Chapter-10

Relevant Costing

The information provided by the total cost is not sufficient in solving the management
problems. Marginal costing technique is used in providing assistance to the
management in vital decision making, especially in dealing with the problems
requiring short-term decisions where fixed costs are excluded. The following are the
important areas where managerial problems are simplified by use of marginal costing:

 The Make or Buy Decision

 Sell or Further Process
 Add or Drop Products
 Operate or Temporary Shutdown
 Addition a New Product Line
 Introduce Shifting
 Buy or Lease
 Taking Special Order etc.

1. Important Cost Concept Related with Short-term Managerial Decision

1.1 Relevant Cost

A relevant cost is a cost whose magnitude will be affected by a decision being made.
It has two characteristics:
 Relevant costs are future costs that will differ depending on the actions of the
management.

1.2 Irrelevant Cost

Irrelevant cost is a cost whose magnitude will not be affected by a decision being
made. Example: Historical costs.

1.3 Sunk Cost

A sunk cost is the cost that has already been incurred. Generally known as
unavoidable cost, it refers to all past cost since these amounts cannot be changed once
the cost is incurred.
Example: Depreciation

1.4 Opportunity Cost

Opportunity cost is the sacrifice involved in accepting the alternative under

consideration. This concept is used in problems of alternative choice.
Opportunity cost is a pure decision making cost and is not entered in the books of
accounts.
1.5 Differential Cost
Differential cost is the difference in total costs between any two alternatives. It is
ascertained by subtracting the cost of one alternative from the cost of another
alternative.

1.6 Shut down Cost

Shut down costs are those costs which have to be incurred under all situations in the
case of stopping manufacture of a product or closing down the department or a
division. Shutdown costs are always fixed costs.
Example: Property Tax, Watchman’s Salary, Rent etc.

2. The Make or Buy Decision

A concern can utilize its idle capacity by making component parts instead of buying
them from market. In arriving at such a make or buy decision, the price asked by the
outside suppliers should be compared with the marginal cost of producing the
component parts. If the marginal cost is lower than the price determined by the
outside suppliers, the component parts should be manufactured in the factory itself to
utilized unused capacity. Fixed expenses are not taken in the cost of manufacturing
component parts on the assumption that they have been already incurred, the
additional cost involved is only variable cost.

In addition to the quantitative factors, the qualitative factors which are taken into
consideration to influence the make or buy decision are as follows:

 Quality of goods supplied by the supplier.

 Uninterrupted supply by the supplier meeting the delivery dates.
 Goodwill of the supplier.
 The financial stability of the supplier.
 Additional working capital requirement.
 The long term character and size of the market.
 Any adverse effect on labor relations if it is decided to buy from
outside instead of making.
 The facility of wider selection in case of buy decision.

Sell or Further Process

ANZ manufactures three products from a common input in a joint processing

operation. Joint processing costs up to the split-off point total Tk. 3, 50,000 per
quarter. The company allocates these costs to the joint products on the basis of their
total sales value at the split-off point. Unit selling prices and total output at the split-
off point are as follows:

Products Selling Price Quarterly Output

A Tk. 16 per pound 15,000 pounds
B Tk. 8 per pound 20,000 pounds
C Tk. 25 per pound 4,000 pounds
Each product can be processed further after the split-off point. Additional processing
requires no special facilities. The additional processing costs (per quarter) and unit
selling prices after further processing are given below:

Products Additional Processing Cost Selling Price

A Tk. 63,000 Tk. 20 per pound
B 80,000 Tk. 13 per pound
C 36,000 Tk. 32 per pound

Required:
Which product or products should be sold at the split-off point and which product or
products should be processed further? Show computations.

Add or Dropping Product

A company has had the following per unit cost estimates for its three products for the
first three months:

Particulars Products
A B C
Tk. Tk. Tk.
Direct Materials 20 16 12
Direct Labor 14 22 16
Indirect Expenses 20 18 10
Total Cost 54 56 38
Profit/(Loss) 10 (1) 12
Sale Price 64 55 50

During the period 10,000 units of A, 2,000 units of B and 8,000 units of C are to be
produced. Once half of indirect expenses is fixed.

Required:
a) Calculate Profit for the period.
b) Would it be profitable to stop production B?
c) Management wants to close down production of B and increase
production of A or c by 2,000 units. Which product should be
produced more?

Operate or Temporary shutdown

Royal Ltd. manufactures a uniform product. Variable cost per unit of the product is
Tk. 43.00 and fixed cost Tk. 10.00. The company sells annually 8,000 units at Tk.
70.00 per unit. The fixed cost is fully realized on sales. The company is afraid of the
fact that next year sales would be reduced to 2,000 units due to sudden trade
depression even if the sale price reduced to Tk. 60. The company expects that the
original level of business would be restored within a year. The company is
considering whether operation can be suspended for a year. If the company suspends
its operations for a year, its fixed cost would be reduced to Tk. 20,000. In that case of
course, the following additional cost would be incurred:

Compensation to workers and employees Tk. 12,000; overhauling of plant Tk.

10,000; training of workers Tk. 5,000 and others Tk. 4,000.

Should the operations be suspended for a year?

Extra Shift Operated or Not

A company operates two shifts and produces 6,000 units of production in a month.
The cost per unit is as follows:

Direct materials Tk. 26; direct labor Tk. 15 and overhead Tk. 12 (75% of which is
fixed). Administrative and selling expenses per month amount to Tk. 34,500.
The feasibility of stating the third shift is being studied. Greater quantity of raw
material purchases will reduce cost of all purchases by Tk. 1 per unit. Labor cost of
late night shift will be 50% higher. Fixed overhead and administrative and selling
expenses will increase by Tk. 2,500 and Tk. 3,100 respectively. The sale price of the
product will be reduce from Tk. 70 to Tk. 65 if the third shift is introduced.

Required:

A statement showing the effect of the third shift on the monthly income.

Price Fixation

Susex Ltd. produces 5,000 units of a product by using 40% capacity. Total cost of
production is given below:

Taka
Direct Materials 65,000
Direct Labor 80,000
Indirect expenses:
Variable 30,000
Fixed 25,000

Fixed cost would increase by Tk. 2,500 if the capacity is the increased to 60%. The
company wants to earn Tk. 15,000 profit on additional production. The additional
production can be sold abroad.
What price should be charged for the additional producing?

Expansion or Not

A company is considering expansion. Fixed costs amount to Tk. 4, 20,000 and are
expected to increase by Tk. 1,25,000 when expansion is completed. The present plant
capacity is 80,000 units per year. Capacity will increase by 50% with the expansion.
Variable costs are currently Tk. 6.80 per unit and are expected to go down by Tk. 0.40
per unit with expansion. The current selling price is Tk. 16 per unit and is expected to
remain same under either alternative. When alternative is better-expand or not to
expand? Why?

Make or Buy Decision

Problem 1:
Royal company manufactures 20,000 units of parts R-3 each year for use on its
production line. The cost per unit for part R-3 is as follows:

Direct Material Tk. 5

Direct Labor 7
Variable Manufacturing Overhead 3
Fixed Manufacturing Overhead 10
Total Cost Tk. 25

An outside supplier has offered to sell 20,000 units of part R-3 each year to Royal
Company for Tk. 23.50 per part. If Royal Company accepts this offer, the facilities
now being used to manufacture part R-3 could be rented to another company at an
annual rental of Tk. 1, 50, 000. However, Royal Company has determined that Tk. 6
of the fixed manufacturing overhead being applied to part R-3 would continue even if
part R-3 were purchased from the outside supplier.

Required:
Prepare computations to show the net amount advantage or disadvantage of accepting
the outside suppliers offer?

Problem 2:

Climate control Company manufactures a variety of heating and air-conditioning

units. The company is currently manufacturing all of its own component parts. An
outside supplier has offered to sell a thermostat to climate control for Tk. 20 per unit.
To evaluate this offer, Climate Control Company has gathered the following
information relating to its own cost of producing the thermostat internally:

Per 15,000 units

unit per year
Direct material Tk. 6 Tk. 90,000
Direct Labor 8 1,20,000
Variable Manufacturing Overhead 1 15,000
Fixed Manufacturing Overhead, traceable 5* 75,000
Fixed Manufacturing Overhead, common 10 1,50,000
but allocated
Total Cost 30 Tk. 4,50,000

 40% supervisory salaries and 60% depreciation of special equipment

(no resale value).
Required:
a) Assume that the company has no alternative use for the facilities now
being used to produce the thermostat, should the outside suppliers offer
be accepted? Show all computation.
b) Suppose that if the thermostat were purchased, Climate Control
Company could use the freed capacity to launch a new product. The
segment margin of the new product would be Tk. 65,000 per year.
Should Climate Control Company, accept the offer to buy the
thermostats from the outside supplier for Tk. 20 each? Show
computation.

Problem 3:

Vivan company currently makes all the components for a laser compact disk player.
They have been approached by a company Malaysia to supply a main part for tk. 50
each. Vivan’s managers are convinced that foreign firm can supply these parts with
consistent quality and acceptable delivery schedules. An analysis of the cost records
associated with this part shows the following:
Tk
Materials 15.00
Labor (1 hr.) 10.00
Overhead 40.00
65.00
Normal volume is 10,000 units a month. Overhead consists of Tk. 15.00 per hour in
costs that vary directly with labor hours. Tk. 5.00 per hour allocated for rent on
machinery used exclusively to produce this part and Tk. 20.00 consisting of allocated
general factory rent, supervision, accounting and computer costs.

Required:

At 10,000 units per month, should Vivan managers elect to make or buy this
component?