosen over another alternative. [Relevant]
Sunk costs Costs that are incurred already and cannot be avoided regardless
of what decision is made. [Irrelevant]
Shutdown costs Usual costs that a company will continue even if it decides to
discontinue or shutdown the operation of a company segment.
[Irrelevant]
Joint costs 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. [Irrelevant]
Further processing Costs incurred beyond the split-off point as separated joint
costs products are to be processed further. [Relevant]
Split-off point The earliest stage in the production where joint products can be
recognized as distinct and separate products.
Bottleneck resources Any particular resource or operation where the capacity is less
than the demand placed upon it.

Short-Term Decision Making Guidelines

Basic rule: choose the action that will yield the best profit position.
Highest revenues
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Highest possible profit

Lowest costs

Nature of Alternatives Description Decision Guidelines

1. MAKE or BUY a Should a part or product be Choose the option that has
part/product manufactured (in-sourced) the lower cost. In most
or bought (outsourced) cases, fixed costs are
from outside supplier? irrelevant. Consider
opportunity costs, if any.
2. ACCEPT or REJECT a Should a special order that Accept the order when the
special order requires a price lower than additional revenue from
the regular selling price be the special order exceeds
accepted? additional cost, provided
the regular market will not
be affected.
3. CONTINUE or Should a business segment, Continue if segment’s
SHUTDOWN a business which may be a product avoidable revenue is
segment line, a department or a greater than its avoidable
branch, be continued or costs. Otherwise, consider
discontinued? shutting down the segment.
Since allocated fixed cost is
usually unavoidable, it is
considered irrelevant.
4. SELL or PROCESS Should a product, after Process further if
FURTHER a product undergoing the joint additional revenue from
process, be sold at the split- processing further is
off point or be processed greater than further
further beyond the split-off processing costs. Joint
point? costs, since already
incurred prior to the split-
off point, are considered
sunk costs and irrelevant.
5. BEST PRODUCT Which product(s) should be Identify and measure the
COMBINATION produced and sold when constraint on the limited
(Optimization of Scarce there is a given limited resource(s). Rank the
Resources) resources or bottleneck product(s) according to the
operation? highest contribution
margin per unit of limited
resources.
6. CHANGE IN PROFIT Should any of the profit Identify the factor to
FACTORS factors, such as selling change and the amount of
price, unit sales, variable contemplated change.
cost, fixed cost and sales Change the profit factor if it
mix be manipulated to will cause an improvement

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 increase profit? on the company’s over-all
profit position.

Make or Buy a Component Part

A product is composed of different parts. Not all parts of the products are manufactured by
a company. A part may be outsourced from a supplier based on the following reasons:
1. Lack of technology, man labor hours, machine hours, systems expertise and
financing money
2. Unprofitable operations
3. Savings
The total relevant costs of each option should be taken when deciding to make or buy a
part. Whichever option gives a lower relevant cost would be a better alternative, assuming
no other quantitative and qualitative factors are to be considered.

Illustration: Make or Buy a Part

JKL Corporation manufactures part X-24 for use in its production cycle. The cost per unit of
10,000 units of part X-24 are as follows:
Direct materials P 6.00
Materials handling costs (20%) 1.20
Direct labor 20.00
Variable overhead 5.00
Fixed overhead 11.00
Total P43.20

XYZ Company has offered to sell JKL Corporation 10,000 units of part X-24 for P40 per unit.
If JKL accepts XYZ’s offer, P4 of the fixed overhead per unit could be eliminated. The
materials handling costs pertain to the cost of receiving and inspecting incoming materials
and other components which are not included in the overhead.
If the part is outsourced form an outside supplier, one-half of the released facilities could
be used to produce a new product, Citrus, which is expected to generate a contribution
margin of P90,000 per year. Additionally, a savings of p15,000 is expected if the parts are
purchased outside. The other half of the released facilities could be rented out for P60,000
per annum.
The outside supplier requires that an equipment be leased to meet the order of the
company. The equipment rental cost of P80,000 shall be charged to the company.
Required:
1. Make or buy the part? By how much is its advantage?
2. Indifference price of the two alternatives.
3. Purchase price to have a savings of P10.00 per part
4. The sunk cost (or irrelevant cost) in the decision of making or buying part.
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Computations Cost to MAKE Cost to BUY

Purchase price 10,000 x P40 P400,000
Direct materials 10,000 x P6 P60,000
Materials handling costs P60,000 x 20% 12,000 80,000 (P400,000 x 20%)
Direct labor 10,000 x P20 200,000
Variable overhead 10,000 x P5 50,000
Avoidable fixed overhead 10,000 x P40 40,000
Savings if the part is bought (15,000)
Rental income from released facilities (60,000)
Contribution margin from a new product (90,000)
Rental expense if the part is bought 80,000
Total relevant costs P362,000 P395,00
Savings if parts are made P33,000
Solutions/Discussions:
1. Although, qualitative variables are sometimes much more considered in making a
decision, our discussion is limited only to the quantitative aspects. We will consider
only those that could be quantitatively measured in monetary terms based on the
principle of objectivity.
 The tabulated relevant costs of making or buying the part is as follows:

 Variable production costs (e.g., direct materials, direct labor, and variance
overhead) are incremental costs, differential costs, and are relevant costs.
 Avoidable fixed overhead costs are also relevant costs since they vary from one
option to another. If a part is manufactured, the avoidable fixed cost is incurred. But
if the part is purchased, it is avoidable.
 Unavoidable fixed overhead cannot be avoided regardless of decisions made
whether make or buy. It does not change. It is irrelevant.
 Materials handling costs apply to both materials and other items being purchased.
The rate used in the allocation of the materials handling costs is constant but the
amount allocated to various departments differs depending on the base amount of
items. These make the materials handling costs relevant for the make or buy short-
term decision.
 Savings from parts bought, rental income from released facilities, and contribution
margin from a new product all happen when the part is bought. They are all inflows,
either in the form of savings or additional income, and as such are deducted from
the costs of buying.
 The rental expense, in this case, is an incremental cost of buying the part, hence,
added to the cost of buying.
 Variable and fixed selling and administrative expenses are not considered in the
analysis because they are not affected by the decisions, will not change, and are
irrelevant in the decision on hand.
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  Based on the quantitative analysis above, it is advisable for JKL Corporation to make
the part.
Unit cost to make P362,000/10,000 P36.20
Relevant costs to buy, except the purchase price:
Rental expenses P80,000/10,000 (8.00)
Contribution margin from a new product P90,000/10,000 9.00
Rental income from released facilities P60,000/10,000 6.00
Savings if the part is bought P15,000/10,000 1.50
Gross purchase price including handling costs P65.00

2. The indifference price of the alternatives (make or buy) is computed as follows:

3. The purchase price with a P10 savings per part shall be computed as follows:
Gross purchase price including handling cost P65.00
(10.00
Savings )
Gross purchase price with savings P55.00
Net purchase price P45.83

4. The sunk cost in the decision to make or buy the part shall be the unavoidable fixed
costs of P70,000 (10,000 x P7).

Accept or Reject a Special Sales Order

This pertains to special sales order outside the regular sales of the business. In deciding
whether to accept or reject a special order, the paramount consideration is incremental
profit, which is normally determined as follows:
Incremental revenue (inflows) P x
Incremental costs (x)
Incremental profit (loss) P x

The following factors are to be considered in the decision to accept or reject a special sales
order: possible competition and idle capacity.
 Is unnecessary competition created?
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If the acceptance of the special sales order creates an unnecessary competition on the
regular product sales, the special sales order is normally rejected. If regular sales are
lost due to the acceptance of a special sales order, the lost contribution margin from
regular sales becomes an opportunity cost that should be deducted from the
incremental profit of accepting the special order.
Normally, a regular market is distinguished from a special market in that one is
domestic and the other foreign. The products, regular product or special product, can be
visibly identified for each other through marks, color, or other distinguishing features.
 Do we have an idle or no idle capacity?
If there is no alternative use of capacity, the incremental profit (loss) is the difference
between incremental sales and incremental costs and expenses.
The incremental profit (loss) from the special sales should be compared with the best
benefit that may be derived from the alternative use of the capacity to get the net
advantage or disadvantage from accepting the special sales order.

Illustration: Accept or Reject a Special Order

The manufacturing capacity of JKL Corporation’s facilities is 50,000 units of product a year.
A summary of operating results for the year-end December 31, 2017 is as follows:
Total Per Unit
Sales (38,000 units) P3,800,000 P100.00
Less: Variable costs and expenses 2,090,000 55.00
Contribution margin 1,710,000 P45.00
Less: Fixed costs and expenses 900,000
Operating income P810,000

A distributor company has offered to buy 12,000 units at P90 per unit during 2018. Assume
that all of the corporation’s costs would be at the same levels and rates in 2018 as to 2017.
Required: Should JKL Corporation accept or reject the special sales order?
(Consider the following cases independently)
1. The corporation has no alternative use of the idle capacity.
2. The corporation can rent out the idle capacity for P200,000.
3. The corporation can use the idle capacity to produce a new product that could
contribute a P600,000 contribution margin.
4. If the special order is accepted, 2,000 units of regular sales are expected to be lost.
5. Assuming a distributor has ordered 16,000 units and the corporation has to sacrifice
some of its regular customers to accommodate the special order.
Solutions/Discussions:
1. Solution to number 1 is as follows:

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 Incremental sales (12,000 units x P90) P 1,080,000
Incremental costs (12,000 units x P55) 660,000
Incremental profit P 420,000
The incremental costs here refer to variable costs and expenses. The total fixed costs
and expenses are assumed to be the same whether the special order is accepted or not,
and therefore are irrelevant in the analysis.
The unit variable cost is P55 (i.e., P2,090,000/38,000 units).
2. Solution to number 2 is presented below:
Incremental CM (12,000 x P35) P 420,000
Rent income if the facility is rented out (200,000)
Net advantage of accepting the special order P 220,000
The incremental UCM is P35 (i.e., P90 – P55). The benefit that could be derived from the
alternative use of the facility, in this case rental income, is compared with the
incremental profit from accepting the special order. Since the incremental income from
accepting the special sales order is greater than renting out the facility by P220,000, it is
more advantageous for the business to accept the special sales order.
3. Solution to number 3 is as follows:
Incremental CM (12,000 x P35) P 420,000
CM from a new product (600,000)
Net advantage of rejecting the special order P (480,000)
Still, the incremental profit or loss from accepting the special sales order is compared
with the net benefit derived from an alternative use of the facility, in this case, the
contribution margin from a new product. Inasmuch as the profit from producing a new
product is greater than the profit from accepting the special sales order, the special
sales order should be rejected and the new product be produced.
4. Solution to number 4 is presented below:
Incremental CM (12,000 x P35) P 420,000
CM lost from regular sales (2,000 units x P45) (90,000)
Net increase in profit from accepting the special sales P 330,000
The CM lost from regular sales out of accepting the special sales order is an opportunity
cost to be deducted from the incremental contribution margin to determine the net
increase in profit in the business operations.
5. Solution to number 5 is as follows:
Incremental CM (16,000 units x P35) P 560,000
Less; Contribution margin (4,000 units x P45) (180,000)
Net incremental profit P 380,000
The UCM of the special order is still P35 (i.e., P90 – P35). The P16,000 units ordered on
a special basis is greater than the idle capacity of 12,000 units (i.e., 50,000 units –
38,000 units of regular sales). To accept the special order, 4,000-unit regular sales
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Relevant Costing

should be sacrificed. Accordingly, the contribution margin of the 4,000-unit regular

sales would be lost. Hence, deducted from the income from special sales.

Continue or Drop a Business Segment

A business segment represents a division, product line, department or business unit.
Depending on what it intends to describe, segment margin is sometimes labeled as division
margin, product margin or department margin. If the segment margin is positive, it means
that the segment is contributing to the overall profitability of the organization. If you drop
the segment, the overall profitability of the business will be diminished by the amount of
the positive segment margin.
Companies fold up their segment operations for strategic, operating or financial reasons.
Strategically, an enterprise folds up its business segment when it is consolidating its
business vertically or horizontally. Financially, business segments are closed to raise funds
and finance more profitable segments. Operationally, an enterprise closes a segment to
avoid recurring losses from the segment’s normal operating activities.
In this discussion, we will consider only the operating reason where the continuance of a
segment is anchored on its ability to be profitable.
The profitability of a segment is measured by its segment margin. If its segment margin is
positive, it contributes to the overall profitability of the enterprise and should be
continued, assuming there is no alternative use of the released facilities if the segment is
discontinued. If there is an alternative use of the released facilities, compare the segment
margin from the net benefit of the alternative. If the segment margin is still greater, then
continue. Otherwise, discontinue the division and better undertake the alternative use of
the facilities.
Principally, the segment margin is determined as follows:
Contribution margin P x
Less: Avoidable fixed costs and expenses x
Segment margin P x
Alternatively, segment margin is computed as shown below:
Pro-Forma
Marginal Income Statement
Sales P x
Less: Variable costs x
Manufacturing margin x
Less: Variable expenses x
Controllable margin x
Less: Controllable direct fixed costs and expenses x
Controllable margin x
Less: Non-controllable direct fixed costs and expenses x
Segment (direct) margin x
Less: Indirect (allocated) fixed costs and expenses x
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 Operating income P x

Illustration: Drop or Continue a Division

JKL Company plans to discontinue a division with a P200,000 contributions to overhead.
Overhead allocated to the division is P500,000, of which P50,000 cannot be eliminated.
Should JKL Company discontinue the division?
Solutions/Discussions:
 The controllable segment margin is computed as follows:
Contribution margin P 200,000
Less: Avoidable fixed costs (P500,000 – P50,000) 450,000
Controllable segment margin P (250,000)

 The division should be discontinued because it has a negative controllable segment

margin. If the division margin is dropped, the loss is eliminated and the overall profit of
the enterprise will increase by P250,000.

Sell-As-Is or Process Further a Product

Goods undergo several conversion processes from original source to final consumption. For
example, eggs may be hatched to chicks, chicks may be raised to hens, hens may be sold live
or may be retained to become layers, chickens may be sold live or otherwise, or may be
sold chopped or cooked. In each conversion process, the business has an opportunity to sell
now or sell after further processing. If the product is processed further, the unit sales price
is expected to increase. However, there is also a cost for subsequent processing (i.e., cost of
further processing, upgrading cost, or cost of additional processing).
Again, focus on the incremental profit. If the incremental sales are greater than the
incremental costs of further processing, it is advisable to process further the product to
maximize profit. The joint production costs (or common costs) and all other costs of
preceding processes are considered irrelevant in deciding whether to sell now or process
further.

Illustration: Sell-As-Is or Process Further a Product

JKL Corporation produces three (3) main products. Its production and costs data are given
below:
X Y Z
Unit sales price after further processing P300 P550 P220
Unit sales price before further processing 250 530 190
Costs of separate (further) processing 120,000 65,000 190,000
Units produced and sold 2,000 4,000 7,500
Total joint costs, P1,400,000
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Which of the products should be processed further?

Solutions/Discussions:
 The incremental (decremental) profit or of further processing per product is presented
below:
X Y Z
Incremental sales (2,000 units x P50) 100,000
80,00
(4,000 units x P20) 0
(7,500 units x P30) 225,000
65,00
Incremental costs 120,000 0 190,000
15,00
Increase (decrease in profit) 20,000 0 35,000

 Products Y and Z should be processed further to maximize profit while product X

should be sold now or at split-off point.
 Incremental sales equal increase in unit sales price times the number of units sold. The
unit sales price normally increases after further processing.
 Incremental costs are those incurred in the act of processing further the product.
 The total joint cost is irrelevant in this decision because it does not change regardless of
selling the products at split-off point or processing further.

Continue Operations or Shut Down

Demands for products vary due to seasonal, cyclical or random variations. Products
manufactured for Christmas season may not be highly saleable in other months. Summer
clothes are not greatly saleable during rainy days. Also, there are months in a year where
businesses in a given economy experience slowdowns caused by natural, psychological, or
environmental conditions of the place where the business operates. During slack seasons,
businesses incur operating losses. Hence, management may contemplate temporarily
stopping its operations to avoid losses.
Yet, if operations are temporarily shut down, the business will still lose because of the
shutdown costs. Costs incurred even after operations temporarily stopped are called as
shutdown costs. Examples are, salaries of remaining executives and skeletal personnel,
security, insurance, rental, interests, depreciation, property taxes, advertising, and similar
unavoidable costs. On top of it, the business will incur restart-up costs once it resumes its
operations. Restart-up costs include costs of rehiring and retraining personnel, refueling,
aligning, and retuning machineries and equipment, and refurbishing the plant.

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Either way, continue or shutdown, the business will have a loss. It is a choice between two
evils. In this case, you have to choose the lesser evil. The guideline is, “which option will
give a lesser amount of loss?”
Technically, if continuing the operations will result to sales greater than the shutdown
point, it is better to continue operating and be spared of more losses from discontinuing
operations. Shutdown point is the level of operations where the loss from continuing is
equal to the loss from discontinuing (i.e., shutdown costs). Expressed mathematically, we
have:
Loss from continuing = loss from discounting
Where: Loss from continuing = (CM – FC)
Loss from discounting = (0 – Shutdown costs)
At shutdown point:
(CM – FC) = (0 – SDC)
QS (UCM) – FC = (0 – SDC)
QS (UCM) = FC – SDC
Therefore, shutdown point equals:
QS = FC – SDC
UCM

where:
CM = contribution margin
FC = Fixed costs
SDC = Shutdown costs
UCM = Unit contribution margin
QS = Quantity sold
Illustration: Shut Down or Continue Operations
JKL Company produces and sells 140,000 units monthly except for the months of July and
August when the number of units sold normally decline to 10,000 units per month.
Management contemplates of temporarily shutting down operations in the months of July
and August with the belief that the business will be spared of more losses during the
period. If the business temporarily shuts down, security and maintenance amounting to
P220,000 per month would still be incurred. Restarting the operations will cost the
business P300,000 for mobilization and other costs. The business incurs a total of P24
million annual fixed costs allocated evenly over a 12-month period. This fixed cost is
expected to drop by 60% during the months the operations are shut down.
Other sales and costs data are as follows:
Unit sales price P 300
Unit variable production costs 140
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Unit variable expenses 40

Required:
1. How much is the total shutdown cost?
2. What is the shutdown point?
3. Should the business continue or shut down?
Solutions/Discussions:
1. The shutdown costs of P2,340,000 is determined as follows:
Allocated fixed costs (P24 million x 2/12 x 40%) P 1,600,000
Security and insurance (P220,000 x 2 months) 440,000
Restart-up cost 300,000
Shutdown cost P 2,340,000

2. The total fixed cost in the months of July and August if the operations are continued is
P4 million (i.e., P24 million x 2/12). The unit contribution margin is P120 (i.e., P300 –
P180). Therefore, the shutdown point is 13,834, computed as follows:
Shutdown point = P4,000,000 – P2,340,000 / p120 = 13,833.33 units (say 13,834 units)
To prove, we have:
Contribution margin (13,833.33 x P120) P 1,660,000
Less: Fixed costs and expenses 4,000,000
Loss from continuing the operations (2,340,000)
Shutdown cost P 2,340,000

Shutdown point is where the loss from continuing equals the shutdown costs.
3. Continue or Shut Down?
Contribution margin (10,000 units x 2 months x P120) P 2,400,000
Less: Fixed costs and expenses 4,000,000
Loss from continuing the operations (1,600,000)
Less: Shutdown costs (2,340,000)
Advantage of continuing the operations P 740,000

Alternatively, the P740,000 may be computed as (20,000 – 13,833) x P120.

Bid Price… Maximize or Minimize?

Pricing is an important part in closing a deal. It is more important when participating in a
bidding process to get a contract or a project. The process of bidding could vary depending
on the practices and circumstances of the bidding process. Bidding could be done through

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public auction, or through sealed bidding, or through whispering one’s bid (e.g.,
“bulungan’) as practiced by some domestic fish dealers.
Now, assume that you are operating in a purely competitive business environment. In this
case, the concept of incremental costing is of importance. If you are in a construction
business and are bidding for a construction contract, you have to submit the minimum bid
price to win the contract. The minimum bid price should not be less than your incremental
costs. If you are bidding for the acquisition of an important item or object, you have to
submit the highest bid to win.
Generally, the minimum bid price is computed as follows:

Minimum bid price = Incremental costs - Savings

The opportunity costs refer to the highest possible benefit that may be derived from the
best alternative use of capacity.
Illustration: Minimum Bid Price
JKL Systems, Inc. manufactures truck engines for industrial users. The cost of a particular
jet engine the company manufactures is shown below:
P300,00
Direct materials 0
Direct labor 190,000
Overhead:
Supervisor’s salary 40,000
Fringe benefits on direct labor 19,000
Depreciation 50,000
Rent 10,000
P609,00
Total costs 0

If production of this engine were discontinued, the production capacity would be idle and
the supervisor would be laid off. When asked to bid on the next contract for this engine,
what should be the minimum bid price?
Solutions/Discussions:
 The minimum price should be at least equal to the incremental cost of manufacturing.
Direct materials P300,000
Direct labor 190,000
Supervisor’s salary 40,000
Fringe benefits on direct labor 19,000
Incremental costs/Minimum Price P549,000
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 The depreciation and rent expenses are unavoidable costs whether the contract is
obtained or not. They are constant regardless of alternatives. They are therefore
irrelevant.

Illustration: Maximum Bid Price

JKL Company has its own cafeteria with the following annual costs:
P2,300,00
Food 0
Labor 820,000
Overhead 550,000
P3,670,00
Total 0

The overhead is 30% fixed. Of the fixed overhead, P72,000 go to the salary of the cafeteria
supervisor. The remainder of the fixed overhead has been allocated from total company
overhead. Assuming the cafeteria supervisor remains and that JKL continues to pay the
supervisor’s salary, what is the maximum cost JKL would be willing to pay an outside firm
to service the cafeteria?
Solutions/Discussions:
 The incremental cost of operating the cafeteria is the maximum price that the company
should be willing to pay an outside canteen operator. The incremental cost is
P3,505,000 computed as follows:
P2,300,00
Food 0
Labor 820,000
Variable Overhead (P550,000 x 70%) 385,000
P3,505,00
Incremental costs/Maximum price 0

 The salary of the cafeteria supervisor is irrelevant in the analysis because it will still be
incurred regardless of who operates the cafeteria. The remaining fixed overhead is
allocated and is, therefore, definitely irrelevant because the total allocated overhead
would not change regardless of the option chosen.

Organization of Scarce Resources

Wherever and whoever you are, resources will always be limited. We live in a world of
scarcity. Businesses are saddled with the reality that operations are to be done in an
environment of scarce resources. Although, the level of resource scarcity varies from one
organization to another. Still, the challenge to management is to produce extraordinary
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results from scarce resources. Money, machine hours, direct labor hours, supply of
materials, and technology are subject to scarcity.
To optimize scarce resources, sales and production should be allotted to a product that
gives the highest profit per scarce resource. If the scarce resource is direct labor hour, then
produce the product that gives the highest contribution margin per direct labor hour. The
CM per hour is computed as follows:
Unit contribution margin P x
/ Hours per unit x hrs.
Contribution margin per hour P x

UCM P x
X Units per hour x
CM per hour P x

As much as possible, use all your resources in producing the product that has the highest
CM per hour unless such product has market limitation. In such case, after satisfying all the
market need of the product that has the highest CM per hour, produce and sell the product
that has the next highest CM per hour, and so on.

Illustration: Maximization of Scarce Resources

JKL Corporation has 52,000 available machine hours and has a fixed overhead rate of P4
per hour. It is considering to produce two popular products with the following production
and costs data:
Dragon Ball Samurai X
Cost if purchased from outside supplier P70 P105
Direct materials 11 22
Direct labor 25 38
Factory overhead at P9 per hour 18 27
Annual demand in units 20,000 15,000

Required:
1. Assuming that there is no market limitation, which product should JKL Corporation
produce?
2. Considering the market limits, how would JKL Corporation use its limited machine
hours to maximize profit?
3. Assuming that the unit direct materials cost of Samurai X decreases to P10 and
considering the market limit, how would the limited machine hours be used to
maximize profit?
Solutions/Discussions:
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1. No market limit. The product to be produced and sold should give the highest
contribution margin per machine hour. The unit sales price to be used shall be the unit
price offered by competitors.
Other relevant data not readily given by the problem are computed and presented
below:
Dragon Ball Samurai X
Unit sales price
(P18 per unit/P9 per hour) 2 hrs.
(P27 per unit/P9 per hour) 3 hrs.
Fixed overhead per unit
(P4 per hr. x 2 hrs. per unit) P8
(P4 per hr. x 3 hrs. per unit) P12
Variable factory overhead
(P18 – P8) P10
(P27 – P12) 15

The contribution margin per hour is computed as follows:

Dragon Ball Samurai X
Number of hours per unit P70 P105
Unit direct materials cost (11) (22)
Direct labor (25) (38)
Variable factory overhead (10) (15)
Unit contribution margin 24 30
/ No. of hours per unit 2 3
Contribution margin per hour P12 P10
Rank 1 2

JKL Corporation should produce and sell Dragon Ball because it has a higher
contribution margin per hour. It should use all its 52,000 machine hours to produce
26,000 units (i.e., 52,000 hrs./2 hrs.) of Dragon Ball.
2. With market limits. Given the market limitations as provided in the problem, the
52,000 machine hours would be used as follows:
Product Units Hours per unit Total hours
Rank 1 Dragon Ball 20,000 2 hrs. 40,000
Rank 2 Samurai X 4,000 3 hrs. 12,000 (squeezing bal.)
Total 52,000

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 The 52,000 machine hours will be used to produce 20,000 units of Dragon Ball and
4,000 units of Samurai X to maximize profit. Take note, Dragon Ball has a market limit
of 20,000 units.
3. Sensitivity analysis – e.g., change in unit direct material cost. The unit direct
materials of Samurai X decreases by P12 (i.e., P22 – P10). This means that the limit
variable cost decreases and, correspondingly, the unit contribution margin increases by
P12. The new contribution margin per hour is determined as follows:
Dragon Ball Samurai X
Unit contribution margin P24 P42*
/ No. of hours per unit 2 3
Contribution margin per hour P12 P14
Rank 2 1
*P42 = P30 + P12
The 52,000 machine hours would be used as follows:
Hours per Total
Product Units unit hours
Rank 1 Samurai X 15,000 3 hours 45,000
Rank 2 Dragon Ball 3,500 2 hours 7,000 (squeezing balance)
Total 52,000

This time Samurai X has a higher CM per hour and is therefore to be prioritized. The
52,000 machine hours shall be used to produce 15,000 units of Samurai X and 3,500
units of Dragon Ball to maximize profit.

Sell Now or Later

There are instances where the sales price of a product is expected to increase after a period
of time. Examples of these are fashion clothes, wines, artifacts, paintings, historical items,
jewelries, and land. If the product is not sold now, it will be secured and, sometimes, stored
in a special place. Keeping the product would entail storage costs, maintenance costs, and
opportunity costs of the money locked in the product. If the expected incremental sale is
greater than the incremental costs of keeping the product, then sell it later.

Illustration: Sell Now or Later

JKL Corporation has 12,000 units of product Laos, a high-end men’s wear, in storage. This
product is now out-of-fashion but is expected to regain market acceptance in the next 10
months. The total cost of producing the product is P240,000, sixty percent of which is
variable. It is now kept in a special storage of which the company pays monthly rental of
P8,000.
The product has a regular sales price of P20 per unit but is expected to be sold at P14 per
unit when fashion acceptability recovers. A merchandiser has offered to buy all the 12,000
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19
Relevant Costing

units of product Laos at a price of P8 per unit who will be picking up the products in the
company’s storage.
Should the company sell now or sell the products later?
Solutions/Discussions:
 The relevant costs analysis is presented below:
Sell Now Sell Later
Sales (12,000 x P8) P96,000 P168,000*
Storage costs (P8,000 x 10 months) - (80,000)
Incremental profit 96,000 P88,000
Net advantage P8,000
*168,000 = 12,000 x P14
 The company should be advised to sell its products now due to its net benefit of P8,000
over the alternative of selling the products later.
 The costs of producing products, variable and fixed, are irrelevant costs in this decision-
making situation. These costs are already sunk, past, and unavoidable regardless of
decision to make.

Replace or Retain an Asset

Over time, assets age. Normally, assets deteriorate or become dysfunctional while others
appreciate in value. Those that deteriorate or become dysfunctional are eventually
replaced. Those that become obsolete due to technological advances would have to be
discarded.
The issue here is “when the asset is still functionally useful and has not yet reached its
point of technological or physical obsolescence, should management retain or replace the
old asset now?” Maintenance-wise, the old asset needs higher budget than the new one. If
the asset is replaced, there is an immediate outflow of cash. However, there would be
savings that are expected to be derived from a reduced operating expenses of maintaining
the new asset compared with that of the old asset. Also, there is a possible inflow from the
current salvage value of the old asset. If the net cash flow is positive, meaning, the cash
inflows are greater than the cash outflow over the life of the asset, then it is advisable to
replace the old asset and generate net benefit over its useful life.
We do this analysis under the assumption that the useful life of the new asset, compared to
the old asset, is equal, without considering the time value of money and effects of taxes.

Illustration: Retain or Replace an Old Asset

JKL Industries, Inc. has an opportunity to acquire new equipment to replace one of its
existing equipment. The following data are gathered relative to the new and old assets:
Old New
Book value P700,00
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 0
P1,200,00
Purchase price 0
Life in years 5 years 5 years
Salvage value - current 50,000
Salvage value – after 5 years none none
1,300,00
Variable operating expenses 0 1,000,000
Should the company retain or replace its old equipment?
Solutions/Discussions:
 The net cash inflows:
Savings (P300,000 x 5 years) P1,500,000
Salvage value of old equipment 50,000
Purchase price of new equipment (1,200,000)
Net cash inflows in favor of replacing (5 years) P350,000

 It is advisable to replace the old equipment now and generate a net benefit of P350,000
over a period of 5 years. It should be noted that the time value of money and tax effects
are not included in the analysis.
 The book value of the old equipment is a sunk cost, unavoidable, and is irrelevant in the
decision making.

Scrap or Rework a Defective Unit

There are products that do not meet the standard production specifications. Some of these
products are defective which could be sold as scrap or could be reworked and sold later at
a higher value. In deciding whether to sell as scrap or rework, the profit from reworking
should be compared with the profit of selling as scrap without regard to the past costs of
producing the product.

Illustration: Scrap or Rework

A company has 5,000 obsolete cutting supplies carried in inventory at a manufacturing cost
of P40 per unit. If the toys are reworked for P8 per unit, they could be sold for P12 per unit.
If the toys are scrapped, they could be sold for a total of P15,800.
Required:
1. Should the company sell the cutting supplies as scrap or rework it?
2. What is the sunk cost in the decision to be made?
Solutions/Discussions:
1. The solution for number 1 is as follows:
Incremental revenue from reworking (5,000 units x P12) P60,000
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Relevant Costing

Incremental costs of reworking (5,000 units x P8) 40,000

Incremental profit from reworking 20,000
Incremental profit from selling as scrap (15,800)
Net advantage of reworking P4,200

The manufacturing costs of producing the product are irrelevant cost in this decision
situation. These costs will not change and will remain constant regardless of decision to
make.
2. The sunk cost in this decision is the manufacturing cost of P200,000 9e.g., 5,000 x P40).
These costs, either variable or fixed manufacturing costs, have been incurred, can no
longer be changed, and are irrelevant.

Indifference Point
Indifference point is where the outcome of alternatives is the same. So, regardless of
choices the manager makes, he will arrive at the same profit or loss. Examples of
indifference point computations are the breakeven point, shutdown point, economic order
quantity, and internal rate of return. A special application of indifference point is to be
discussed here.
Illustration: Indifference Point
JKL Motors employs 30 sales personnel to market an office equipment. The average
equipment sells for P350,000 and the company is currently paying 8% commission to its
salespersons. It is considering a scheme paying its sales persons a flat rate of P7,000 per
month plus 2% commission on sales made.
What is the amount of sales that would produce the same total compensation paid to
salespersons?
Solutions/Discussions:
 The indifference point is computed as follows:
Let x = units sold
350,000 x = total sales
Commission 1 = 8% (350,000x) = 28,000x
Commission 2 = 2% (350,000x) + 210,000* = 7,000x + 270,000
*210,000 = 7,000 per month x 30 sales personnel
At indifference point:

Commission 1 = Commission 2
28,000x = 210,000
21,000x = 210,000/21,000
x = 10 units
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 Total sales = P350,000 (10 units)
= P3,500,000

The total sales of P3,500,000 may also be computed as follows:

Total sales = P210,000 / (8%-2%)
= P3,500,000

To prove the indifference point of sales, we have:

Commission 1 = 8% (P3,500,000) = P280,000
Commission 2 = 2% (p3,500,000) + P210,000 = P280,000

References and Supplementary Materials

Books and Journals
1. Rodelio S. Roque (2016). Management Advisory Services. CM Recto, Manila. GIC
Enterprises and Co., Inc.
2. Leonardo E. Aliling, Ma. Flordeliza L. Anastacio (2015). Management Accounting 1.
856 Nicanor Reyes, Sr. St., CM Recto Avenue, Manila. Rex Book Store, Inc.
3. Franklin T. Agamata (2019). Management Services. Certs Publications. Agdao, Davao
City, Philippines
4. Ray H. Garrison, Eric W. Noreen, Peter C. Brewer, 16 th ed. Managerial Accounting. The
McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York

Online Supplementary Reading Materials

1. https://tools.mheducation.ca/college/garrison5/graphics/garrison5mag_student/
slideshow/sld13.pdf
2. https://www.managementaccounting.info/relevant-costing/
3. http://www.cerritos.edu/dljohnson/_includes/docs/
ACCT_102_Ch_23_PP_Wild_7e_CH23_Accessible.pptx
4. http://webhome.auburn.edu/~jonesj6/ac610/relcost.pdf
5. http://www.financialaccountancy.org/marginal-costing/relevant-and-irrelevant-
costs-for-short-term-decision-making/
6. http://www.accountingnotes.net/cost-accounting/cost-analysis/difference-between-
relevant-costs-and-irrelevant-costs/6118