RELEVANT COSTING

CHAPTER 11
Decision Making Process

Steps:

1. Define strategies: business goals and tactics to achieve them

2. Identify the alternative choices or courses of action
3. Collect and analyze the relevant data on the choices
4. Choose the best alternative to achieve goals
5. Evaluate performance
Identifying Relevant Costs

Relevant costs- expected future costs which differ between the decision
alternatives

ANY COST THAT IS AVOIDABLE IS RELEVANT FOR DECISION PURPOSES.

Examples of Relevant Costs

1. Variable costs

2. Avoidable/Incremental fixed cost

3. Out-of-pocket costs/Imputed costs

4. Opportunity costs

5. Savings
Examples of Irrelevant Costs

1. Sunk Costs

2. Allocated costs/Joint costs

3. Discretionary costs

4. Committed costs

5. Future costs that do not differ between the alternatives at hand

Identifying Relevant Costs

Analytical steps:

1. Determine all costs associated with each alternative being

considered.
2. Drop those costs that are sunk or historical.
3. Drop those costs that do not differ between alternatives
4. Make a decision based on the remaining costs.
Illustration

Laurel Corporation has its own cafeteria with the following annual costs:

Food P100,000 RELEVANT

Labor 75,000 RELEVANT
Overhead 110,000 (66k; Relevant)

The overhead is 40% fixed. Of the fixed overhead, P25,000 is the salary of the
cafeteria supervisor. The remainder of the fixed overhead had been allocated
from total company overhead. Assuming the cafeteria supervisor will remain and
that Laurel will continue to pay his/her salary. Identify the relevant costs.
Illustration

Power Systems, Inc., manufactures jet engines for the United States armed forces on cost
plus basis. The cost of a particular jet engine the company manufactured is shown below.

Direct materials P200,000 RELEVANT

Direct labor 150,000 RELEVANT
Overhead:
Supervisor’s salary 20,000 RELEVANT
Fringe benefits on DL 15,000 RELEVANT
Depreciation 12,000 IRRELEVANT
Rent 11,000 IRRELEVANT
Total cost P408,000
Illustration

If the production of this engine were discontinued, the production capacity

would be idle, and the supervisor would be laid off. Identify the relevant costs.
Approaches in Analyzing Alternatives
TOTAL APPROACH
• Analyzes information by preparing
complete set of financial reports for
each alternative
• Reports include all revenues and
expenses whether relevant or not
DIFFERENTIAL ANALYSIS
• Analyzes only information that
changes between alternatives
• Costs that will remain the same are
excluded
Indifference Point

 The point wherein the cost of alternatives are the same.

 Under these conditions, the decision maker will heavily rely on

qualitative information to determine the best alternative.
Illustration

J Motors, Inc., employs 45 sales personnel to market its line of luxury mobiles.
The average car sells for P23,000, and a 6% commission is paid to the
salesperson. JJ Motors is considering a change to a commission arrangement that
would pay each salesperson a salary of P2,000 per month plus a commission of 2%
of the sales made by that salesperson. The amount of total monthly car sales at
which JJ Motors would be indifferent as to which plan to select is?

Cost of Alternative 1 = Cost of Alternative 2

6%x = 2,000 + 2%x
0.04x = 2,000
X = 50,000
Types of Decisions

1. Make or Buy
2. Add or Drop a Product or Other Segments
3. Sell Now or Process Further
4. Special Sales Pricing
5. Utilization of Scarce Resources
6. Shutdown or Continue Operations
7. Pricing
Make or Buy

 It is basically an analysis of avoidable costs.

 If you make, you will avoid the cost of buying.

 If you buy, you will avoid the cost of making.

 Choose the option that involves the lowest cost.

Make or Buy

 RELEVANT COST TO MAKE:

a. Variable costs
b. Avoidable fixed costs
c. Opportunity costs

 RELEVANT COST TO BUY:

a. Acquisition price
b. Incidental costs to the purchase
Illustration

Garfield Company manufactures Part G for use in its production cycle. The costs
per unit for 10,000 units for Part G are as follows:

Direct materials P3
Direct labor 15
Variable overhead 6
Fixed overhead 8
Illustration

Odie Company has offered to sell Garfield 10,000 units of Part G for P30 per unit.
If Garfield accepts Odie’s offer, the released facilities could be used to save
P45,000 in relevant costs in the manufacture of Part H. In addition, P5 per unit
of the fixed overhead applied to Part G would be totally eliminated.
Solution

 Relevant cost to make

Direct materials P3
Direct labor 15
Variable overhead 6
Avoidable fixed cost 5
Opportunity cost 4.5
Total P33.50

Relevant cost to buy = P30

Solution

 Relevant cost to make

Direct materials P3
Direct labor 15
Variable overhead 6
Avoidable fixed cost 5
Total P29

Relevant cost to buy

Acquisition cost P30
Opportunity cost (4.5)
25.5
Adding or Dropping Products/Segments

 The only relevant costs are those that a company would

avoid by dropping the product or customer.
Solution

A B TOTAL
Sales 400,000 360,000 760,000
Variable expenses 280,000 216,000 496,000
Fixed expenses:
Salaries of
product line 30,000 32,000 62,000
supervisors
Marketing cost 11,158 10,042 21,200
Administrative costs 33,000 33,000 66,000
Total expenses 354,158 291,042 645,200
Operating income
45,842 68,958 114,800
(loss)
Assuming that in addition to the data given, the following changes are expected:
1. Sales of Product A and Product B increase by 10% and 15% respectively.
2. Marketing costs will remain unchanged.
3. Salaries of Product A and B’s product line supervisors would increase by 8%
and 10% respectively due to the increased sales.
4. No increase in total assets is required.
Solution

A B TOTAL
Sales 440,000 414,000 854,000
Variable expenses 308,000 248,400 556,400
Fixed expenses:
Salaries of
product line 32,400 35,200 67,600
supervisors
Marketing cost 10,923 10,277 21,200
Administrative costs 33,000 33,000 66,000
Total expenses 384,323 326,877 711,200
Operating income
55,677 87,123 142,800
(loss)
Sell Now or Process Further

 Joint product costs- Manufacturing costs that are incurring in

producing the joint products up to the split-off point.

 Separable costs- relevant costs

 A B C
Incremental
revenue from 20,000 45,000 15,000
further processing
Incremental cost
of further 25,000 30,000 5,000
processing
Profit (loss) from
(5,000) 15,000 10,000
further processing
Special Sales Pricing

Special order- one-time order that is not considered part of

the company’s ongoing business
Illustration
Differential Approach

Incremental
revenue from 12,800
special order
Incremental costs (10,100)
Incremental profit 2,700
Total Project Approach

Without Special With Special Difference

Order Order
Sales 80,000 92,800 12,800
Less: Variable
53,000 63,100 10,100
expenses
Contribution margin 27,000 29,700 2,700
Less: Fixed costs 19,500 19,500 -
Operating profit 7,500 10,200 2,700
Utilization of Scarce Resources

 A scarce resource is a constraint.

 Choose the course of action that will maximize the firm’s contribution
margin per limited resource

 Prioritize the product with the highest contribution margin per limited
resource
Illustration

Homes Company produces three products, with costs and selling prices as shown
below:

A B C
Selling price per
P30 P20 P15
unit
Variable costs per
18 15 6
unit
Contribution
P12 P5 P9
margin per unit
Illustration

A particular machine is a bottleneck. On that machine, 3 machine hours are

required to produce each unit of Product A, 1 hour is required to produce each
unit of Product B, and 2 hours are required to produce each unit of Produce C. In
what order should it produce its products?

A B C
Contribution margin
12 5 9

÷ Production hrs. 3 1 2
CM/hr P4 P5 P4.5
Illustration
Illustration
Hard rolls Soft rolls
Contribution margin
4 4

X Units to be
300 500
produced
CM/ machine hour 1,200 2,000
Shut Down or Continue Operations

 It involves an analysis if a business segment, which may be a product

line, a department, or a branch be discontinued.

 Whether the company continue or discontinue a segment, it will still

incur losses.

 The goal is to MINIMIZE losses.

Illustration

Zorro Company produced and sells 8,000 units of Product X each year. Each
unit of Product X sells for P10 and has a contribution margin of P6. It is
estimated that if Product X is discontinued, P51,000 of the P60,000 in fixed
costs charged to Product X could be eliminated.

Contribution margin48,000
Avoidable fixed cost (51,000)
Incremental net loss (3,000)

Therefore, Zorro Company may choose to discontinue Product X because it

can save P51,000, though it will lose P48,000 of contribution margin.
Shut Down Point

Fixed costs if
operations are - Shut down costs
continued
Shut down point =
Contribution margin per unit

Decision guide:

• If units sold are GREATER than the shutdown point in units, company may continue the
segment because of a minimized loss.

• If units sold are LOWER than the shutdown point in units, company may already
discontinue the segment.
Illustration
Solution

SHUTDOWN POINT

In units: (5,000 – 2,000) / P1 = 3,000 units

In Pesos: 3,000 units x P3 = P9,000
Pricing Decisions

1. Cost Plus Pricing

2. Target Costing
Cost Plus Pricing
Illustration
Absorption Costing
Variable Costing
Mark Up Percentage
Target Costing

Target cost = Anticipated selling price – Desired profit

X = P1,300 - P80
X= P1,220
Additional Illustrations
Make or Buy
Solution

Answer: No, because making the blades would save Dana Company P2,500.
Sell Now or Process Further
Solution
Special Order
Solution
Utilization of Scarce Resources
Solution
Solution