STRATEGIC COST MANAGEMENT

RELEVANT COSTING

AL F. BERBANO
RELEVANT COST – are those costs used in making decisions.

CHARACTERISTICS OF RELEVANT COSTS

1. DIFFERENTIAL – cost that changed from one alternative to another (In making decisions, there
should be at-least two alternatives or options).
2. FUTURE-ORIENTED – referred to as planned costs, budgeted costs, projected costs or estimated
costs.

Relevant costs include variable costs, direct fixed costs ( traceable fixed costs), avoidable costs,
opportunity costs etc.

Irrelevant costs include sunk cost (past or historical costs), fixed cost (except direct), unavoidable costs,
common costs (allocated costs) etc.

SHORT-TERM NON-ROUTINE DECISION GUIDELINES

SITUATIONS
1. Make or buy (insource or Where can we save?
outsource) a component part?
2. Accept or reject special sales If there is an incremental profit,
order? accept!
3. Drop or continue a division? If the direct segment margin is
positive, continue!
4. Sell as is or process further? If there is a profit from further
processing, then – go ahead!
5. Continue operations or temporary If sales is greater than the shut-down
shut down? point, better continue operating!
6. Maximize or minimize bid price? Focus on the incremental costs…..
7. Optimization of scarce resources Prioritize the product that gives the
highest contribution margin based on
the limited resource.
8. Sell now or later? If the expected increase in sales is
greater than the incremental costs of
storage, then sell later!
9. Replace or retain an old asset? If the net cash inflows (NCI) is greater
than the net cash outflows (NCO),
replace the asset! (Disregard the time
value of money and the tax effects are
not considered)
10. Scrap or rework a defective unit? Choose the alternative that gives the
highest short-term profitability.
11. Determining the indifference Point of equality, where the outcome
point of the alternatives are the same.
 PROBLEM EXERCISES

1. SELL AS IS OR REWORK. Prior to the 2019 PBA finals, a Cubao area clothes retailer
purchased 5,000 T-shirts that read: GINEBRA - FOR LIFE. The company paid, on average,
P350.00 for each of these customized T-shirts. With Ginebra losing early in the play-offs, the
retailer is now stuck with 2,000 of the T-shirts. The first 3,000 T-shirts were sold during the play-
offs at an average price of P800.00. The company has learned from one of its suppliers that
each shirt could be reworded at a cost of P50.00 per shirt (which involves removing the word
“FOR LIFE” from each shirt). The retailer could sell each shirt for P200. Alternatively, the
retailer can sell the shirts for P90.00 each to clothes wholesaler.
Required:
a. Which costs are sunk in this decision?
b. What are the relevant costs of each decision alternative, and what should the company do?

2. MAKE OR BUY DECISION. Pia Plastics Inc. manufactures plastic housings for air
conditioners. One of the parts to manufacture air conditioner plastic housing is currently
produced by Pia at a rate of 90,000 units annually. The management is considering purchasing
the part from an external vendor, Glenda Plastics, Inc. the following data are made available for
making a decision:
Cost per unit to manufacture: Cost per unit to buy:
Direct materials P20 Purchase price P60
Direct labor 30 Freight charges 5
Variable overhead ✓ 13 avoidable Total costs P65
or H
T unavoidable
Fixed overhead-applied 12
Total costs P 75
relevant
Required: ro

a. Assuming all of Pia’s internal production costs are all avoidable if it purchases rather than
make the parts, which alternative is better and by how much is the net advantage?
b. Assuming that Pia’s fixed overhead is unavoidable regardless of the alternative chosen, how
much is the opportunity cost of the decision↳ to buy the part from an outside supplier?
irrelevant

3. MAKE OR BUY DECISION. Golden State Corporation manufactures all of the component
parts of its product. The cost to manufacture its product is given below:
Per Unit 8,000 units per year
Direct materials P4 P32,000
Direct labor 7 56,000
Variable manufacturing overhead relevant 3 24,000
Fixed manufacturing overhead, traceable 6 48,000
Fixed manufacturing overhead, common =
irrelevant
5 40,000
The traceable fixed overhead is composed of 40% depreciation of special equipment and 60%
fixed irrelevant
supervisory salaries. → relevant ↳
,

→ cost buy
to

An outside supplier has offered to use the 8,000 parts at P18 per part. If the parts are bought
from outside supplier, the relevant facilities could be used to produce a new product that is
expected to generate a contribution margin of P32,000.
Required:
a. For each alternative, make or buy, compute the net relevant costs.
b. What alternative would you advise the company? Why?

4. ACCEPT OR REJECT A SPECIAL ORDER. Sweetness Company produces organic fertilizer which is
retailed through farm supply companies. Presently, the company uses 85% of its maximum
capacity of 2,000 tons a year. Under its present capacity, the company has the following costs
structure of producing a ton of fertilizer:
Direct materials P 1,600
Direct labor 2,400
Variable overhead 2,100
Fixed overhead prob )
1,000
is silent (irrelevant

TOTAL P 7,100
 sale is or rework
①
as

units 350 F- 700,000

a.) cost × =

sunk = 2,000
Kasi nabenta naman
↳ naiwan Ung 3k
Ung ,

D) relevant costs from reworking (2000×50) =

# 100,000

as is none
selling
relevant cost from =
-
-

inflows from
reworking
(0--200 -
50) ✗ 2000 units =
300,000

Inflows from selling as -

is (2000×90) = 180,000

Net advantage of reworking 120,0€

buy
②
Make or

Avoidable

a.) Relevant cost to make the part f- 75.00

( 65.007
" "
the
buy

Advantage of
buying the part /U 10.00

(90,000×10)
Total advantage of buying parts F- 900,000

Unavoidable
b.)

20
Relevant cost to make (20-130+13) 63 1-
=

"
30
" 165)
buy 13
Advantage of
making
/U v1 cost to
buy 6¥
⑨
ftp.oo
*

Total advantage
of making (90,000×2) 180,000
③ Make or
buy

compute the net relevant cost

a.) For each alternative , make or
buy ,

Make
Buy
* 144,000
purchase price (8,000×18)
14) # 112,000
(8,000 ×
Var production cost

↳ (4+7+3)

28,000
Avoidable fixed cost (48,000×60010)

( 32,000 )
CM lost
-

pen product
112,000
* 140,800
1) Relevant costs

2) Savings 281,800

④ Accept or
reject

1) DM 1600

DL 2400
2100
VOH

Unt RC 6,100

Total RC 1 250 × 61007

=
F- 1
, 525,000
tons

2) # 1,700,000
Inventory sales (250 ×
6,800)
( 1,525,000 )
Inventory cost

Inventory profit p= 175,000

↳ there is incremental profit

so we accept the order

3) If the company rejects the special order

,
the incremental profit of

F- 175,000 becomes the opportunity cost

 The average sales price of the fertilizers is P10,000 per ton. The firm has been approached
by a Malaysian Company about supplying 250 tons of fertilizer next year at a price of P6,800 per
ton, FOB Sweetness’ plant. No production modifications would be necessary to fulfill the order
from the Malaysian Company.
Required:
a. What are the relevant costs to the decision to accept this order?
b. What would be the peso effect on pre-tax income if this order is accepted?
c. Determine the opportunity costs if Sweetness Company rejects the special order?

5. DROP OR CONTINUE A DEPARTMENT. The Income Statement of Happy Company’s

Department 4 for October, 2015 is given below:
Happy Company
Income Statement – Department 4
For the month ended, October 31, 2015

Sales P2,400,000
Less: Variable costs and expenses 1,800,000
Contribution margin 600,000
Less: Fixed costs and expenses 800,000
NET INCOME (P 200,000)
Sixty percent of the total fixed costs and expenses are allocated from the head office.
The company’s president is contemplating to drop Department 4 on account of its unfavorable
performances. The discontinuance of Department 4 would not affect sales of other
departments.
Required:
a. Compute the segment margin of department 4 in October 2015.
b. Would you recommend Department 4 to drop or continue operating?

6. DROP OR CONTINUE A PRODUCT. The Indomitable Company manufactures and sells three
products. Product A, F, and B. for the coming year, sales are expected to be as follows:
Product Sales price Quantity Total Sales
A P10 5,000 P 50,000
F 6 7,000 42,000
B 15 3,000 45,000
P137,000
At the expected quantity and mix, the manufacturing cost per unit is as follows:
A F B
Direct materials 2 2 4
] is
¥ If
6
:
I :-.
Direct labor 2 1 3
Factory overhead
Variable 1 £4 1 on 2
Fixed 1 1 3
Variable marketing expense is P1 per unit for A and F and P2 per unit for B. Budgeted fixed
-
-

marketing expense for the coming year are P3,000 and budgeted fixed administrative expenses are
P6,000.
The sales manager has recommended dropping Product F from the product line and using the
production capacity currently committed to production of T to produce more A.
The production manager reports that 4,000 additional units of A can be produced with the
production capacity now used in manufacturing F. to sell 4,000 additional units of A, the sales manager
believes that the advertising budget will have to be increased by P5,000.
Required:
a. Should the sales manager’s proposal be accepted? Support your answer by computing the
change in profitability that would result from this action.
b. In addition to the factors mentioned by the production and sales manager, what other
factors should be considered?
 continue
⑤ Drop or

1) contribution margin 600,000

Direct to (800,000×0-40) ( 320,000)

continue
segment margin ago , ooo

continue
⑥ Drop or
room

F- 7,000
(
✗

CM product
F 7,000 #
1)
a.)
-

Incremental profit
-

product A :

increase in an
-
p .
-
A :
(4,000 ×
4) f- 16000

↳ ' °O°)
u

increase in adv .
11,000

A
product g. ooo
Net advantage of Producing

⑦ Goo bojan Going

140 210
Unit sales price 100
cost 160 ) ( 1007 GOO)
Unit var

40 40 110
Unit cm
10 ÷5 → 20 :3 do :S
µ µ
2hr5 4hr5 8hr5
Hrs / unit

↳ 40 40

2hr5
Furs É÷
10
=
# 20 =p = # 13.75
1st 3rd 2nd

standard hrs req / unit = DLC

DLR / nr

2)
tlrslunlt-totaltwsrqnk.GOV
products Unity
4,00° 2 8,000

4,000 (balance)
2 500 8
oolong
12,000

3) bian
140 Ranke Products Unity Hrslun Totality
oojan
2000
4 8000
( 52)
I

4000 lbal )
d°°° °
2 6000
gg 12,000

4hr7
=
22 1st rank na
7. OPTIMIZATION OF SCARCE RESOURCES. Dragon Ball Corporation is considering to
produce the following products. Below are the following relevant information:
Goco Gojan Goteng
Unit sales price P100 P140 P210
Unit variable cost 60 100 100
Unit direct labor cost 10 20 40
The direct labor rate per hour is P5 and only 12,000 hours of the direct labor time are
available.
Required:
a. Assuming the market for each product is unlimited, which product should the company
produce and how much should this product earn?
b. Assuming the demand for Product Goco is 4,000 units and the other products have no
market limits, what is the optimum product mix to maximize profit?
c. Assuming that the unit variable cost for Product Gojan could be reduced to P52, and the
market demand for Product Gojan is 2,000 units while the other products have unlimited
market, determine the optimum product mix to maximize profit.

8. SELL NOW OR PROCESS FURTHER. Twister Company manufactures three products from a
common production process. Joint costs up to the split-off point total P400,000. The company
allocates these costs to the joint products on the basis of the number of units produced. The
unit sales price and number of units manufactured are given below:
P1 P2 P3
Units produced 20,000 30,000 60,000
Unit sales price at split-off point P3 P4 P2.50
Each product may be sold at split-off point or can be processed further.
Additional processing requires no special facilities. The additional processing costs and the sales
value after further processing are shown below:
P1 P2 P3
Additional processing cost P35,000 P40,000 P12,000
Sales value P90,000 P160,000 P180,000
Required:
a. Which product(s) is(are) to be processed further?
b. How much is the increase in the overall profit, if products are processed further to optimize
profit?
c. How much is the relevant costs associated with the decision of further processing product(s)
to maximize profit?

9. RETAIN OR REPLACE EQUIPMENT. Allaina Company is considering replacing its old

equipment. Relevant data are given below:
OLD NEW
Purchase cost P120,000 P150,000
Accumulated depreciation to date 70,000 -0-
Current salvage value 10,000 -0-
Salvage value for 5 years - -0-
Estimated annual operating costs P90,000 P60,000
Remaining useful life 6 years 6 years
Required:
a. Identify the sunk cost in this decision.
b. Should the company retain or replace its old equipment?
c. What is the opportunity cost of the better alternative?

10. SHUT DOWN TEMPORARILY OR CONTINUE OPERATIONS. East Asian Industries

Corporation is engaged in the production and sales of a seasonal product. Its regular sales and
costs data are assembled below:
Monthly sales in units (Nov – June) 200,000 lbs.
Unit sales price P8 per lb.
Unit variable production costs P2 per lb.
Unit variable expenses P0.80 per lb.
 Fixed overhead P800,000
Fixed operating expenses P500,000
In the months of July and August, the company has been experiencing a tremendous
scaling down of sales to 44,000 units per month. Because of this, management is contemplating
of closing down the operations in the months of July and August. This would decrease the
monthly fixed overhead to P200,000 and fixed operating expenses by 40%.
If operations are temporarily stopped in July and August, security and insurance costs,
not included in the regular fixed overhead and expenses, would have to be additionally incurred
at a cost of P120,000 per month. On top of these costs, the firm is expected to incur a re-start
up cost of P300,000 before the operation commenced normally in November.
The sales price per unit will remain the same. Unit variable costs are also expected to
be unchanged.
Required:
a. Determine the shut-down costs.
b. Calculate the shut-down point.
c. What is the net advantage or disadvantage of continuing the operations in the months of
July and August?

11. SHUT DOWN TEMPORARILY OR CONTINUE OPERATIONS. The Beach and Sun Division of
Philippines Entertainment Inc., has been experiencing operational losses in the past 5 years in
the months of August and September. Its typical monthly income statement during this period
is as follows:
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 has to pay its unavoidable monthly fixed costs and expenses of P200,000. Re start up
costs before the resumption of regular operations in October are expected to be P80,000.
During the shutdown period, the company would have the chance of renovating some of its
facilities and would cost the firm a total of P150,000.
Required:
a. Determine the shut-down costs.
b. Calculate the shut-down point.
c. What is the net advantage or disadvantage of continuing the operations in the months of
August and September?

12. MINIMUM BID PRICE. Honey Company specializes in packaging bulk drugs in standard dosages
for local hospitals. The company has been in business since 2016 and has been profitable since
its second year of operations. John Lloyd, director of cost accounting, installed a standard cost
system after joining the company in 2015.
Marikina Memorial Hospital has asked Honey to bid on the packaging of one million doses of
medication at full cost of no more than 9% after income taxes. Marikina defines costs as
including all variable costs of performing the service, a reasonable amount of non-variable
overhead, and reasonable administrative costs. The hospital will supply all packaging materials
and ingredients. Marikina has indicated that any bid over P0.015 per dose will be rejected.
John Lloyd, accumulated the following information prior to the preparation of the bid.
Direct labor P5 per hour
Variable factory overhead 2 per direct labor hour
Fixed factory overhead 5 per direct labor hour
Administrative costs P1,000 for the order
Production rate 1,000 doses per direct labor hour
Required:
a. Calculate the minimum bid price per dose that Honey can bid for the Marikina Memorial
Hospital job and not reduce Honey’s net income.
b. Calculate the bid price per dose using the full cost criterion and the maximum allowable
return specified by Marikina Memorial Hospital.
13. SCRAP OR REWORK. Manila Company has just rejected 100,000 units of its product Z as
below its production quality. It is now considering two options on what to do with these
rejected units: sell as scrap for P200 each or rework further and sell each unit at P500. The
company has to spend P180 each if it has to rework the rejected units. In the process of
producing the units that have been rejected, a total variable production costs of P1,200 per unit
were incurred by the firm.
Required:
a. What is the sunk cost in the decision of scrapping or reworking the rejected units?
b. What is the better alternative and how much is its net advantage over the other?