RELEVANT COSTING

Decision Making – the process of identifying, evaluating and choosing from at least two alternative courses of
action. For business, management must choose in favor of the option most beneficial to the company in order to
achieve company objectives.

Decision Making Process

1. Define the problem

2. Specify the objective and criteria
3. Identifying the alternative courses of action
4. Determining and evaluating the possible consequence of the alternatives
5. Choosing the best alternative and making the decision
6. Evaluating the results of the decision

Types of costs and terminologies used in decision making

Short-term decision-making alternatives:

Nature of alternatives Decision problem Decision guidelines

MAKE OR BUY
ACCEPT OR REJECT
CONTINUE OR SHUTDOWN
SELL OR PROCESS FURTHER
PRODUCT COMBINATION
CHANGE IN PROFIT FACTORS
Should a part or product be
manufactured or brought from an
outside supplier?
In this case, the selling price is
usually lower than the regular
selling price because of the special
order. Is the order worth
accepting? Are regular sales
affected?
Should a business segment, which
may be a product line,a
department, or a branch be
continued or discontinued?
Should a product, after undergoing
the joint process, be sold at the
split-off point or be processed
further?
Which product/s should be
produced and sold when there are
limited resources or bottleneck
operations?
Should any of the profit factors
(selling price, unit sales, variable
cost, fixed cost and sales mix? Be
manipulated to increase profit?
Choose the option that involves the
lower cost. In most cases, fixed
costs are irrelevant. Consider
opportunity costs, if any.
Accept the order when the
additional revenue from the special
order exceeds additional cost,
provided the regular market will
not be affected. In most cases,
fixed costs are irrelevant.
Opportunity cost is considered in
case there are regular sales
sacrificed in order to meet the
special order.
Continue if avoidable revenue of
the segment involved is greater
than its avoidable costs; otherwise,
consider shutting down the
segment. Since allocated fixed cost
is usually unavoidable, it is
considered irrelevant.
Process further if additional
revenue from processing further is
greater than further processing
costs.
Identify and measure the
constraint on the limited
resource/s. Rank the product/s
according to the highest
contribution margin per unit of
limited resource.
Identify the factor to change and
the amount of contemplated
change. Change the profit factor if
it will cause an improvement on
the company’s overall profit
position.
1. MAKE OR BUY DECISIONS
Compare the cost to make with the cost to buy and choose the least costly option. The possible costs for
each are provided below:

Cost to Make:
Avoidable variable costs:
 Direct materials
 Materials Handling*
 Direct Labor
 Variable manufacturing overhead

Avoidable fixed costs

Opportunity Cost

Cost to Buy

Purchase price

Materials handling*

Materials handling – are costs allocated to the product that pass through the receiving department. The
receiving department would check the material or product that enters the company and the costs
incurred for checking would be allocated to the product. These are avoidable costs.

Q: Are all variable costs avoidable?

A: No. Variable selling and administrative selling expenses are variable costs but are not avoidable.

Opportunity costs are the income sacrificed or foregone when a certain alternative is chosen over
another alternative.

2. ACCEPT OR REJECT a Special Order

Accept the order when the incremental revenue exceeds the incremental cost. Incremental costs would
depend on whether the company has excess capacity to satisfy the special order or not (the latter would
incur opportunity costs). Suggested formula, as follows:

Incremental Revenue
Less: Incremental Costs
Direct Materials
Direct Labor
Variable manufacturing overhead
Variable selling expenses
Opportunity costs
Additional fixed cost
Incremental Profit

Q: How come Variable Selling expenses are included in the computation? It wasn’t included in Make or
Buy decisions.
A: Because in special order decisions, when we choose to accept the special order, we SELL to the one
who made the special order. The act of selling to the buyer would trigger variable selling expenses. So
aside from producing the product to be sold, we also consider the expenses related to the sale itself.

Q: What does the problem mean when it says “without excess capacity”?
A: If we are talking about special orders, it may result from 1 or 2 scenarios. 1) When the company is
selling at full capacity, which means, all units produced are to be sold to regular customers. SO if we were
to cancel sales to regular customers, the lost contribution margin would be our opportunity costs. 2)
When the company is producing at full capacity, which means, if the company wants to accept the special
order, then it must acquire additional fixed costs in order to produce additional units for the special order.

Q: Why are additional fixed costs included?

A: Normally, fixed costs are irrelevant. However, when the special order requires additional fixed factory
overhead (e.g. supervision and clerical costs), then these should be included in our analysis.
3. CONTINUE OR SHUTDOWN a business segment, product line or branch

 Continue if avoidable revenue is greater than its avoidable cost.

Avoidable Revenues
Sales revenue
Opportunity costs

Avoidable Costs
Variable Costs
Traceable Fixed Costs
Avoidable Common Fixed Costs
Other Avoidable Costs

 Look for the segment margin. If it is positive, better to continue. If the company has no choice
but to drop a segment, drop the one with the least segment margin.

Segment Margin

Sales
Less: Variable expenses_____
Contribution Margin
Less: Traceable fixed expenses
Segment Margin
Less: Common fixed expenses
Net Income

4. SELL OR PROCESS FURTHER a Product

Compare the additional revenue to additional costs. Additional revenue is the difference between the
revenue (or selling price) after processing further while additional costs mainly pertains to the costs of
processing further. Note that joint manufacturing costs are irrelevant for these are costs incurred in the
past and would not differ in the two decision alternatives (whether to sell at split-off or process further).

Suggested Formula:

Revenue or Selling price after processing further

Less: Revenue or selling price at split-off_______
Additional Revenue
Less: Cost of processing further______________
Incremental Revenue

5. PRODUCT COMBINATION
Compute for the contribution margin per constrained resource and rank them from highest to lowest. The
suggested formula is presented below:

Selling Price
Less: Variable Cost per unit
Contribution margin per unit (CM/u)
Divide: Constrained resource per unit (CR/u)

OR

Multiply: Number of units produced per constrained resource (u/CR)

CONTRIBUTION MARGINE PER CONSTRAINED RESOURCE (CM/CR)