DIFFERENTIAL COST ANALYSIS 4 (Relevant Costing) 8 This chapter aims that the students be able to: Describe the different steps in decision making process and the managerial accountant's role in that process. Understand the concept of incremental analysis (differential costing). Understand the concept of relevance in differential costing analysis. Identify relevant costs for specific (non-routine) decisions and their respective benefits, giving proper treatment to other type of costs such as irrelevant costs (sunk costs), opportunity costs and unit costs. List and explain the different criteria that must be satisfied by relevant information in different decision making areas. Explain the relationship between quantitative and qualitative analyses in decision making. Introduction Decision-making is a fundamental part of management, Decisions about different situations, such as acquisition of plant assets, product mix, methods of production, pricing strategies, etc, confront managers in all types of organizations. This chapter will focus on the role of management accounting information in the most common short-term decisions. The managerial accountant's role in the decision-making process is to provide relevant information tothe managers who make the decisions. The following are the basic steps in decision making process: > Clarify the decision problem or opportunity 2 Problem can be solved only if the decision to be made is clear to the decision- maker. For example, in a problem to accept or reject a certain special order, the decision to make is clear, it's either accept or reject. > ify the decision criterion ' Specify the athe decision to be made has been clarified, the manager should specify the iterion upon which a decision will be made. _In the problem to accept or reject, the ietion be set is profit, For as long as this activity could give profit, most likely the decisionsmaker would accept the offer, though, qualitative factors must take the foremost consideration. For example, the special offer could give additional profit in the \d affect the present regular market in the long run, short run, however, this decision coul: p : thet saad probably the decision would be otherwise - not accepting the special offer. > Identify alternatives i me sions are being made because there are available alternatives, ve Dt dcos re bg sale Ne beet wilt dependent on both quantitative and qualitative aspects. However, in this chapter, thediscussion is focused on quantitative aspect, ent to make the choice. that the information at hand may not be suflic isic ] eA tion of the choi war se model is a simpli on at smnportant elements of the Pre eT aa ae re iy only the relevant information, decision cig constraints and the alternative. > Maa my ere rt Si constraints and different alternative, the decision- maker wil just compate altematns by looking at the advantages and disadvantages. — Evalustes t ose advantages ang disadvantages and select the most acceptable alternative. The ae to make may not necessarily the best alternative but because of some constraints in the present situation the company is in, the decision-maker may settle for the said alternative. Quantitative versus Qualitative Analysis Decision making problem using accounting data is typically called quantitative information. The criteria in such problems usually include objectives such as prof maximization or cost minimization, either way, bottom line is profitability. When a manager makes a final decision, however, the qualitative characteristics of the alternatives are just as important as the quantitative measures. Qualitative characteristics are the factors in a decision problem that cannot be expressed effectively in numerical terms. For example, the management is considering eliminating its service department because it is loosing. All analyses made showed that the company could increase its profit by eliminating such support service department, say by P1,000,000, however in making decisions the manager should consider qualitative issues such as, effect on the morale of the remaining employees, and may be the effect on the company’s total profile with respect to its competitors and customers. Though this qualitative issues could be settled by putting a price in which it must be equal ot greater than 1,000,000. The skill, experience, judgment, and ethical standards of managers must all com together to come up with a decision, ‘The decision-maker must be able to identify informati 2 \ F problem. Different decisions typically will fake disencae ie a peste pertinent to a decision problem must also be accurate, otherwi. . it will be of little use This means thatthe information must be precise. For instance, in elimiatine ihe eosin cena we mentioned in our previous example, an opportunity cost, sa the service depart from the released facilities such rent revenue must » Bay Tent revenue could be ree precise, due to incomplete data, the usefulness of the inf and accurate data are of value only if they are timely, Concept of Incremental Analysis Incremental analysis is the process used to j m e te i 4 2 v ndet alternative courses of action, These data are relevant te tres mercial data that change future among the possible alternatives, decision because they will vary #poset Oferta et Arata gg eg concept of Relevance in Incremental Analysis » Information must be associ; sociated wi ¥. order for the informatens” ed with hit decision or question under consideration in = Differential cost - is a cost = Increment: - i iti i ia ea te the eeditional cost of producing or selling the product or fendered, semis can feces went i nes ste a ei e either varii i 4 are relevant while most fixed costs are ein EE SEM dasa * Incremental revenue - is the additional revenue resulting from the sale of goods or service. = Opportunity cost - represents the potential benefit fc action is chosen over an: : Pt \efit foregone because one course of > The difference between the incremental revenue and incremental cost of particular alternative is the positive or negative incremental benefit of such course of action. Management can compare the incremental benefits of various alternatives to decide on the most profitable or least costly alternative or set of alternative. > Most of the relevant factors, such as the prime product costs, are easily identified and quantified, and are integral parts of the accounting system. However, there are other factors that are not part of the accounting system, such as opportunity costs, that are quantifiable and very relevant, and, in most cases, serve as the deciding factors in decision making. > The need for specific information depends on how important the information is in relation to management objectives. > Information can be based on the present or on past data, however, only information ing on future events is relevant in decision-making. Historical costs that are incurred costs in the past that will not have any bearing in future events are walled sunk cost, and are irrelevant to future decision-making, > Identifying relevant costs and benefits for specific decisions in relevant costs satisfy two criteria: (1) they affect the future, and (2) they differ between alternatives. . managerial accounting identifies relevant costs and benefits. In this bases ra a rT be focused only on the most common situations faced by r, discussio! 5 includit ir decision criteria: Management and how decisions are being made including their decision crit Asoume a General ae ies routes domestic between Manila and the various cities in the airline © Philippines, or service decision. ossengers as part of thei package service. The meals ne ate presently serving are as follows: 4, In "Make" or “Buy” a product The airline is serving following costs of one completeChapter 8 Differential Cost Analysis Variable costs: 6.00 Ingredients ey Direct labor pp Variable overhead " Fixed costs (allocated to products): i ins ii ic costs . Supervisory salaries and other fixes io Depreciation of flight kitchen equipment Total cost per meal tering servic .00 each. Assume further Aca service has offered to supply the meals for P20.00 « er tha P1.00 of the total fixed costs could be eliminated. Fixed cost per unit was computed using the normal operations of 2,000 meals per month. ‘ Tt seems that the airline will accept the offer since it is cheaper than to prepare the meals, However, the accountant must consider only relevant costs because some costs included in the P25.00 cannot be eliminated or avoided even they buy from the catering company, Computational procedure could be presented as follows: Relevant cost approach: Relevant costs Relevant costs Kinds of costs to make to buy 1. Cost of ingredients and other Variable costs P14.00 2. Purchase price of meal 20.00 3. Fixed costs avoided if they will buy 1.00 Total cost per meal P15.00 P20.00 Average number of meals per month 2,000 2,000 Total relevant costs P30,000 P40,000 Decision: Considering the cost on a per unit basis, the airline must make the meals. Total cost approach: Total Kinds of costs vomake ne eee 1. Cost of ingredients and other y Variable costs P1400 2. Purchase price of the meal roan 3. Fixed costs avoided if they will buy 1.00 fi 4. Fixed costs that cannot be avoided if they will buy Total cost per meal me pom ‘Average number of meals per month 2.000 0.00) Total relevant costs per month 250,000 Poon Notice that in either presentation, decision to buy wil the decision to make. For presentation purposes, marge oe 2 P10,000 costs higher at relevant costs. The irrelevant cost in the total cost appreech Te te LY, be interested in TE avoided if the company would buy the meals: The cost e fixed cost that canno! alternatives are called irrelevant costs. 'S that will be incurred in bo!crap 8DiferentalcostAnayis lag Te an peal to make = Total cost to buy () + Total FC = TC = VC(x) + Total FC Total fixed costs incurred is normally the fi i d ly the fixed costs that cannot be avoided whether the company ores or buy. Total fixed costs to the company if they will make is P22,000 [P11.00 OT ‘ ‘, x 2,000], while, the total fixed costs if the company will buy is P20,000 [P11- Therefore, indifference point is computed as follows: To Make = ToB 22,000 + Pl4x. on 20}000 + P20x P20x = Pld x = P22,000 - P20,000 P6x = P2000 x cr P2,000/ P6 = 333,33 or 333 meals To prove: Tomake = 333.33 x P14+P22,000 = P26,666.62 or P26,667.00 To buy = 333,33 x P20 +P20,000 =. P26,666.60 or P26,667.00 This means that if the company needs only about 333 meals per month either alternative could give the same total costs. But if the company needs higher or lower than 333 the total costs will be different. Assume a meal requirement of 400 or 250 per month. At 400 meals: Tomake : 400xP14+ ‘22,000 = P27,600 To buy 400 x P20 + P20,000 = P28,000 Quantitatively, the company must make the meals. At 250 meals: i 250 x P14 + P22,000 = P25,500 To make : To buy 250 x P20 + P20,000 = 25,000 Quantitatively, the company must buy the meals. Note that this decision must also consider the qualitative aspect, say the employees that will be affected by the decision to buy the meals. ortunity revenues that the company could avail if they would relea ses, there Aecigion to buy. This opportunity cost could be treated as a “relevant cost to wre as gn additional cost to make or as a reduction from the total relevant cost to buy. Bither method, the net advantage will be the same. Ina situation like this, the followi Seneral qualitative factors are assumed £0 be present: In some cases, there are OPP’Chapter 8 Differential Cost Analysis —220 > The company has the technical know ho’ > The company has the present facilities in ma’ > The supplier is dependable and supply is ie > Quality of the product or service is comparable. win making the product or service. king the product or service. B. Inan “Accept " or "Reject" an order at a special price decision. Assume that a Japanese Tourist Agency approached the president of the airline about flying chartered vous fights from Manila to Japan. The tourist Soon has offered the aitline P150,000 per round-trip flight on a jumbo jet. Given the airline's usual occupancy rate and air fares, a round trip jumbo jet flight brings in revenue of 250,000. This requires careful analysis because the price is a special price which is lower than its regular revenue. In analyzing this particular decision, the following general situations are considered to be present: > The offer is ona one time deal that is why it could be priced lower than the regular price, otherwise, it should be treated as part of the regular services in the long-run. » The airline has an excess capacity. If the company has no excess capacity, and to accept the offer requires taking some services from regular routes, then, the lost contribution margin on such routes must be included in the analysis as a cost of accepting the offer. > The acceptance of the special offer will not affect the present market of the company. Assume the following data as a typical flight between Manila to Japan: Revenues: Passenger 250,000 ae 30.000 P280,000 Expenses: Variable expenses of flight 90,000 Fixed expenses allocated to each flight 100,000 1981900 Profit P20,000 If the offer is accepted the company will not incur ‘ ae estimated to be P5,000. Teservations and ticketing cost Assume there is an excess capacity enough to produce additional units of the special offer: Special price of the offer Less, Relevant cost of the special offer: P150,000 Variable costs per flight Savings on reservations & ticketing 90,000 Net variable costs of the special offer {_5,000) Contribution margin from the special offer 85,000 268,000 Decision: Since the ofr increases net income, the ofr could be accepted cepted,ghepter6Diferential CostAnaysis 22 ‘Assume there is no excess capacity: Assume that there is no excess capaci in fli ; acity and i il 1 certain flight that realized contributi ti a ‘ sont the offer will temporarily cancel a Special price of the offer Less, Relevant cost of the special offer: ree Variable costs per flight 90,000 Savings on reservations & ticketing __5,000) Net variable costs of the special offer 85,000 Contribution margin from the special offer P 65,000 Less Contribution margin lost from the foregone flight(_80,000) Net disadvantage in accepting the offer 15,000 Decision: Since the offer decreases net income, the offer must be rejected. C. In "Drop/Eliminate", "Retain" or "Add" a service, product or department decision. The airline is presently offering its passengers to join in a club that entitles them to use the club facilities, The controller ascertained that all variable costs can be avoided if the club operation will be discontinued including some fixed costs: 1. Supervisor's salaries 20,000 2. Airport fees 5,000 3. Depreciation on some equipment 10,000 Responsibility, accounting report showed a net loss from this department as shown on the next page: Sales Revenue 200,000 ‘Less, Variable Costs: Food and beverages a Labor costs . Variable overhead 25,000 jaune Contribution Margin x Less, Fixed E e Depreciation: ‘on furniture & equipment Foe Supervisor's salaries 30000 Insurance 3,000 Airport fees Genel overhead, allocated 10,000 ee ‘Net Loss‘Phapter 8 Diterentil Cost Anansi ‘An analysis below could be done to determine whether the responsibility center tony be eliminated or to be retained: Eliminate Different Retain the club the club cost PO P200) Sales Revenue, P200,000. 000 Less, Variable Costs: 7 Pi Food and beverages P70,000 a a Labor costs P40,000 0 Variable overhead P25,000 a peta Total Variable Costs P135,000 a me £00 Contribution Margin PP65,000 000 Less, Fixed Expenses: Depreciation on furniture & equipment P30,000 P20,000 10,000 Supervisor's salaries P20,000 0 20,000 Insurance P10,000 10,000 0 Airport fees P5,000 0 5,000 General overhead, allocated P10,000 10,000 Q Total Fixed Expenses P75,000 40,000 35,000 | Net loss (P10,000) 220000] Notice that the net loss to keep the club is P10,000, while, if the club will be eliminated, the net loss to be absorbed by the entire company increased to P40,000 or a net differential cost of P30,000. Therefore, it will be better to keep/retain the club operations, assuming that there is no alternative use for the facilities that will be released from the club operations. Another approach could be in the form of comparing contribution margin lost and the avoidable costs. Contribution margin lost P65,000 Fixed costs avoided 38,000 Net contribution margin ost (decrease in net income) 30,000 This could be restated using the direct contribution margin (segment margin) approach: Sales Less: Direct costs avoided: 200,000 Total variable costs P135,000 Fixed costs avoided i ibutic 35.000 170,000 Direct contribution/segment margin 120,000 £30,009 Decision rule, in general: 1, _ If the Direct Contribution Margi lene However, in some cases, soopeaa is positive ~ retain or continue 1 eliminated. Opportunity revenus nity Tevenue is available if the segment released if discontinue the deta the form of alternative use ofthe facili segment or new product line, center or could be used to operate #cuoscopaesaicost antes ag If positive but with opportunity revenue Positive DCM > o} Positive DOM < or need even misetain opportunity revenue = eliminate 2. Ifthe Direct Contribution Margin is negative ~ eliminate or drop The decision is valid whether there is an opportunity revenue or none. D. In “Shut Down” (temporary closing operation) or, "Continue" firm's operation decision. This situation will be encountered only if the management determines that the operation would generate sales lower that the break-even point of the product or service on a temporary basis. That the company will definitely incur net loss if it will continue to operate, though by temporary closure it will also be a net loss. The management will only be choosing two losses and, thus, just choose the lesser one. Quantitative presentation would require the determination of the following: Shut down costs for the entire period of temporary closure or shut down. Shut down costs include the following: a. The reduced fixed costs during the shut down period Pxx b. Any additional costs incurred if will shut down xx c. Any estimated costs to restart operation xx Total shut down costs Px Note: If the company will shut down, the total loss to shut down will always be equal to the total shut down costs. Shut down savings / . "shut down savings Include the following: a. Total normal fixed costs if to operate Pxx b. Less, the total shut down costs x Total shut down savings Bx OR can be computed as follows: i Total fixed costs avol Less, Additional costs incurred if will shut down Pxx Estimated costs to re start operation oe Total shut down savings Shut down point Shut down savings number of units SDP = ———~ ; CM per unit (during, the shut down per(Chapter 8 Diterentia! Cost Anavaie SSCS termined and the shut down point, = continue operation than shut down costs. Decision rule: Compare the demand as de a. Ifthe "Demand" > shut down point Because "Loss to continue" is smaller b. Ifthe "Demand" < shut down point = shut down operation Because "Loss to continue’ is bigger than shut down costs. c. Ifthe "Demand" = shut down point = either decision could give the same loss, Ir, just depends on the management prerogative. Assume the club operations of the airline in the previous example, heavy raing experienced brought by La Nina phenomenon, reduced the expected demand below the break even point of the club which is expected to last for 6 months. The company is contemplating to temporary close operations. The controller gathered the following information: Assume the typical monthly operating revenues and costs: Selling price per membership 200 Variable costs per membership 135 Contribution margin 65 Fixed costs per month 75,000 Fixed costs avoided if stop operation 35,000 ‘Additional costs during shut down period for 6 months 20,000 Estimated costs to re start operation 50,000 If they will continue operating, the company will be forced to reduce the membership selling price by 125%. a. Shut down costs: Reduced fixed costs (unavoidable fixed costs) for 6 months (P75,000 - P35,000) x 6 months 240,000 Additional costs during the shut down period 20,000 Estimated re starting costs 50,000 Total Shut Down Costs P310.000 b. Shut down savings: Normal fixed costs for 6 months (P75,000 x 6 Less, shut down costs (75,000 x 6 mos.) P450,000 Total Shut Down Savings OTT Or Total fixed costs avoided for 6 months Less, Additional costs during the 210,000: shut down period P20,000 Estimated restarting costs 50,000 70,000 —Z20,000 Total Shut down savings 240,000commmceumeniacodoaeae c. Shut down point: P140,000 SDP [200 x 875%) - PL PI35 | 3,500 for six months If demand is 4,00) If demand is 3,00 If demand is 3; D>SDP = continue D further processing costs = Process further If incremental selling price < further processing costs = sell as is Note that the total joint costs is not considered in the computation because whatever the decision would be, the total joint costs has been incurred, thus, this is called a sunk cost or irrelevant cost in a decision like this. F. In a problem of profit maximization by utilizing limited or scarce resources (product mix or combination) It is just typical for many manufacturing firms to have limited resources. It could be ited machine hours, direct man-hours or even floor spaces or even raw materials, Ina problem such as this, management often asks questions,on which products must be produced more and which should be produced less in order to maximize profit. Managers, using quantitative aspect, will decide in favor of the product that is considered to be the most profitable. Simple step or procedure must be done before a decision has to be made: 1. Single scarce resource: 1. Determine the contribution margin per unit for each product line. 2. Determine the required number of the scarce resource (say hours required 0 produce and sell 1 unit) needed to produce and sell one unit of such product. 3, Determine the contribution margin per scarce resource CM per unit CM per Scarce Resource = Required Scarce Resource per unit 4, Rank the products using the CM per constrained resource. ‘The highest is the most profitable. ints 0° 5, Maximize production of the most profitable considering the straints : ig the demand cons! This procedure is applicable on the assumption that the entire capacity could be used produce either of the products, and no special machine for a specified seeAssume the followii J wing products and its related selling price and production data. ~ - Combo. _| Cheepy | ___Selling price per uni Selling price per unit P10.00| _P14.00 , Variable costs: Prime costs Factory overhead a0 aa retin administrative expenses 1,00 2,00 variable costs £2.00 | __Pi2.00 A) Contribution margin per unit P1.00 P2.00. B) Machine hours required per unit O2hours | _.05hours B 7 B)= Contribution margin per machine | _P50.00[ _P40.00 our Ranking First Second ‘Assume that the firm has a maximum hours of 100 ‘Assume, further the following situations in relation to market: 1. without market limit (means it can sell all what it can produce) 2. with market limit of 4,000 None 3. with market limit of 4,000 300 SOLUTIONS 1. Units produced 5000 __| None Hours used 100 None Maximize production of the product with the highest CM per scarce resource (hour) 2. Units produced 4,000 i ‘Hours used 80. 0 of units only up to its market limit and use the a i ira hours for the product with the next highest cm per scarce resource. 4,000 300 oduced Af 2 ‘units only up to its market limit on both pe el nee ja an excess number of hours. 6 ill be 5 hours unused since it will not be wise to utilize . Note in assumption No.3 ea result into excess supply in the market. This is what ah eae Product oe where a chance of accepting a special order since it will not affect excess or idle cap: the present market. 2. Multiple scarce resources: limited amount of both machine hours and labor da h how, Some inane tact + oitabiity wll be more complicated. The choice as ‘ours. In this case, ther to which product is most profitable typically will ae eT ini eee 10 sary resources. Solving such a problem requires @ Pe of "Mathematical Tools ane linea, programming, which is will be illustrated in the chapter cision G. In aproblem of continue using the present equipment or replace it with a new one management to consider replacing the old equipment competitive or could be more efficient. However decision- making. Assume the following Some situations will force the machine with one that could make them more the questions are on the costs that are relevant in the information: 4 The Airline has a three-year old loader truck used to load in-flight meals onto airplanes, The box on the truck can be lifted hydraulically to the level of a jumbo jet's side doors. The management is considering replacing it with a new type of loader that is much cheaper than the old hydraulic loader and costs less to operate. However, the new loader would be operable for only one year before it would need to be replaced. Pertinent data for the decision are as follows Acquisition cost of the old loader P100,000 Depreciation on straight line basis from the time of acquisition 4years No salvage value considered for computing depreciation Disposal value now (year 3) 5,000 Annual variable operating costs for the loader (gasoline, cost of operator & maintenance costs). 80,000 Acquisition cost of new loader 15,000 Useful life ; one year Annual operating costs 45,000 Solutions: As shown in the above data the initial reaction of the management may be is not © replace since he thinks that the company will lose P20,000 000 Jess proceeds from sale of old loader of P3,000. equal to the book value of P25 Relevant costs of the old loader: Annual Operating costs Relevant costs of the new loader: 80,000 Depreciation cost (equal to its cost useful life is only 1 year) Annual Operating costs P15,000 Total relevant costs 45,000 Less, Proceeds of the old loader P60,000 Net relevant cost of the new loader 5,000) Net advantage (disadvantage) to replace the old loader 35,000 Reduction in net operating costs 225,000 Or it could be analyzed using the total cost approach: