Chapter 10 Relevant Cost Concepts in Decision Making

Answer 1
(a)
Sniff should consider the following factors when making a further processing decision.
– Incremental revenue. The new perfume, once further processed, should generate a higher
price and the extra revenue is clearly relevant to the decision.
– Incremental costs. A decision to further process can involve more materials and labour.
Care must be taken to only include those costs that change as a result of the decision and
therefore sunk costs should be ignored. Sunk costs would include, for example, fixed
overheads that would already be incurred by the business before the further process
decision was taken. The shortage of labour means that its ‘true’ cost will be higher and
need to be included.
– Impact on sales volumes. Sniff is selling a ‘highly branded’ product. Existing customers
may well be happy with the existing product. If the further processing changes the
existing product too much there could be an impact on sales and loyalty.
– Impact on reputation. As is mentioned in the question, adding hormones to a product is
not universally popular. Many groups exist around the world that protest against the use of
hormones in products. Sniff could be damaged by this association.
– Potential legal cases being brought regarding allergic reactions to hormones.

(b)
Production costs for 1,000 litres of the standard perfume

($399,800 – $199,800) ÷ 2,000 hrs = $100/hr

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The Male version of the product is worth further processing in that the extra revenue exceeds
the extra cost by $6,040.

The Female version of the product is not worth further processing in that the extra cost
exceeds the extra revenue by $5,080.

In both cases the numbers appear small. Indeed, the benefit of $6,040 may not be enough to
persuade management to take the risk of damaging the brand and the reputation of the
business. To put this figure into context: the normal output generates a contribution of $170
per litre and on normal output of about 10,000 litres this represents a monthly contribution of
around $1·7m (after allowing for labour costs).

Future production decisions are a different matter. If the product proves popular, however,
Sniff might expect a significant increase in overall volumes. If Sniff could exploit this and
resolve its current shortage of labour then more contribution could be created. It is worth
noting that resolving its labour shortage would substantially reduce the labour cost allocated
to the hormone added project. Equally, the prices charged for a one off experimental
promotion might be different to the prices that can be secured in the long run.

(c)
The selling price charged would have to cover the incremental costs of $166,000. For 808
litres that would mean the price would have to be

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or about $60·13 per 100 ml.

This represents an increase of only 1·05% on the price given and so clearly there may be
scope for further consideration of this proposal.

(d)
Outsourcing involves consideration of many factors, the main ones being:
– Cost. Outsourcing often involves a reduction in the costs of a business. Cost savings can
be made if the outsourcer has a lower cost base than, in this case, Sniff. Labour savings
are common when outsourcing takes place.
– Quality. Sniff would need to be sure that the quality of the perfume would not reduce.
The fragrance must not change at all given the product is branded. Equally Sniff should be
concerned about the health and safety of its customers since its perfume is ‘worn’ by its
customers.
– Confidentiality. We are told that the blend of aromatic oils used in the production process
is ‘secret. This may not remain so if an outsourcer is employed. Strict confidentiality
should be maintained and be made a contractual obligation.
– Reliability of supply. Sniff should consider the implications of late delivery on its
customers.
– Primary Function. Sniff is apparently considering outsourcing its primary function. This
is not always advisable as it removes Sniff’s reason for existence. It is more common to
outsource a secondary function, like payroll processing for example.
– Access to expertise. Sniff may find the outsourcer has considerable skills in fragrance
manufacturing and hence could benefit from that.

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ACCA Marking Scheme

Answer 2
(a)
The relevant costs of the decision to cease the manufacture of the TD are needed:

Conclusion: It is not worthwhile ceasing to produce the TD now.

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(b)
Complementary pricing
Since the washing machine and the tumble dryer are products that tend to be used together,
Stay Clean could link their sales with a complementary price. For example they could offer
customers a discount on the second product bought, so if they buy (say) a TD for $80 then
they can get a WM for (say) $320. Overall then Stay Clean make a positive contribution of
$130 (320 + 80 – 180 – 90).

Product line pricing

All the products tend to be related to each other and used in the utility room or kitchen. Some
sales will involve all three products if customers are upgrading their utility room or kitchen
for example. A package price could be offered and as long as Stay Clean make a contribution
on the overall deal then they will be better off.
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(c)
Outsourcing requires consideration of a number of issues (only 3 required):
– The cost of manufacture should be compared to cost of buying in from the outsourcer. If
the outsourcer can provide the same products cheaper than it is perhaps preferable
– The reliability of the outsourcer should be assessed. If products are delivered late then the
ultimate customer could be disappointed. This could damage the goodwill or brand of the
business.
– The quality of work that the outsourcer produces needs to be considered. Cheaper
products can often be at the expense of poor quality of materials or assembly.
– The loss of control over the manufacturing process can reduce the flexibility that Stay
Clean has over current production. If Stay Clean wanted, say, to change the colour of a
product then at present it should be able to do that. Having contracted with an outsourcer
this may be more difficult or involve penalties.

ACCA Marking Scheme

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Answer 3
(a)

Notes
Note 1: Lunch
This past cost is a ‘sunk cost’ and should therefore be excluded from the cost statement. It has
already arisen and is therefore not incremental.

Note 2: Engineers’ costs

Since one of the engineers has spare capacity, the relevant cost of his hours is Nil. This is
because relevant costs must arise as a future consequence of the decision, and since his wage
will be paid regardless of whether he now works on the contract for Push Co, it is not an
incremental cost.

The situation for the other two engineers is slightly different. Their time is currently fully
utilised and earning a contribution of $5 per hour each. This is after deducting their hourly
cost which, given a salary of $4,000 per month each, is $25 per hour ($4,000/4 x 40).
However, in one week’s time – when they would otherwise be idle – they can complete
Contract X and earn the contribution anyway. Therefore, the only relevant cost is the penalty
of $500 that will be payable for the delay on Contract X.

Note 3: Technical advisor

Since the advisor would have to work overtime on this contract, the relevant cost is the
overtime rate of $60 ($40 x 1·5) per hour. This would total $480 for the whole job.

Note 4: Site visits

This is a cost paid directly by Push Co to a third party. Since it is not a relevant cost for T Co,
it has been excluded.

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Note 5: Training costs
Since the trainer is paid a monthly salary irrespective of what work he does, this element of
his cost is not relevant to the contract, since it is not incremental. However, the commission of
$125 will arise directly as a consequence of the decision and must therefore be included.

Note 6: Handsets
Although T Co has 80 of the 120 handsets required already in inventory, they are clearly in
regular use in the business. Therefore, if the 80 are used on this contract, they will simply
need to be replaced again. Consequently, the relevant cost for both the 40 that need to be
bought and the 80 already in inventory is the current purchase price of $18·20 each. 120 x
$18·20 = $2,184.

Note 7: Control system

The historic cost of Swipe 1, $5,400, is a ‘sunk’ cost and not relevant to this decision.
However, since the company could sell it for $3,000 if it did not use it for this contract, the
$3,000 is an opportunity cost here. The current market price for Swipe 1 of $5,450 is totally
irrelevant to the decision as T Co has no intention of replacing Swipe 1, since it was bought in
error. In addition to the $3,000, there is a modification cost of $4,600, bringing the total cost
of converting Swipe 1 to $7,600. This is still a cheaper option than buying Swipe 2 for
$10,800, therefore the company would choose to do the modification to Swipe 1. The cost of
$10,800 of a new Swipe 2 system is therefore irrelevant now.

Note 8: Cable
The cable is in regular use by T Co, therefore all 1,000 metres should be valued at the current
market price of $1·30 per metre. The $1·20 per metre is a sunk cost and not relevant.

(b)
Relevant costing principles
Relevant costs are those costs that change as a result of making a particular decision. In
simple terms, a relevant cost is a future cash flow arising as a direct consequence of a
decision. In order for a cost to be relevant to a decision, it must therefore meet all three of
these criteria:

Future – any costs which have already been incurred are regarded as ‘sunk’ costs and will
prevent a cost from being considered relevant.

Cash flow – the cost must be a cash flow and not just an accounting adjustment, such as a
provision for a debt or depreciation. Also, cash flows that are the same for all alternatives are
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not relevant.

Direct consequence – this criteria means that the cash flow must be incremental. For
example, if a cost has already been committed to, then it will arise irrespective of whether the
decision goes ahead. It will not therefore meet the ‘direct consequence’ criteria.

Opportunity cost – this is the value of the best alternative that is foregone as a result of
making a decision. In the case of the telephone system that Push Co needs for the contract, the
foregone sales proceeds of $3,000 are an example of an opportunity cost since, by using the
system for this contract, Push Co foregoes these sales proceeds.

(Note: candidates would not be required to write all of this for the available marks.)

Significance of minimum price calculated

The cost calculated in part (a) is a starting point only, showing the minimum cost that could
be charged to the customer. If T Co charged this price, it would be no better or worse off than
if it did not carry out the work, i.e. it would make no profit or loss. This means that T Co
would not be rewarded for the risk that it takes in completing the work, unless some kind of a
mark-up is also incorporated.

Also, other costs – such as the lunch of $400 – whilst not incremental to the decision now,
have been incurred. Ideally, therefore, T Co should seek to recover them.

It could also be that, for example, in one week’s time, when the engineers are busy completing
the delayed contract X, another opportunity comes up that the company has to reject because
the engineers are busy on Contract X. Therefore, with hindsight, it would be seen that there
was an opportunity cost associated with using the engineers on this work and delaying
contract X.

Furthermore, none of the business’s overheads have been considered in the cost statement
and, in the long term, these would need to be covered.

It is clear, therefore, that the relevant cost calculated in part (a) is only a starting point for T
Co to use when deciding how to price the contract. The purpose of accepting contracts is to
make profit and increase shareholder wealth. This will only be done if a price higher than the
relevant cost of the contract is charged. In setting this price, however, T Co also needs to give
consideration to the fact that it hopes to attract future work from Push Co. The price needs to
be attractive enough for the customer to return in the future.
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ACCA Marking Scheme

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Answer 4
(a)

(b)

(c)

Product R should be sold at split-off point, since the additional further processing costs
exceed the incremental revenues. The overall profit will therefore rise from £244,000 to
£284,000.

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