Cost Accounting

Prof. Ranjan DasGupta

Cost Accounting (IIM Raipur AY 2023-24) - Prof. Ranjan

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 To follow and refer:
Books:
Text:
Horngren’s Cost Accounting A Managerial Emphasis 16th Ed.
(Indian) by Datar and Rajan.

Reference:
Accounting Text and Cases 13th Ed. By Anthony, Hawkins and
Merchant.

Follow:
Handouts.
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 Evaluation Components:

1. Quizzes (1*5+1*15) - 20
2. Assignment (2*10) - 20
3. Class Participation - 10
4. End term - 50
Total - 100

1st Quiz (??); 2nd Quiz (after Session 8)

Case study (Group) assignments [bonus marks system]; and 1
individual assignment will be there [2*10]
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 Learning Objectives:
❑ Understanding managerial decision process

❑ Understanding differential, relevance and sunk costs &

revenues (as applicable) – examples

❑ Understanding and illustrating different types of decisions

(short-run [including pricing; product-mix, etc.])

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 LO 1:

Understanding managerial decision process

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 Managerial Decision Models:
❖ Managers usually follow a decision model for choosing among
different courses of action.

❖ A decision model is a formal method of making a choice that often

involves both quantitative and qualitative analyses.

❖ Managers use the five-step decision-making process (presented in the

next slide).

❖ Management accountants analyze and present relevant data to guide

managers’ decisions.

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 Five-Step Decision-Making Process:

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 Types of Information:
• Quantitative factors are outcomes that can be measured in numerical
terms.

• Qualitative factors are outcomes that are difficult to measure accurately

in numerical terms, such as satisfaction.
• Qualitative factors are just as important as quantitative factors even
though they are difficult to measure.

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 The concept of Relevance:
• Relevant information has two characteristics:
• It occurs in the future.
• It differs among the alternative courses of action. (differential)

• Relevant costs are expected future costs.

• Past costs (historical costs) are never relevant and are also called sunk costs.

• Relevant revenues are expected future Revenues.

• Not all expected future revenues and expected future costs are relevant.
Expected future revenues and expected future costs that do not differ among
alternatives are irrelevant and, hence can be eliminated from the analysis.

• The31-10-2023
key question is always,CostWhat difference
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will an action make?
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 LO 2:

Understanding differential, relevance and sunk

costs & revenues (as applicable) – examples

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 Differential:
Differential cost—the difference in total cost between two alternatives.
The terms out-of-pocket costs and avoidable costs are used generally
to mean the same thing as differential cost.
Differential revenue—the difference in total revenue between two
alternatives.

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 Example 1: Relevant costs and revenues

A firm has an inventory of 1,250 assorted parts for a line of

missiles that has been discontinued. The inventory cost is
Rs.76,000. The parts can be either (a) remachined at total
additional costs of Rs.26,500 and then sold for Rs.33,500 or (b)
sold as scrap for Rs.2,500.

Which action is more profitable? Show your calculations.

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Example 2: Relevant costs and revenues
A truck, costing Rs.10,00,500 and uninsured, is wrecked its
first day in use.
It can be either (a) disposed of for Rs.1,80,000 cash and
replaced with a similar truck costing Rs.10,30,000 or (b)
rebuilt for Rs.8,80,500 and thus be brand-new as far as
operating characteristics and looks are concerned.

Which action is less costly? Show your calculations.

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 Sunk Costs Are Irrelevant in Decision Making
• Costs that have already occurred and cannot be changed are
classified as sunk costs.
• All historical costs (for example, the book value of depreciable assets) are sunk costs. Since it exists
because of actions taken in the past, a sunk cost is not a differential cost. However, if the machine had
a disposal value, this fact would be relevant during replacement decisions because the machine’s sale
would then bring in additional cash.

• Sunk costs are excluded because they cannot be changed by

future actions.

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 LO 3:

Understanding and illustrating different types of

decisions (short-run [including pricing; product-mix,
etc.])

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 Decisions Contexts:
• One-time-only special orders

• Short-run pricing decisions

• Insourcing vs. outsourcing (Make-or-Buy)

• Product-mix with capacity constraints

• Customer profitability and Relevant Costs

• Branch/segment: adding or discontinuing

• Equipment replacement
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 One-Time-Only Special Orders
• Accepting or rejecting special orders when there is idle
production capacity and the special orders have no long-run
implications.

• Decision rule: Does the special order generate additional

operating income?
• Yes—accept
• No—reject

• Compares relevant revenues and relevant costs to determine

profitability.

• Qualitative factors relevant also needs to be considered along

with profitability.
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 Example 1: Accepting Special Order
The decision to accept additional business should be based on
incremental costs and incremental revenues. Incremental
amounts are those that occur if the company decides to accept
the new business.

FasTrac currently sells 100,000 units of its product. They are

operating at 80% of full capacity. The company has per unit and
annual total sales and costs as shown in the following
contribution margin income statement.

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 Example 1: Accepting Special Order

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 Example 1: Accepting Special Order
A current buyer of FasTrac’s products wants to purchase
additional units of its product and export them to another
country. This buyer offers to buy 10,000 units of the product at
$8.50 per unit, or $1.50 less than the current price. The offer price
is low, but FasTrac is considering the proposal because this sale
would be several times larger than any single previous sale and
it would use idle capacity. In addition, FasTrac will only incur
$0.20 for distributing and $0.10 as administrative costs.

Should FasTrac accept the offer?

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Solution to Example 1: Accepting Special Order

Comment: FasTrac should accept the offer.

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 Example 4: Choosing Output Levels
The Titan Company manufactures medals for winners of athletic
events and other contests. Its manufacturing plant has the capacity to
produce 11,000 medals each month. Current production and sales are
10,000 medals per month. The company normally charges Rs.150 per
medal. Cost information for the current activity level is as follows:
Particulars Amount (Rs.)
Variable costs that vary with number of units produced
Direct materials 3,50,000
Direct manufacturing labour 3,75,000
Variable costs (for setups, materials handling, quality
control, and so on) that vary with number of batches, 200
batches*Rs.500/batch 1,00,000
Fixed manufacturing costs 3,00,000
Fixed marketing costs 2,75,000
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 Example 4: Choosing Output Levels

Titan has just received a special one-time-only order for 1,000

medals at Rs.100 per medal. Accepting the special order would
not affect the firm’s regular business. Titan makes medals for
its existing customers in batch sizes of 50 medals (200 batches
× 50 medals per batch = 10,000 medals). The special order
requires Titan to make the medals in 25 batches of 40 medals.

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 Example 4: Choosing Output Levels
You are required to:
1) Should Titan accept this special order? Show your calculations.
2) Suppose plant capacity were only 10,500 medals instead of
11,000 medals each month. The special order must either be
taken in full or be rejected completely. Should Titan accept the
special order? Show your calculations.
3) As in requirement 1, assume that monthly capacity is 11,000
medals. Titan is concerned that if it accepts the special order, its
existing customers will immediately demand a price discount of
Rs.10 in the month in which the special order is being filled.
They would argue that Titan’s capacity costs are now being
spread over more units and that existing customers should get
the benefit of these lower costs. Should Titan accept the special
order under these conditions? Show your calculations.
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 Potential Problems with Relevant-Cost Analysis:
Managers should avoid two potential problems in relevant–cost
analysis:
1. Avoid incorrect general assumptions such as that “All variable costs
are relevant and all fixed costs are irrelevant.” Even in the last
example, we had irrelevant, variable marketing costs.

2. Be aware that unit-fixed-cost data can potentially mislead managers

in two ways. (See next slide for details)

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 Beware: unit-fixed-cost data
Unit-fixed-cost data can be misleading in two ways:
1. Fixed costs per unit may include costs that are irrelevant to a
particular decision or may be irrelevant in total for a particular
decision, and

2. Unit fixed costs are accurate only for that particular level of output.
For this reason, managers often use total fixed costs rather than per unit
data especially when output levels are a variable for a particular
decision.

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 Short-run pricing decision:
A special order decision is, in many respects, a short-run pricing decision.

Sometimes, the decision is simply about setting an acceptable price.

Remember the decision rule?

Any price above incremental costs will improve operating income;
however, consideration must be given to capacity constraints, current
market conditions, customer demand, competition, etc.

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Insourcing vs. outsourcing / Make-or-Buy decision:
• Outsourcing is purchasing goods and services from outside
vendors.

• Insourcing means you’ll produce the good (or provide the

service) within the organization.

• Decisions about whether to insource or outsource are called

Make-or-Buy decisions.

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Insourcing vs. outsourcing / Make-or-Buy decision
rule
• Decision rule: Select the option that will provide the firm
with the lowest cost, and therefore the highest profit.

• Same as special order: choose the alternative that maximizes

operating income.

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 Example 2: Make-or-Buy decision

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Example 2: Make-or-Buy decision Extended

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 Example 5: Make-vs.-Buy Decision
Burner India (BI) produces gas grills. This year’s expected production is
20,000 units. Currently, BI makes the side burners for its grills. Each
grill includes two side burners. BI’s management accountant reports
the following costs for making the 40,000 burners (units):
Particulars Cost p.u. Costs for
40,000 units
Direct materials Rs.8.00 Rs.3,20,000
Direct manufacturing labour 4.00 1,60,000
Variable manufacturing overhead 2.00 80,000
Inspection, setup, materials handling 8,000
Machine rent 12,000
Allocated fixed costs of plant administration, 80,000
taxes and insurance
Total Costs Rs.6,60,000
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 Example 5: Make-vs.-Buy Decision

BI has received an offer from an outside vendor to supply any

number of burners it requires at Rs.14.80 per burner. The
following additional information is available:
Inspection, setup, and materials-handling costs vary with the
number of batches in which the burners are produced. BI
produces burners in batch sizes of 1,000 units. BI will produce
the 40,000 units in 40 batches.
BI rents the machine it uses to make the burners. If BI buys all
of its burners from the outside vendor, it does not need to pay
rent on this machine.
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 Example 5: Make-vs.-Buy Decision
You are required to:
1) Assume that if BI purchases the burners from the outside vendor, the facility where the burners
are currently made will remain idle. On the basis of financial considerations alone, should BI
accept the outside vendor’s offer at the anticipated volume of 40,000 burners? Show your
calculations.

2) For this question, assume that if the burners are purchased outside, the facilities where the
burners are currently made will be used to upgrade the grills by adding a rotisserie attachment.
(Note: Each grill contains two burners and one rotisserie attachment.) As a consequence, the
selling price of grills will be raised by Rs.48. The variable cost per unit of the upgrade would be
Rs.38, and additional tooling costs of Rs.1,60,000 per year would be incurred. On the basis of
financial considerations alone, should BI make or buy the burners, assuming that 20,000 grills are
produced (and sold)? Show your calculations.

3) The sales manager at BI is concerned that the estimate of 20,000 grills may be high and believes
that only 16,000 grills will be sold. Production will be cut back, freeing up work space. This space
can be used to add the rotisserie attachments whether BI buys the burners or makes them in-
house. At this lower output, BI will produce the burners in 32 batches of 1,000 units each. On the
basis of financial considerationsCost
alone, should BI purchase the burners from the outside vendor?
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 Example 5: Make-vs.-Buy Decision Solution
1) Calculations
Particulars Amount
Relevant costs under buy alternative:
Purchases (40,000 units*Rs.14.80) Rs.5,92,000
Relevant costs under make alternative:
Direct materials Rs.3,20,000
Direct manufacturing labour 1,60,000
Variable manufacturing overhead 80,000
Inspection, setup, materials handling 8,000
Machine rent 12,000
Total Relevant Costs under Make Alternative Rs.5,80,000
Comment: The allocated fixed plant administration, taxes, and insurance will not
change if BI makes or buys the burners. Hence, these costs are irrelevant to the
make-or-buy decision. The analysis indicates that it is less costly for BI to make
rather than buy the burners from
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 Example 5: Make-vs.-Buy Decision Solution
2) Calculations
Particulars Amount
Relevant costs under make alternative:
Relevant costs (as computed in requirement 1) Rs.5,80,000
Relevant costs under buy alternative:
Costs of purchases (40,000 units*Rs.14.80) Rs.5,92,000
Additional tooling costs 1,60,000
Additional contribution margin from using the space where the (Rs.2,00,000)
burners were made to upgrade the grills by adding rotisserie
attachments, 20,000  (Rs.48 – Rs.38)
Total Relevant Costs under Buy Alternative Rs.5,52,000

Comment: BI should buy the side burners from an outside vendor and use its own
capacity to upgrade its grills.
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 Example 5: Make-vs.-Buy Decision Solution 3) Calculations
In this requirement, the decision on making the rotisserie attachments
is irrelevant to the analysis because the rotisserie attachments increase
operating income and they will be made whether the burners are
purchased or made.
Particulars Amount
Relevant costs of manufacturing burners:
Variable costs (Rs.8 + Rs.4 + Rs.2 = Rs.14)  32,000 units Rs.4,48,000
Batch costs (Rs.200/batch*  32 batches) 6,400
Machine rent 12,000
Total Relevant Costs of Manufacturing Burners Rs.4,66,400
Relevant cost of buying burners (Rs.14.80  32,000 burners) Rs.4,73,600
* Rs.8,000  40 batches = Rs.200 per batch

Comment: In this case, BI should make the burners.

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 Qualitative Factors for Make-or-Buy Decisions:
• Nonquantitative factors may be extremely important in an evaluation
process for each of the decisions we cover here, yet do not show up
directly in calculations:
• Quality requirements
• Reputation of outsourcer
• Employee morale
• Logistical considerations—distance from plant, and so on
• For make/buy decisions, buying can be risky, especially if sourcing
internationally.

(Q1)

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 Thank You

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