SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY

Accountancy Department
SHORT TERM 2021
A.Y. 2020-2021

MGMT 1033 - Strategic Cost Management

Week 5 – Differential Cost Analysis (Relevant Costing)

Learning Outcomes: At the end of this module, you are expected to:
1. Discuss the concept of differential cost analysis and its relevance as a
cost management tool;
2. Elaborate the concepts used in most differential cost decisions;
3. Explain the qualitative factors in making differential cost decisions;
4. Apply differential cost analysis on the following management
decisions:
a. Special Orders
b. Sell or Process Further
c. Make of Buy
d. Scrap or Rework
e. Eliminating a Division or Product Line
f. Shutting Down Operations
g. Product Mix or Combinations

LEARNING CONTENT:

Introduction:

When making management decisions, the quantitative aspect of certain issue is given reasonable emphasis.
It is based on a fundamental premise that the benefits derived in pursuing an option exceed the costs
associated to it. Hence, when there are alternatives available for consideration, the manager must be able to
justify which among alternatives would best benefit, not only a certain aspect of the operation, but to the
business as a whole. The decision should also encompass qualitative areas of the business that could have
drastic and long-term adverse effect.

The role of differential cost analysis emphasizes those areas where costs vary for each alternative or option.
In considering the better or best option, as a rule, choose the option that gives the LEAST COST or
HIGHEST MARGIN.
DEFINITIONS:
• Differential Cost Analysis – is the study of relevant costs that are associated with a decision
among possible courses of actions so that the most appropriate alternative may be selected.
• Differential (Incremental) Costs – is the difference in cost between two alternatives.
• Relevant Costs – are expected future costs that will differ among alternatives.
• Opportunity costs – are the foregone benefits from an alternative not selected. Opportunity costs
do not require an actual cash outlay.
• Avoidable costs – are costs that will not be incurred if an activity is suspended.
• Marginal costs – are costs of producing or selling one more unit of product and added to total
costs.
• Sunk costs – are historical (past) costs incurred as a result of past decisions and not relevant in
current decision making.
• Out-of-pocket costs – are costs required for immediate or near future cash outlays.
• Imputed costs – are hypothetical costs representing the cost or value of a resource measured by
its value. Imputed costs do not involve cash outlay and are not recorded in the books. However, in
decision problems, imputed costs are relevant and important.

CONCEPTS USED IN MOST DIFFERENTIAL COST DECISIONS

1. The only relevant costs or revenues are those expected future costs and revenues that differ
among alternatives.
2. All costs incurred in the past (sunk cost) are irrelevant, unless they have future tax effects.
3. Opportunity costs, the expected income obtainable from an alternative, must be considered.

RELEVANT ITEMS IN DECISION MAKING

1. They are expected future costs or revenues: and
2. They differ among alternatives.

QUALITATIVE FACTORS THAT MUST BE CONSIDERED IN DECISION MAKING:

1. Effect on present and future customers.
2. Effect on employee morale, schedule and other internal elements.
3. Relationship with suppliers.

MANAGEMENT DECISIONS INVOLVE:

1. Special Orders – accepting or refusing certain orders.
2. Sell or Process Further – determining whether to sell or process further.
3. Make of Buy – producing internally or buy component parts outside.
4. Scrap or Rework – determining whether to sell as scrap (junk) or to rework (modify).
5. Eliminating a Division or Product Line – determining whether to discontinue a losing product
line or division.
6. Shutting Down Operations – determining whether to continue or shut down operations.
7. Product Mix or Combinations – to determine which products should be given priority in
production
CRITERION FOR SHORT-TERM DECISIONS
1. The only revenues and costs that are relevant in making decisions are the expected future
revenues and costs that differ among available (alternative) choices. These are called Differential
Revenues and Costs also termed as Incremental Revenues and Costs.
2. Revenues and costs that have already been earned or incurred (past revenues and costs) are
irrelevant in making decisions. They are only used to aid in predicting future revenues and costs.
3. Opportunity costs (benefit lost) by choosing one alternative as opposed to another are relevant
costs.

ILLUSTRATION 1 – “SPECIAL ORDER”

Jilly Boy Company produces a ball bearing used in bantam cars. Each ball bearing sells for P45
and the company sells approximately 500,000 ball bearings each year. Unit cost data for 2021 given
below:
Fixed Variable Fixed Variable
Direct material - P12 Factory overhead P8 P4
Direct labor - 10 Distribution costs 2 4

Jilly Boy received an offer from a foreign buyer to purchase 50,000 ball bearings. Domestic sales
would not be affected by this transaction. The offer price is P37. If the offer is accepted, variable
distribution costs will increase P2 per ball bearing for shipping, insurance, and import duties. The
company has idle capacity to produce the offer.
Required:
1. What is the relevant unit cost to this special order?
2. Determine the net effect of the special order.
Solution:
1.

Variable Production Costs:

Direct materials P12
Direct labor 10
Factory overhead __4 P 26
Variable Distribution Costs:
Regular sales P4
Special order 2 __6
Relevant Unit Cost P 32

2.

Differential
Incremental Revenues (50,000 x P37) P 1,850,000
Incremental Costs (50,000 x P32) 1,600,000
Increase in Operating Income P 250,000
ILLUSTRATION 2 – “SELL OR PROCESS”
Jilly Boy Company uses a joint process to produce Products A, B, and C. Joint production costs for 2021
were P200,000 and are allocated using the relative-sales value at split-off method.
Each product may be sold at its split-off point or processed further. Additional processing costs are
entirely variable. Relevant data are given below:

Product Sales Value Additional Final Sales

at Split-Off Processing Costs Value
A P100,000 P 40,000 P200,000
B 200,000 50,000 240,000
C 40,000 60,000 80,000
P340,000 P150,000 P520,000

Required:
1. To maximize profit, which product or products should be sold at split-off point and which product
or products should be processed further?
2. If the alternatives were either to sell all at split-off point or process further all the products, which
alternative would you recommend?
SOLUTION:
To Process Further: Product A Product B Product C
Revenues: P200,000 P240,000 P 80,000
Additional Costs: 40,000 50,000 60,000
Net Revenues P160,000 P190,000 P 20,000
To Sell Outright: 100,000 200,000 40,000
Differential Income P 60,000 (P10,000) (P20,000)

1. To maximize profit, only Product A should be processed while Products B and C should be sold
at split-off point.
2. To process further is a better alternative because the total differential income for Products A, B,
and C (P60,000-P10,000-P20,000) is P30,000.

ILLUSTRATION 3 – “MAKE OR BUY”

Jilly Boy Company has 15,000 hours of idle capacity. They need 20,000 units of a component part used in
its product lines. It is estimated that each unit will take one-half machine hour for production. The
following information is available:
Cost to make the parts:
Materials P14
Direct labor 18
Factory overhead (75% of direct labor cost per unit)
Variable factory overhead (40% of factory overhead per unit)
Cost to buy the parts per unit from the supplier P45
If Jilly Boy Company buys the parts rather than producing them, it will save 60% of fixed overhead cost
per unit.
Required:
1. Determine the relevant unit costs.
2. Determine the relevant total costs and differential costs.
3. Should Jilly Boy Company manufacture the parts, or should it but them from the outside
supplier?
SOLUTION:
1.
Make Buy
Materials P14.00
Direct labor 18.00
Variable factory overhead (P18 x 75% x 40%) 5.40
Fixed factory overhead (P18 x 75% - P5.40) x 60% 4.86
Cost to buy P 45
Relevant unit costs P42.26 P45.00

2.
Relevant Costs:
To Buy: (20,000 x P45.00) P 900,000
To Make: (20,000 x 42.26) 845,200
Differential Savings to Make the Parts P 54,800

3.
Jilly Boy Company is better of making the needed parts because it will save the company
P54,800.

ILLUSTRATION 4 – “SCRAP OR REWORK”

Jilly Boy Company has 5,000 obsolete truck parts that are carried in their inventory at a cost of P50,000.
The company is faces with a decision whether to scrap the parts or modify them. If the parts were junked,
it would realize only 10% of its cost. Should the company modify the parts, it will spent P10,000 for
materials, P3,000 for direct labor, and overhead equal to 40% of direct labor. The new parts will sell for
P25,000 in the market.

Required: Should Jilly Boy Company modify or scrap the parts? Determine the relevant and differential
costs.
SOLUTION:

Relevant Revenues: Scrap Modify Differential

Sales Price P 5,000 P25,000 P20,000
Relevant Costs:
Materials (P10,000) (10,000)
Labor ( 3,000) ( 3,000)
Overhead ( 1,200) ( 1,200)
Net Revenues P 5,000 P10,800 P 5,800

To modify is better because it gives a Differential Income of P5,800.

ILLUTRATION 5 – “ELIMINATE OR CONTINUE A PRODUCT LINE”

The following data were taken from the Jilly Boy Company. Based on these data, the management of Jilly
Boy is considering eliminating product line B. They assumed that by operating only product line A and C,
the company would have higher profits.
Product A Product B Product C
Sales P 100,000 P200,000 P300,000
Cost of Sales:
Materials P 25,000 P 80,000 P 75,000
Labor 20,000 50,000 40,000
Variable overhead 10,000 15,000 20,000
Fixed overhead 5,000 35,000 15,000
Total P 60,000 P 180,000 P 150,000
Gross Margin P 40,000 P 20,000 P 150,000
Selling and Administrative:
Variable P 12,000 P 10,000 P 30,000
Fixed 8,000 30,000 40,000
Total P 20,000 P 40,000 P 70,000
Net Income (Loss) P 20,000 P (20,000) P 80,000

It was determined that if product line B is discontinued, 60% o the fixed overhead can be avoided and
50% of fixed selling and administrative expenses can also be avoided.

Required: Based on the above data, should product line B be eliminated? Present your solution.
SOLUTION:
Product Line B:
Sales P 200,000
Variable Costs:
Materials P 80,000
Labor 50,000
Overhead 15,000
Selling and administrative 10,000 155,000
Contribution Margin P 45,000
Fixed Costs avoided if eliminated:
Overhead (60%) P 21,000
Selling and administrative 15,000 36,000
Excess of Contribution Margin P 9,000

Product line B should be continued because its contribution margin (P45,000) is greater than the
costs to be avoided from fixed overhead (60% x P35,000) and fixed selling and administrative
(60% x P30,000) totalling P36,000.

ILLUSTRATION 6 – “SHUTDOWN OR CONTINUE OPERATIONS”

The Jilly Boy Company is in the fish canning industry. Its regular monthly production from January to
October averages 100 tons of tuna fish that will produce 1,000,000 cans of canned tuna that can be sold at
P10 per can in the market. Its annual fixed costs amount to P18,000,000 which are evenly allocated on a
twelve-month period.
During the months of November and December, the supply of tuna fish goes down to average of 20 tons
monthly or 200,000 cans of canned tuna monthly.
Management is considering to shutdown operations during the months of November and December on the
belief that the company will be saved from greater losses during these months.
If management decides to shutdown operations, additional costs of P50,000 monthly will be incurred for
security and insurance of the plant. The company will also spend additional P60,000 in re-starting
operations in January.
The following data are gathered from the records of Jilly Boy Company;

Raw materials and ingredients P 5.20

Direct labor 0.55
Variable overhead 0.25
Total variable cost per can P6.00

Variable selling and administrative expenses averages P0.10 per can. It is assumed that the market can
absorb all canned tuna produced.
Shutdown operations will reduce fixed costs during November and December by 40%.
Required:
1. Compute the shutdown costs.
2. Determine the shutdown point.
3. Evaluate the result of continued operations and compare with shutdown of operations.

SOLUTION:
1. Computation of Shutdown Costs:
Unavoidable Fixed Costs: (P18,000,000/12) x 2 months x 60% P1,800,000
Additional Shutdown Costs:
Security and Insurance (P50,000 x 2 months) 100,000
Re-starting Costs 60,000
Total Shutdown Costs P1,960,000

2. Computation of Shutdown Point:

Total Fixed Costs – Shutdown Costs *P3,000,000 – P1,960,000

Shutdown Point = =
Contribution Margin per Can P10.00 – (P6.00 + P0.10)

*(P18,000,000/12) x 2 = P3,000,000

Shutdown Point = 266,667 Cans

3. Result of Continued Operations:

Sales (400,000 x P10) P4,000,000
Variable Costs:
Production Costs: (400,000 x P6.00) P2,400,000
Selling and Administrative (400,000 x P0.10) 40,000 2,440,000
Contribution Margin P1,560,000
Fixed Costs (3,000,000)
Net loss from operations (P1,440,000)
Total Shutdown Costs 1,960,000
Advantage of Continued Operations P 520,000
ILLUSTRATION 7 – “PRODUCT MIX – SCARCE RESOURCES”
Jilly Boy Company manufactures and sells three lines of product with contribution margins per unit as
follows: Product A =P12; Product B = P2; Product C =P5
Each unit of product requires production time as follows: Product A = 3 hours; Product B = 10 minutes;
Product C = 2 hours
The company has plant capacity of 20,000 machine hours a month. The market can absorb 2,000 units of
Product A, 24,000 units of Product B and 15,000 units of Product C.
Required:
1. What is the most profitable product line on the basis of contribution margin per machine hour?
2. Complete the maximum contribution margin for the month that will meet the conditions stated.

SOLUTION:
1.

Product CM Per Unit M.T. Per Unit CM per Hour

A P12 3 hours P 4.00
B 2 10 minutes 12.00
C 5 2 hours 2.50

Product B is the most profitable product on the basis of contribution margin per machine hour.
2.
Product Units of Product Machine Hours CM Per Hour Total CM
A 2,000 6,000 P 4.00 P 24,000
B 24,000 4,000 12.00 48,000
C **5,000 *10,000 2.50 25,000
Totals 31,000 20,000 P 97,000

*(20,000 – 4,000 – 6,000) = 10,000 hours **(10,000 hours/2) = 5,000 units

ILLUSTRATION 8 – “KEEP OR REPLACE”
The Jilly Boy Company is considering to replace its old machine with a book value of P75,000 and still
have remaining useful life of 5 years. The old machine will be replaced with a new one that will cost
P250,000, will have 5-year useful life and no salvage value.
The annual operating costs of the old machine amount to P90,000 which can be reduced by 60% if a new
machine is acquired. The old machine would require reconditioning that will cost P10,000 if not replaced
which will be incurred before it starts operation. The old machine will have zero disposal value after 5
years, but can be disposed now at P20,000.
Required:
Ignoring the time value of money and income taxes, determine the relevant and differential costs.
(Quantify for five-year period)

SOLUTION:
Relevant cost to Replace:
Cost of new machine P250,000
Add: Operating Costs: (P90,000 x 40% x 5 years) 180,000 P 430,000
Less: Disposal Value of old machine P 20,000
Reconditioning of old machine 10,000 30,000
Total Relevant Costs to Replace P400,000
Relevant Costs to Keep:
Operating Costs of Old Machine (P90,000 x 5) 450,000
Differential Cost P 50,000

Note: The book value of the old machine is a sunk cost and is not relevant to the decision.
Reconditioning costs of the old machine is an avoidable cost and is relevant if the decision is to
replace the old machine. This problem would normally fall under CAPITAL BUDGETING (last
topic for the final term) when time value of money and income taxes are being considered.

END