Topic: Relevant Costs in Decision Making Prof. Ma. Teresa B.
De Jesus
The accountant provides management relevant information to serve as a guide in its decision-making process.
He presents management not only the quantitative factors but also the qualitative ones.
a) Quantitative Factors – are measurable in terms of monetary unit which includes production costs , selling and
administrative expenses.
b) Qualitative Factors – are those which cannot be measured and includes social responsibility, quality
considerations, expertise required, adequate supply of raw materials, maintenance of formula and design, supply
of labor force and the like.
Steps in the Decision-Making
1. Identify the problem.
2. Specify the objectives and determine the criteria for choosing the solution.
3. Develop alternatives.
4. Analyze the alternatives (determine quantitative and qualitative factors).
Qualitative factors are usually determined through its weight.
5. Select the best alternative.
6. Implement the best alternative.
7. Monitor the results.
Costs in Decision-Making
1. Differential Cost – difference between costs in two or more alternatives.
2. Marginal Cost – increase in total cost arising from the production and sale of an additional unit of a product.
3. Relevant Cost – future differential cost; cost that vary in amount from one alternative to another.
4. Irrelevant Cost – cost do not vary or does not change in amount regardless of the alternative.
5. Direct Costs – cost identified with a particular function, product, or department.
6. Indirect Costs – cost identified with two or more functions, products, or departments.
7. Avoidable Costs – those costs which will not be incurred even if a particular activity / product / or department is
discontinued.
8. Out-Of-Pocket Costs – those costs which requires cash outlay.
9. Sunk Costs – past or historical costs and are considered irrelevant in decision-making process.
10. Opportunity Costs – the benefit or advantage foregone in favor of another alternative.
11. Imputed Costs – are those value assigned to an item, but which has not been a result of any transaction.
Management Problem Technique Used Evaluation
1. Shutdown or Determine the Shutdown Point (SP): Estimated Sales > Shutdown Point =
Continue Operating Operate (Otherwise, Shutdown)
SP Units = (FC – SC) / CM/unit
SP Sales = (FC – SC) / CM%
2. Accept or Refuse Incremental Approach: Incremental Income : + = Accept
Special Order Incremental Income : - = Reject
Incremental Sales XX
3. Sell as Is or Process Less: Incremental Cost XX
Further
Incremental Income XX
4. Elimination of Loss Contribution Margin (XX) NI : + = Do not drop or eliminate.
Product Line or NI : - = Drop or eliminate.
Department
Avoidable Cost XX
Increase/(Decrease) in Income XX
5. Make or Buy Whichever alternative gives the least cost
Cost to Make: is the one to be chosen.
Variable Manufacturing Costs XX
Add: Opportunity Costs XX
Avoidable Fixed Costs:
CM Foregone of Producing XX
Another Product
Rent Income Foregone XX XX
Total Cost to Make XX
Cost to Buy:
Purchase Price XX
Net Advantage of Make or Buy XX
PROBLEMS
A. Elimination of Product Line
Miss Jane Young, accountant of Everlasting Co. has prepared the following product line income data:
Total Product A Product B Product C
Sales 140,000 P 45,000 P 55,000 P 40,000
Variable expenses 88,000 26,000 37,000 25,000
Contribution margin 52,000 19,000 18,000 15,000
Fixed expenses:
Rent 10,000 3,500 4,000 2,500
Depreciation 7,000 2,500 2,500 2,000
Utilities 7,000 2,500 3,000 1,500
Supervisors’ salaries 9,000 2,000 5,000 2,000
Maintenance 4,000 1,500 1,500 1,000
Administrative expenses 8,500 2,000 3,500 3,000
Total 45,500 14,000 19,500 12,000
Net Operating Income 6,500 5,000 (1,500) 3,000
The following additional information is available:
1. The factory rent of P4,000 assigned to Product B is avoidable if the product is dropped.
2. The company’s total depreciation would not be affected by dropping Product B.
3. Eliminating Product B will reduce the monthly utility bill from P3,000 to P2,000.
4. All supervisors’ salaries are avoidable.
5. If Product B is discontinued, the maintenance department will be able to reduce monthly expenses from P4,000 to
P3,000.
6. Elimination of product B will make it possible to cut two persons from the administrative staff: their combined
salaries total P3,000.
Required:
a) Lost Contribution margin of dropping Product B is (18,000)
b) The total fixed expenses that can be avoided is 14,000
c) The net advantage or (disadvantage) of Dropping product B is (4,000)
If B is Retained If B is Dropped Difference
(Avoidable)
Sales 140,000 85,000 55,000
Variable expenses 88,000 51,000 37,000
Contribution margin 52,000 34,000 (18,000)
Fixed expenses:
Rent 10,000 6,000 4,000
Depreciation 7,000 7,000 -
Utilities 7,000 6,000 1,000
(2.5+1.5+2)
Supervisors’ salaries 9,000 4,000 5,000
Maintenance 4,000 3,000 1,000
Administrative expenses 8,500 5,500 3,000
Total 45,500 31,500 14,000
Net Operating Income 6,500 2,500 (4,000)
The impact of eliminating product B is a decrease in profit by P4,000 or profit will decrease to P2,500.
Decision: Do not eliminate B.
B. Most Profitable Product Line
Data concerning three product lines of John Corporation are given below:
A B C
Selling Price 30 40 40
Variable Cost Per Unit 21 24 30
Production Time (Hours) 3 4 5
Market Limit (Units) 5,000 20,000 10,000
Total Hours 15,000 80,000 50,000 145,000
Total Hours Available (Constraint) 120,000
Total Fixed Costs 200,000
Required:
a) Determine the most profitable product line and compute the Total Contribution Margin.
Hours to Market Total Hours Units to be Total Contribution
Product CM/Unit CM/Hour Rank
Process Limit Available Produced Margin
A 9 3 3 2nd 5,000 15,000 5,000 45,000
B 16 4 4 1st 20,000 80,000 20,000 320,000
C 10 5 2 3rd 10,000 25,000 5,000 50,000
Total 120,000 415,000
b) Assuming all products have no market limit, determine the best mix.
Hours to Market Total Hours Units to be Total Contribution
Product CM/Unit CM/Hour Rank
Process Limit Available Produced Margin
A 9 3 3 2nd NL - - -
B 16 4 4 1st NL 120,000 30,000 480,000
C 10 5 2 3rd NL - - -
Total 120,000 480,000
c) Assuming Product A has no market limit, determine the best mix.
Hours to Market Total Hours Units to be Total Contribution
Product CM/Unit CM/Hour Rank
Process Limit Available Produced Margin
A 9 3 3 2nd NL 40,000 13,333 120,000
B 16 4 4 1st 20,000 80,000 20,000 320,000
C 10 5 2 3rd 10,000 - - -
Total 120,000 440,000
d) Assuming Product B has no market limit, determine the best mix.
Hours to Market Total Hours Units to be Total Contribution
Product CM/Unit CM/Hour Rank
Process Limit Available Produced Margin
A 9 3 3 2nd 5,000 - - -
B 16 4 4 1st NL 120,000 30,000 480,000
C 10 5 2 3rd 10,000 - - -
Total 120,000 480,000
e) Assuming Product C has no market limit, determine the best mix.
Hours to Market Total Hours Units to be Total Contribution
Product CM/Unit CM/Hour Rank
Process Limit Available Produced Margin
A 9 3 3 2nd 5,000 15,000 5,000 45,000
B 16 4 4 1st 20,000 80,000 20,000 320,000
C 10 5 2 3rd NL 25,000 5,000 50,000
Total 120,000 415,000
C. Sell as Is or Process Further
Products A and B are produced jointly in Dept Z. Each product can be sold as is at the split off point or processed further.
During January, Department Z recorded a joint cost of P150,000. The following data for January are available:
Selling Price Per Unit
Product Quantity Costs After Split-Off Point
At Split-Off Point If Process Further
A 20,000 5.00 8.00 40,000
B 10,000 1.50 2.50 15,000
C 25,000 4.00 6.00 35,000
Required:
a) The product/s that must be processed further is/are A & C
Product Incremental Sales Incremental COS Incremental Income Decision
A (20,000 x 3) 60,000 40,000 20,000 Process Further
B (10,000 x 1) 10,000 15,000 (5,000) Sell as Is
C (25,000 x 2) 50,000 35,000 15,000 Process Further
Sales:
A (20,000 x 8) 160,000
B (10,000 x 1.50) 15,000
C (25,000 x 6) 150,000 325,000
Cost of Sales:
Joint Cost 150,000
Costs After Split-Off Point (40,000 + 35,000) 75,000 225,000
Gross Profit 100,000
b) How much is the total profit if all products are sold as is? 65,000
Sales:
A (20,000 x 5) 100,000
B (10,000 x 1.50) 150,000
C (25,000 x 4) 100,000 215,000
Cost of Sales:
Joint Cost 150,000
Gross Profit 65,000
c) How much is the total profit if all products are processed further? 95,000
Sales:
A (20,000 x 8) 160,000
B (10,000 x 2.50) 25,000
C (25,000 x 6) 150,000 335,000
Cost of Sales:
Joint Cost 150,000
Costs After Split-Off Point
90,000 240,000
(40,000 + 15,000 + 35,000)
Gross Profit 95,000
D. Shutdown
Leviticus Company is planning to discontinue its operations for one quarter due to expected sales volume of 500 units per
month. Normal capacity is 15,000 units. The following data are available.
Sales Price Per Unit 20 Variable Operating Expense Per Unit 6
Variable Production Cost Per Unit 8 Total Annual Fixed Costs 120,000
Fixed cost during the shutdown period can be saved up to 40 % but additional shutdown costs of P6,000 will be incurred.
Should the company continue or shutdown operations for one quarter? OPERATE
Shutdown Operate Per Month Per Quarter
Units 1,000 500 1,500
Sales 20 100% - 20,000 10,000 30,000
Variable Costs 14 70% - 14,000 7,000 21,000
Contribution Margin 6 30% - 6,000 3,000 9,000
Fixed Costs 24,000 30,000 30,000 30,000
Net Income (Loss) (24,000) (24,000) (27,000) (21,000)
Decision Shutdown Operate
Fixed Costs (FC) (120,000 x 3/12) 30,000
Less: Fixed Costs Savings (40% x 30,000) 12,000
Fixed Costs, Net 18,000
Additional Cost 6,000
Shutdown Cost (SC) 24,000
FC −SC 30,000−24,000
Shutdown Point ∈Sales= = =20,000
CM % 30 %
FC−SC 30,000−24,000
Shutdown Point ∈Units= = =1 , 000 Units
CM /Unit 6
Additional Loss of Shutdown
Loss Contribution Margin (1,500 x 6) (9,000)
Additional Cost of Shutdown (6,000)
Avoidable Cost: Fixed Cost Savings (40% x 30,000) 12,000
Increase/(Decrease) in Profit (3,000)
E. Make or Buy
Patterson Company manufactures 10,000 units of component A per year that sells for P50 per unit. This component is
used in the production of a main product. The following are the cost to make the component per unit.
Direct Materials 14 Variable Overhead 10 Variable Operating Expenses 8
Direct Labor 12 Fixed Overhead 6 Fixed Operating Expenses 4
If the company buys the component from an outside supplier, the company can rent-out the released facilities for P20,000
a year, 70% of the fixed overhead applied will continue regardless of what decision is made. The cost of the component
per unit as quoted by the supplier is P45 per unit.
a) What is the economic advantage or disadvantage of making the component ?
b) What purchase price per unit will enable the company to maintain its current income.
c) What purchase price per unit will increase the current income by P20,000?
d) Assume that the released facilities will not be rented out but will be used to manufacture 6,000 units of component
B at a selling price of P40 with the following unit costs:
Direct Materials 10 Variable Factory Overhead 4
Direct Labor 6 Variable Operating Expenses 2
Total fixed cost remains the same.
Determine the net advantage or disadvantage of making the component.
F. Acceptance or Rejection of an Order / Outsourcing
Jimbo Company produces a single product. The cost of producing and selling a single unit of this product at the
company's normal activity level of 20,000 units per month is as follows:
Direct Materials 25
Direct Labor 20
Variable Manufacturing Overhead 16
Fixed Manufacturing Overhead 10
Variable Selling & Administrative Expense 4
Fixed Selling & Administrative Expense 5
The normal selling price of the product is P85 per unit.
An order has been received from an overseas customer for 3,000 units to be delivered this month at a special discounted
price. This order would have no effect on the company's normal sales and would not change the total amount of the
company's fixed costs. The variable selling and administrative expense would be P1.00 less per unit on this order than on
normal sales. Direct labor is a variable cost in this company.
Required:
a) Suppose the company has ample idle capacity to produce the units required by the overseas customer and the
special discounted price on the special order is P 74 per unit. By how much would this special order increase
(decrease) the company's net operating income for the month?
b) Suppose the company is already operating at capacity when the special order is received from the overseas
customer. What would be the opportunity cost of each unit delivered to the overseas customer?
c) Suppose the company does not have enough idle capacity to produce all of the units for the overseas customer
and accepting the special order would require cutting back on production of 2,000 units for regular customers.
What would be the minimum acceptable price per unit for the special order?
Summertime Products makes outdoor shirts. Data relating to the coming year’s planned operations follows:
Sales (200,000 shirts) 5,000,000
Cost of Goods Sold 3,500,000
Gross Profit 1,500,000
Selling and Administrative Expenses 1,100,000
Income 400,000
The factory has capacity to make 240,000 shirts per year. Fixed cost included in cost of goods sold was P1,000,000. The
only variable selling, general, and administrative expenses are a 10% sales commission and a P2.00 per shirt licensing
fee paid to the designer.
A chain store manager has approached the sales manager of Summertime Products offering to buy 30,000 shirts at P18
per shirt. These shirts would be sold in areas where Summertime’ shirts are not now sold. The sales manager believes
that the accepting the offer would result in a loss because the average total cost of a shirt is P19.50 ([3,000,000+P
900,000]/200,000). He feels that even though sales commissions would not be paid on the order, a loss would still result.
Required:
a) Determine whether the company should accept the offer.
b) Suppose that the order was for 60,000 shirts instead of 30,000. What would be the company’s income if it
accepted the order?
c) Assuming the same facts as in requirement a , what is the lowest price that the company could accept and still
earn P 400,000?
d) How many units of sales at the regular price could the company loose before it becomes unprofitable to accept
the order in requirement b ?
