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Relevant Costing with Linear Programming

Decision Making
The process of making choices from at least two alternatives by identifying a problem, gathering
information, and evaluating alternative solutions. It is an inherent function of management. For
business entities, management usually chooses the option that maximizes company profit.

Costs Terms
1. Relevant costs - future costs that are different among alternatives.
2. Differential costs - increases or decreases in total costs resulting from choosing one option
over another. [Relevant]
3. Avoidable costs - costs that will be saved or will not be incurred if a certain decision is made.
[Relevant]
4. Marginal or incremental costs - costs of producing and selling additional units of product.
[Relevant]
5. Opportunity costs - benefit foregone or highest income sacrificed when an option is chosen
over another. [Relevant]
6. Out-of-Pocket costs- costs that are required for immediate or near future cash outlays based
on a particular decision. Non-cash expenses that are deemed relevant are called imputed
costs. [Relevant]

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7. Sunk costs - historical or past costs that cannot be avoided regardless of what decision is
made. [Irrelevant]
8. Shutdown costs - costs that will remain to be incurred even if operations are discontinued.
[Irrelevant]
9. Joint costs - costs incurred in processing joint products until the split-off point. [Irrelevant]
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10. Further processing costs - costs incurred in processing separate products beyond the split-off
point. [Relevant]

Three Classifications of Business Decisions

1. Strategic decisions - decisions with long-term influence or effect (> 1 year).
2. Tactical decisions - decisions with medium-term influence or effect (< 1 year).
h

3. Operational decisions - specific business decisions made on a daily basis and have short-term
influence or effect.
tc

➢ Non-routinary decisions - are those decisions that are not covered by the organization’s
standard operating procedures since they are unusual, non-recurring, and non-repetitive.

Short-Term Non-Routine Management Decisions

Ba

These refer to decisions that are unusual, complex, and typically require a significant degree of
judgment. These decisions often arise in situations that are new or unexpected, where there are no
established procedures or policies to guide the decision-making process.

ACCEPT OR REJECT a special order or business proposal

❖ Should a special order that requires a price lower than the regular selling price be accepted or
rejected?
❖ Costs to look for are the Incremental Costs and Opportunity Costs.
❖ The opportunity cost in this case is equal to the contribution margin of regular sales. Generally,
variable production costs are incremental, while fixed costs are irrelevant.
❖ The minimum selling price acceptable is equal to the sum of incremental cost and opportunity
cost.
❖ Accept the order if the additional revenue exceeds additional cost.
Increase in Contribution Margin xx
Increase in Fixed Cost, if any (xx)
Opportunity Cost (xx)
Profit (Accept)/Loss (Reject) x(x)

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PROBLEM I
QRS company’s budgeted sales for the year is 500,000 units at Php 100 each. Variable production
cost was budgeted at Php 40 per unit and fixed production cost at Php 25 per unit. A special order
offering to buy 50,000 units for Php 58 each was received by the company. It had sufficient capacity
to produce additional units. However, the overtime work has to be done at an additional cost of Php 8
per unit.
1. How much is the incremental profit/loss from this special order?
2. Should the company accept or reject this special order?
3. Assuming there is no sufficient capacity to produce additional units, should the company
accept or reject?

PROBLEM II
QRS company plans to produce and sell 40,000 units of its product based on 80% plant capacity. The
selling price of each unit is Php 10. The company’s contribution margin is 40%. The expected net
income from this planned level of production is Php 40,000. An analysis of costs and expenses
reveals that variable manufacturing cost is Php 4.50 per unit and the variable selling expense is Php
1.50 per unit. The company received an order for additional 7,000 units for Php 7 each. No variable
selling expense is to be incurred on these sales but an incremental cost of Php 1 per unit will be
incurred. Also, the fixed cost will be increased by Php 5,000.
1. Should the company accept or reject the 7000-unit special order?
2. What would be the company’s income if it accepted the order?

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3. What is the minimum acceptable selling price so that QRS will still achieve its expected
income?
4. If the special order is for 12,000 units, should the company accept or reject?
5. What would be the company’s income if it accepted a special order of 12,000 units instead of
7,000 units?
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6. What is the minimum acceptable selling price for the 12,000-unit special order so that QRS will
still achieve its expected income?

MAKE OR BUY a product or material

❖ Should a product or material be internally manufactured (‘insource’) or bought from an outside
supplier (‘outsource’)?
h

❖ Costs to look for are Avoidable Costs and Opportunity Costs.

❖ Generally, variable production costs are avoidable costs. In most cases, fixed costs are
tc

irrelevant. Consider if there is any opportunity cost.

❖ Maximum Purchase Price is equal to Cost to Make (Avoidable) ÷ units.
❖ Choose the option that has the lower total avoidable cost.
Make Buy
Ba

Variable Cost xx Purchase Price xx

Opportunity Cost xx Others (e.g. freight) xx

Total xxx Total xxx

PROBLEM III
QRS Company produces and sells a product with the following costs:
● Prime costs of Php 10
● Variable indirect manufacturing costs of Php 6
● Variable marketing costs of Php 8
● Fixed indirect manufacturing costs of Php 4
● Fixed marketing costs of Php 3

If the company decides to buy the product from an outside supplier rather than continue making it,
the variable marketing costs would be reduced by 60%.
1. What is the maximum unit price that the company would be willing to pay the supplier without
decreasing its operating income?
2. Assuming the outside supplier sells the product at Php 21 per unit, shall the company continue
producing or buy from the supplier?

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PROBLEM IV
QRS company manufactures 10,000 units of its Product A annually with the following cost data: DM
Php 5; DL Php 12; VFOH Php 3; and FFOH Php 8. The FFOH has the following components: Overall
Overhead Php 4; Depreciation Php 2.50; and Supervisory Salaries Php 1.50.

An outside supplier offered QRS to manufacture Product A for Php 24 per unit plus freight cost of Php
1 per unit. If QRS purchases from the outside supplier, its facilities could be used to produce more of
its Product B and is expected to generate an additional contribution margin of Php 20,000. Also, the
supervisory salaries will be eliminated.
1. Should the company make or buy?
2. How much is the advantage of choosing the better alternative?
3. What is the maximum acceptable purchase price (indifference price)?
4. What is the indifference point (units) of the two alternatives?
5. What is the relevant cost at indifference point?
6. What would be the required purchase price if QRS wants to save Php 1.5 per unit by purchasing
from the outside supplier?

KEEP OR DROP a business segment

❖ Should a business segment (e.g., product line, division, department, or branch) be continued
(‘keep’) or discontinued (‘drop’)?
❖ Costs to look for are Avoidable Costs and the financial impact of the decision on other
divisions, lines, and/or segments.

Contribution Margin
Direct or Traceable Fixed Cost
24
❖ Continue if avoidable revenue is greater than its avoidable costs. Any allocated fixed cost to
the segment is usually considered irrelevant.
xx
(xx)
20
Segment Margin x(x)
Indirect or Allocated/Common Fixed Cost (xx)
Operating Income xxx

Segment Margin > 0 Keep

Segment Margin < 0 Drop
h

Segment Margin = 0 Indifferent

*assuming there is no financial impact on other segments
tc

❖ In computing the overall impact of dropping a segment, use this formula below:
Positive Segment Margin (xx)
Negative Segment Margin xx
Ba

Effects on Other Segments x/(x)

Overall Impact xx/(xx)

PROBLEM V
QRS Company plans to discontinue a department with the following average monthly operating
results:
● Contribution Margin of Php 50,000 (SR of 120,000; VC of 70,000)
● Fixed Cost of Php 80,000

If the department is discontinued, Php 35,000 of the fixed cost could be eliminated.
1. What would be the effect of the discontinuance of the department on the company’s pretax
profit? (Determine if increase or decrease.)
2. Should the company keep or drop the department?

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PROBLEM VI
QRS company has the following data for its three divisions:

Division A Division B Division C Total

Units sold 3,000 5,000 2,000 10,000

Sales 70,000 50,000 40,000 160,000

Variable cost (32,000) (26,000) (16,000) (74,000)

Cont. Margin

Direct FC (14,000) (19,000) (12,000) (45,000)

Segment Margin

Allocated FC 20,000

Net Income

Indirect fixed costs are allocated based on the number of units to be sold.

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Case 1: The management considers dropping division B. If this happens, the sales of Division A will
increase by 10% while the sales of Division C will decrease by 5%.
1. Should Division B be kept or dropped?
2. What is the overall impact of dropping the division?
20
3. What will be the overall income if the division is dropped?

Case 2: Assume a new division will be created to replace Division B which will increase fixed costs by
Php 20,000. The new division’s contribution margin is 30% and is expecting sales of Php 90,000.
1. What is the overall impact of dropping the division?
2. What will be the overall income if the division is dropped?
h

SELL OR PROCESS FURTHER a product

tc

❖ Should a product, after undergoing the joint process, be sold at the split-off point or be
processed further beyond the split-off point?
❖ Costs to look for are Incremental Costs and Opportunity Costs.
❖ Process further if additional revenue from processing further is greater than further processing
Ba

costs. Joint costs are considered sunk costs and irrelevant.

Incremental Revenue xx
Incremental Costs (xx)
Profit (Process)/Loss (Sell) x(x)

PROBLEM VII
QRS company produces two joint products from one unit of raw materials which costs Php 5,000.
Conversion costs incurred in the joint manufacturing process amount to Php 10,000. The two
products can be sold at the split-off point or they can be processed further and sold at a higher price.
The sales values of the two products are:
SV at SO SV after FP
Product X Php 1,000 Php 1,900
Product Y Php 800 Php 1,500

The additional processing cost is Php 750 per unit for both products.
1. Should the company sell or process further product X?
2. Should the company sell or process further product Y?

Assume the joint cost is equally distributed and the number of units produced is 10 units each
1. What is the increase in product X’s profit if it was processed further? 1,500 [150 x 10]
2. What is the decrease in product Y’s profit if it was processed further? 500 [50 x 10]

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PROBLEM VIII
QRS company’s joint process results in three products which can be processed further and resold.
The joint cost amounted to Php 100,000 which is allocated based on the number of units produced.
The data below are presented in relation to the decision making of management:

Product A Product B Product C

Units produced 15,000 20,000 30,000

Unit Sales Price at SO 5 8 6.50

Unit SP after FP 11 15 9

Unit Further Proc. Cost 3.50 4 1.50

If the above products are processed further, a special production facility is required.
➢ For Product A, a special equipment should be rented at a total cost of Php 30,000.
➢ For Product B, the production should be outsourced since the company has no enough
manpower to accommodate such subsequent processing. The total cost of outsourcing the
production is Php 70,000.
➢ For Product C, an incremental fixed cost of Php 20,000 will be incurred.

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1. Which product/s are to be processed further?
2. Which product/s are to be sold at the split-off point?
3. What should be the minimum sales price after further processing for Product B?
20
SCRAP OR REWORK a product
❖ Shall a substandard or obsolete product be sold as scrap (‘junk’) or be reworked (‘modify’)?
❖ Costs to look for are Incremental Costs and Opportunity Costs.
❖ Rework if additional revenue after rework is higher than rework costs. The original cost or
carrying value is considered irrelevant.
Incremental Revenue [Rework sales less Scrap sales] xx
h

Incremental Costs [Rework cost less Disposal cost] (xx)

Profit (Rework)/Loss (Scrap) x(x)
tc

PROBLEM IX
QRS company has 600 units of finished goods that were deemed defective. The manufacturing cost
of each defective unit was Php 30 and were supposed to be sold at a sales price of Php 50 per unit.
Ba

The company has two options on these defective products.

➢ Option 1 - scrap units for Php 18,000 with no disposal cost.
➢ Option 2 - rework for Php 9,000 so the products can be sold at regular price.

1. Should the goods be scrapped or reworked?

2. What is the effect on the company’s overall profit if goods were reworked? (State if increase or
decrease.)

CONTINUE OR SHUTDOWN operations

❖ Should the operations be continued or temporarily shutdown?
❖ Costs to look for are Shutdown Costs and compare with the Operating Loss.
❖ Shutdown cost includes start-up cost, which is the cost to resume operations.
❖ Choose the alternative with a lower amount of loss.
❖ Compute the Shutdown Point (Indifference Point) and compare it with actual sales or demand.
Shutdown point level of operations where two alternatives generate the same loss.
➢ Shutdown Point = (Fixed Cost from continuing operation - Shutdown Cost) ÷ UCM
■ If Shutdown Point > Actual Sales, then shutdown.
■ If Shutdown Point < Actual Sales, then continue.

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PROBLEM X
QRS company has the following monthly sales and cost data:
● Sales (units) 20,000
● Unit SP Php 15
● Unit VC Php 10
● Monthly F.FOH Php 40,000
● Monthly F.OPEX Php 20,000

For the next 2 months, the management expects the sales to drop to 8,000 units per month due a
recent economic downturn. If the operations are temporarily closed, the fixed FOH will decrease by
Php 15,000 per month while the fixed OPEX will decrease to Php 12,000 per month. Also, a start-up
cost of Php 10,000 is expected to be incurred before the operations can be resumed.
1. What is the net advantage or disadvantage of continuing the operations?
2. What is the shutdown point?
3. Should the operations be continued or temporarily shutdown?

Prioritizing the USE OF CONSTRAINED RESOURCES

❖ Which product(s) should be given priority in production, given limited resources and/or market
limitations?
❖ If buying is more optimal than making, then there will be no scarcity.
❖ Identify and measure constraint(s). Allocate limited resources to products from highest to
lowest CM per unit of limited resources.
❖ CM ÷ hr/unit OR CM x unit ÷ hour

PROBLEM XI
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QRS Company produced four products. This year, the company expects that it can only provide a
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maximum of 2,400 machine hours per month. Below are the cost data of its products:
● Product 1 (SP of 75; VC of 35; MHrs of 10 hrs)
● Product 2 (SP of 90; VC of 55; MHrs of 5 hrs)
● Product 3 (SP of 100; VC of 50; MHrs of 25 hrs)
● Product 4 (SP of 125; VC of 80; MHrs of 3 hrs)
h

1. If there is no market limit (demand) for any product, which product must be sold and how
many units will be produced?
tc

2. Assume that the maximum demand for each product is P1 - 500 units; P2 - 300 units; P3 - 0
units; and P4 - 250 units. What is the best product combination?
3. If #2 is followed, what would be the total CM per product?
Ba

Quantitative Techniques
These are used in developing the necessary information needed by the management in carrying out
their functions that include planning, controlling, and decision making.

Commonly Used Quantitative Models

1. Linear programming
2. Regression analysis
3. Learning curve
4. Probability analysis
5. Inventory models
6. Present values
7. Sensitivity analysis
8. Decision tree
9. Gantt chart
10. Program evaluation & review technique (PERT)

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Linear Programming
❖ is a quantitative technique used to achieve the best outcome (maximum profit or lowest cost)
in a mathematical model whose requirements are represented by linear relationships.
❖ LP usually starts by identifying decision variables. Most LP problems are characterized by an
objective function that is to be maximized or minimized subject to multiple constraints.
➢ OBJECTIVE FUNCTION – an equation that deals with maximizing revenue/profit or
minimizing costs e.g., Maximize Z = 5A + 10B
➢ CONSTRAINT FUNCTIONS – inequality relationships representing resource limitation
and consumption. Example: 2A + 4B < =100
NOTE: The non-negativity constraint of the identified decision variables is often
assumed even if it is not specified in linear programming problems e.g., A, B >=0.
❖ LP models are useful in resource allocation problems with multiple constraints (as opposed to
relevant costing which can typically handle one constraint only).
❖ In LP, limited resources are often allocated based on the optimal product mix that aims to
achieve the maximum possible profit.

Methods for Solving Linear Programming Problems

1. Graphical method - limited to problems with only two variables
2. Simplex method - applicable even when there are more than two variables. It is based on
matrix or linear algebra and provides a systematic way of algebraically evaluating each corner
point in the feasible area.

PROBLEM XII
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QRS Company produces two products which must be processed in two departments. Department A
has 240 hours per month, while Department B has 192 hours. The number of hours required to
20
process the products in the two departments and the contribution margin per unit of the product are
as follows:
Product X Product Y
Department A 4 hours 2 hours
Department B 2 hours 4 hours
CM per Unit Php 32 Php 24
h

Using the graphical method of linear programming:

1. How many units of Product X must be produced to maximize profit?
tc

2. How many units of Product Y must be produced to maximize profit?

Multiple-Choice Questions (Theoretical)

1. Identify the best description for relevant costs in the decision-making process.
Ba

a. Past costs that are expected to be different under each alternative

b. Past costs that are expected to be the same under each alternative
c. Future costs that are expected to be different under each alternative
d. Future costs that are expected to be the same under each alternative

2. A cost incurred in the past and hence irrelevant for current decision making is a:
a. Sunk cost c. Fixed cost
b. Direct cost d. Discretionary cost

3. Which of the following costs is generally considered irrelevant in the decision-making process?
a. Direct labor c. Direct materials
b. Fixed factory overhead d. Variable factory overhead

4. Which of the following cost classification schemes is most relevant to decision making?
a. Fixed vs. variable c. Direct vs. common
b. Joint vs. common d. Avoidable vs. unavoidable

5. The salary that you would otherwise earn by working rather than attending the CPA review is a
good example of a (an):
a. Sunk cost c. Joint cost
b. Opportunity cost d. Unavoidable cost

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6. An opportunity cost is usually:

a. Relevant and part of traditional accounting records
b. Relevant, but not part of traditional accounting records
c. Irrelevant, but part of traditional accounting records
d. Irrelevant and not part of traditional accounting records

7. In a make-or-buy decision
a. Only variable costs are relevant
b. Only conversion costs are relevant
c. Fixed costs that can be avoided in the future are relevant
d. Fixed costs that will continue regardless of the decision are relevant

8. In a make-or-buy decision, the cost to buy is compared with the

a. Total cost to make
b. Variable manufacturing costs
c. Relevant cost to make
d. Variable selling & administrative expenses

9. What is the opportunity cost if making a component part in a factory given that there is no
alternative use of the capacity?
a. Zero
b. Variable costs of the component
c. Fixed costs of the component
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d. Total manufacturing costs of the component
20
10. In an accept-or-reject decision, which cost is usually considered to be irrelevant?
a. Fixed cost of the product
b. Direct fixed costs associated with the order
c. Variable cost of the product
d. Opportunity costs of the temporary idle capacity
h

11. If there is an excess capacity, then the minimum acceptable price for a special order must
cover
tc

a. Usual fixed manufacturing costs

b. Variable and usual fixed manufacturing costs
c. Variable and incremental fixed costs associated with the special order
d. Variable manufacturing costs plus contribution margin foregone on lost regular units.
Ba

12. If a company is operating at maximum or full capacity, the minimum special-order price must
cover
a. Variable costs associated with the special order
b. Variable and incremental fixed costs associated with the special order
c. Variable and fixed manufacturing costs associated with the special order
d. Variable costs and incremental fixed costs associated with the special order plus
contribution margin foregone on regular units not produced.

13. If the margin lost by dropping a product line is higher than avoidable fixed costs, then the
product line
a. Operates at a loss
b. Shall be continued
c. Shall be shutdown
d. Has no impact on company profit

14. Assuming there is a material amount of shutdown costs, then the shutdown point must be
a. Nil or zero
b. Above its break-even point
c. Below its break-even point
d. Equal to its break-even point

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15. Which is usually considered irrelevant in ‘sell or process further’ decision making?
a. Joint costs
b. Sales value at the split-off point
c. Further processing costs
d. Sales value after further processing

16. A company that has a limited number of labor hours and abundant machine hours should
produce first the product that has the highest
a. Demand in units
b. Contribution margin per labor hour
c. Contribution margin per unit
d. Contribution margin per machine hour

17. In programming, the expression “Maximize Z = 50X + 100Y” is most likely a (an)
a. Objective function
b. Cost function
c. Constraint function
d. Restriction function

18. The term ‘constraints’ in a linear programming model generally refers to:
a. Committed costs
b. Scarce resources
24 c. Inefficiencies
d. Decision variables

19. In determining whether to manufacture a part or buy it from an outside vendor, a cost that is
irrelevant to the short-run decision is
20
a. Prime costs
b. Variable overhead
c. Fixed overhead that will be avoided if the part is bought from an outside vendor
d. Fixed overhead that will continue even if the part is bought from an outside vendor.

20. In a make-or-buy decision, the relevant costs include variable manufacturing costs as well as
h

a. Factory management costs c. General office costs

b. Avoidable fixed costs d. Depreciation costs
tc
Ba

References:
1. Abitago, K. G. Strategic Cost Management (2024). Real Excellence Publishing, Inc.
2. Roque, R. S. Reviewer in Management Advisory Services (2016). GIC Enterprises & Co., Inc.
3. Review Materials from Review School of Accountancy

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