MAS – Relevant Costing

Steps in Decision-Making Process

• Identify the decision problem.
• Determine the decision alternatives.
• Evaluate the costs and benefits of the alternatives.
• Make the decision.
• Review the results of the decision.

Relevant Costs and Benefits

• It must occur in the future, not the past. Sunk costs are never relevant.
• The total amount of the cost or benefit must change depending on which alternative is selected.
• Relevant costs are sometimes called differential costs, incremental costs, or avoidable costs. Costs
that will not change regardless of the alternative selected are irrelevant and should be ignored.
• Opportunity costs are the forgone (lost) benefits of choosing one alternative over another. Opportunity
costs occur when resources are limited or when capacity constraints are reached. They are always
relevant for decision-making.

Accept or Reject a Special Order

• A special order is outside the scope of normal sales. If the incremental revenue exceeds the
incremental costs of filling the special order, it will increase short-term profitability.
• If a company has excess capacity, only the variable costs of filling the special order are relevant.
• Fixed costs do not change in the short run and are therefore not included in the incremental analysis.
• If a company is operating at full capacity, the opportunity cost of lost sales is relevant and should be
incorporated into the incremental analysis.
• Other qualitative factors such as the effect on routine customers and the opportunity to capture new
customers must also be considered.

Make-or-Buy Decision
• Make-or-buy decisions involve deciding whether to perform a particular function in-house versus buying it
from an outside supplier. They are also called in source versus outsource decisions.
• The relevant costs of making a product or providing a service internally include all variable costs plus any
incremental fixed costs.
• The opportunity costs of making something internally include alternative uses for the internal resources.
• Many qualitative considerations including quality, reliability and environmental concerns are also
important in make-or-buy decisions.

Keep-or-Drop Decision
• Managers must often decide whether to eliminate a business segment that is not performing as well as
expected.
• To decide whether to eliminate a segment, managers should focus on the segment margin, or the amount
of profit generated by the segment after variable costs and direct fixed costs have been deducted.
• Common fixed costs would be incurred even if the segment is eliminated and are not relevant to the
decision.
• Managers must also consider how elimination of the segment would affect other segments or product
lines and whether alternative uses for the resources currently devoted to the business segment exist.

Sell-or-Process Further Decision

• A sell-or-process further decision determines whether to sell a product as is or continue to refine it.
• The incremental revenue should be compared to the incremental cost of continuing to enhance the
product or service.

Theory of Constraints
• A constrained resource occurs when its capacity is insufficient to meet the demands placed on it.
• The most constrained resource is also called the bottleneck, which limits the system’s overall output.
• To maximize short-term profit, managers should prioritize products based on the amount of contribution
margin earned per unit of time for the most constrained (bottleneck) process.

Questions:
1. Which of the following steps in the managerial decision-making process involves differential analysis?
A. Identify the decision problem
B. Determine the decision alternatives
C. Evaluate the costs and benefits of the alternatives
D. Make the decision

2. Which of the following is not another term for relevant costs?

A. differential costs
B. incremental costs
 C. opportunity costs
D. avoidable costs

3. Which of the following statements is false?

A. Sunk costs are never relevant.
B. Sunk costs are costs that occurred in the past.
C. To be relevant, a cost must be an opportunity cost.
D. To be relevant, a cost must occur in the future.

4. The manager of Hampton, Inc. is trying to decide whether to make or buy a component of the product it
sells. Which of the following costs and benefits is not relevant to the decision?
A. Direct labor cost involved in making the component
B. The purchase price of the component if it is bought
C. Variable manufacturing overhead involved in making the component
D. The selling price of the product

5. Which of the following is true of a firm that has reached the limit on its resources?
A. It has idle capacity
B. Opportunity costs are now relevant
C. It has no relevant costs
D. It has excess capacity

6. For cost control purposes, fixed costs are classified as

A. product or period costs.
B. discretionary or committed.
C. direct or common.
D. sunk or avoidable.

7. Avoidable costs are usually

A. committed.
B. common.
C. discretionary.
D. joint.

8. Which kind of costs could be eliminated by closing a sales office?

Direct Discretionary Committed

a. yes yes no
b. yes no yes
c. yes no no
d. no no yes

9. Which of the following is an example of a committed fixed cost?

A. investment in production facilities
B. advertising
C. preventive maintenance
D. employee training programs

10. Which of the following is least likely to be a discretionary cost?

A. salaries of salespeople
B. advertising
C. maintenance
D. insurance

Problems:
1. Capitol has received a special order for 2,000 units of its product at a special price of P195. The
product normally sells for P260 and has the following manufacturing costs:

Per unit
Direct Materials P78
Direct Labor 52
Variable Overhead 39
Fixed Overhead 65

Assume that Capitol has sufficient capacity to fill the order without harming normal production and sales
and all fixed overhead is unavoidable.
 a. If Capital accepts the order, what effect will the order have on the company's short-term profit?
b. What minimum price should Capital charge to achieve a P65,000 incremental profit?
c. Now assume Capital is currently operating at full capacity and cannot fill the order without harming
normal production and sales. If Capitol accepts the order, what effect will the order have on the
company's short-term profit?

2. Bancroft currently manufactures a subcomponent that is used in its main product. A supplier has
offered to supply all the subcomponents needed at a price of P240. Bancroft currently produces 20,000
subcomponents at the following manufacturing costs:

Per unit
Direct Materials P90
Direct Labor 60
Variable Overhead 70
Fixed Overhead 50

a. If Bancroft has no alternative uses for the manufacturing capacity, what would be the profit impact of
buying the subcomponents from the supplier?
b. If Bancroft has no alternative uses for the manufacturing capacity, what would be the maximum price
per unit they would be willing to pay the supplier?
c. Now assume Bancroft would avoid P640,000 in equipment leases and salaries if the subcomponent
were purchased from the supplier. Now what would be the profit impact of buying from the supplier?

3. Shirley Inc. has three divisions, King, West and Gold. Following is the income statement for the
previous year:

King West Gold Total

Sales P1,000,000 P575,000 P425,000 P2,000,000
Variable Costs 400,000 345,000 300,000 1,045,000
Contribution 600,000 230,000 125,000 955,000
Margin
Fixed Costs 375,000 215,625 159,375 750,000
Profit Margin 225,000 14,375 (34,375) 205,000

Of the fixed costs, P300,000 is for corporate costs and is allocated equally to the three divisions.

a. How much does Gold Division have in direct fixed costs?

b. What is Gold Division's segment margin?
c. What would Shirley's profit margin be if Gold Division were dropped?

4. Legacy Company currently produces three products from a joint process. The joint process has total
costs of P1,200,000 per month. All three products, A, B & C, are immediately saleable as they come
out of the joint process. Alternatively, any of the products could continue on with additional processing
and be sold as a more complete product. The following information is available:

Units Immediate Sales Later Sales Unit Cost of

Price Price Processing
Further
A 50,000 P5 P10 P6
B 75,000 P10 P15 P4
C 100,000 P15 P17 P3

a. Should Product A be sold immediately or sold after processing further? How much will the decision
affect profit?
b. Should Product B be sold immediately or sold after processing further? How much will the decision
affect profit?
c. Should Product C be sold immediately or sold after processing further? How much will the decision
affect profit?

5. Pasadena Corp produces three products, and currently has a shortage of machine hours since one of
its two machines is down - only 360 hours are available this month. The selling price, costs, labor
requirements, and demand of the three products are as follows:

Product A Product B Product C

Selling Price P5.00 P3.00 P5.00
Variable Cost per unit P3.50 P2.00 P2.00
 Machine hours per 0.75 0.25 1
unit
Demand 300 400 210

a. In what order should Pasadena prioritize production of the products?

b. How many of each product should be sold while the machine is down to maximize profit?
c. What is the total contribution margin if Pasadena prioritizes production according to its limited
resources?

Self-assessment Questions
6. Collins Company uses 12,000 units of a part in its production process. The costs to make a part are:
direct material, P15; direct labor, P27; variable overhead, P15; and applied fixed overhead, P32.
Eichholtz has received a quote of P60 from a potential supplier for this part. If Collins buys the part, 75
percent of the applied fixed overhead would continue. Collins Company would be better off by
A. P30,000 to manufacture the part.
B. P348,000 to buy the part.
C. P60,000 to buy the part.
D. P216,000 to manufacture the part.

7. Marshall Company has only 30,000 hours of machine time each month to manufacture its two products.
Product X has a contribution margin of P60, and Product Y has a contribution margin of P72. Product X
requires 6 hours of machine time, and Product Y requires 10 hours of machine time. If Marshall
Company wants to dedicate 85 percent of its machine time to the product that will provide the most
income, the company will have a total contribution margin of
A. P216,000
B. P228,600.
C. P287,400
D. P300,000

8. Phillips Company has 3 divisions: X, Y, and Z. Division X's income statement shows the following for
the year ended December 31:

Sales P1,000,000
Cost of goods sold (800,000)
Gross profit P 200,000
Selling expenses P100,000
Administrative expenses 250,000 (350,000)
Net loss P (150,000)

Cost of goods sold is 75 percent variable and 25 percent fixed. Of the fixed costs, 60 percent are
avoidable if the division is closed. All of the selling expenses relate to the division and would be
eliminated if Division X were eliminated. Of the administrative expenses, 90 percent are applied from
corporate costs. If Division X were eliminated, Phillips’s income would
A. increase by P150,000.
B. decrease by P 75,000.
C. decrease by P155,000.
D. decrease by P215,000.

9. Buxton Company is currently operating at a loss of P15,000. The sales manager has received a special
order for 5,000 units of product, which normally sells for P35 per unit. Costs associated with the product
are: direct material, P6; direct labor, P10; variable overhead, P3; applied fixed overhead, P4; and
variable selling expenses, P2. The special order would allow the use of a slightly lower grade of direct
material, thereby lowering the price per unit by P1.50 and selling expenses would be decreased by P1.
If Buxton wants this special order to increase the total net income for the firm to P10,000, what sales
price must be quoted for each of the 5,000 units?
A. P23.50
B. P24.50
C. P27.50
D. P34.00

10. Wightman Industries has two sales territories-East and West. Financial information for the two
territories is presented below:

East West
Sales P980,000 P750,000
Direct costs:
Variable (343,000) (225,000)
Fixed (450,000) (325,000)
 Allocated common costs (275,000) (175,000)
Net income (loss) P(88,000) P 25,000

Because the company is in a start-up stage, corporate management feels that the East sales territory is
creating too much of a cash drain on the company and it should be eliminated. If the East territory is
discontinued, one sales manager (whose salary is P40,000 per year) will be relocated to the West
territory. By how much would Wightman's income change if the East territory is eliminated?
A. increase by P88,000
B. increase by P48,000
C. decrease by P267,000
D. decrease by P227,000

11. Birmingham Corporation manufactures batons. Birmingham can manufacture 300,000 batons a year at
a variable cost of P750,000 and a fixed cost of P450,000. Based on Birmingham's predictions, 240,000
batons will be sold at the regular price of P5.00 each. In addition, a special order was placed for 60,000
batons to be sold at a 40 percent discount off the regular price. The unit relevant cost per unit for
Birmingham's decision is
A. P1.50.
B. P2.50.
C. P3.00.
D. P4.00.

12. It costs Hickory, Inc. P220 per unit to manufacture 1,000 units per month of a product that it can sell for
P290 each. Alternatively, Hickory could sell the units at an earlier stage of processing, which would
save P80 per unit. Hickory could sell the simpler product for P200 each. How would selling the simpler
product affect Hickory's profit?
A. Profit would increase by P10,000.
B. Profit would increase by P50,000.
C. Profit would decrease by P10,000.
D. Profit would decrease by P50,000.

13. Spencer Inc. manufactures a product that costs P36 per unit plus P32,000 in fixed costs each month.
Spencer currently sells 1,000 of these units per month for P80 each. If Spencer leased a machine for
P8,000 a month, it could add features to the product that would allow it to sell for P120 each. It would
cost an additional P12 per unit to add these features. How much would Spencer's profit be affected if it
leased the machine and added features to its product?
A. Increase P32,000
B. Decrease P32,000
C. Increase P20,000
D. Decrease P20,000

14. Castor Corp. produces three products, and is currently facing a labor shortage - only 3,000 hours are
available this month. The selling price, costs, labor requirements, and demand of the three products are
as follows:

Product A Product B Product C

Selling Price P50.00 P30.00 P40.00
Variable Cost per unit P35.00 P10.00 P30.00
Direct labor hours per 1.5 3 2
unit
Demand 1,000 2,000 500

What is the total contribution margin if Castor Corp. prioritizes production according to its limited
resources?
A. P30,000
B. P25,000
C. P20,000
D. P60,000

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