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HOLY NAME UNIVERSITY

CPA Review
Tagbilaran

MANAGEMENT ADVISORY SERVICES

RELEVANT COSTING AND DIFFERENTIAL ANALYSIS

Relevant Information
Is the expected future data that differ among alternative courses of actions. In decision-making, revenue and
costs are often the key factor.

Relevant Costs – can be defined as a cost that is applicable to a particular decision in the sense that it will have
a bearing on which alternative the manager selects.

Decision making – is the process of studying and evaluating two or more available alternatives leading to a
final choice. This selection is not automatic; rather, it is a conscious procedure.

STEPS IN MAKING DECISIONS

1. Define strategies: business goals and tactics to achieve them.
2. Identify the alternative choices or courses of actions.
3. Collect and analyze the relevant data on the choices.
4. Choose the best alternative to achieve goals.

IDENTIFYING RELEVANT COSTS

Any cost that is avoidable is relevant for decision purposes.

Avoidable cost – can be defined as a cost that can be eliminated (in whole or in part) as a result of choosing one
alternative over another in a decision-making situation. All costs are considered avoidable, except:
 Sunk costs
 Future costs that do not differ between the alternatives at hand.

Relevant costs – are expected future costs which differ between the decision alternatives.

Under the concept of relevant cost, decision-making process involves the following analytical steps:
1. Determine all costs associated with each alternative being considered.
2. Drop those costs that are sunk or historical.
3. Drop those costs that do not differ between alternatives.
4. Make a decision based on the remaining costs. These costs will be the future differential or avoidable
costs, and hence, the costs relevant to the decision to be made.

Sunk Cost (historical costs) – are never relevant in decisions because they are not avoidable and therefore
must be eliminated from the manager’s decision framework.

Opportunity costs – are the profits lost by the diversion of an input factor from one use to another. They are
the net economic benefit given up when an alternative is rejected.

Out-of-pocket costs – involve either an intermediate or near-future cash outlay; they are usually relevant to
decisions.

APPROACHES IN ANALYZING ALTERNATIVES IN NONROUTINE DECISION-MAKING

The two commonly used approaches in evaluating alternative courses of action are:
1. Incremental or differential analysis approach
2. Total project analysis approach or comparative statements approach

Incremental, Differential, or Relevant Cost analysis contrasts choices by comparing the differential revenues,
differential costs, and differential contribution margins. It has the advantage of showing only relevant amounts.

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Total Project Analysis approach shows all the items of revenue and cost data (whether relevant or not) under
the alternatives and compares the net income results. Comparative statements under this approach are prepared
in Contribution format.

TYPES OF DECISIONS
The decisions that commonly occur in all business activities are as follows:
1. Make or Buy
2. Add or Drop a Product or Other Segments
3. Sell Now or Process Further
4. Special Sales Pricing
5. Utilization of Scarce Resources
6. Shut-down or Continue Operations
7. Pricing

Make or Buy Decisions

This is a management decision about whether an item should be made internally or bought from an outside
supplier. The managerial accountant is often asked to compare the cost of manufacturing a part internally with
the cost of purchasing it. The company may use its idle capacity to manufacture the product especially when the
cost of purchasing from the outside supplier exceeds the cost of manufacturing the product.

Adding or Dropping Products/Segments

Over time, consumer’s preference change. Some products become obsolete and are dropped from product lines,
others are developed to replace them. When management is considering dropping a product line or customer
group, the only relevant cost are those that a company would avoid by dropping the product or customer. An
important factor in deciding whether to add or drop a product is the decision’s effect on operating income.

Sell Now or Process Further

In some industries, a number of end products are produced from a single or common raw material input, they
are called joint products.

Joint Product costs - are used to describe those manufacturing costs that are incurring in producing the product
up to the split-off point. These are irrelevant in decisions from the split-off point forward because they are
already incurred.

Split-off point – is the point in the manufacturing process at which the joint product can be recognized as
separate products.

Separable costs – costs incurred after the split-off point for the benefit of only one particular product. They are
relevant in the sell-or-process-further decision.

Incremental revenue from processing further should exceed the incremental processing costs, for such decision
to always be profitable.

Special Sales Pricing

Special Order – is a one-time order that is not considered part of the company’s ongoing business. Managers
often consider accepting a special order at a reduced price to make use of the excess or idle facilities.

Utilization of Scarce Resources

When capacity becomes pressed because of a scarce resource, the firm is said to have a constraint.
Because of this, the company cannot fully satisfy demand and thus, must decide on how to utilize the scarce
resource.

Fixed costs are usually unaffected by such choices, so manager should select the course of action that will
maximize the firm’s contribution margin. With a single constrained, the important measure of profitability is
the contribution margin per unit of scarce resource used.If there are multiple constraints, these are usually
solved by a computer or by hand. The optimal proper combination or product mix, can be found by using the
quantitative method known as linear programming.

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Shut-down or Continue Operations

Management is concerned with the fact that a further drop in sales volume will create sales and they are under
consideration a recommendation that operations be suspended until favorable conditions can be attained and a
better selling price can be set.

Before making their final decision, the company executives must recognize that not all non-variable costs will
be eliminated by a temporary closing of the plant. As a first step, an estimate of the shutdown costs be made.

Pricing Products and Services

1. Cost-based pricing – it starts with the determination of cost, then a price is set so that such price
will recover all the cots in the value chain and provide a desired return on investment.

COST-PLUS PRICE = COST + MARKUP

 Based on Total Cost

Price = Total cost + (Total cost x MU%)

 Based on Absorption Product Cost (Absorption Approach)

Price = Absorption Product Cost + (Absorption Product Cost x MU%)

 Based on Variable Manufacturing Cost

Price = Variable Manufacturing Cost + (Variable Manufacturing Cost x MU%)

 Based on Total Variable Cost (Contribution Approach)

Price = Total variable cost + (Total variable cost x MU%)

Determining the markup percentage:

Absorption approach:

Contribution approach:

2. Market-based pricing (or buyer-based pricing) – prices are based on the products’ perceived
value and competitors’ actions, rather than on the products/services’ costs.

Example: a glass of orange juice may have a higher price in a classy restaurant than at the school
canteen.

 Target price – the expected market price for a product/service, considering the customers’
perceptions of value and competitors’ reactions.

Target Price – Target Profit = Target Cost

 Target costing – a company first determines the price (the target price or market price) at
which it can sell its product/service, and then design the product or service that can be
produced at the target cost to provide the target profit.

Target Cost = Anticipated Selling Price – Desired Profit

 Value engineering – a means of reaching the target cost. It involves a systematic

assessment of all the aspects of the value chain costs of a product/service – from research
and development, design of the product, process design, production, marketing,
distribution, and customer service. The objective is to minimize cost without sacrificing
customer satisfaction.

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 Life-cycle costing – involves the determination of a product’s estimated revenues and

expenses over its expected life-cycle. Including research and development stage.

 Whole-life costs - composed of life-cycle costs, and after purchase cost incurred by
customers.

3. Competition-based pricing – price is largely on competitor’s prices.

4. New product pricing (introductory price setting)

 Price skimming – the introductory price is set at a very high level. The objective is to sell to
customers who are not concerned about price, so that firm may recover its research and
development costs.
 Predatory pricing – the introductory price is set at a very low level. The objective is to gain deep
market quickly.

EXERCISES:
1. On December 31, 2015, Company A completed the construction of a new P900,000 machine. On
January 3, 2016, a salesman from an equipment supplier offered to sell the company an P800,000
machine that can replace the constructed machine and provide operating savings of P200,000 per year
for the next five years (the life of both machines). The machine built by Company A has no salvage
value. Which costs are relevant?

2. Mar Company owns a rice milling machine that was purchased three years ago for P250,000 with five
years remaining life. Its present book value is P156,250 and resale value is P100,000. The company is
contemplating replacing this machine with a new one which will cot P500,000 and have a five-year
useful life with no salvage value. The new machine will generate the same amount of revenue as the old
one but will substantially decrease the variable operating costs. based on normal sales volume of 20,000
units, the annual sales and operating costs of the old and the proposed replacement are estimated as
follows:

Old Machine New Machine

Sales (P30) P600,000 P600,000
Variable Costs 350,000 200,000
Contribution Margin P250,000 P400,000
Fixed Costs:
Depreciation (SLM) 31,250 100,000
Insurance, Taxes, salaries, etc. 40,000 40,000
Total 71,250 140,000
Net Operating Income P178,950 P260,000

Required: Identify Relevant and Irrelevant Costs.

3. Marinel Company, a manufacturer of rattan baskets, ordinarily sells regular baskets for P32.00. at the
beginning of the year 2016, an exporter has offered Marinel P875,000 for 50,000 baskets or P17.50 per
basket. This sale will not affect regular business in any way. Furthermore, it will not change fixed costs
nor require additional variable selling and administrative expense and it will put to use idle
manufacturing capacity. Marinel’s manufacturing product cost of a basket is P20 of which P12 is
variable cost. The income statement for the year just ended, December 31, 2015 showed the following
results, Sales of P8,000,000; variable manufacturing expenses P3,000,000; fixed manufacturing
expenses P2,000,000, variable selling and administrative expenses, P750,000; fixed selling and
administrative expenses P1,250,000. Should Marinel accept the special order at a sales price of P17.50?
(use differential analysis approach and total project analysis approach to support the answer)

4. Lisette Company is purchasing 2,000 parts from an outside suppliers of P170 a part. If the company
makes the part internally, costs will be assigned to the part as follows: Direct Materials P120,000, Direct
Labor P100,000; Variable Overhead P60,000; and Fixed Overhead P80,000.
Required:
a. Should the company manufacture the parts or buy them from an outside supplier?

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5. Suppose a company furnishes the following recent operating statement for its three product lines, A, B,
and C.
A B C Total
Sales P400,000 P360,000 P300,000 P1,060,000
Variable Expenses 280,000 216,000 240,000 736,000
Fixed Expenses:
Salaries of product line
supervisors 30,000 32,000 40,000 102,000
Marketing cost allocated
to product line basis of
sales 8,000 7,200 6,000 21,200
Administrative cost
allocated equally 22,000 22,000 22,000 22,000
Total expenses 340,000 277,200 308,000 925,200
Operating income (loss) P60,000 P82,800 P (8,000) P134,800

Management is considering discontinuing Product C operations. The company can sell assets used in
Product C at book value. They would lay off the Product C supervisor with no termination pay.
Required:
a. Assuming no other changes are expected, should the company drop Product C?
b. Assuming that in addition to the data give, the following changes are expected:
 Sales of Product A and Product B increase by 10% and 15% respectively.
 Marketing costs will remain unchanged.
 Salaries of Product A and B’s product line supervisors would increase by % and 10%
respectively due to the increased sales.
 No increase in total assets required.

Should the company drop Product C?

6. Assume that three products are derived from a single raw material input. Cost and revenue data relating
to the products are presented before (along with an analysis of which products should be sold at the
split-off point and which should be processed further).
Products
A B C
Sales value at split-off point P60,000 P75,000 P30,000
Sales value after further
processing 80,000 120,000 45,000
Allocated joint product costs 40,000 50,000 20,000
Cost of further processing 25,000 30,000 5,000

Required: Which of the product lines should be processed further and which should be sold at the split-
off point?

7. Rudmichael Enterprises Inc. has an annual plant capacity to produce 2,500 units. Its predicted operations
for the year are:
Sales revenue (2,000 units at P40 each) P80,000
Manufacturing costs:
Variable P24 per unit
Fixed P17,000
Selling and administrative costs:
Variable (commission on sales) P2.50 per unit
Fixed P2,500
Required: Should the company accept a special order for 400 units at a selling price of P32 each, which
is subject to half the usual commission rate per unit? Assume no effect on regular sales at regular price.

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8. Madelyn Company makes two kinds of bread – hard rolls and soft rolls. Assume that the company can
sell all the bread it produces. Madelyn’s cost and revenue information are presented below:
Hard Rolls Soft Rolls
Sales revenue per unit P10.00 P9.00
Less: Variable cost per unit
Materials 4.00 2.50
Labor 1.50 2.00
Variable overhead 0.50 0.50
Total 6.00 5.00
Contribution margin per unit P4.00 P4.00

Fixed manufacturing costs : P800,000 per month

Marketing and administrative costs (all fixed) : P200,000 per month
Required: Suppose that the company’s capacity is limited to 720 machine hours per month and the
machine may be used to produce either 300 hard roll per machine-hour or 500 soft rolls per machine
hour. Which product should the company produce to maximize its profit?

9. The Marie Company, now operating below 50% of its practical capacity expects that the volume of sales
will drop below the level of 5,000 units per month. An operating statement prepared for the monthly
sales of 5,000 units shows the following:
Sales (5,000 units at P3) P15,000
Less:
Variable costs P10,000
Non-variable costs 5,000 15,000
Net income (loss) -0-

Management is concerned with the fact that a further drop in sales volume will create a loss. Assume
that a conservative estimate of costs if plant operations are suspended indicates a shot down cost of
P2,000 per month. Since there is no immediate possibility of profit under present condition, the problem
of the company is the possibility of minimizing the loss.

Required: Determine if the company should shut down temporarily or continue operation.

10. Mae Company is in the process of setting a selling price on a product that has just undergone some
modifications in the design. The following costs estimates or the redesigned product have been provided
by the Accounting Department.

Per unit Total

Direct Material P12
Direct Labor 8
Variable manufacturing overhead 6
Fixed manufacturing overhead P140,000
Variable selling, general and
administrative expenses 4
Fixed selling, general and
administrative expenses 120,000

The cost above are based on an anticipated volume of 10,000 units produced and sold each period. The
company uses cost-plus pricing, and it has the policy of obtaining target selling prices by adding a
markup of 50% of unit manufacturing cost or by adding a markup of 100% of variable cost.

Required: Assuming that the company uses absorption costing approach to cost-plus pricing, how much
will be the target selling price for one unit of product be?

11. Lou Supply, Inc. is a producer and distributor of auto supplies. The company desires to cater a rapidly
growing market for long-life batteries that is based on a newly discontinued technology. Management
believes that to be fully competitive, the new battery that the company is planning cannot be priced more
that P1,100. At the price, management is confident that the company can sell 12,500 batteries per year.
The batteries would require permanent investment of P5,000,000 and the desired ROI is 20%. Compute
the target cost of the battery.

-END OF HANDOUTS-
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