Relevant Cost Analysis

For decision making purpose, it is necessary to classify costs and revenues based on
whether they are relevant or irrelevant to the decisions. Relevant costs and revenues are
those, that are influenced by the decisions. Irrelevant costs and revenues are those, that
are not affected or influenced by the decisions. Relevant costs are those expected future
costs that are essential but differ for alternative courses of action. It is a future cost that
would arise as a direct consequence of the decision under review.

Types of of business decisions:

1. Strategic decisions-Focus on growth, stability and sustainability and its objective
is to meet the needs of investors. Have long-term effects (more than a year)
2. Tactical decisions-Regularly made to have medium-term effects (1 year or less) in
organizational results.
3. Operational decisions-Are made on a daily basis where the judgmental call of a
supervisor is at its greatest use.

Relevant costs:
1. Differential costs- costs that are present in one alternative in a decision making
case, but are absent in whole or in part in another alternative.
2. Avoidable costs-costs that can be eliminated, in whole or in part, when one
alternative is chosen over another in a decision-making case.
3. Opportunity costs-refers to the contribution to income that is forgone (or lost) when
one action is taken over the next best alternative course of action.

Irrelevant costs:
1. Sunk cost or (Past cost)
2. Future costs that do not differ between or among the alternatives under
consideration

Relevant costing is a management accounting toolkit that helps managers reach

decisions when they are posed with the following questions:
1. Make or buy (insource or outsource) a component part?

Decision guidelines:
The alternative that gives lower relevant costs, gives savings and should be
preferred.
 Sample given #1 (Make or Buy):
It costs P450,000 to make 15,000 units of a part in this plant. This cost includes
material of P90,000, direct labor of P120,000, variable overhead of P15,000, and
P225,000 in fixed overhead inclusive of P45,000 in depreciation and common
overhead allocation of P150,000. The balance is for the section supervisor's salary.
The part can be purchased for P20 a unit. If the part is purchased, the space
released can be rented for P65,000. If the part is purchased, the company will

Sample given #2 (Make or Buy):

A Company is considering whether to make 2,000 units of product Whirl which costs
P16 a unit or buy it from outside for P15 a unit. A further analysis shows that if
product Whirl is outsourced, fixed costs of P8,000 attributable to this product will be
reduced by 25%. If the product is outsourced, Sylvan will

2. Accept or reject special sales order?

Decision guidelines:
If there is an incremental profit, accept!

Special sales characteristics:

1. Non-recurring, one-time only, sales order;
2. The customer is not regular;
3. The market is distinguishable; and
4. The requested sales price is lower than the regular sales

Incremental sales xx
Incremental costs (xx)
Incremental profit (loss) xx
Opportunity costs (benefit) from the alternative use
of capacity (xx)
Net advantage (disadvantage) of accepting the
special sales order xx
 Sample given #1 (Accept or reject special sales order):
The A Company has received a special order for 300 units of product X for P6 a
unit. It usually sells for P9.50 a unit with a cost of P7.50 a unit inclusive of 75
centavos a unit as sales commission that will not be paid on this order. The cost
also includes P3 in manufacturing overhead, two-third of which is for the fair share
of depreciation, rent, utilities and supervisor's salary. The latter’s (supervisor's
salary) accounts for one-half of this amount. Assuming that excess capacity is
available, and this order requires a mold that costs P150, accepting the order will
increase

Sample given #2 (Accept or reject special sales order):

Tinga Corporation currently manufactures all component parts that are used in the
manufacture of various hand tools. A steel handle is used in three different tools.
The budgeted costs per unit based on 20,000 units are:
Direct material P6.00
Direct labor 4.00
Variable overhead 1.00
Fixed overhead 2.00
Total unit cost P13.00
Sans Steel, Inc. has offered to supply 20,000 units of the handle to Tinga for P12.50
each delivered. If Tinga currently has idle capacity that cannot be used for any
other purpose, accepting the offer will

3. Drop or continue an organizational segment (e.g., division, department or product

line)?

Decision guidelines:
If the direct segment margin is positive and there is no other more beneficial
alternative, then, continue! If there are complimentary effects, they should be
considered.

With NO alternative use of capacity With alternative use of capacity

If the segment margin is positive, continue Compare the segment margin from the net
the division benefit of the alternative. If the segment
margin is greater, then continue.
Otherwise, discontinue the division and
undertake the alternative that gives the
higher profit
 Benchmark Computation Alternative Computation
Contribution margin xx Contribution margin xx
- Avoidable FxCe xx - Controllable Direct FxCe xx
Segment margin xx Controllable margin xx
- Non-controllable Direct
FxCE xx
Segment (direct) margin xx
The indirect (or allocated) fixed costs and expenses shall be deducted from the segment
margin to arrive at the profit.

If there is an alternative use of facility, the quantification should be:

Segment margin xx
- Net benefit from the best alternative use of facilities xx
Net advantage (disadvantage) of continuing the division xx

Sample given #1 (Drop or continue an organizational segment):

A Co. mines three products. Gold Ore sells for P1,000,000 per ton, variable costs are
P600,000 per ton, and fixed mining costs are P6,000,000. The segment margin for 2007
was P1,200,000. The management of A Co. was considering dropping the mining of Gold
Ore. Only one-half of the fixed expenses are direct and would be eliminated if the
segment was dropped. If Gold Ore were dropped, net income for A Co. would

Sample given #2 (Drop or continue an organizational segment):

A Company plans to discontinue a segment with a P32,000 segment margin. Common
expenses allocated to the segment amounted to P45,000, of which P20,000 cannot be
eliminated if the segment were closed. The effect of closing down the segment on Conde
Company’s before tax profit would be

4. Sell-as-is or process further a product?

Decision guidelines:
If there is a profit from further processing, then process further!

The basic computational guidelines:

Incremental sales xx
 Incremental costs (xx)
Savings from further processing xx
Incremental profit (loss) xx

Sample given #1 (Sell-as-is or process further a product):

A Company is starting business and is unsure of whether to sell its product assembled or
unassembled. The unit cost of the unassembled product is P40 and A Company would
sell it for P90. The cost to assemble the product is estimated at P18 per unit and A
Company believes the market would support a price of P116 on the assembled unit.
What is the correct decision using the sell or process further decision rule?

Sample given #2 (Sell-as-is or process further a product):

Sales of 25,000 units at P7.20 per unit are made monthly. The unit cost is P5.90.
Incremental costs of P1.35 per unit to further process the units will result in the 25,000
units being sold for P8.75 each. Which course of action should the company take?

A. Commit its resources to a different product

B. Sell the units at the current stage of completion
C. Do further processing and sell the units at P8.75
D. Do further processing on only one-half of the units

5. Continue operations or temporarily shut down the operations?

Decision guidelines:
If sales are greater than the shut down point, it would be better to continue
operating!

E.g. of shutdown costs:

1. Salaries of remaining executives
2. Skeletal force of personnel and security
3. Insurance
4. Rental
5. Interests
6. Depreciation
7. Property taxes
8. Advertising
9. Restart up costs (rehiring, retraining personnel, refueling, aligning, retuning
machineries and equipment and refurbishing the plant)
Shutdown point- loss form continuing = loss from discontinuing

Loss from continuing = (CM-FC)

Loss from discontinuing = (0- Shutdown costs)

And at shutdown point

Loss from continuing = Loss from discontinuing
CM-FC = 0-SDC
QS (UCM)-FC = 0-SDC

then:
Shutdown point = FC-SDC
UCM

where:
FC = Fixed costs
SDC = Shutdown costs
UCM = Unit Contribution Margin

Technically, if:

Sales>Shut down point =continue the operations

Sales<Shut down point =shut down (discontinue) the operations
Sample given #1 (Continue operations or temporarily shut down the operations):
A Company has a single product called a CAD. The company normally produces and
sells 60,000 CADS each year at a selling price of P32 per unit. The company’s unit costs
at this level of activity are given below:

Direct materials P10.00

Direct labor 4.50
Variable manufacturing overhead 2.30
Fixed manufacturing overhead 5.00
Variable selling expenses 1.20
Fixed selling expenses 3.50
Total cost per unit P26.50

Due to a strike in its supplier’s plant, A Company is unable to purchase more material for
the production of CADS. The strike is expected to last for two months. A Company has
enough material on hand to continue to operate at 30% of normal levels for the two
months. If the plant were closed, fixed overhead costs would continue at 60% of their
normal level during the two-month period; the fixed selling costs would be reduced by
20% while the plant was closed. How much is the advantage or disadvantage of closing
the plant for the two-month period?
A. Disadvantage, P144,000
B. Advantage, P144,000
C. Disadvantage, P15,000
D. Advantage, P15,000

Sample given #2 (Continue operations or temporarily shut down the operations):

A Company is considering temporarily closing its operations in the month of July and
August due to slack business conditions. Also during this time, general reconditioning and
repairs would be done in preparation for the fourth quarter peak services. The following
data are gathered in relation to this proposal:

Entrance fee per guest 150

Unit variable costs per guest 60
Regular number of monthly guests 40,000
Estimated number of monthly guests in July and August 4,000
Regular monthly fixed costs and expenses:
Salaries 2,280,000
Rent 400,000
Promotions and advertising 250,000
Other fixed costs and expenses 550,000
Total 3,480,000

Estimated monthly fixed costs and expenses in July and August

If the operations are shut down:

Salaries 750,000
Rent 160,000
Promotion and advertising 30% unavoidable based on
contracts
Other fixed costs and expenses to be reduced by 60%
Restart-up costs 300,000
Cleaning and other operating improvements during
the shut down months 500,000

Required:
A. Shut down costs
B. Shut down point
C. Effect on profit if the business continues operating in July and August

6. Maximum or minimum bid price?

Decision guidelines:
Focus on the incremental costs

✓ The maximum bid price should not be in excess of the expected utility value
of the item or object under bid.
✓ The minimum bid price should not be less than the incremental costs of
servicing the activity.
✓ Minimum bid price equals incremental costs plus opportunity costs of using
the facilities.
Min Bid Price= Incremental costs + Opportunity costs
 Sample given #1 (Maximum or minimum bid price):
A Co. has considerable excess manufacturing capacity. A special job order’s cost
sheet includes the following applied manufacturing overhead costs:
Variable costs P56,250
Fixed costs 45,000

The fixed costs include a normal P6,800 allocation for in-house design costs,
although no in-house design will be done. Instead, the special job will require the
use of external designers costing P13,750. What is the minimum acceptable price
for the job?

Sample given #2 (Maximum or minimum bid price):

Balagtas & Company expects to incur the following costs at the planned production
level of 10,000 units:
Direct materials P100,000
Direct labor 120,000
Variable overhead 60,000
Fixed overhead 30,000

The selling price is P50 per unit. The company currently operates at full capacity
of 10,000 units. Capacity can be increased to 13,000 units by working overtime.
Variable costs would increase by P14 per unit for overtime production. Fixed
overhead costs remain unchanged when overtime operations occur. Balagtas has
received a special order from Florante, Inc. who has offered to buy 2,000 units at
P45 each.

What is the incremental cost associated with this special order?

7. Optimization of scarce resources

Decision guidelines:
Prioritize the product that gives the highest contribution margin per limited
resource.

✓ Money, machine hours, direct labor hours, supply of materials, technology,

and other business resources are subject to scarcity.
✓ To optimize scarce resources, sales and production should be allotted to a
product that gives the highest profit per scarce resource. If the scarce
 resource is a direct labor hour, then produce the product that gives the
highest contribution margin per direct labor hour, computed as follows:
CM per hour = UCM / No. of hours per unit
CM per hour = UCM x No. of units per hour

Sample given #1 (Optimization of scarce resources):

A Company has only 25,000 hours of machine time each month to manufacture its
two products. Product X has a contribution margin of P50 and Product Y has a
contribution margin of P64. Product X requires 5 machine hours and Product Y, 8
hours. If Isla Verde wants to dedicate 80% of its machine time to the product that
will provide the most income, it will have a total contribution margin of

Sample given #2 (Optimization of scarce resources):

The A Corporation manufactures two products: X and Y. Contribution margin
per unit is determined as follows:

Product X Product Y
Revenue P130 P80
Variable costs 70 P38
Contribution margin P 60 P42

Total demand for X is 16,000 units and for Y is 8,000 units. Machine hour is a
scarce resource. 42,000 machine hours are available during the year. Product X
requires 6 machine hours per unit while product Y requires 3 machine hours per
unit.

How many units of X and Y should A Corporation produce?

8. Sell now or later?

 Decision guidelines:
If the expected increase in sales is greater than the incremental cost of storage,
then sell later!

Sample given #1 (Sell now or later):

Dalig Company produces a product that can be sold for P250,000 at an intermediate
stage. If Dalig finishes the product, they will incur P75,000 of additional material
costs and another P15,000 in labor and overhead costs. When finished, Dalig will
be able to sell the product for P350,000.

Which of the following answers is correct?

A. Sell now
B. Finish the product because profits will increase by P25,000
C. Finish the product because profits will increase by P12,500
D. Finish the product because profits will increase by P10,000

9. Replace or retain an old asset?

Decision guidelines:
If the net cash inflows are greater than the net outflows, replace the asset! (here
the time value of money and tax effects are not considered)

Sample given #1 (Replace or retain an old asset):

Banaba Company has an opportunity to acquire a new machine to replace one of
its present machines. The new machine would cost P90,000, have a 5-year life and
no estimated salvage value. Variable operating costs would be P100,000 per year.
The present machine has a book value of P50,000 and a remaining life of 5 years.
Its disposal value now is P5,000, but it would be zero after 5 years. Variable
operating costs would be P125,000 per year. Ignore income taxes. Considering
the 5 years in total, what would be the difference in profit before income taxes by
acquiring the new machine as opposed to retaining the present one?
 Sample given #2 (Replace or retain an old asset):
A Co. is considering disposing an equipment that costs P50,000 and has P40,000
of accumulated depreciation to date. A Co. can sell the equipment through a broker
for P25,000 less 5% commission. Alternatively, Minton Co. has offered to lease the
equipment for five years for a total of P48,750. Darren will incur repair, insurance,
and property tax expenses estimated at P10,000. At lease-end, the equipment is
expected to have no residual value. The net differential income from the lease
alternative is:

10. Scrap or rework a defective unit?

Decision guidelines:
Choose the alternative that gives the higher short-term profitability.

Sample given #1 (Scrap or rework a defective unit):

Shelley & Company has 24,000 defective units of a product that cost P8 per unit to
manufacture, and can be sold for P4 per unit. These units can be reworked for P2
per unit and sold at their full price of P12 each. If Shelley reworks the defective units,
how much incremental net income will result?

11. Determining the indifference point

Decision guidelines:
Indifference point is the “point of equality”, where the results of the alternatives are
the same, in terms of profit.

Sample given #1 (Determining the indifference point):

A Industries is a multi-product company that currently manufactures 30,000 units of
Part QS42 each month for use in the production of its main product. The facilities
now being used to produce Part QS42 have fixed monthly cost of P150,000 and a
capacity to produce 84,000 units per month. If A were to buy Part QS42 from an
outside supplier, the facilities would be idle, but 60 percent of its fixed costs would
not continue. The variable production costs of Part QS42 are P11 per unit.

If A Industries is able to obtain Part QS42 from an outside supplier at a unit purchase
price of P12.875, the monthly usage at which it will be indifferent between
purchasing and making Part QS42 is
Sample given #2 (Determining the indifference point):
Mabacong's Shop can make 1,000 units of a necessary component with the
following costs:
Direct Materials P64,000
Direct Labor 16,000
Variable Overhead 8,000
Fixed Overhead ?

The company can purchase the 1,000 units externally for P104,000. The
unavoidable fixed costs are P5,000 if the units are purchased externally. An analysis
shows that at this external price, the company is indifferent between making or
buying the part. What are the fixed overhead costs of making the component?
A. P21,000
B. P16,000
C. P11,000
D. Cannot be determined