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Relevant costing

Cost Concepts for Decision-Making

- A relevant cost or benefit is a cost or benefit that differs between alternatives.
Differential costs are relevant costs. Any cost or benefit that does not differ between
alternatives is irrelevant and can be ignored in a decision.
a. All sunk costs (i.e., costs already irrevocably incurred) are irrelevant since they will be
the same for any alternative. All future costs that do not differ between alternatives are
irrelevant.
b. Any cost that is avoidable is potentially relevant. An avoidable cost is a cost that can be
eliminated (in whole or in part) because of choosing one alternative over another.
c. When deciding; eliminate all irrelevant costs. Make the decision based on the remaining
relevant costs.

SHORT-TERM DECISION
1. Adding or Dropping a Segment. Decisions relating to dropping old products (or
segments) and adding new products (or segments) are among the most difficult that a
manager makes. Two basic approaches can be used to analyze data in this type of
decision.
a. Compare contribution margins and fixed costs. A segment should be added only if
the increase in total contribution margin is greater than the increase in fixed cost. A
segment should be dropped only if the decrease in total contribution margin is less
than the decrease in fixed cost.
b. Compare net incomes. A second approach is to calculate the total net income under
each alternative. The alternative with the highest net income is preferred.

2. The Make or Buy Decision. A make or buy decision is concerned with whether an
item should be made internally or purchased from an external supplier

Advantages of making an item internally.

a. Producing a part internally reduces dependence on suppliers and may ensure a
smoother flow of parts and material for production.
b. Quality control may be easier when parts are produced internally.
c. Profits can be realized on the parts and materials.

Advantages of buying an item from an external supplier

a. By pooling the requirements of several users, a supplier can realize economies of
scale and may be able to move more quickly up the learning curve.
b. A specialized supplier may be able to respond more quickly and at less cost to
changing future needs.
c. Changing technology may make producing one’s own parts riskier than purchasing
from the outside. Opportunity costs should be considered in decisions. There is no
opportunity cost involved in using a resource that has excess capacity. However, if
the resource is a constraint (i.e., there is not excess capacity) then there is an
opportunity cost.

3. Special Order. Special orders are one-time orders that do not affect a company’s
normal sales. The profit from a special order equals the incremental revenue less the
incremental costs. If the incremental revenue exceeds the incremental costs, the order
should be accepted. If there is no idle capacity, opportunity costs should be included as
part of the incremental costs.

4. Utilization of a Constrained Resource. A constraint is whatever prevents an

individual or organization from getting more of what it wants. There is always a
constraint if desires are unsatisfied. A production constraint can be a raw material, a
part, a machine, or a workstation. If the constraint is a machine or workstation, it is
called a bottleneck.

In addition to making sure that the best product mix is chosen by ranking products
based on the contribution margin per unit of the constrained resource managers should
seek ways to increase the effective capacity of the constraint.

Increasing the capacity of the constraint or bottleneck is called “relaxing the constraint”
or “elevating the constraint”. Conceptually, there are two ways one can go about
increasing the effective capacity of the bottleneck: increase the rate of output at the
bottleneck or increase the time available at the bottleneck. Some specific examples of
ways to elevate the constraint follow:
 Pay workers overtime to keep the bottleneck running after normal working hours.
 Shift workers from non-bottleneck areas to the bottleneck areas.
 Hire more workers or acquire more machines specifically to augment the bottleneck.
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Relevant costing
 Subcontract some of the production that would use the bottleneck. If an
unimportant part requires a lot of time on the bottleneck and can be purchased
cheaply from an external supplier, this is a way to increase profits. The bottleneck
can be shifted to more profitable uses.
 Streamline the production process at the bottleneck to eliminate wasted time.
Improvement programs such as TQM and Business Process Reengineering should be
focused on the bottlenecks. A decrease in processing time at the bottleneck can
have an immediate and dramatic effect on profits because of the increased rate of
output that is possible. A decrease in processing time at a non-bottleneck is likely to
have no immediate impact on profits; it just creates more excess capacity.
 Reduce defects. A part that is processed on the bottleneck and later rejected
because it is defective uses valuable bottleneck processing time.

5. Sell or process further decisions. A decision often must be made about selling a
joint product as is or processing it further.
a. It is profitable to continue processing a joint product after the split-off point so long
as the incremental revenue from such processing exceeds the incremental processing
costs.
b. In such decisions, the joint product costs incurred before the split-off point are not
relevant. They would be relevant in a decision to shut down the joint process
altogether, but they are irrelevant in any decision about what to do with the joint
products once they have reached the split-off point.

ILLUSTRATIVE PROBLEMS

Problem 1. Part 1. Intel Chemical Co. recently received an order for a product it does not
normally produce. Since the company has excess production capacity, management is
considering accepting the order. In analyzing the decision, the assistant controller is
compiling the relevant costs of producing the order. Production of the special order would
require 8,000 kilograms of the theolite. Intel does not use theolite for its regular product,
but the firm has 8,000 kilograms of the chemical on hand from the days when it used
theolite regularly. The theolite could be sold to a chemical wholesaler for P 21,750. The
book value of the theolite is P 3 per kilogram. Intel could buy theolite for P 3.10 per
kilogram.
1. What is the relevant cost of theolite for the purpose for the purpose of analyzing the
special-order decision?
2. Discuss each of the numbers given in the exercise about its relevance in making the
decision.

Problem 1. Part 2. Intel’s special order also requires 1,000 kilograms of genatope, a solid
chemical regularly used in the company’s products. The current stock of genatope is 8,000
kilograms at a book value of P 12.15 per kilogram. If the special order is accepted, the firm
will be forced to restock genatope earlier than expected, with a predicted cost of P 12.75
per kilogram. Without special order, the purchasing manager predicts that the price will be
P 12.45 when normal restocking takes place. Any order of genatope must be 5,000
kilograms.
What is the relevant cost of genatope?

Problem 2. Dent Company uses 10 units of part R37 each month in the production of
dentistry equipment. The cost of manufacturing one unit of R37 is the following:

Direct material P 3,000

Material handling (20% of direct material cost) 600
Direct labor 24,000
Manufacturing overhead (150% of direct labor) 36,000
Total manufacturing cost P 63,600

Material handling represents the direct variable costs of the Receiving Department that are
applied to direct materials and purchased components based on their cost. This is a
separate charge in addition to manufacturing overhead. Dent’s annual manufacturing
overhead budget is one-third variable and two-third fixed. Scott Supply, one of Dent’s
reliable vendors, has offered to supply part number R 37 at a unit price of P 45,000.

REQUIRED:
1. If Dent purchases the R37 units from Scott, the capacity Dent used to manufacture
these parts would be idle. Should Dent decide to purchase the parts from Scott, the unit
cost of R37 would increase or decrease by what amount?
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Relevant costing
2. Assume Dent Company is able to rent out all the idle capacity for P 75,000 per month.
If Dent decides to purchase the 10 units from Scott Supply, Dent’s monthly cost for R37
would increase or decrease by what amount?
3. Assume Dent Company does not wish to commit to a rental agreement but could use its
idle capacity to manufacture another product that would contribute P 156,000 per
month. If Dent elects to manufacture R37 to maintain quality control, what is the net
amount of Dent’s cost from using the space to manufacture part R37?

Problem 3. Teillard Company manufactures watches. A national sporting goods chain

recently submitted a special order for 4,000 sport watches. Teillard was not operating at
capacity and could use the extra business. Unfortunately, the order’s offering price of P
1,400 per watch was below the cost to produce the watches. The controller was opposed to
taking a loss on the deal. However, the personnel manager argued in favor of accepting the
order even though a loss would be incurred; it would avoid the problem of layoffs and would
help maintain the community image of the company. The full cost to produce a sport watch
is presented below:

Direct materials P 650

Direct labor 500
Variable overhead 325
Fixed overhead 250
Total P 1,725

No variable selling or administrative expenses would be associated with the order. No unit-
level activity costs are a small percentage of total costs and are therefore not considered.

1. Assume that the company would accept the order only if it increased total profits.
Should the company accept or reject the order?
2. Consider the personnel manager’s concerns. Discuss the merits of accepting the order
even if it decreases total profits.

Problem 4. Wilderness Products makes outdoor shirts. Data relating to the coming year’s
planned operations are as follows.

Sales (230,000 shirts) P 4,140,000

Cost of goods sold 2,760,000
Gross profit P 1,380,000
Selling and administrative
expenses 805,000
Income P 575,000

The factory has the capacity to make 250,000 shirts per year. Fixed costs included in the
cost of goods sold are P 690,000. The only variable selling, general, and administrative
expenses are a 10% sales commission and a P 1.50 per shirt licensing fee paid to the
designer.

A chain store manager has approached the sales manager of Wilderness Products offering to
buy 15,000 shirts at P 14 per shirt. These shirts would be sold in areas where Wilderness’
shirts are not now sold. The sales manager believes that accepting the offer would result in
a loss because the average total cost of a shirt is P 15.50
([2,760,000 + P 805,000]/230,000). He feels that even though sales commissions would
not be paid on the order, a loss would still result.

REQUIRED:
1. Determine whether the company should accept the offer.
2. Suppose that the order was for 50,000 shirts instead of 15,000. What would the
company’s income be if it accepted the order?
3. Assuming the same facts as in requirement 1, what is the lowest price that the company
could accept and still earn P 575,000?
4. How many units of sales at the regular price could the company lose before it becomes
unprofitable to accept the order in requirement 2?

Problem 5. Under Company has a single product called a Trac. The company normally
produces and sells 72,000 Tracs each year at a selling price of P 28.00 per unit. The
company’s unit costs at this level of activity are given below:

Direct materials P12.00

Direct labor 2.50
Variable manufacturing overhead 1.80
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Relevant costing
Fixed manufacturing overhead 3.20 (P 230,400)
Variable selling expense 1.50
Fixed selling expense 3.00 (P 216,000)
Total cost per unit P24.00

Several questions relating to the production and sale of Tracs follow. Each question is
independent.

REQUIRED:
1. Assume that Under Company has sufficient capacity to produce 90,000 Tracs each year
without any increase in fixed manufacturing overhead costs. The company could
increase its sales by 20% above the present 72,000 units each year if it were willing to
increase the fixed selling expenses by P 60,000. Would the increase in fixed selling
expenses be justified?
2. Assume again that Under Company has sufficient capacity to produce 90,000 Tracs each
year. A customer in a foreign market wants to purchase 15,000 Tracs. Import duties on
the Tracs would be P 1.40 per unit, and costs for permits and licenses would be P
15,000. The only selling costs that would be associated with the order would be P 2.60
per unit shipping cost. Compute the order per unit break-even price on this order.
3. The company has 800 Tracs on hand that have some irregularities and are therefore
considered to be “seconds”. Due to the irregularities, it will be impossible to sell these
units at the normal price through regular distribution channels. What unit cost figure is
relevant for setting a minimum selling price? Explain.
4. Due to the strike in its supplier’s plant, Under Company is unable to purchase more
material to produce Tracs. The strike is expected to last for two months. Under
Company has enough material on hand to operate at 30% of normal levels for the two-
month period. As an alternative, Under Company could close its plant down entirely for
the two months. If the plant were closed, fixed overhead costs would continue at 60%
of their normal level during the two-month period and the fixed selling costs would be
reduced by 20%. What would be the impact on profits of closing the plant for the two-
month period?
5. An outside manufacturer has offered to produce Tracs for Under Company and to ship
them directly to Under’s customers. If Under Company accepts this offer, the facilities
that it uses to produce Tracs would be idle; however, fixed overhead costs would be
reduced by 80%. Since the outside manufacturer would pay for all the shipping costs,
the variable selling costs would be only one-third of their present amount. Compute the
unit cost that is relevant for comparison to the price quoted by the outside
manufacturer.

Problem 6. The Cocina Company has assembled the following data pertaining to its two
most popular products.
Blender Mixer
Direct materials P6 P 11
Direct labor 4 9
Overhead @ P 16 per MH 16 32
Cost of purchased form
outside supplier 20 38
Annual demand in units 20,000 28,000

Past experience has shown that the fixed manufacturing overhead component included in
the cost per machine hour averages P 10. Cocina Company’s management has a policy of
filling all sales orders, even if it means purchasing units from outside suppliers.

REQUIRED:
1. If 50,000 machines hours are available, and management desires to follow an optimal
strategy, how many units of each product should the firm manufacture? Purchased?
2. With all other things constant, if management can reduce the direct materials cost for a
mixer to P 6 per unit, how many units of each product should be manufactured?
Purchased?

Problem 7. Exquisite Company received an order for a piece of special machinery from
Rizal Company. Just as Exquisite completed the machine, Rizal declared bankruptcy,
defaulted on the order, and forfeited the 10 percent deposit paid on the selling price of P
217,500.

Exquisite’s manufacturing manager identified the costs already incurred in the production of
the special machinery for Rizal as follows:

Direct material P 49,800