Relevant costs

(part 1)

F. M. Kapepiso
Learning objectives

At the end of the lecture, you should be able to:

 Understand the concept of relevance
 Distinguish between relevant and irrelevant information
 Calculate relevant costs of special order, process further or
sale and make or buy decisions
 Introduction

Decision making is important for planning and to control

activities.
A manager involved in decision making need to:
• predict costs with reasonable accuracy
• Understanding cost behaviour is vital
• Identify the difference between relevant and irrelevant cost
• Implement the decisions etc.…
 Relevant costs

• Relevant Cost or Revenue (avoidable, differential,

incremental, changeable, future) - a cost or revenue
applicable to the particular decision being made.
• Relevant if differs (changes)
• Relevance applies to tactical decisions/ short term decisions
• Strategic decisions (long term decisions): all variables change
 Irrelevant costs

• The term Common Cost, also known as Allocated Cost

is usually irrelevant to a decision .
 Two broad categories of costs are never relevant in any
decision. They include:
 Sunk costs: already incurred/ committed
 Future costs that do not differ between the alternatives.
 Steps in decision making when
identifying relevant costs
 Identify the course of action available in a decision
 Assemble all cost data from the information given
 Identify all future costs and income
 Eliminate all irrelevant cost/ revenues
 Make a decision based upon the remaining information
 Example 1-identifying relevant costs

Tango is contemplating whether he should travel to work by

his car or taxi. A weekly taxi ticket costs N$ 100. He already
owns one ticket he purchased for N$75. If he decide to travel
by taxi, he now needs to purchase only three more ticket for
the remaining weeks in a month. The ticket expires in one
month. If he travels by car, fuel costs amount to N$ 200 per
month. The monthly insurance premium for his car is N$ 150,
which is unavoidable in short run.
Required: which mode of transport should Tango use?
(Show all calculations)
Solution-Assuming that insurance is
unavoidable:
Solution- Assuming that insurance is
avoidable (for 1 month only)
 Tactical decisions/ short term:

 Are decisions that can be changed quickly to take advantage

of better opportunities
 They include:
◦ accepting special orders,
◦ process further or sale and
◦ make or buy
◦ Add or eliminate a product
◦ Utilization of scarce resources
 Accepting special orders:

 Special orders are once-off orders that are not part of the
normal business. Many times management comes across a
situation requiring decision whether to accept a special offer
at discount.
 Generally such decisions relate to export offers, selling the
product into different markets, selling to special groups or
selling on special occasions or modify existing product.
 Generally, a contract will be accepted if it increase
contribution and profit; and rejected if it reduces profit
 If an organization has spare capacity a special offer should be
accepted if the price offered makes some contribution to
fixed costs and profit
 Accepting special orders:

 Steps involved in special order decisions

◦ Identify the courses of action available in a decision
◦ Determine if the organisation has surplus capacity to meet the special
order
◦ Identify all future costs and revenue
◦ Calculate incremental revenue and incremental costs of the special
order
◦ Decision: if incremental revenue exceed incremental cost accept the
special order. If incremental revenue is lower than incremental cost do
not accept the special order
 Accepting special orders…
Example 2
Bubbles Galore Ltd is a manufacturer of bubblegum. Their variable
production capacity for a month amounts to 1 000 000 units of
bubblegum, while sales are only 800 000 units in a month. Bubblegum
is sold at $4 per unit.
At the end of December a leading toy manufacturer approaches
Bubble Galore to supply 150 000 units of bubblegum, which will have
to be modified in size in order to fit into their newest toy-bubble
ship.
The toy manufacturer has offered a total contract price of $450 000
for delivery in January. The variable cost of the special bubblegum
will be the same as normal bubblegum, except that an additional $75
000 will be incurred for the modification. The variable cost of normal
bubblegum is $1 per unit. Fixed costs for the Bubble Galore facility
amount to $300 000 per month.
Required: assess whether the toy manufacturer, s order
ought to be accepted
 Accepting special orders…

Example 2: Solution
 Exercise 1
Gear Seal Ltd manufactures bearings and seals for both the automotive and
industrial sectors. The company operates in two divisions: the rubbers division
and the steel division. Their bearings and seals are used in all makes of motor
vehicles as well as for industrial equipment and machinery, both locally and
internationally. The bearings are manufactured in the steel division, while the
seals are manufactured in the rubber division. The cost to produce a bearing is
N$4.44 and the cost to produce a seal is N$2.

They are currently producing 60 000 seals and 27 000 bearings for the month
which represents 75% capacity. The total costs for the steel division is
N$120 000 of which 70% is variable. They have received an order from
Nadasen’s auto manufacturers to supply 8 000 bearings for a vintage model
Supra at a price of N$8 per bearing.

Required:
Based on the above information, should Gear Seal Ltd accept the special
order?
 Process Further or Sale
Sometimes a manufacturing process may provide two or more
products from the same raw material. Such products are known
as joint products.
• For example when zinc ore is processed, the products
obtained are zinc, cadmium, silver and sulphuric acid. Similarly
various petroleum products are obtained from refining of
crude oil.
• After spilt-off point some products are further processed
while others are sold instantly at this point a decision has to
be taken whether to process further or to sell immediately.
• The decision to sell a joint product at split-off point or
process it further, is based on whether the incremental
revenue from further processing exceeds the incremental
cost of further processing. Joint costs are irrelevant to this
decision, since they are past costs and therefore cannot be
changed.
 Process Further or Sale
Decision methodology:

Additional revenue > additional cost = process further

Additional revenue < additional cost = Sell

NB: additional revenue = revenue from further process less revenue

at split off point
◦ costs incurred up to split off point are irrelevant
Example: 3
Pacific Industries produce two products A and B from common
processing of the same raw material. The products are salable at
the split off point or after further processing.
Joint costs include: Material cost N$ 300000 and labour cost N$
250000.
All overheads are considered to be joint costs and amount to N$
150000. The selling price at split off point is N$ 10 per unit of
product A and N$ 12 per unit of product B. The production
manager suggests processing them further which requires an
expenditure of N$6 per unit for product A and N$7 per unit for
product B.
The unit selling prices after further processing are estimated to be
N$21 and N$18 respectively.

Required: a decision has to be taken whether to process

further or sell immediately.
Example 3: Solution:
The decision regarding further processing will be based on
the following calculation:
Product A Product
B
Incremental Revenue(21-10) 11 6
(18-12)
Incremental cost 6 7
Incremental profit 5 (1)

Based on this analysis it is clear that further processing of

product A will result in higher profits ( N$ 5 per unit) while
it is profitable to sale product B at the spilt off point it self
 Exercise 2
(sell at split-off point or process further)

Joint product 1 Joint product 2

Sales value at split-off 1 875 2 250
point
Sales value after further 2 625 5 250
processing
Allocated joint costs 1 704.55 2 045.45
Cost of further processing 800 2 500

Required:
Determine whether joint products 1 and 2 should be sold
at split-off point or be further processed.
 Make or Buy: outsourcing
• It entails evaluating the costs of manufacturing a
component internally in contrast to acquiring it from an
external party (outsourcing)
• The make option gives management more direct control
over the work but buy option has the benefit that the
external organization has specialist skill and expertise

Steps involved in make or buy decisions

• Identify the courses of action available in a decision
• Identify all future costs and revenue
• Calculate incremental costs
• Decision: choose the option with the lowest costs
Decision criterion
Incremental cost (IC) of Manufacturing > Buying cost = Buy
When IC < BC = Make
Example 4:
Turf enterprises is currently operating at 70% capacity and producing
annually 20000 units of the final product. Presently a component
used in the product is bought from an outsider at the rate of N$42
per unit.
To make use of idle capacity, plant manager is considering the
research and development department’s suggestion to manufacture
the component which will cost as follows:
Material N$ 20 per unit
Labour N$ 16 per unit
Variable factory overhead N$4 per unit.
It is also expected that cost accountant will allocate fixed overhead
of N$15 per unit to this component.

You are required to answer the following:

(a) Should the enterprise make or buy the component?
(b) Suppose the part of factory required for manufacturing the
component can be let out for monthly rent of $4000. How would
this affect your decision in (a)?
 Example 4:Solution:
A. Since there is unutilized capacity and variable cost of
manufacturing is less than purchase price (N$40 <N$ 42) it
will save N$ 40000 on annual requirement of 20000
components. (2x20000). Allocated fixed overhead are not
relevant for decision making. Therefore it is suggested to make
the product internally.
B. If there is a possibility to rent out the facility, cost of the
alternatives will be calculated as follows.

Hence, it is clear that buying the product will be more

beneficial as cost of making (N$ 848000) is more than cost of
buying (N$ 840 000).
 HOME-WORK
GD Ltd produces cartridge oil filters for commercial vehicles. These oil filters are
extremely popular because of their strength and durability; they also have exceptional
filtration properties which improve engine performance. The company currently
produces and sells 40 000 units at N$100 each. The operating results for last period are
as follows:

Sales 4 000 000

Less: Variable costs 1 597 500
Direct material 675 000
Direct labour 810 000
Variable overheads 112 500
Contribution 2 402 500
Less: Fixed costs 500 000
Net profit 1 902 500

GD Ltd has received an order from a new customer who requires an extra 15 000 oil
filters at a discounted price of N$85 each. In order to fulfil this order, the direct labour
workers would have to work overtime; this will cost the company an extra 15% in an
overtime premium. Extra raw materials would have to be purchased and the company
would qualify for a quantity discount of 2% on material purchases. The order would
increase fixed cost by N$87 500.

REQUIRED Marks

1.1. Why would a company consider special orders that are below normal
selling price?
5

1.2. State whether the order should be accepted. (Draft a differential

marginal cost statement to support your answer.)
20

TOTAL MARKS 25
Thanks