Sample Problems for Relevant Costing

I. Make or Buy
Barrus Corporation makes 30,000 motors to be used in the productions of its power lawn mowers. The average cost per motor at
this level of activity is as follows:

Direct materials ₱9.50

Direct labor ₱8.60
Variable manufacturing overhead ₱3.75
Fixed manufacturing overhead ₱4.35
This motor has recently become available from an outside supplier for ₱25 per motor. If Barrus decides not to make the motors, none
of the fixed manufacturing overhead would be avoidable and there would be no other use for the facilities. If Barrus decides to
continue making the motor, how much higher or lower will the company's net operating income be than if the motors are purchased
from the outside supplier? Assume that direct labor is a variable cost in this company.

Solution
Relevant cost to make:
Direct materials (₱9.50 per unit × 30,000 units) ₱285,000
Direct labor (₱8.60 per unit × 30,000 units) 258,000
Variable manufacturing overhead (₱3.75 per unit × 30,000 units) 112,500
Total relevant cost to make 655,500
Total cost to buy (₱25.00 per unit × 30,000 units) 750,000
Cost saved by making the units ₱94,500

II. Accept or Reject Special Order

Accept or reject a special sales order
With Idle or Without Idle Capacity
Situation No Alternative use of Capacity With Alternative use of Capacity
With idle capacity Incremental Sales PX Incremental Sales PX
Incremental Costs (X) Incremental Costs (X)
Incremental profit(loss) PX Incremental profit(loss) X
Opportunity cost (benefit) from the
alternative use of capacity (X)
Advantage (Disadvantage) of
Accepting the special sales PX

The opportunity cost here refers to the net benefit that could have
been derived from another alternative had the special sales order not
accepted.

If the order is not accepted, the idle capacity may be

• Rented out to others, or
• Use to produce another product and give additional
contribution margin.
No Idle Capacity Incremental Sales PX Incremental Sales PX
Incremental Costs (X) Incremental Costs (X)
Incremental profit(loss) PX Incremental profit(loss) X
Opportunity cost, net of best benefit foregone
From alternative use of capacity (X)
Advantage (Disadvantage) of
Accepting the special sales PX

Opportunity cost here refers to the lost contribution margin form

regular sales or from the best use of the sacrificed capacity.
A customer has requested that Gamba Corporation fill a special order for 3,000 units of product Q41 for ₱25.00 a unit. While the
product would be modified slightly for the special order, product Q41's normal unit product cost is ₱21.40:
Direct materials ₱5.70
Direct labor 3.40
Variable manufacturing overhead 5.80
Fixed manufacturing overhead 6.50
Unit product cost ₱21.40

Direct labor is a variable cost. The special order would have no effect on the company's total fixed manufacturing overhead costs. The
customer would like modifications made to product Q41 that would increase the variable costs by ₱7.00 per unit and that would
require an investment of ₱15,000 in special molds that would have no salvage value.

This special order would have no effect on the company's other sales. The company has ample spare capacity for producing the special
order. If the special order is accepted, the company's overall net operating income would increase (decrease) by:

Solution:
Incremental revenue (3,000 units × ₱25.00 per unit) ₱75,000
Less incremental costs:
Direct materials (3,000 units × ₱5.70 per unit) 17,100
Direct labor (3,000 units × ₱3.40 per unit) 10,200
Variable manufacturing overhead
38,400
(3,000 units × (₱5.80 per unit + ₱7.00 per unit))
Special molds 15,000
Total incremental cost 80,700
Incremental net operating income (₱5,700)

III. Optimization of Scarce Resources

Oruro Chemical Corporation manufactures a variety of household cleaners, solvents, and beverages. Because of a recent shortage of
Mytron, a key ingredient needed for three of its products, the corporation must decide what amount of each product would be most
advantageous to produce. Information related to the three products that use Mytron are shown below:

Hand Soap Paint Remover Root Beer

Contribution margin per case ₱24 ₱20 ₱12
Contribution margin ratio 50% 70% 60%
Mytron required per case (in ounces) 3 5 2
Maximum monthly demand (in cases) 500 200 2,000

Assume that Oruro only has 3,000 ounces of Mytron available next month. What is the maximum amount of contribution margin
that Oruro can generate next month from the three products above given the shortage of Mytron?

Solution:
Hand Soap Paint Remover Root Beer
Contribution margin per case ₱24 ₱20 ₱12
Mytron required per case (in ounces) 3 5 2
Contribution margin per ounce of mytron ₱8 ₱4 ₱6
Rank in terms of profitability 1 3 2
 Monthly demand for Hand Soap 500
Amount of constrained resource required to produce one unit of Hand Soap 3
Total amount of constrained resource required to produce Hand Soap 1,500
Remaining amount of constrained resource available
(3,000 ounces – 1,500 ounces) 1,500
Monthly demand for Root Beer 2,000
Amount of constrained resource required to produce one unit of Root Beer 2
Production of Root Beer (1,500 ounces ÷ 2 ounces per unit) 750

Hand Soap Root Beer Total

Contribution margin per case ₱24 ₱12
Production 500 750
Total contribution margin ₱12,000 ₱9,000 ₱21,000

IV. Sell or Process Further

Kosakowski Corporation processes sugar beets in batches. A batch of sugar beets costs $66 to buy from farmers and $17 to crush in
the company's plant. Two intermediate products, beet fiber and beet juice, emerge from the crushing process. The beet fiber can be
sold as is for $23 or processed further for $13 to make the end product industrial fiber that is sold for $36. The beet juice can be sold
as is for ₱2 or processed further for $20 to make the end product refined sugar that is sold for $84. How much more profit (loss)
does the company make by processing one batch of sugar beets into the end products industrial fiber and refined sugar?
Solution:
Combined final sales value ($36 + $84) $120
Less costs of producing the end products:
Cost of further processing ($13 + $20) $33
Cost of crushing 17
Cost of sugar beets 66 116
Profit (loss) ₱4

V. Continue operations or Shut Down Temporarily

The Beach and Sun Division of Philippine entertainment, Inc., has been experiencing operational loses in the last
5 years in the months of August and September. Its typical monthly income statement during this period is as
follows (in thousands):

Beach and Sun Division

Income Statement
For the Month Ended, August 31, 2008
Sales (3,000 visitors) P1,200,000
Variable costs and expenses (840,000)
Fixed costs and expenses (500,000)
Net loss P (140,000)
If the company temporarily shuts down its operations in the months of August and September, it still must pay its
unavoidable monthly fixed costs and expense of P200,000. Re-start up costs before the resumption of regular
operations in October are expected to P80,000. During the shut down period, the company would have a chance
of renovating some of its facilities and would the firm a total of P150,000.

Required:

1. From the data given, identify the irrelevant cost in deciding to shut down or not.
2. Compute the shutdown point.
3. Should the company shut down or continue its operations in the months of August and September?
 Solution:

VI. Indifference Point

Charm 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 of
paying its salespersons 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?

Solution:

Let X = Quantity/Unit Sold

350,000X = Total Sales
Commission 1 = 8%(350,000X) = 28,000X
Commission 2 = 2%(350,000X) + 210,000 = 7,000X + 210,000

At indifference point:
Commission 1 = Commission 2
28,000X = 7,000X + 210,000
21,000X = 210,000
X = 10 units

Total Sales = 350,000 X 10 = P3,500,000

To prove the indifference point of sales, we have:

Commission 1 = 8%(3,500,000) = 280,000
Commission 2 = 2%(3,500,000) + 210,000 = 280,000