Remember these Rules:

B E N E A T … . . A L W A Y S ! ! ! P R E S E N T A T I O N M A T T E R S .

I N V E S T I N A R U L E R

L A B E L M O N E Y V A L U E S W I T H A ‘ P ’ ! ! … … A L W A Y S .
P5.50, NOT 5.50

 MONEY IS MONEY, NOT A DECIMAL!! P6.2 IS NOT
P6.20. SIX PULA TWENTY THEBE IS WRITTEN AS
P 6.20
RELEVANT COSTS
FOR DECISION-
MAKING
INTRODUCTION - RELEVANT COSTS FOR
DECISION-MAKING
In order for a manager/organisation to make the
right decision, the requirement is that the focus
should be on relevant costs and relevant revenues
ONLY.

Thus for decision-making purposes, the key word in

cost analysis is relevance !!
 How to Identify Relevant information

A Simple Example: Lunch Decision

Option 1: Buy Nandos ¼ Chicken [P44.00] and coke

[P8.00]

Option 2: Buy MOX [P32.00] and coke [P 8.00]

Decision is: Nandos or MOX? Coke

is irrelevant as it is common to both options.
 Decision:

Based on Relevant Quantitative Cost Principles

select the option with MOX as it is cheaper [by P 12.00] .

Only the Nandos and the MOX are relevant (we

consider them). The coke is irrelevant as it is not part
of the decision (it is common to both).

What if your decision was based on Qualitative

Factors? Which Option would you select ???
 Relevant Cost / Revenues
Relevant costs [revenues]: are those future costs [& revenues] which
will be affected or altered by a decision.

Irrelevant costs [revenues] will not be affected, they are excluded.

Some pointers:
1. Past or sunk costs are irrelevant as they cannot be altered at the time
of making the decision.

2. The only costs and revenues that ‘differ’ amongst options are relevant
in the decision-making process.

3. Classification of costs into variable or fixed are often important because

in the short term little can be done in relation to fixed costs, such that
the need for a decision will generally [i.e. not always] focus on variable
costs.
 Sunk Costs

Sunk costs cannot be refunded or recovered.

Examples:
Once rent is paid or petrol poured in a car, the
money has been permanently lost.

Goods from a 2015 discontinued car parts shop

stored in a warehouse.
 Sub-Topics

Decisions that require the analysis of relevant costs for

decision-making are several, but the most common
are:
Special Order to use Spare Capacity
Existence / Use of a Limiting Factor
Keep or Replace an Existing Asset
Abandonment of a Business Line
Make in-House or Buy Externally [Make or Buy]
 1. Special Order to Use Spare Capacity

At times [and when spare capacity exists] it

may be beneficial for a company to sell its
products at less that the normal selling price.

This should only be done in the short term

and for special orders so as not to affect
prices in the long term.
 BASIC RULE:

Since existing fixed costs are already

covered by normal production
[SALES], the general rule is that special
orders should be able to cover for their own
variable costs [plus a bit more in order to
make profits !].
Special orders should however cover for
any increases in fixed costs that could arise
from their manufacture, sale etc.
 BASIC RULES cont …….

THUS minimum offer price [price floor] for

special orders is set by:

 The variable costs per unit

 … plus any additional fixed costs arising
from the special order.
 Meepo Company Solution

[i] Variable costs per Unit

Total Cost P440,000 – Fixed Cost P 180,000 = VC

Variable costs P 260,000

P260,000 / 1,300 units = P200 per unit

[ii] CM / unit = P1,000 – P200 = P800

 Cont…

[iii]
Each unit sold at P 400 to students earns an additional
contribution margin of P 200.00 [P400 – P 200 vc/unit]

This P 200 is an addition to profit as fixed costs have

already been covered by normal business [the 1,300 units].

Thus, in deciding whether to sell to students or not (special

offer), fixed costs are irrelevant.

Thus the special order by UB students should be accepted.

 Cont..

[iv] Minimum acceptable price = P 200, the variable

costs per unit
 Cont…

[v] ADDITIONAL FIXED COSTS OF P 150, 000 ?

DETERMINE THE MINIMUM SELLING PRICE PER
Mini-Computers for the Special Order.

Variable costs per mini-comp: P 200.00

Additional fixed costs per mini-comp
{P150,000 / 300} 500.00
Min Selling Price / unit for special order P 700.00
 Dangers of one-off special offers at special prices

1. The one-time special offer could drive prices [&

profits] down in the long-term.
2. Competitors may start price wars.
3. Accepting the offer prevents Meepo from accepting
more profitable offers.
4. May introduce a culture of price bargaining with
regular customers.
 2. Existence of a Limiting Factor

In the short-run the demand for a company’s

products may exceed current production
capacity due to limitations caused by an input
factor [labour, material supplies, machine hours
etc]

The item which restricts production is called the

limiting factor. The Company will need to decide
how best to maximise profits while the limiting
factor exists
 Cont……..

Contribution margin per limiting factor helps to

determine this. The CM per limiting factor can
be defined as the CM per unit for each product
÷ by the product’s use of the limiting factor.

Fixed costs are irrelevant as they are not

affected by any product mix that is selected.
 WHERE IS THIS USEFUL?

Where a company manufactures various products

which compete for the same resources e.g. Botswana
Breweries etc.

In car-showrooms [e.g. Motor Centre]

In shop-shelf spacing [e.g. Spar, Choppies, etc]

In production of similar commodites such as
beverages [KBL].
 Suggested Answer

Solution: Vee Max

 Step 1:Determine the contribution margin per unit for each product:
  Aye Bee Exe Zee
(P) (P) (P) (P)
SP per unit 120 80 160 90
Less Variable Costs:
Materials (P8.00 per kg) (48) (40) (64) (32)
Labour (P5.00 per hour (35) (20) (30) (10)
CONTRIBUTION MARGIN 37 20 66 48
 
 
 Cont.. : Determine CM per limiting factor
 

Where Material (88,000 kgs) is the limiting factor

 
  Aye Bee Exe Zee
CONTRIBUTION MARGIN (P) 37 20 66 48
Divided by material used / unit 6 5 8 4
Contribution margin /limiting factor 6.167 4 8.25 12 .

Step 3:
Determine RANK / Production Order 3 4 2 1
 
 
STEP 4:
Determine Production Quantities
   BALANCE
Zee 4000 x 4kgs = 16 000kgs 88 000 -16 000 = 72 000kgs
Exe 4000 x 8kgs = 32 000kgs 72 000 -32 000 = 40 000kgs
Aye 4000 x 6kgs = 24 000kgs 40 000 -24 000 = 16 000kgs

(Bee 4000 x 5kgs = 20 000kgs)

Bee requires 20,000 kgs, however there are only 16 000 kgs left. These 16 000
kgs can produce 2,000 units (16 000kgs/5kgs= 3,200 units)
 
We therefore produce 4,`000 units of Aye, Exe and Zee, and only 3,200 units of
Bee.
 
 
 Cont…
LIMITING FACTOR (Labour) – Vee Max
 
Where Labour (50,000 hrs) is the limiting factor
   Aye Bee Exe Zee
CONTRIBUTION MARGIN / unit (P) 37 20 66 48
Divided by labour used / unit 7 4 6 2
Contribution margin /limiting factor 5.29 5 11 24

RANK or Production Order 3 42 1

 
NOW COMPLETE !!!
(Answer: 4,000 of Zee and Exe, 2,571 of Aye, and
nothing of Bee)
 Try Missiles Botswana (on Moodle)

Assignment / Tutorial
 ACC 409 Problem 1: Tebo Transport

Tebo Transport freights goods between Lusaka and Gaborone. In a year the company makes 5 deliveries to
Lusaka, and has annual revenue of P 400 000.
The company currently owns a single truck, Old One, which the company is contemplating replacing Old One
with a new model of truck commonly referred to as New Box. The New Box is bigger and can bring in annual
revenue of P 470,000. The Old One was purchase 3 years ago with 6 years of useful use expected from it. The
New Box is expected to have three years useful life if purchased now.
The Old One uses leaded petrol which it consumed at the rate of P2.00 per kilometer while the New Box uses
unleaded petrol which is consumed at the rate of P2.30 per kilometer. The distance between Lusaka and
Gaborone is 800 kilometers. A truck driver is paid P 165,000 annually for trips to Lusaka. Other information
on the Old One and the New Box are as follows:

Old One [P] New Box [P]

Initial Purchase Price P 480,000 P 600,000
Disposal value of old machine P 120,000 -
Annual maintenance costs P 30,000 P 50,000
Annual operating expenses P 58,000 P 44,000
Annual Freight Insurance P 10,000 P 10,000

Required: Use relevant costing to determine if the Old One should be kept or replaced.
 
3. Decision to Keep or Replace an Existing Asset

Relevant costing can be applied when

making decisions on whether to keep or
replace an existing asset.
The key factors in this decision process are
that:
1. Past purchase costs / price of an
asset and future depreciation on such
assets are irrelevant / sunk.
2. They are also not cash-flows.
 Cont…
3. Book value of an existing asset is irrelevant
as it ‘un-depreciated’ amounts of the original
asset.
4. Only the salvage values is relevant as it
represent REAL money from the sale.
5. We compare over the same number of years
(Example: 3 years left of old machine, 3 years
life span of new machine).
 Analysis – Tebo Transport

Old One: bought 3years ago P 480,000. Useful life is 6 years,

straight-line Dpn, no salvage value at the end but can be sold
for P 120,000 if replaced.
Revenue P 400,000 annually, operating costs P58,000
annually.

New Box: Purchase price P 600,000, useful life 3 years

straight line Dpn.
Revenue P 470,000 annually, operating costs P44,000
annually.

Required: Should we keep or replace old machine?

 Suggested Answer: 3-year analysis
Old One New Box
Revenue
(P400.000: P470,000 x 3 yrs) P 1,200,000 P1,410,000
Salvage of Old One P 120,000
Less: Costs
Purchase of New (P600,000)
Maintenance costs
(P30,000, P50,000 : x 3 yrs) (90,000) ( 150,000)
Operating Costs
(P58,000, P44,000 : x 3 yrs) (174,000) ( 132,000)
Petrol
(800 x2 = 1,600 x 5 trips = 8000 km p.a)
8,000 x 3 yrs = 24,000
24,000: P2.00 x P2.30 (48,000) (55,200)
Total Relevant Profit P888,000 P592,800

Difference in favour of keep Old One: P295, 200

 Short version – Differential Analysis if Old One is
Retained

Reduction in revenue( P70,000 x 3 yrs) (P 210,000)

Disposal of Old One not realized (P120,000)

Costs:
No purchase of New Box P600,000
Reduction in Maint Exp (P20,000 x 3 yrs) P 60,000
Increase on Operating Exp (14,000 x 3 yrs) (P42,000)
Reduction in petrol Exp (P0.30 x 1,600x 5 x3 yrs) P 7,200
Net Reduction in Costs P295,200
 Cont….

1. Original purchase price of the old machine and the

book value are irrelevant.
2. The 10,000 per annum for insurance and the
P165,000 salary for the driver are both irrelevant as
they are common to both.
Qualitative Factors of Asset Replacement
 4: Add or Drop a Product / Business Segment

Management may become concerned if one [or more] lines

of business is not able to cover the product’s own costs or is
reducing overall profits, therefore opting to drop that
product line.

The key to this type of problem is that often the unprofitable

line of business will be consuming a share of fixed
costs. Therefore discontinuing the line will result in the
allocation of some or all its fixed costs to the remaining
products.

It may therefore be better to keep the unprofitable line if it

makes a contribution towards fixed costs
 Fixed Costs:

There are two types of fixed costs to consider:

Common Fixed costs: These are costs shared by

all products. These costs will be re-allocated to
remaining products.

Traceable Fixed costs: Are fixed costs incurred

specifically on that particular product. They
discontinue with the product.
 Asanah Company

The Asanah Company has three divisions; Saint, Lou and Iz. Results for the year ending 31 st
March 2020 are presented below:

  Saint Lou Iz Total

Units sold 4,000 5,000 2,000 10,000

Revenue
P80,000 P50,000 P40,000 P170,000
Less variable costs
32,000 25,000 18,000  75,000
Less attributable fixed
14,000 19,000 12,000 45,000
Less allocated fixed costs

8,000  10,000    4,000 22,000

Net income
P26,000 [P4,000] P 6,000 P28,000
Asanah Company allocates allocated fixed costs to products based on the number of units sold.
Since the Lou division has a net loss, Asanah Company feels that it should be discontinued.
Asanah Company feels if the division is closed, that sales at the Saint division will decrease by
20%, and that sales at the Iz division will stay the same.
Required: Prepare a statement / analysis showing the effect of discontinuing the Lou division
on the remaining divisions. Advise management accordingly.
Workings:
Selling price per unit of Saint= P 20.00
Variable cost per unit of Saint= P 8.00

Revised Distribution of Allocated Fixed Costs=

3,200 sales units of Saint = 3,200/5,200 x P22,000 = P13,538
2,000 sales of Iz = 2,000/5,200 x P22,000 = P8,462
2,000 sales of Iz
5,200
 Class Example: Asanah Company
  Saint Iz Total
Units sold 3,200 2,000 5,200

Revenue
P64,000 P40,000 P104,000

Less variable costs 25,600 18,000 43,600

Less attributable fixed

14,000 12,000 26,000

Less allocated fixed costs

13,538    8,462 22,000

Net income
P10,862 P 1,538 P12,400
 Cont…

1. Attributable fixed costs of Lou (P 19,000) will

discontinue as they are attributable FC specifically for
Lou.
2. Decision: Do not discontinue Lou as profits decrease
from P28,000 to P 12,400 (by P15,600)
 Short Method

Reduction / increase in Profit can be

ascertained by analysis only those figures that
are relevant:
Gain to profits:
Discontinued Attributable FC of Lou P19,000
Loss t0 Profit:
Discontinued Contrib. Margin of Lou - P25,000
Discontinued Contrib. Margin of Saint - P 9,600
Difference in Profits - 15,600
 Limitations / Qualitative factors of Discontinuing product lines

Discontinuing a product can affect the sale of

remaining products adversely.

External market and competitors may perceive this

to be indicative of problems in the company.

The morale employees may be affected by

discontinuations.