ACCTG 312 Relevant

Costs for

decision making

Chapter 11

Relevant costs and revenues

• The relevant financial inputs for decision-making are future cash flows that will differ between the various alternatives being considered.

• Therefore only relevant (incremental/differential) cash flows should be considered.

• Relevant costs and revenues are required for special decision makings.

Not every cost is relevant (e.g. joint costs are not relevant for further

process decision-making).

Examples of decisions using relevant

costs and revenues

1. Special selling price decisions (e.g. less than your regular

price).

2. Decisions on replacement of equipment.

3. Outsourcing (Make or buy)decisions.

4. Discontinuation decisions.

5. Product-mix decisions when capacity constraints exist.

• Decisions should not be based only on items that can be expressed in quantitative terms — qualitative factors must also be considered.

(e.g. reputation, satisfaction, etc.)

Relevant cost of direct materials

• Generally, the relevant cost of direct materials is

replacement cost (e.g. when you have them in stock).

• If direct materials are already owned but would not

be replaced, then the relevant cost is the higher of

current resale value or the value of putting the direct

materials to an alternative use (e.g. making a

different product).

• If direct materials are owned and would not be

replaced and have no resale value or other possible

use, then the relevant cost =0

Direct materials – decision tree

Do you own the

direct materials?

Relevant cost =

purchase price Are the DMs

going to be

replaced?

Do the DMs have an

alternative use?

Relevant cost

= purchase price

Relevant cost

= scrap value

Relevant cost = higher of

alternative use value

or scrap value

Yes

No Yes

No Yes

No

Special pricing decisions

Special pricing decisions are typically one-time only orders and/or orders below the prevailing market price.

Example 1 (A short-term order) Monthly capacity for a department within a company = 50,000 units Expected monthly production and sales for next quarter at normal selling

price of $40 for 35,000 units are as follows: $ (total) $ (unit) Labour (fixed in short-term) 420,000 12 Variable costs 350,000 10 Manufacturing non-variable overheads 280,000 8 Marketing and distribution costs 105,000 3 Total costs 1,155,000 33 Sales 1,400,000 40 Profit 245,000 7 The excess capacity is temporary and a company has offered

to buy 3,000 units each month for the next three months at a price of $20 per unit. Extra selling costs for the order would be $1 per unit.

Example 1 cont.

• Evaluation of the order ($’s monthly costs and revenues)

(1) (2) (3)

Do not Accept Difference

accept order order (Relevant

costs)

Labour 420,000 420,000

Variable costs 350,000 380,000 30,000

Manufacturing non-

variable overheads 280,000 280,000

Extra selling costs 3,000 3,000

Marketing /dist. costs 105,000 105,000 ______

Total costs 1,155,000 1,188,000 33,000

Sales 1,400,000 1,460,000 60,000

Profit 245,000 272,000 27,000

Total additional profit for three months: $81,000 ($27,000*3)

Relevant costing

Only variable costs, the extra selling costs and sales revenues differ between alternatives and are the only relevant costs/revenues.

Two approaches to presenting relevant costs — Present only columns 1 and 2 or just column 3.

Since relevant revenues exceed relevant costs the order is acceptable subject to the following assumptions:

1. Normal selling price of $40 will not be affected.

2. No better opportunities will be available during the period.

3. The resources have no alternative uses.

4. The fixed costs are unavoidable for the period under consideration.

• Note that the identification of relevant costs depends on the circumstances (e.g. in this question labour costs was fixed and not relevant)

Longer-term decisions

Example 1 (A longer-term order)

• Assume now spare capacity in the foreseeable

future (Capacity = 50,000 units and demand = 35,000

units) and that an opportunity for a contract of

15,000 units per month at $25 SP emerges involving

$1 per unit special selling costs.

• No other opportunities exist so if the contract is not

accepted labour will be reduced by 30%,

manufacturing non-variable costs by $70,000 per

month and marketing by $20,000. Unutilised

facilities can be rented out at $25,000 per month.

Example 1 – longer term

• Evaluation of the order ($’s monthly costs and revenues): (1) (2) (3) Do not accept Accept the Difference orders orders (Relevant

costs) Units sold 35,000 50,000 15,000 $ $ $ Labour 294,000 420,000 126,000 (30%) Variable costs 350,000 500,000 150,000 Manufacturing non- variable overheads 210,000 280,000 70,000 Extra selling costs 15,000 15,000 Marketing/dist.costs 85,000 105,000 20,000 Total costs 939,000 1,320,000 381,000 Revenues-facilities rental 25,000 (25,000) Sales revenues 1,400,000 1,775,000 375,000 Profit 486,000 455,000 (31,000)

Example 1 – longer term

• Company will be better off by $31,000 per month if it

reduces capacity (assuming there are no qualitative

factors).

• In the longer-term all of the above costs and

revenues are relevant.

• Look at important difference between short-term and

long-term decisions: We accepted $20 price for

short-term but didn’t accept $25 price for long-term

Decisions on replacement of equipment The original purchase cost of the old machine, its written down

value (RDW) and depreciation are irrelevant for decision-

making.

Example

WDV of existing machine (remaining life of 3 years) £90,000

Cost of new machine

(expected life of 3 years and zero scrap value) £70,000

Operating costs (£3 per unit old machine)

(£2 per unit new machine)

Output of both machines is 20,000 units per annum

Disposal value of old machine now £40,000

Disposal value of new and old machines

(3 years time) Zero

© 2000 Colin Drury

• Total costs over a 3 year period are as follows:

(1) (2) (3)

Retain Buy Difference

£ £ £

Variable operating costs:

20,000 units at £3

per unit (3 yrs) 180,000

20,000 units at £2

per unit (3 yrs) 120,000 (60,000)

Old machine disposal value (40,000) (40,000)

Initial purchase price

of new machine _______ 70,000 70,000

Total cost 180,000 150,000 30,000

• Note that the depreciation charge is not a relevant cost.

• Columns 1 and 2 or just column 3 can be presented but it

is more meaningful to restate column 3 as follows:

Savings on variable operating costs (3 years) 60,000

Sale proceeds of existing machine 40,000

100,000

Less purchase cost of replacement machine 70,000

Savings on purchasing replacement machine 30,000

Outsourcing (make or buy decisions)

Involves obtaining goods or services from outside

suppliers instead of from within the organization.

Example: A division currently manufactures 10,000 components per annum.

The costs are as follows:

Total (£) Per unit (£)

Direct materials 120,000 12

Direct labour 100,000 10

Variable manufacturing

overhead costs 10,000 1

Fixed manufacturing

overhead costs 80,000 8

Share of non-manufacturing

overheads 50,000 5

Total costs 360,000 36

A supplier has offered to supply 10,000 components per

annum at a price of £30 per unit for a minimum of three

years.

If the components are outsourced the direct labour will be

made redundant.

Direct materials and variable overheads are avoidable and

fixed manufacturing overhead would be reduced by

£10,000 per annum but non-manufacturing costs would

remain unchanged.

The capacity has no alternative uses.

Assuming there is no alternative use of the released

internal capacity arising from outsourcing,

annual costs will be as follows:

(1) (2) (3)

Make Buy Difference

(£) (£) (£)

Direct materials 120,000 120,000

Direct labour 100,000 100,000

Variable manufacturing

overhead 10,000 10,000

Fixed manufacturing

overheads 80 000 70,000 10,000

Non-manufacturing

costs 50,000 50,000

Outside purchase cost incurred/

saved _______300,000 (300,000)

Total costs incurred/

saved 360 000 420 000 (60 000)

Columns 1 and 2 can be presented or just column 3

which shows that the relevant costs of making are

£240,000 (120,000 +100,000 + 10,000 + 10,000)

compared with £300,000 from outsourcing/buying).

Where the released internal capacity arising from

outsourcing can be used to generate rental income

or a profit contribution, the lost income or profit

contribution represents an opportunity cost

associated with making the components.

Assume that the released capacity from outsourcing

enables a profit contribution of £90,000 to be generated.

The relevant costs of making will now be:

Relevant costs (described above) £240,000

Opportunity cost (Lost profit contribution) 90,000

Total relevant costs of making 330,000

Outsourcing is now the cheaper alternative.

330,000 – 300,000 = 30,000 saving

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. (you may think

closing Central division improves your total profit by 56000 but you

need to look at relevant information for such a decision as follows):

• 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.

Workshop 1

Q1: Foster Industries manufactures 20,000 components per year. The manufacturing

cost of the components was determined as follows:

Direct materials $150,000

Direct labour 240,000

Variable manufacturing overhead 90,000

Fixed manufacturing overhead _120,000

Total $600,000

An outside supplier has offered to sell the component for $25.50

per unit.

Required:

A: What is the effect on income if Foster Industries purchases

the component from the outside supplier?

B: Assuming that Foster Industries is able to rent out its

manufacturing facilities for $45,000, what is the effect on

income if Foster purchases the component from the outside

supplier?

Workshop 2 Q2: Miller Company produces speakers for home stereo units. The

speakers are sold to retail stores for $30. Manufacturing and other

costs are as follows:

Variable costs per

unit:

Fixed costs per month:

Direct materials $ 9.00 Factory overhead $120,000

Direct labour 4.50 Selling and admin. __60,000

Factory overhead 3.00 Total $180,000

Distribution __1.50

Total $18.00

The variable distribution costs are for transportation to the retail

stores. The current production and sales volume is 20,000 per year.

Capacity is 25,000 units per year.

Workshop 2

Required:

• A: Tennessee manufacturing firm has offered a one-year contract to supply speaker parts at a cost of $6.00 per unit. If Miller Company accepts the offer, it will be able to reduce variable costs by 30 percent and rent unused space to an outside firm for $18,000 per year. All other information remains the same as the original data. What is the effect on profits if Miller Company buys from the Tennessee firm?

• B: San Diego wholesaler has proposed to place a special one-time order of 10,000 units at a reduced price of $24 per unit. The wholesaler would pay all distribution costs, but there would be additional fixed selling and administrative costs of $3,000. All other information remains the same as the original data. What is the effect on profits if the special order is accepted?

Workshop 2

Required:

• C: An Atlanta wholesaler has proposed to place a special

one-time order for 7,000 units at a special price of $25.20 per

unit. The wholesaler would pay all distribution costs, but

there would be additional fixed selling and administrative

costs of $6,000. In addition, assume that overtime

production is not possible and that all other information

remains the same as the original data. What is the effect on

profits if the special order is accepted?

• D: The speakers are currently unpackaged. Packaging them

individually would increase costs by $1.20 per unit.

However, the units could then be sold for $33.00. All other

information remains the same as the original data. What is

the effect on profits if Miller Company packages the

speakers?

Workshop 3

Q3: The operations of Smits Ltd. are divided into the Childs Division and

the Jackson Division. Projections for the next year are as follows:

Childs Jackson

Division Division Total

Sales $250,000 $180,000 $430,000

Variable costs __90,000 _100,000 _190,000

Contribution margin $160,000 $ 80,000 $240,000

Direct fixed costs __75,000 __62,500 _137,500

Segment margin $ 85,000 $17,500 $102,500

Allocated common costs __35,000 __27,500 __62,500

Operating income (loss) $ 50,000 $(10,000) $ 40,000

A: What is the operating income for Smits Ltd. as a whole if the Jackson

Division were dropped (assuming that direct fixed costs for the division

can be avoided)?

Workshop 4

Q4: The operations of Knickers Ltd. are divided into the Pacific Division and

the Bulls Division. Projections for the next year are as follows:

Pacific Bulls

Division Division Total

Sales $420,000 $252,000 $672,000

Variable costs _147,000 _115,500 _262,500

Contribution margin $273,000 $136,500 $409,500

Direct fixed costs _126,000 _105,000 _231,000

Segment margin $147,000 $ 31,500 $178,500

Allocated common costs __63,000 __47,250 _110,250

Operating income (loss) $ 84,000 $(15,750) $ 68,250

What is the operating income for Knickers Ltd. as a whole if the Bulls

Division were dropped (assuming that direct fixed costs for the division can

be avoided)?

Workshop 5

Q5: The following information relates to Ewing Company's three products:

D E F

Unit sales per month 900 1,400 800

Selling price per unit $6.00 $11.25 $ 7.50

Variable costs per unit _3.00 __9.00 __7.80

Unit contribution margin $3.00 $ 2.25 $(0.30)

Required:

A: Assume that product F is discontinued and the space used to produce product

F is rented for $600 per month. What is the impact on monthly profits?

B: Assume that product F is discontinued and the space is used to produce E.

Product E's production is increased to 2,200 units per month, but E's selling

price of all units of E is reduced to $10.20. What is the impact on monthly

profits?

C: Assume that the selling price of product F is increased to $8.25 with a

reduction in monthly sales to 400 units. What is the impact on monthly profits?

Workshop 6

Q6: Reggie Ltd. manufactures a single product with the following unit costs for

1,000 units:

Direct materials $2,400

Direct labour 960

Factory overhead (30% variable) 1,800

Advertising expenses (50% variable) 900

Administrative expenses (10% variable) ____840

Total per unit $6,900

Recently, a company approached Reggie Ltd. about buying 100 units for $5,100

each. Currently, the models are sold to dealers for $7,800. Reggie Ltd.'s capacity

is sufficient to produce the extra 100 units. No additional selling expenses would

be incurred on the special order.

A: What is the profit earned by Reggie Ltd. on the original 1,000 units?

B: How much will income change if the special order is accepted?

C: If Reggie Ltd. wants to increase its profit only by $18,000 on the special

order, what is the minimum price it should charge per unit?

Workshop 7

1. Junior Company currently buys 30,000 units of a part used to manufacture its

product at $40 per unit. Recently the supplier informed Junior Company that a

20 percent increase will take effect next year. Junior has some additional space

and could produce the units for the following per-unit costs (based on 30,000

units):

Direct materials $16

Direct labour 12

Variable overhead 12

Fixed overhead 10

Total $50

If the units are purchased from the supplier, $200,000 of fixed costs will continue to

be incurred. In addition, the plant can be rented out for $20,000 per year if the

parts are purchased externally.

Required:

• Should Junior Company buy the part externally or make it internally?