DECISION MAKING – USE OF RELEVANT COSTING
Decisions under consideration:
Relevant costs:
Non – relevant costs:
Make or buy decision
The decision to make a component or product ‘in-house’ or to buy from an outside supplier.
The underlying assumption of this decision is that all fixed costs of manufacture are general
to the organisation as a whole and hence only the marginal cost of making the component is
relevant.
Decision criteria : Compare marginal (variable) cost of making to the purchase price
(the marginal cost of buying).
Example 1 Clemence Ltd
Clemence Ltd produces a number of components, two of which it is considering
buying in, components X and Y.
Cost of making (£) X Y
Variable 14 28
Fixed 4 4
Total 18 32
Purchase price (from outside supplier) 17 25
Required:
Should Clemence Ltd make or buy in?
Example 2 PCO Ltd
PCO Ltd is considering the alternatives of either purchasing a component from an
outside supplier or producing the component itself. The estimated costs to the
company of producing a component are as follows:
Direct labour 100
Direct materials 300
Variable overheads 50
Fixed overheads 200
650
The outside supplier has quoted a price of £400 for supplying the component.
Required:
Should PCO Ltd produce or buy the component from the supplier?
Example 3 Central Ltd
Central Ltd makes four components, W, X, Y and Z, for which costs in the coming
year are expected to be as follows:
W X Y Z
Production units 1,000 2,000 4,000 3,000
Unit marginal costs £ £ £ £
Direct materials 4 5 2 4
Direct labour 8 9 4 6
Variable production overheads 2 3 1 2
14 17 7 12
Direct attributable fixed costs per annum and committed fixed costs are:
incurred as a direct consequence of making W 1,000
incurred as a direct consequence of making X 5,000
incurred as a direct consequence of making Y 6,000
incurred as a direct consequence of making Z 8,000
other fixed costs (committed) 30,000
50,000
A sub-contractor has offered to supply units of W, X, Y and Z for £12, £21, £10, and
£14 respectively.
Required:
Should the company make or buy the component?
Other important factors to consider
1. If the components are sub-contracted, the company will have spare capacity. How
should that spare capacity be profitably used, that is, are there hidden benefits to be
obtained from sub-contracting?
2. Would the sub-contractor be reliable with supply and delivery time?
3. Would the sub-contractor supply the same or improved quality components as the one
produced internally?
4. Does the company wish to be flexible and maintain better control over operations by
making everything itself?
5. The going concern of the sub-contractor should also be considered.
Shutdown (discontinuance) decisions
The decision whether to shut down a part or segment of a business. The focus of the question
is the impact of the shutdown on the cost base. Revenue will be foregone but which costs
will be affected.
The avoidable costs include variable costs and specific fixed costs. Specific fixed costs are
those costs specific to the part or segment of the business to be shutdown. General fixed
costs will not be relevant.
The simplest way to consider such a problem is to re-draft any information in the form of a
marginal costing profit statement.
Any product that produces a positive contribution is worth undertaking as it will contribute to
profit, unless
● The company can use the capacity used by this product to produce another new product
with a higher contribution than that of this first product.
● The capacity used by this product can be used to produce more of the other existing
product with higher contribution.
Example 4 Jones Ltd
Jones Ltd operates three divisions within a larger company. The CEO has been
shown the latest profit statements and is concerned that division C is losing money.
You are required to advise her whether or not to close down division C.
Division A B C
(000s) (000s) (000s)
Sales 100 80 40
Variable costs 60 50 30
Fixed costs 20 20 20
Profit/(loss) 20 10 (10)
You are also informed that 40% of the fixed cost is product specific, the remainder
being allocated arbitrarily to the divisions from head office.
Required:
Should division C be shut down?
Example 5 Fantum Ltd
Fantum Ltd has three operating divisions. The expected financial results of each
division next year are as follows:
Division A Division B Division C
£ £ £
Sales 50,000 30,000 40,000
Variable costs (30,000) (18,000 (20,000)
Specific fixed cost (12,000) (10,000) (10,000)
Apportioned head office costs (5,000) (4000) (5000)
Profit or loss 3,000 (2000) 5000
Required:
Taking only the financial results next year into consideration, recommend
whether or not division Y should be closed down.
