Lesson 2

Relevant Costs for

Decision Making
Learning Outcomes

 At the end of this chapter, the students should be able

to:
 Discuss the principles of decision making including the
identification of relevant cashflows and their use alongside
non-quantifiable factors in making decisions
 Explain why joint costs must be allocated to final products
for financial reporting purposes
Joint Costs

 Insome industries, a number of end

products are produced from a single raw
material input.
 Twoor more products produced from a
common input are called joint products.
 The point in the manufacturing process
where each joint product can be
recognized as a separate product is called
the split-off point.
Joint product costing

 The main feature of joint and by-product costing is that

the products are not identifiable as different products
until a specific point in the production process is
reached (split-off point)
 Until the point, all costs are considered joint and
cannot be traced to individual products
By Product costing

 When a group of individual products

is simultaneously produced and the
product has a minor sales value.
 By-product are incidental to the
main products
 All costs incurred in producing the
by-product after the split-off point
is charged to the by-product
Joint Products
Joint
Costs Oil

Common
Joint
Production Gasoline
Input
Process

Chemicals

Split-Off
Point
Joint Products
Joint
Separate Final
Costs Oil
Sale
Processing

Common
Joint Final
Production Gasoline
Input Sale
Process

Separate Final
Chemicals
Processing Sale

Split-Off Separate
Point Product
Costs
1. Joint products are not identifiable as different individual products until split- off
point. Therefore, joint costs cannot be traced to individual products.
2. By- products emerge incidentally from the production of the major products and
have relatively minor sales value.
© 000 Colin Drury
The Pitfalls of Allocation

Joint costs are really

common costs incurred to
simultaneously produce a
variety of end products.

Joint costs are often

allocated to end products on
the basis of the relative
sales value of each product
or on some other basis.
Joint Product costing

 When a group of individual products is simultaneously

produced and each product has a significant sales value.
 Method of allocating costs
 Based on physical measures like volume, weights
 Relative to the market value of the products i.e. sales
value at split-off point
Example of joint cost apportionments
Joint costs for the period £60 000
Output and sales
X = 4 000 units at £7.50
Y = 2 000 units at £25
Z = 6 000 units at £3.33

There are no further processing costs after split-off point.

Physical measures method
Apportioned Profit
Output costs Sales (loss)
(units) £ £ £
Product X 4 000 (1/3) 20 000 30 000 10 000
Product Y 2 000 (1/6) 10 000 50 000 40 000
Product Z 6 000 (1/2) 30 000 20 000 (10 000)
12 000 60 000 100 000 40 000
Sales value method
Apportioned Profit
Sales costs (loss)
£ £ £
Product X 30 000 (30%) 18 000 12 000
Product Y 50 000 (50%) 30 000 20 000
Product Z 20 000 (20%) 12 000 8 000
100 000 60 000 40 000
Net realizable value (NRV) method

• Where further processing costs are incurred sales values at

split-off point may not be available.
• Further processing costs are deducted from sales value to
estimate NRV at split-off point.

Example
Further %Joint
process cost
Sales costs NRV allocated
£ £ £
Product A 36 000 8 000 28 000 28%
Product B 60 000 10 000 50 000 50%
Product C 24 000 2 000 22 000 22%
120 000 20 000 100 000
Constant gross profit percentage method
• Based on the assumption that the gross profit should be identical for each
product.
• Joint costs are therefore allocated so that the gross profits at split-off point are
identical for each product.
• Using the example on sheet 3 and assuming that joint costs are £60 000 the
gross profit is £40 000 (£120 000 sales less £80 000 total costs). Therefore, the
total gross profit is 33.33%.
Product Product Product Total
A B C
£ £ £ £
Sales value 36 000 60 000 24 000 120 000
Gross profit (33.33%) 12 000 20 000 8 000 40 000
Cost of goods sold 24 000 40 000 16 000 80 000
Less further processing
costs 8 000 10 000 2 000 20 000
Allocated joint costs
(balance) 16 000 30 000 14 000 60 000
Comparison of methods
• Cause-and-effect criterion cannot be applied so allocation should be
based on
benefits received.
• If benefits received cannot be measured allocation should be based on
the
principle of equity or fairness.
• Literature tends to advocate the net realizable method.
• Also note that with the physical units method the joint cost allocation
bears no
relationship to the revenue producing power of the individual products.

Accounting for by-products

• The major objective is to produce the joint products. Therefore the joint
costs
should be charged only to the joint products.
• Further processing costs should be charged to the by-product.
• Net revenues from the sale of the by-product should be deducted from
the cost of
the joint process.
Example
Joint product costs £3 020 000
Output of the joint products A – 30 000 kgs
B – 50 000 kgs
C – 5 000 kgs
By-product C requires further processing at a cost of £1 per kg
after which it can be sold for £5 per kg.
• The accounting entries are:
Dr. By-product stock (5 000 × £4) 20 000
Cr.Joint process WIP account 20 000
With the net revenue due from the production of the by-
product
Dr. By-product stock 5 000
Cr. Cash 5 000
With the separable manufacturing costs incurred
Dr.Cash 25 000
Cr.By-product stock 25 000
With the value of the by-product sales for the period
Sell or Process Further
It will always profitable to continue
processing a joint product after the
split-off point so long as the incremental
revenue exceeds the incremental
processing costs incurred after the split-
off point.
Let’s look at the Sawmill, Inc. example.
Sell or Process Further
 Sawmill, Inc. cuts logs from which
unfinished lumber and sawdust are the
immediate joint products.
 Unfinished lumber is sold “as is” or
processed further into finished lumber.
 Sawdust can also be sold “as is” to
gardening wholesalers or processed further
into “presto-logs.”
Sell or Process Further
Data about Sawmill’s joint products includes:

Per Log
Lumber Sawdust
Sales value at the split-off point $ 140 $ 40
Sales value after further processing 270 50
Allocated joint product costs 176 24
Cost of further processing 50 20
Sell or Process Further
Analysis of Sell or Process Further
Per Log
Lumber Sawdust
Sales value after further processing $ 270 $ 50
Sales value at the split-off point 140 40
Incremental revenue 130 10
Sell or Process Further
Analysis of Sell or Process Further
Per Log
Lumber Sawdust
Sales value after further processing $ 270 $ 50
Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing 50 20
Profit (loss) from further processing $ 80 $ (10)
Sell or Process Further
Analysis of Sell or Process Further
Per Log
Lumber Sawdust
Sales value after further processing $ 270 $ 50
Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing 50 20
Profit (loss) from further processing $ 80 $ (10)

Should we process the lumber further

and sell the sawdust “as is?”
Cost Concepts for Decision
Making
A relevant cost is a cost that
differs between alternatives.
Adding/Dropping Segments

One of the most important decisions managers make is

whether to add or drop a business segment such as a
product or a store.

Let’s see how relevant costs

should be used in this
decision.
Adding/Dropping Segments

Due to the declining popularity of digital

watches, Lovell Company’s digital watch line
has not reported a profit for several years.
An income statement for last year is shown
on the next screen.
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Investigation has revealed
Variable manufacuring coststhat
$ total fixed general
120,000
Variable factory
shippingoverhead
costs and general
5,000
Commissions expenses would not
administrative 75,000 200,000
be affected if
Contribution margin $ 300,000
the digital watch
Less: fixed expenses
line is dropped. The fixed
general
General factory
factory overhead$ and
overhead general
60,000
administrative expenses assigned
Salary of line manager to this product
90,000
Depreciation of equipment
would be reallocated to other 50,000 product lines.
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
The equipment
Variable used to
manufacturing manufacture
costs $ 120,000
Variable shipping costs 5,000
digital watches has no resale
Commissions 75,000 200,000
valuemargin
Contribution or alternative use. $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct
Should Lovell
100,000
retain or drop
Rent - factory space the digital70,000
watch segment?
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
A Contribution Margin
Approach
DECISION RULE
Lovell should drop the digital watch segment
only if its profit would increase. This would
only happen if the fixed cost savings exceed
the lost contribution margin.

Let’s look at this solution.

A Contribution Margin
Approach Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped $ (300,000)
Less fixed costs that can be avoided
Salary of the line manager $ 90,000
Advertising - direct 100,000
Rent - factory space 70,000 260,000
Net disadvantage $ (40,000)
Comparative Income
Approach
The Lovell solution can also be obtained by preparing
comparative income statements showing results with
and without the digital watch segment.

Let’s look at this second

approach.
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000
Salary of line manager 90,000
Depreciation 50,000 If the digital watch line
Advertising - direct 100,000
Rent - factory space 70,000
is dropped, the
General admin. expenses 30,000 company gives up its
Total fixed expenses 400,000 contribution margin.
Net operating loss $ (100,000)
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000
Depreciation 50,000
Advertising - direct On100,000
the other hand, the general
Rent - factory space factory
70,000overhead would be the
General admin. expenses
same.
30,000
So this cost really isn’t
Total fixed expenses 400,000
Net operating loss $ (100,000) relevant.
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses
But we wouldn’t
120,000
need a manager
- 120,000
Shipping for the product5,000line anymore.- 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
If the
Less digital
variable watch line is dropped, the net book- value of the
expenses:
Manufacturing
equipment expenses
would be written 120,000 -
off. The depreciation 120,000
that
Shipping 5,000 - 5,000
would
Commissions have been taken will flow
75,000 through the- income 75,000
statement as a 200,000
Total variable expenses loss instead. - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000 - 100,000
Rent - factory space 70,000 - 70,000
General admin. expenses 30,000 30,000 -
Total fixed expenses 400,000 140,000 260,000
Net operating loss $ (100,000) $ (140,000) $ (40,000)
Beware of Allocated Fixed
Costs
Why should we keep
the digital watch
segment when it’s
showing a loss?
Beware of Allocated Fixed
Costs
The answer lies in the
way we allocate
common fixed costs to
our products.
Beware of Allocated Fixed
Costs
Our allocations can
make a segment look
less profitable than it
really is.
Discontinuation decisions
• Routine periodic profitability analysis by cost objects provides attention-
directing information that highlights those potential unprofitable activities
that require more detailed (special studies).
• Assume the periodic profitability analysis of sales territories
reports the following:
Southern Northern Central Total
£000 £000 £000 £000
Sales 900 1 000 900 2 800
Variable costs (466) (528) (598) (1 592)
Fixed costs (266) (318) (358) (942)
Profit/(Loss) 168 154 (56) 266
• Assume that special study indicates that £250 000 of Central fixed costs
and all variable costs are avoidable and £108 000 fixed costs are
unavoidable if the territory is discontinued.

© 2000 Colin Drury

• The relevant financial information is as follows:

Keep Central Discontinue Difference

open Central
£000 £000 £000
Variable costs 1 592 994 598
Fixed costs 942 692 250
Total costs to be assigned 2 534 1 686 848
Reported profit 266 214 52
Sales 2 800 1 900 900

• Columns 1 and 2 can be presented or just column 3 which shows that the
relevant revenues arising from keeping the territory open are £900 000 and the
relevant (incremental) costs are £848 000.Therefore Central provides a
contribution of £52 000 towards fixed costs and profits.

© 2000 Colin Drury