RELEVANT COSTS FOR NON-

ROUTINE DECISION MAKING

 RELEVANT COSTS FOR NON-ROUTINE DECISION MAKING

Relevant information
The expected future data that
differ among alternative courses of action.
Irrelevant Information must be eliminated
from the manager’s decision framework.
Relevant cost
This can be defined as a cost that is
applicable to a particular decision in the
sense that it will have a bearing on which
alternative the manager selects.

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The Decision Making Process
The process of studying and evaluating two or more available alternatives
leading to a final choice
 The steps are outlined as follows:

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.

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Identifying
Relevant Costs
5
 Identifying Relevant Costs

Any cost that is voidable is relevant for decision purposes.

Avoidable cost can be defined as a cost that can be
eliminated (in whole or in part) as a result of choosing one
alternative over another in a decision-making situation.
All costs are considered avoidable, except:
1. Sunk costs
2. Future costs that do not differ between the
alternatives at hand.
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 Identifying Relevant Costs

Relevant costs are expected future costs which differ between the
decision alternatives. These are costs that will be increased or decreased as a
result of a Decision.
Under the concept of relevant cost, decision-making process involves the
following 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. These costs will be the future differential or
avoidable costs, and hence the costs relevant to the decision to be made

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 Lastly, any
A. Sunk or historical costs future cost that
does not differ between
the alternatives in a
decision situation is not
Never relevant in decisions because they are not avoidable a relevant cost so far as
and therefore they must be eliminated from the manager's that decision is
concerned.
decision framework
Depreciation relating to the book value of old equipment is not relevant in decision
making. However, it is not correct to assume that depreciation of any kind is irrelevant in
the decision making process. Depreciation is irrelevant in decision only if it relates to a
sunk cost.
Depreciation on a new machine is relevant because the investment in the new machine
has not yet been made and therefore it does not represent depreciation of a sunk cost.

The resale of disposal value of an existing asset will be relevant in any decision that
involves disposing of the asset.
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B. Opportunity costs

❖ The profits lost by the diversion of an input factor from one use to
another.
❖ They are the net economic benefit given up when an alternative is
rejected.
❖ They are relevant when a company is considering eliminating one
activity and using plant facilities advantageously in another
activity.

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C. Out-of-pocket costs

❖ involve either an intermediate or near-future cash outlay; they are

usually relevant to decisions. Frequently, variable costs fall into
this classification

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Approaches in Analyzing
Alternatives in Non-Routine
Decision Making
The two commonly used approaches in evaluating alternative courses of action
are
Approaches in Analyzing Alternatives in Non-Routine Decision Making

The two commonly used approaches in evaluating alternative

courses of action are

1) Incremental or Differential analysis approach

2) Total Project Analysis approach or Comparative
Statements approach.

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 Approaches in Analyzing Alternatives in Non-Routine Decision Making

Inc remental, Differential, or Relevant

C os t analys is contrasts choices by comparing
differential revenues, differential costs and
differential contribution margins. It has the
advantage of showing only relevant amounts. All
sunk and non-differential items are disregarded

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Approaches in Analyzing Alternatives in Non-Routine Decision Making

The following steps are followed

in us ing this approac h:
1. Gather all costs associated with
each alternative.
2. Drop the sunk costs and non-
differential costs.
3. Select the best alternative based
on the remaining cost data.
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Approaches in Analyzing Alternatives in Non-Routine Decision Making

Total Projec t A nalys is approac h

shows all the items of revenue and cost data
(whether they are relevant or not) under the
different alternatives and compares the net
income results.
Comparative income statements under this
approach are prepared in a Contribution
format.
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TYPES OF DECISIONS

These decisions that commonly occur in

all business activities are as follows:
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. Shut-down or Continue Operations
7. Pricing
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 TYPES OF DECISIONS

I. Make or Buy Decision

The make-or-buy decision is a management decision
about whether an item should be made internally or
bought from an outside supplier. To put idle capacity
to use, firms often consider manufacturing a part or
subassembly they are currently purchasing.

When these opportunities arise, the managerial

accountant is often asked to compare the cost of
manufacturing a part internally with the cost of
purchasing it.
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 TYPES OF DECISIONS

II. Adding or Dropping Products/Segments

When management is considering dropping a product
line or customer group, the only relevant costs are
those that a company would avoid by dropping the
product or customer..

An important factor in deciding whether to add or drop

a product is the decision's effect on operating income
Add: More Favorable Operating Income.
Drop: Operating Income better off without the
product.
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 TYPES OF DECISIONS

III. Sell Now or Process Further

Firms that produce several end products from a
common input are faced with the problem of deciding
how the joint product cost of that input is going to be
divided among the joint products.
Joint product costs is used to describe those
manufacturing costs that are incurring is producing the
joint products up to the split-off point. The split-off
point is that point in the manufacturing process at
which the joint product can be recognized as separate
products. 19
 TYPES OF DECISIONS

III. Sell Now or Process Further

Joint product costs are irrelevant in decisions
regarding what to do with a product from the split off
point forward because they have already been incurred
and therefore are sunk costs.
Costs incurred after the split-off point for the benefit of
only one particular product are called separable costs.
They are relevant costs in the sell-or-process-further
decision.

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 TYPES OF DECISIONS

III. Sell Now or Process Further

In sell-or-process-further decision, it will always be
profitable to continue processing a joint product after
the split-off so long as the incremental revenue from
such processing exceeds the incremental processing
costs.
Sell now: No incremental profit from
processing
Process Further: Incremental revenue from
processing exceeds incremental costs
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 TYPES OF DECISIONS

IV. Special Sales Pricing

Managers often must evaluate whether a special order
should be accepted, or if the order is accepted, the
price that should be charged.
A special order is a one-time order that is not
considered part of the company's ongoing business.

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 TYPES OF DECISIONS

V. Utilization of Scarce Resources

When capacity becomes pressed because of a scarce
resource, the firm is said to have a constraint. Because
of the constrained scarce resource, the company
cannot fully satisfy demand, so the manager must
decide how the scarce resource should be used.

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 TYPES OF DECISIONS

V. Utilization of Scarce Resources

Fixed costs are usually unaffected by such choices, so
the manager should select the course of action that will
maximize the firm's total contribution margin.
This is based on the assumption that the product
choices as short-run decisions because we have
adopted the definition that in the short run, capacity is
fixed, while in the long-run, capacity can be changed.

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 TYPES OF DECISIONS

V. Utilization of Scarce Resources

Contribution in Relation to Scarce Resources

To maximize total contribution margin, a firm should not

necessarily promote those products that have the highest
contribution margins per unit. With a single constrained
resource, the important measure of profitability is the
contribution margin per unit of scarce resource used.

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 TYPES OF DECISIONS

VI. Shut down or Continue operations

Management is concerned with the fact that a further
drop in sales volume will create a loss.
This concern has been intensified by the sales
manager's opinion that the selling price of the
company's product will soon have to be adjusted to
meet the increasing pressure of competition.

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 TYPES OF DECISIONS

VI. Shut down or Continue operations

Before making their final decision, the company
executives must recognize that not all of the non-
variable costs will be eliminated by a temporary closing
of the plant.

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 TYPES OF DECISIONS

VI. Shut down or Continue operations

As a first step, an estimate of the shutdown costs must be made.

Shut down point -= Fixed costs if operations are continued – Shut down costs

Contribution Margin per unit

Shut down: Avoidable costs > revenues

Continue: Losses on shut down would be greater.

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 TYPES OF DECISIONS

VII. Pricing Products and Services

In many situations however, the firm is faced with the problem of selling its own
prices. The pricing decision can be critical because
1.the prices charged for a firm's products largely determine the
quantities customers are willing to purchase and
2.the prices should be high enough to cover all the costs of the firm.
A . Cos t-Plus Pric ing
The most basic approach in pricing decision is that the price of the product or
service should cover all the costs that are traceable to the product and service,
variable as well as fixed. If revenues are not sufficient to cover these traceable
costs, then the firm would be better off without
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the product or service.
 TYPES OF DECISIONS

VII. Pricing Products and Services

In many situations however, the firm is faced with the problem of selling its own
prices. The pricing decision can be critical because
1.the prices charged for a firm's products largely determine the
quantities customers are willing to purchase and
2.the prices should be high enough to cover all the costs of the firm.

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 TYPES OF DECISIONS

VII. Pricing Products and Services

A . C os t-Plus Pric ing
The most basic approach in pricing decision is that the price of the
product or service should cover all the costs that are traceable to the product
and service, variable as well as fixed. If revenues are not sufficient to cover these
traceable costs, then the firm would be better off without the product or service.
In addition to the traceable costs, all products and services must assist
in covering the common costs of the organization. These common costs may
include general factory, selling and administrative costs.

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 TYPES OF DECISIONS

VII. Pric ing Produc ts and Servic es

A. Cost-Plus Pricing
of course, the selling price should not only cover all the costs of the
organization but also provide a return on invested capital.
Cos t-Plus Pric ing formula
Target selling price = [Cost + (Markup percentage x cost)]

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 TYPES OF DECISIONS

VII. Pric ing Produc ts and Servic es

A. Cost-Plus Pricing
Products however, may be costed in at least two different ways:
1.By the absorption approach where the cost base is defined as the
cost to manufacture one unit and therefore excludes all selling general and
administrative expenses.

2.By the contribution approach where cost base consists of all the
variable costs associated with a product including variable selling, general and
administrative expenses (SGA).
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 TYPES OF DECISIONS

VII. Pric ing Produc ts and Servic es

A. Cost-Plus Pricing
Determining the Markup Percentage
To facilitate the computation of selling price, formulas can be used to
determine the appropriate markup percentage assuming that the desired return
on Investment (ROI) and unit sales volume are given.
Under the absorption approach to cost-plus pricing:
Markup percentage on absorption cost

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 TYPES OF DECISIONS

VII. Pric ing Produc ts and Servic es

A. Cost-Plus Pricing
Under the abs orption approac h to cos t-plus pric ing:
Markup percentage on absorption cost
= Desired return on assets employed + SGA expenses
Volume in units’ x unit manufacturing costs
Under the contribution approac h to cos t-plus pric ing:
= Desired return on assets employed + Fixed costs
Volume in units’ x unit variable costs
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 TYPES OF DECISIONS

VII. Pric ing Produc ts and Servic es

B. Target costing
This pricing approach is used when company will already know what
price should be charged and the problem will be to produce the product that
can be marketed profitably.
Target costing is the process of determining the maximum allowable
cost for a new product and then developing a sample that can be profitably
manufactured and distributed for that maximum target cost figure.

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 TYPES OF DECISIONS

VII. Pric ing Produc ts and Servic es

B. Target costing
The target cost is computed as follows:
Target cost = Anticipated selling price - Desired Profit

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BASIC PROBLEMS
5 PROBLEMS
 PROBLEM 1

Company A manufactures bicycles. It can produce 1,000 units in a month for a fixed cost of $100,000 and variable
cost of $500 per unit. Its current demand is 600 units which it sells at $1,000 per unit. It is approached by Company
B for an order of 200 units at $700 per unit. Should the company accept the order?

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PROBLEM 2

The estimated costs of producing 6,000 units of a component are:

Per Unit Total
Direct Material $10 $60,000
Direct Labor $8 $48,000
Applied Variable Factory Overhead $9 $54,000
Applied Fixed Factory Overhead ($1.5 per direct labor dollar) $12 $72,000
Total $39 $234,000

The same component can be purchased from market at a price of $29 per unit. If the component is
purchased from market, 25% of the fixed factory overhead will be saved. Should the component be
purchased from the market?

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 PROBLEM 2

Per Unit Total

Direct Material $10 $60,000
Direct Labor $8 $48,000
Applied Variable Factory Overhead $9 $54,000
Applied Fixed Factory Overhead ($1.5 per direct labor dollar) $12 $72,000
Total $39 $234,000

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 PROBLEM 3

Product A and B are produced in a joint process. At split-off point, Product A is complete whereas product B can
be process further.
The following additional information is available:
Product A B
Quantity in Units 5,000 10,000
Selling Price Per Unit
@Split-off $10 $2.5
@ Process Further $5.0
Cost after split off $20,000

Perform sell-or-process-further analysis for product B. Should the company sell at split-off or process further

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 PROBLEM 3

Product A B
Quantity in Units 5,000 10,000
Selling Price Per Unit
@Split-off $10 $2.5
@ Process Further $5.0
Cost after split off $20,000

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 PROBLEM 4

Lars Company manufactures a part for use in its production of coats. When
10,000 items are produced, the costs per unit are:
Direct materials $0.70
Direct manufacturing labor 3.50
Variable manufacturing overhead 1.40
Fixed manufacturing overhead 1.80
Total $7.40
Kalamar Company has offered to sell to Lars Company 10,000 units of the
part for $7.00 per unit. The plant facilities could be used to manufacture
another item at a savings of $8,000 if Lars accepts the offer. In addition,
75% per unit of fixed manufacturing overhead on the original item would
be eliminated.
Required:
a.What is the relevant per unit cost for the original part?
b.Which alternative is best for Lars Company? By how much?

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 PROBLEM 5

Problem 5
Merci Beacoup Inc. manufactures mobile cellular equipment and develops
a price for the product. Merci incurs variable costs of P2,500,000 in the
production of 100,000 units, while total Manufacturing costs are at
P2,400,000, and Total Costs Incurred are at P3,000,000. Fixed costs total
P500,000, Selling and Administrative Expenses are at P600,000. The
company employs P5,000,000 of assets and wishes to earn a profit equal to
a 11% rate of return on assets.

A. Compute the Markup percentage using the Total Cost

Concept
B. Compute the Markup percentage using the Absorption
approach of product pricing.
C. Compute the Markup percentage using the Contribution
approach of product pricing.

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 Any questions?

Sources:
Cabrera (2017). Management accounting: concepts and application
Brewer, P., et al. (2016). Introduction to managerial accounting
Warren, C., et al. (2014). Managerial accounting, Australia: Cengage Learning
Roque, R. (2016).Reviewer in management advisory services,
PPT designed by Jimena Catalina
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