RELEVANT COSTING

Types of Business Decisions

- Business decisions may be classified as strategic, tactical, or operational.
- Strategic decisions have long-term effects (eg. More than a year), its focus is growth, stability, and
sustainability and its objective is to meet the needs of investors (i.e. wealth accumulation).
- Tactical decisions are regularly made to have medium-term effects (eg. 1 year or less) in organizational
results.
- Operational decisions are made on a daily basis where the judgmental call of a supervisor is at its
greatest use; it is made regularly and has short-term effects. The focus of tactical and operations
decisions is profitability and liquidity and their immediate goal is customer’s satisfaction.
- Short-term non-routine decisions are within the ambit of tactical and operational decisions. However,
these decisions are not covered by the standard operating policies (SOPs) of an organization. They are
non-recurring and non-repetitive in nature.
- Profitability is the primordial criterion in making short-term non-routine decisions.

Relevant Costs
- Relevant costs are those being used in making a decision.
- A cost to be relevant must be both differential and future cost.
- Differential costs (or incremental costs) change from one alternative to another. In making a decision, you
have at least two (2) alternatives or options. If a cost differs from one option to another, that cost is
differential. The normal examples of differential costs are the variable production costs of direct materials,
direct labor variable overhead and variable expenses. Avoidable fixed overhead is also an incremental
cost. Incremental variable production costs are avoidable fixed overhead are, normally, relevant costs.
- Those costs that remain the same from an option to another are irrelevant in that particular decision
situation.
- Incremental costs are those that increase from one alternative to another; decremental costs are those
that decrease from one option to another.
- Future costs are referred to as planned costs, budgeted costs, projected costs or estimated costs. Future
costs are yet to be incurred in the upcoming activities. If a cost is not a future cost, it is automatically not
relevant.
- Sunk cost (or past costs, historical cost) cannot be changed further, cannot be incurred in the future and
is not relevant in decision-making.
- A cost may be relevant in one decision setting but may be irrelevant in another.
- Since short-term non-routine decisions use relevant costs, such are called relevant costing, incremental
costing or differential costing.

Topics in the short-term nonroutine decisions

- Short-term non routine decisions (or relevant costing) are applied in all possible situations where standard
operating policies are not available. However, only the following decisional situations are normally given
in the LECPA.
Short-term Non-routine situations Decision Guidelines
1. Make or buy The alternative that gives lower relevant costs, gives
savings should be preferred.
2. Accept or reject special sales order? If there is an incremental profit, accept.
3. Drop or continue an organizational segment If the direct segment margin is positive and there is no
other more beneficial alternative, then continue. If
there are complementary effects, they should be
considered.
4. Sell-as-is or process further a product? If t here is a profit from further processing, then
process further.
5. Continue operations or temporarily shut down If sales are greater than the shut down point, it would
the operations? be better to continue operating
6. Maximum or minimum bid price? Focus on the incremental costs
7. Optimization of scarce resource Prioritize the product that gives the highest
contribution margin per limited resource.
8. Sell now or later? If the expected increase in sales is greater than the
incremental cost of storage, then sell later
9. Replace or retain an old asset If the net cash inflows are greater than the net
outflows, replace the asset (here the time value of
money and tax effects are not considered)
10. Scrap or rework a defective unit Choose the alternative that gives the higher short-
term profitability.
11. Determining the indifference point Indifference point is the point of equality where the
results of the alternatives are the same, in terms of
profit
12. Miscellaneous topics Use the benefit-costs analysis
MAKE OR BUY
- The tabulation of relevant costs in making and buying a part is as follows:
Cost to Cost to
make buy
Purchase price Px
Direct materials Px
Materials handling costs x X
Direct labor X
Variable overhead X
Avoidable fixed overhead X
Savings if the part is bought (x)
Rental income from released facilities (x)
Contribution margin from a new product being produced using the released (x)
facilities
Rental expense if the part is bought x
Total relevant costs Px Px
If all of these alternatives are present, the best alternative should be chosen.

- The variable production costs (e.g. direct materials, direct labor and variable overhead) are incremental
costs, and are normally relevant costs.
- The avoidable fixed overhead is also a relevant costs since it varies from one option to another, i.e. from
option making to option buying.
- The unavoidable fixed overhead cannot be avoided regardless of decision made whether to make or to
buy the part. This cost does not change, and therefore is irrelevant.
- Materials handling costs apply to materials and other purchases and are normally allocated based on the
purchase cost. Inasmuch as the cost of purchase changes, consequently, the allocated costs change as
well, and therefore are relevant costs in the short-term decision making.
- 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 deducted from the costs of buying.
- The released facilities, however, may be used only either as a rented space to others or to produce a new
product. In this case, the better alternative in terms of higher profit would be considered.
- The rental expense, if the part is bought, is an incremental cost of buying the part, hence, added to the
cost of buying.

ACCEPT OR REJECT A SPECIAL SALES ORDER

- A special sales order being considered in this topic is different from the regular sales. Special sales have
the following characteristics:
o Non-recurring, one-time only, sales order
o The customer is not regular
o The market is distinguishable and
o The requested sales price is lower than the regular sales
- In deciding whether to accept or reject a special order, the paramount consideration is incremental profit,
determined as follows:
o Incremental sales Px
o Incremental costs (x)
o Incremental profit (loss) x
o Opportunity costs (benefit) from alternative use of capacity (x)
o Net advantage (disadvantage) of accepting the special sales order Px
▪ The opportunity costs her erefer to the net benefit that could have been derixed from
another alternative had the special sales order not been accepted. If the order is not
accepted, the idle capacity could be
• Rented out to others or
• Used to produce another product and generate additional contribution margin
- If there is no idle capacity, the opportunity cost here refers to the lost contribution margin from regular
sales or from the best use of the sacrificed capacity.

CONTINUE OR DROP A BUSINESS SEGMENT

- The segment margin may be determined either under conditions within alternative use of the capacity or
there is no alternative use of the capacity. Once determined, decisions shall be made as follows:

With NO alternative use of capacity With alternative use of capacity

If the segment margin is positive, continue the division Compare the segment margin from the net benefit of
the alternative. If the segment margin is greater then
continue. Otherwise, discontinue the division and
undertake the alternative that gives the higher profit.

- Segment margin equals

 Benchmark Computation Alternative Computation
Contribution margin Px Contribution margin Px
- avoidable fixed expense x - controllable direct fixed expense x
Segment margin Px Controllable margin x
-Non-controllable direct fixed expense x
Segment (direct) margin Px

The indirect (or allocated) fixed costs and expenses

shall be deducted from the segment margin to arrive
at the profit

- If there is an alternative use of facility, the quantification should be:

Segment margin Px
- net benefit from the best alternative use of facilities x
Net advantage (disadvantage) of continuing the division Px

- Segment margin represents a division’s product line’s or a department’s traceable performance. 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 having positive segment margin, the overall profitability of the
business will be diminished by the amount of the positive segment margin.
- If the segment margin is negative, the segment reduces the overall profitability of the business. Hence,
dropping the segment would increase the overall profitability of the enterprise.
- Complementary effects to the decision to drop or continue a segment should also be considered in
determining the net effect to the overall profitability of the business.

SELL – AS – IS OR PROCESS FURTHER

- The basic computational guidelines is:
o Incremental sales Px
o Incremental costs (x)
o Savings from further processing x
o Incremental profit (loss) Px
- If the product is processed further, the unit sales price is expected to increase. This is because there is
also a cost for subsequent processing (i.e., cost of further processing, upgrading costs, or cost of
additional processing) which is an incremental cost.
- 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. These irrelevant joint costs include variable
and fixed production costs.
- The incremental unit price is the difference in unit sales price at split-off point and after further processing.
The total incremental costs include the incremental variable costs and incremental fixed costs.
- The minimum sales price after further processing shall be the original sales price plus the cost of further
processing.
- The common cost is a sunk cost and is irrelevant in this decision analysis.

CONTINUE OR TEMPORARILY SHUT DOWN OPERATIONS

- Either way, continue or shut down, the business will have a loss. The guideline is, which option will give a
lesser amount of loss?
- Product seasonality and industry cycle (slack season) may heavily restrain income and produce operating
losses. In these cases, management may contemplate to temporarily stop its operations to avoid greater
amount of losses.
- Yet, if operations are temporarily shut down, the business will incur a loss because of the shutdown costs.
Thse costs are those that are still incurred even after the operations are stopped.
- Examples of shutdown costs are: salaries of remaining executives and skeletal force of 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, retuning machineries and equipment
and refurbishing the plant.
- Shutdown point is the where the loss from continuing is equal to the loss from discontinuing (i.e., shut
down costs). Expressed mathematically, we have,
If:
Loss from continuing = ( CM – FC)
Loss from discontinuing = ( 0 – Shutdown costs)
And at shutdown point:
Loss from continuing = loss from discontinuing
CM – FC = 0 – SDC
QS (UCM) – FC = 0 – SDC
Then:
 Shutdown point = (FC – SDC) / UCM
Where:
FC = Fixed costs
SDC = shutdown costs
UCM = unit contribution margin

Technically, if:
Sales > Shut down point = continue the operations
Sales < shut down point = shut down (discontinue) the operations

MINIMUM OR MAXIMUM BID PRICE

- The winning bid price may be a maximum or minimum price.
- The maximum bid price should not be in excess of the expected utility value of the item or object under
bid.
- The minimum bid price should not be less than the incremental costs of servicing the activity.
- Minimum bid price equals incremental costs plus opportunity costs of using the facilities.
o Minimum Bid Price = Increase costs + opportunity costs
- Determining the right amount of bid price entails the use of incremental costs.
- If ever a bid formula is given, just follow it in determining the bid price.

OPTIMIZATION OF RESOURCES
- Money, machine hours, direct labor hours, supply of materials, technology and other business resources
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, computed as follows:
o CM per hour = UCM / No. of hours per unit
o CM per hour = UCM x No. of units per hour
- Use all your resources in producing the product that has the highest CM per hour unless such product
has market limitation (say, the market can accommodate only up to a certain number of units to be sold).
In such case, after satisfying all the market need of the product having the highest CM per hour, produce
and sell the product that has the next highest CM per hour and so on, until all available resources are
exhausted.

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, and land. If the product
is not sold now, it will be kept, 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 sales from selling the item later are greater than the incremental costs of
keeping the product, then sell it later. Otherwise, sell it now.

REPLACE OR RETAIN AN OLD ASSET

- Old assets need higher budget to maintain than the new one. If the old asset is replaced, there is an
immediate outflow of cash. However, there would be savings derived from reduced operating expenses of
maintaining the new asset compared with that of the old one. Also, there is a possible inflow from the
current residual 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.
- All of these are 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.

SCRAP OR REWORK DEFECTIVE UNITS

- These 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 at a higher value. In deciding
whether to sell as scrap or rework, the net profit from reworking should be compared with the net profit of
selling as scrap without regard to the past costs of producing the product.
- The past production costs, both variable and fixed, are irrelevant in this situation. They are sunk, historical
and unalterable.

INDIFFERENCE POINT
- Indifference point is where the outcome of alternatives is the same. Regardless of choice, the manager
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.
- The indifference point reviewed in this topic cover cases not included in the preceding cited examples.
The working principle remains the same that indifference point is where profit is the same regardless of
the alternative chosen.
- Profit is determined as:
o Profit = Sales – total costs
o Proft = contribution margin – fixed costs
Where:
▪ Contribution margin = units sold x UCM
▪ Contribution margin = sales x CMR
▪