RELEVANT COSTING FOR MANAGERIAL DECISIONS

LESSON OBJECTIVES:

At the end of this lesson, you will be able to:

1. Identify relevant and irrelevant costs and benefits in a decision

2. Prepare an analysis showing whether a product line or other business segment should be
added or dropped
3. Prepare a make or buy analysis.
4. Prepare an analysis showing whether a special order should be accepted.
5. Determine the most profitable use of a constrained resource.
6. Determine the value of obtaining more of the constrained resource.

I. GETTING STARTED

Managers must decide what products to sell, whether to make or buy component parts,
what prices to charge, what channels of distribution to use, whether to accept special orders at
special prices, and so forth. Making such decisions is often a difficult task that is complicated by
numerous alternatives and massive amounts of data, only some of which may be relevant. Every
decision involves choosing from among at least two alternatives. In making a decision, the costs and
benefits of one alternative must be compared to the costs and benefits of other alternatives. The key
to making such comparisons is differential analysis — focusing on the costs and benefits that differ
between the alternatives. A difference in cost between any two alternatives is known as a differential
cost. A difference in revenue between any two alternatives is known as differential revenue.
Differential costs and revenues are relevant to decision making, whereas costs and revenues that do
not differ between alternatives are irrelevant to decision making. Because differential costs and
differential revenues are the only inputs that are relevant to decision making, they are also often
referred to as relevant costs and relevant benefits.

Distinguishing between relevant and irrelevant costs and benefits is critical for two reasons.
First, irrelevant data can be ignored—saving decision makers tremendous amounts of time and effort.
Second, bad decisions can easily result from erroneously including irrelevant costs and benefits when
analyzing alternatives. To be successful in decision making, managers must be able to tell the
difference between relevant and irrelevant data and must be able to correctly use the relevant
data in analyzing alternatives. The purpose of this lesson is to develop these skills by illustrating their
use in a wide range of decision-making situations. These decision-making skills are as important in
your personal life as they are to managers. After completing your study of this lesson, you should be
able to think more clearly about decisions in many facets of your life.

II. DISCUSSION OF CONTENT / APPLICATION

DECISION MAKING – is the process of choosing a course of action from at least two alternatives.

SHORT-TERM DECISION ALTERNATIVES

1. Accept or reject a special order
2. Sell or process further a product line
3. Make or buy a part or a product line
4. Continue or shutdown a business segment
5. Choosing the best product combination
6. Selecting a change in profit factors
DECISION MAKING PROCESS

Typical decision making process would involve the following activities:

1. Defining the problem.
2. Specifying the objective and criteria.
3. Identifying the alternative courses of action.
4. Determining and evaluating the possible consequences of the alternatives.
5. Choosing the best alternative and making the decision.
6. Evaluating the results of the decision.

Factors to consider in decision-making:

Qualitative Factors – those that cannot easily and accurately be expressed in terms of
money or any other numerical unit of measure.

Quantitative Factors – those that can easily be expressed in terms of money or other
numerical unit of measure.

TYPES OF COSTS AND TERNMINOLOGIES USED IN DECISION MAKING

1. Differential costs — increases or decreases in total costs that result from selecting one
alternative instead of the other
2. Avoidable costs — costs that will be saved or those that will not be incurred if a certain
decision is made.
3. Sunk costs — costs that are already incurred and cannot be avoided regardless of
what decision is made.
4. Out-of-pocket costs — costs that will require expenditure of cash or incurrence of
liabilities because of a management decision.
5. Joint costs — costs incurred in simultaneously manufacturing two or more products
that are difficult to identify individually as separate types of products until the
products reach a certain processing stage knows as the 'spit-off point'
6. Split-off point — a point in the manufacturing process where some or all of joint
products can be recognized as distinct and separate products.
7. Further processing costs — costs incurred beyond the split-off point as separated
joint products are to be processed further.
8. Bottleneck resources — any resource or operation where the capacity is less
than the demand placed upon it,

SHORT-TERM DECISION MAKING GUIDELINES

Decision objective: decide in favor of the action that will give the organization the BEST PROFIT
POSITION.

Highest revenues
Best profit position
Lowest costs
 NATURE OF ALTERNATIVE DESCRIPTION PROBLEM
1. MAKE or Buy Should a part or product be
A part or a product manufactured (in-sourced) or
bought (outsourced) from
outside supplier?
2. ACCEPT or REJECT Should a special order that
a special order usually requires a price lower
than the regular selling price be
accepted?
3. CONTINUE or SHUTDOWN Should a business segment,
a business segment which may be a product line, a
department or a branch be
continued or discontinued?
4. SELL or PROCESS FURTHER Should a product, after
a product undergoing the joint process, be
sold at the split-off point or be
processed further?
5. PRODUCT COMBINATION Which product(s) should be
Optimization of Scarce produced and sold when there
Resources is given limited resources or
bottleneck operation?
6. CHANGE IN PROFIT Should any of the profit factors
FACTORS such as sales price, volume,
Cost-Volume-Profit variable cost, fixed cost and
Relationships sales mix be manipulated to
increase profit?
DECISION GUIDELINES
Choose the option that involves
the lower cost. In most cases,
fixed costs are irrelevant.
Consider opportunity costs; if any.
Accept the order when the
additional revenue from the
special order exceeds additional
cost, provided the regular market
will not be affected. In most
cases, fixed production costs re
irrelevant.
Continue if avoidable revenue of
the segment involved is greater
than its avoidable costs;
otherwise, consider shutting
down the segment. Since
allocated fixed cost is usually
unavoidable, it is considered
irrelevant.
Process further if additional
revenue from processing further is
greater than further processing
costs. Joint costs, since already
incurred, are considered sunk
costs and irrelevant.
Identify and measure the
constraint on the limited
resource(s). rank the product(s)
according to the highest
contribution margin per unit of
limited resources.
Identify the factor to be changed
and the amount of
contemplated change. Change
the profit factor if it will cause an
improvement on the company’s
over-all profit position.
Approaches in solving problems that involve decision-making:

TOTAL approach – the total revenues and costs are determined for each alternative,
and the results are compared to serve as a basis for making decisions.

DIFFERENTIAL approach – only the differences or changes in costs and revenues are
considered.

1. TOTAL AND DIFERENTIAL ANALYSIS

Eclipse Company has a single product called Vamps. The company normally produces and
sells 80,000 units each year at a selling price of ₱40 per unit. The company’s unit cost at this level of
activity is given below:
Direct materials ₱10.00
Direct labor 8.00
Variable Overhead 4.00
Fixed Overhead 6.00
Variable Selling Expense 2.00
Fixed Selling Expense 3.00
TOTAL (Unit cost) ₱33.00

REQUIRED:
1) Compute Eclipse Company’s income.
2) Eclipse Company could increase sales by 25% if it were to increase the fixed selling
expenses (i.e., placement of advertisements) by ₱120,000. Determine the effect on
company profit using:
A. Total analysis
B. Differential analysis
SOLUTION

Requirement 1:
Sales (80,000 @ P40) 3,200,000
Less: Variable Costs (80,000 x 24) 1,920,000
Contribution Margin 1,280,000
Less: Fixed Costs (80,000 x 9) 720,000
Net Income 560,000

Requirement 2:

A) Should the company decide to increase sales to 125% and fixed costs to P840,000, Net Income
will increase to P760,000.

Sales (80,000 x 1.25 @ P40) 4,000,000

Less: Variable Costs (80,000 * 1.25 x 24) 2,400,000
Contribution Margin 1,600,000
Less: Fixed Costs (80,000 x 9 + 120,000) 840,000
Net Income 760,000
 B) Since the question pertains only to differential analysis, we will just focus on incremental
costing/analysis.

125% 100% Difference

Sales 4,000,000 3,200,000 800,000
Less: Variable Costs 2,400,000 1,920,000 480,000
Contribution Margin 1,600,000 1,280,000 320,000
Less: Fixed Cost 840,000 720,000 120,000
Net Income 760,000 560,000 200,000

Should the company increase sales by 25%, differential contribution margin will increase by
P320,000 and fixed cost will increase by P120,000 which will create additional net income to
the company of P200,000.

2. MAKE OR BUY DECISIONS

GUIDELINE : Compare the cost to make with the cost to buy and choose the least costly option.
The possible costs for each are provided below:

Cost to Make Cost to Buy

Avoidable variable costs: Purchase Price
Direct materials Materials handling
Materials handling
Direct labor
Variable manufacturing overhead
Avoidable fixed costs
Opportunity cost

QUESTION: What are those material handling costs?

ANSWER: These are costs allocated to the product that passes thru the receiving department. The
receiving department would check the validity of the material or product that enters the
company and the costs incurred for checking would be allocated to the product.

QUESTION: Why are direct materials, direct labor and variable manufacturing overhead
avoidable variable costs?

ANSWER: Because when the company chooses to purchase or outsource from an outside
supplier, then it would no longer produce or make the product. These costs are avoidable.

QUESTION: Are all variable costs avoidable?

ANSWER: NO. Variable selling and administrative expenses are variable costs but are not
avoidable. In make or buy decisions, we are talking about either producing our own product (or
material) or purchasing the same from an outside supplier. EITHER WAY, we will still sell the product
where we will incur variable selling expenses. Either way, variable administrative expenses will still
be incurred.

QUESTION: What are the opportunity costs in Make or Buy decisions?

ANSWER: Some common examples are:

1. The facilities used to manufacture the product may be used to manufacture a different
product that will generate additional contribution margin to the company. The amount of
contribution margin is an opportunity cost.
2. The facilities used to manufacture the product may be rented out to another party. The
amount of rent income is an opportunity cost.

There is no limitation as to what constitute opportunity costs, so we rely on its definition.

Opportunity costs are the income sacrificed or foregone when a certain alternative is chose
over another alternative.

CATS Company uses 30 units of Part ‘Miming’ per month in the production of its main product.
The manufacturing costs per unit of Part ‘Miming’ are as follows:

Materials ₱1,000
Handling Cost* 100
Direct Labor 5,000
Factory Overhead (40% fixed) 10,000
TOTAL ₱16,100

*Handling cost is applied at 10% of cost of direct materials and/or any purchased parts.

TIGER Company, a well-known producer of Part ‘Miming,’ has offered to supply the part for
CATS Company at ₱12,000 per unit. Should CATS Company accept TIGER’s offer, the resulting idle
facility may be used to produce another product. Product ‘Meow,’ which is expected to
contribute ₱4,000 per month.

REQUIRED:
Should CATS Company make or buy Part ‘Miming’ from TIGER Company?

SOLUTION

Items MAKE BUY

Materials 1,000 -
Direct Labor 5,000 -
Variable FOH (60% x 10,000) 6,000 -
Fixed FOH (40% x 10,000) - -
Handling Cost* 100 1,200
Purchase Price - 12,000
Total 12,100 13,200

*Handling cost under MAKE option is 100 (Materials x 10%) and 1,200 for BUY option (Purchase
price x 10%).
 Cost to Make Cost to Buy
Avoidable variable costs: 12,100 Purchase Price 13,200
X units 30 X units 30
Total 363,000 TOTAL P396,000
Opportunity cost 4,000
TOTAL COST TO MAKE P367,000

DECISION: The company should make the part “miming” with just a cost of P12,100. It is worth
mentioning that Fixed FFOH of P4,000 (10,000 x 40%) is ignored in both options since it pertains to
avoidable costs and would not be relevant under two options.

3. SPECIAL ORDER DECISION

GUIDELINE : Accept the order when the incremental revenue exceeds the incremental cost.
Incremental costs would depend whether the company has excess capacity to satisfy the special
order or not (the latter would incur opportunity cost). The formula is as follows:

Incremental revenue xxx

Less: Incremental costs:
Direct materials xx
Direct labor xx
Variable FOH xx
Variable selling expenses xx
Opportunity costs xx
Additional fixed costs xx (xxx)
Incremental profit xxx

Q: Why are direct materials, direct labor and variable manufacturing overhead incremental costs?

A: Because in order to comply with the special order, the company would still need to produce the product to
be sold. It would still incur expenses for direct costs and variable manufacturing overhead.
However, some special orders may require different materials so direct materials may be
higher or lower than regular production.

Q: Why not fixed manufacturing overhead? Fixed manufacturing is also a manufacturing cost.
A: Fixed manufacturing overhead is just applied to the finished goods. These expenses would
still be incurred whether we accept the special order or not. These are irrelevant costs.

Q: How come Variable selling expenses are included in the computation? It wasn't included in
Make or Buy decisions.

A: Because in special order decisions, when we choose to accept the special order, we SELL to the
one who made the special order. The act of selling to the buyer would trigger variable selling
expenses, So aside from producing the product to be sold, we also consider the expenses related
to the sale itself.

Opportunity costs would depend on whether we have enough units to satisfy the special order.
Take note, these are special orders. We also have regular orders. If all units are already sold to
regular orders, then in order to satisfy the sale to the special order, we may need to cancel regular
sales. The contribution margin lost on cancelled regular sales is our opportunity cost.

Q: Are there other sources of opportunity costs?

A: Yes. We still go back to the definition of opportunity costs.

Q: What does the problem mean when it says, "without excess capacity"?
A: If we are talking about special orders, it may result from 1 of 2 scenarios. 1) When the company
is selling at full capacity, which means, all units produced are to be sold to regular customers. So, if
we were to cancel sales to regular customers, the lost contribution margin would be our
opportunity costs. 2) When the company is producing at full capacity, which means, if the company
wants to accept the special order, then it must acquire additional fixed costs in order to produce
additional units for the special order,

Q: Why are additional fixed costs included?

A: Normally, fixed costs are irrelevant. However, when the special order requires additional fixed
factory overhead (e.g., supervision and clerical costs), then these should be included in our
analysis.

Antonia Company produces a single product. The cost of producing and selling a single unit of this
product at the company’s normal activity level of 50,000 units per month is as follows:

Manufacturing costs:
Direct materials ₱32.50 per unit
Direct labor 7.20 per unit
Variable manufacturing overhead 1.30 per unit
Fixed manufacturing overhead ₱1,045,000 per unit
Selling and administrative costs:
Variable ₱1.90 per unit
Fixed ₱365,000 per month

The normal selling price of the product is ₱75.00 per unit.

An order has been received from an overseas customer for 3,000 units to be delivered this
month at a special discounted price of ₱65.60 per unit. This order would have no effect on the
company’s normal sales and would not change the total amount of the company’s fixed costs.
The variable selling and administrative expense would be ₱0.30 less per unit on this order than on
normal sales.

REQUIRED:
Should Antonia accept or reject the special order?
 SOLUTION

Selling Price 65.60

Less: Variable Costs
Direct Materials 32.50
Direct Labor 7.20
Variable FOH 1.30
Variable Selling (P1.90 - 0.30 ) 1.60 42.60
CM per unit 23.00
Units sold 3,000
Additional Income 69,000

DECISION: Antonia should accept the special order since it will produce additional income of
P69,000. Variable Selling price is P1.60 since the problem states that should the company accept
the special order, variable selling and admin expenses will decrease by P0.30 per unit versus the
normal sales. Fixed Costs (Product or Period) will not matter since it will be incurred regardless the
company accept or reject the special order.

4. SPECIAL ORDER PRICNG

Conrada Company sells Nokia N99 at a price of ₱27,000 per unit. N99’s costs per unit are:

Direct materials ₱ 7,500

Direct labor 4,000
Variable overhead 4,500
Fixed overhead 6,500
TOTAL ₱22,500

A special order for 1,000 units was received from Marcia Wholesalers, Inc., a well-known cell
phone dealer based in Cavite. Additional shipping costs for this sale are ₱3,000 per unit.

REQUIRED:
What is the minimum selling price per unit if:
A. Conrada is operating at full capacity?
B. Conrada has excess capacity?

SOLUTION

A. Should the company is operating at full capacity, the minimum selling price should be P30,000
(P27,000 SP + DF P3,000).
B. Should the company has received a special order and has an excess capacity, the minimum
selling price should be the total cost in producing the product of P22,500.
5. SHUTTING DOWN OPERATIONS

GUIDELINE 1: Continue if avoidable revenue is greater than its avoidable cost.

Avoidable Revenues Avoidable Costs

Sales revenue Traceable fixed costs
Opportunity costs Avoidable common fixed costs
Other avoidable costs

GUIDELINE 2: Look for the segment margin. If it is positive, better to continue. If the company
has no choice but to drop a segment, drop the one with the least segment margin. You will recall
the computation of segment margin:

Sales XXX
Less: Variable expenses XXX
Contribution margin XXX
Less: Traceable fixed expenses (XXX)
Segment margin XXX
Less: Common fixed expenses (XXX)
Net income XXX

Q: Are fixed expenses relevant in continue or shutdown decisions?

A: Not all. Only traceable fixed expenses are relevant. Common fixed expenses which are
merely allocated to the segment would still be incurred and would just be re-allocated to the
remaining segments. These fixed expenses are generally relevant if they are avoidable.

Q: How can there be opportunity costs?

A: In case the shutdown of one product line, segment or branch would result to the customers
buying the other product line or buying from the other segment or branch, then there would be
benefits foregone if you do not drop the product line, segment or branch. There may also be
instances where the discontinuance of one segment, product line, or b ranch will affect the
remaining branch negatively, e.g., the dropping of one product line may decrease the sales
in another product line
The most recent monthly income statement for Georgia Stores is given below:

North Store South Store Total

Sales ₱1,200,000 ₱800,000 ₱2,000,000
Less: Variable expenses (840,000) (360,000) (1,200,0000)
Contribution margin ₱ 360,000 ₱440,000 ₱ 800,000
Less: Traceable fixed expenses (210,000) (180,000) (390,000)
Segment margin ₱ 150,000 ₱260,000 ₱ 410,000
Less: Common fixed expenses (180,000) (120,000) (300,000)
Net operating income (loss) (₱ 30,000) ₱140,000 ₱ 110,000

Management of Georgia Stores is considering the elimination of the North Store. If the North
Store were, eliminated, then its traceable fixed expenses could be avoided. The total common
fixed expenses are merely allocated and would be unaffected.

A. The elimination of the North Store would result in an overall company net operating income
(loss) of
a. ₱260,000
b. ₱140,000
c. (₱40,000)
d. (₱70,000)

B. Assume that if North Store is closed, one-fifth (20%) of its traceable fixed expense would
continue unchanged. Also, closing of North Store would result in a 20% decrease in sales of
South Store. The overall decrease in operating income will be
a. ₱352,000
b. ₱280,000
c. ₱136,000
d. No decrease; overall income will increase

SOLUTION
A. Analysis should focus on incremental cost (Common fixed costs/ unavoidable cost) which is
indirect cost of P300,000 (P180,000 + P120,000) for segment North& South. The impact of
eliminating North Store is (P40,000) since the common fixed costs is unavoidable.

South
Segment Margin 260,000
Less: Common Fixed Costs (300,000)
Profit (40,000)

B. The total overall impact in operating income is computed as follows:

South
CM (P440,000 * 80%) 352,000
Traceable Cost(South) (180,000)
Traceable Cost(North) (P210,000 * 20%) (42,000)
Common FC (300,000)
Profit (new) (170,000)
Profit (old) 110,000
Total Effect (280,000)
7. PRODUCT ELIMNATION (SHUTDOWN) POINT
Criselda Company expects that the volume of sales will drop below the current level of 5,000 units
per month. An operating statement prepared for the monthly sales of 5,000 units show the
following:

Sales (5,000 @ ₱3) ₱15,000

Less:
Variable costs (5,000 @ ₱2) ₱10,000
Non-variable costs 5,000 15,000
Net income -Nil-

If plant operations are suspended, a shutdown cost (i.e., plant maintenance, taxes and
insurance premiums) of ₱2,000 per month will remain as incurred. Since there is no immediate
possibility of profit under present conditions, the problem of the company is just how to minimize
the loss.

REQUIRED:
1) Shutdown point in units and in pesos.
2) Should the company continue or shut down operations if the company expects demand
to be:
a. 4,000 units? b. 2,000 units?

SOLUTION

1. Shutdown points in units and pesos is computed as follows:

SD point = FC – SD Costs / CM unit

= P5,000 – P2,000 / (P3 – P2)
= P3,000 / 1
= 3,000 units

Since the SD point in units is 3,000 units, the peso value is computed below

SD point in pesos = SD point in units x SP

= 3,000 units x P3
=P9,000

2. A. 4,000 units ( > SD point) : CONTINUE

B. 2,000 units (< SD point) : SHUTDOWN

Contribution Margin @4,000 units: @2,000 units: @3,000 units:

-) Fixed Costs (5,000) (5,000) (5,000)
CONTINUE
Profit (loss) (1,000) (3,000) (2,000)
SHUTDOWN Shutdown Costs ₱2,000 ₱2,000 ₱2,000
8. SELL OR PROCESS FURTHER

GUIDELINE: Compare the additional revenue to additional costs. Additional revenue is the
difference between the revenue (or selling price) after processing further while additional costs
mainly pertain to the costs of processing further. Note that joint manufacturing costs are
irrelevant for these are costs incurred in the past and would not differ in the two decision
alternatives (whether to sell at split-off or process further).

Suggested formula:

Revenue or selling price after processing further PhpXXX

Less: Revenue or selling price at split-off (XXX)
Additional revenue XXX
Less: Cost of processing further (XXX)
Incremental revenue PhpXX

OVAL Company produces four products for a joint cost of ₱10,000. The products are currently
processed beyond the split-off point, and the final products are sold as follows:
Products Sales Additional Processing Cost
M ₱36,00 ₱22,000
I 26,500 12,000
L 10,500 8,000
O 2,500 3,000

The firm could sell the products at the split-off point for the following amounts:
M ₱16,000
I 9,500
L 2,000
O 0

REQUIRED:
1. Which product(s) should the firm sell at split-off point?

SOLUTION

PROCESS FURTHER
SELL Sales Less: APC Net
M 16,000 36,000 22,000 14,000
I 9,500 26,500 12,000 14,500
L 2,000 10,500 8,000 2,500
O - 2,500 3,000 (500)

1. The firm should only sell product “M” at split off point since it is profitable by P2,000 after
processing further.
9. BEST PRODUCT COMBINATION DECISION

GUIDELINE: Compute for the contribution margin per constrained resource and rank them from
highest to lowest.

Bottleneck Co. produces three products: A, B and C. One machine is used to produce the
products. The contribution margins, sales demands, and time on the machine (in hours) are as
follows:

Market Limit Selling Unit Variable Hours on

Price Cost Machine
A 100 units ₱30 ₱10 10 per unit
B 80 units ₱25 ₱7 5 per unit
C 150 units ₱40 ₱15 10 per unit
There are 2,400 hours available on the machine during the week. Total fixed cost is ₱5,000.

REQUIRED:
1) How many units should be produced and sold to maximize the weekly contribution?
a. A, 100; B, 80; C, 150
b. A, 50; B, 80; C, 150
c. A, 90; B, 0; C, 150
d. A, 100; B, 80; C, 100

2) How much is the profit associated with the best product combination?

SOLUTION
Product A Product B Product C
Unit CM ₱20 ₱18 ₱25
Hours per unit 10 hrs. 5 hrs. 10 hrs.
CM per hour 2 3.60 2.50

The company should maximize the product with highest CM per hour (incremental profit) thus the
rankings of Products are as follows: Product B, C and A. We just need to exhaust the available hours
to compute for the best product combination thus,

Available hours 2,400

Allocated to Product B 400 80 units x 5 hours
Balance 2,000
Allocated to Product C 1,500 150 units x 10 hours
Balance 500
Allocated to Product A 500 (500/ 10 hours = 50 units)
Balance -
1. Thus the answer is Product A (50), B (80) & C (150)

2. The profit associated with the best product combination is computed below

Product Units CM per unit CM peso

A 50 20.00 1,000
B 80 18.00 1,440
C 150 25.00 3,750
6,190

CM peso 6,190
Less: FC 5,000
Profit 1,190

- END -