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Relevant Costs for Decision-
Making
Relevant Costing - Lecture Notes 1
Relevant Costs for Decision-Making
Relevant costs are future costs that will differ under each alternative course of action. They are not historical costs or budgetary costs, and they are not necessarily standard costs.
The term "relevant cost" applies to decision situations such as the acceptance of special product orders, the manufacture or purchase of a component part, the determination of product price, and the replacement of equipment.
The relevance of a particular cost to a decision is determined by its potential effect on the decision. Factors like the riskiness of the decision or the number of decision variables are not directly relevant.
A fixed cost is relevant if it is avoidable, meaning it can be eliminated or reduced if a particular decision is made.
Incremental unit costs are similar to the economic marginal cost and the variable cost, but they differ from the manufacturing unit cost.
Opportunity costs, which are not recorded in the accounting records, are vital to decision-making.
The opportunity cost of making a component part in a factory with no alternative use of the capacity is the variable manufacturing cost of the component.
In analyzing whether to build another regional service office, the salary of the Chief Executive Officer (CEO) at the corporate headquarters is irrelevant because it is a future cost that will not differ between the alternatives under consideration.
Maximizing Contribution Margin
When production capacity is limited, the company should produce the product(s) that have the highest contribution margin per hour of machine time.
Imputed Costs
Examples of imputed costs include the use of the firm's internal cash funds to purchase assets and assets that are considered obsolete but maintain a net book value.
The distinction between avoidable and unavoidable costs is similar to the distinction between variable costs and discretionary costs.
Total unit costs are relevant for cost-volume-profit analysis and determining product contribution, but they are irrelevant in marginal analysis.
If a cost is irrelevant to a decision, it could be a sunk cost, a future cost, or an incremental cost, but it cannot be a variable cost.
Sunk costs, in and of themselves, are not relevant to decision-making.
The variable cost of a unit of product made yesterday is an incremental cost.
The manner of determining whether favorable results of an alternative are sufficient to justify the cost of taking that alternative is cost-benefit analysis.
Allocating Scarce Resources
When there is one scarce resource, the product that should be produced first is the one with the highest contribution margin per unit of the scarce resource.
Fixed costs are ignored in allocating scarce resources because they are unaffected by the allocation of scarce resources.
Make-or-Buy Decisions
In a make-or-buy decision, the relevant costs include variable manufacturing costs as well as avoidable fixed costs.
In a make-or-buy decision, the opportunity cost of capacity could be considered to decrease the cost of units manufactured by the company.
The activity within an organization that would be least likely to be outsourced is product design.
The relevant costs in a make-or-buy decision include the cost of direct materials purchased last month and used to manufacture the component, but not the original cost or annual depreciation of the production equipment.
If both potential suppliers charge the same price, the material cost is an irrelevant cost.
The original fair market value of the old equipment does not affect the decision-making process.
During a temporary shutdown of plant facilities, expenses such as depreciation, property tax, interest expense, insurance of facilities, and security of premises will continue.
Evaluating Make-or-Buy Decisions
Unit Costs
The company has the following monthly unit costs to manufacture and market a particular product:
Variable Costs: - Direct materials: $2.00 - Direct labor: $2.40 - Indirect manufacturing: $1.60 - Marketing: $2.
Fixed Costs: - Indirect manufacturing: $1.00 - Marketing: $1.
The supplier has offered to make the product at the same level of quality that the company can make it. If the company accepts the proposal, the fixed marketing costs would be unaffected, but the variable marketing costs would be reduced by 30%.
Maximum Amount the Company Can Pay the Supplier
The maximum amount per unit that the company can pay the supplier without decreasing its operating income is $6.75.
Explanation: - The total variable cost per unit is $8.50 ($2.00 + $2.40 + $1.60 + $2.50). - If the company buys from the supplier, the variable marketing cost would be reduced by 30%, which is $0.75 ($2.50 x 0.30). - Therefore, the maximum amount the company can pay the supplier is $8.50 - $0.75 = $6.75 per unit.
Picnic Items, Inc. - Buying vs. Producing the Freezable Ice
Bag
Picnic Items, Inc. manufactures coolers with a freezable ice bag. The company has the following costs for an annual volume of 10,000 units:
Fixed manufacturing costs: P500,000 Variable costs per unit: - Direct materials: P80 - Direct labor: P15 - Variable factory overhead: P
Bags Corp. offered to supply the assembled ice bag for P40 with a minimum order of 5,000 units. If Picnic accepts the offer, it will be able to reduce variable labor and overhead by 50%. The direct materials for the freezable bag will cost Picnic P20 if it will produce it.
Considering Bags Corp.'s offer, Picnic should buy the freezable ice bag due to a P150,000 advantage.
Explanation: - If Picnic produces the freezable ice bag, the total variable cost per unit would be P115 (P80 + P15 + P20). - If Picnic buys the freezable ice bag from Bags Corp., the total variable cost per unit would be P40 + (P15 + P20) x 0.5 = P57.50. - The fixed manufacturing costs would remain the same in both cases. - Buying the freezable ice bag from Bags Corp. would result in a P150,000 advantage (P500,000 - (5,000 units x P57.50)) compared to producing it.
Savage Industries - Purchasing vs. Making Part QS
Savage Industries currently manufactures 30,000 units of Part QS42 each month. The facilities have a fixed monthly cost of P150,000 and a capacity to produce 84,000 units per month.
If Savage were to buy Part QS42 from an outside supplier, the facilities would be idle, but the fixed costs would continue at 40% of their present amount. The variable production costs of Part QS42 are P11 per unit.
If Savage Industries can obtain Part QS42 from an outside supplier at a unit purchase price of P12.875, the monthly usage at which it will be indifferent between purchasing and making Part QS42 is 48,000 units.
Explanation: - The fixed cost if Savage buys Part QS42 would be 40% of P150,000, which is P60,000. - The variable cost if Savage produces Part QS42 is P11 per unit. - The purchase price from the outside supplier is P12.875 per unit. - The monthly usage at which Savage would be indifferent between purchasing and making Part QS42 is when the total cost of purchasing (48,000 units x P12.875) is equal to the total cost of producing (48,000 units x P11 + P60,000).
Great Electronics - Manufacturing Component 501
Great Electronics is operating at 70% capacity. The plant manager is considering making component 501, which is currently being purchased for P110 each.
The design engineer estimates that each component requires: - Direct materials: P40 - Direct labor: P30 - Plant overhead is 200% of direct labor cost, and 40% of the overhead is fixed cost.
The decision to manufacture component 501 will result in a gain of P28 for each component.
Explanation: - The total variable cost per component is P40 (direct materials) + P30 (direct labor) + P60 (variable overhead) = P130. - The total fixed cost per component is P30 (fixed overhead). - The selling price of the component is P110. - The gain per component is P110 - P130 - P30 = P28.
($0.80 - $0.40). - The total contribution margin for the regular sales is $ (1,000 units x $0.60). - The total contribution margin for the special order is $160 (400 units x $0.40). - The company can lose up to 267 units (($600 + $160) / $0.60) before the special order becomes unprofitable.
Blue Plate Co. - Subcontracting the Hand-Painting Process
The Blue Plate Co. is operating at 50% capacity, producing 100,000 units of ceramic plates per year. The company plans to utilize 75% capacity in the coming year.
The hand-painting process has the following variable costs per plate: - Materials: P4.50 - Labor: P5.50 - Variable overhead: P1.00 (40% of total variable factory overhead)
The total factory overhead is P500 per 100 plates. An offer to subcontract the incremental hand-painting job was given at P10.50 per plate, but the company will have to lease equipment at P10,000 annual rental.
The plates sell for P50.00 per plate at a contribution margin rate of 45%.
The company should accept the offer to subcontract the incremental hand- painting job, as it will earn P15,000 more.
Explanation: - The variable cost per plate for the hand-painting process is P11 (P4.50 + P5.50 + P1.00). - The contribution margin per plate is P22. (P50.00 x 0.45). - The total contribution margin for the 50,000 incremental plates (75% capacity - 50% capacity) is P1,125,000 (50,000 units x P22.50). - The cost of subcontracting the hand-painting process is P525,000 (50, units x P10.50) plus the P10,000 annual rental, which totals P535,000. - The net benefit of subcontracting is P590,000 (P1,125,000 - P535,000), which is P15,000 more than producing the incremental plates in-house.
Pixie Co. - Buying vs. Manufacturing Component 6417
Pixie Co. produces Component 6417 for use in one of its electronic gadgets. The cost per unit lot of the part are: - Direct material: P520 - Direct labor: P200 - Variable manufacturing overhead: P240 - Fixed manufacturing overhead: P320 - Total manufacturing costs per 100 units: P1,
Bobbie Inc. has offered to sell Pixie all 100,000 units it will need during the coming year for P1,200 per 100 units. If Pixie accepts the offer, the facilities used to manufacture Component 6417 could be used in the production of Component 8275, saving P180,000 in relevant costs. Additionally, a P200,000 cost item included in fixed overhead is specifically related to Part 6417 and would be eliminated.
Pixie should buy Component 6417 because of P300,000 savings.
Explanation: - The total cost per unit to manufacture Component 6417 is P12.80 (P1,280 / 100 units). - The purchase price from Bobbie Inc. is P12 per unit (P1,200 / 100 units). - By buying Component 6417, Pixie would save
P180,000 in relevant costs for Component 8275 and eliminate the P200, fixed overhead cost. - The total savings by buying Component 6417 is P300,000 (P12.80 - P12 per unit x 100,000 units + P180,000 + P200,000).
Chow Foods - Replacing the Cafeteria with Vending
Machines
Chow Foods operates a cafeteria for its employees with the following costs: - Fixed costs: P470,000 per month - Variable costs: 40% of sales
The cafeteria sales are currently averaging P1,200,000 per month.
The company has the opportunity to replace the cafeteria with vending machines. The gross customer spending at the vending machines is estimated to be 40% greater than the current sales, and the company would receive 16% of the gross customer spending while avoiding cafeteria costs.
The decision to replace the cafeteria with vending machines will result in a monthly increase in operating income of P182,000.
Explanation: - The current cafeteria sales are P1,200,000 per month. - The variable costs are 40% of sales, which is P480,000 per month. - The fixed costs are P470,000 per month. - The current operating income is P250, per month (P1,200,000 - P480,000 - P470,000). - The estimated gross customer spending at the vending machines is P1,680,000 per month (P1,200,000 x 1.4). - The company would receive 16% of the gross customer spending, which is P268,800 per month. - The company would avoid the cafeteria costs of P950,000 per month (P480,000 variable + P470,000 fixed).
- The increase in operating income would be P182,000 per month (P268,
ABC Company - Special Order for Kleen
ABC Company receives a one-time special order for 5,000 units of Kleen. The cost to manufacture one unit of this particular product is:
Variable costs (per unit): - Direct materials: $1.50 - Direct labor: $2.50 - Overhead: $0.80 - Selling and administrative: $3.
Fixed costs (per year): - Manufacturing: $100,000 - Selling and administrative: $50,
The variable selling costs for each of the 5,000 units will be $1.00.
The differential cost to ABC Company of accepting this special order is $29,000.
Explanation: - The total variable cost per unit is $7.80 ($1.50 + $2.50 + $0.80 + $3.00). - The total variable cost for the 5,000 units is $39,000 (5, units x $7.80). - The variable selling cost for the 5,000 units is $5,000 (5, units x $1.00). - The fixed costs are not affected by the special order, so the differential cost is $39,000 + $5,000 = $44,000. - The revenue from the
to the poor results of operations of the plant in Naga, Dynamics has decided to cease operations and offer the plant's machinery and equipment for sale by the end of 1980. Dynamics wishes to continue serving its customers in Naga and is considering the following three alternatives:
Expand the operations of the Laguna plant by using space presently idle. This would result in a 50% increase in sales, a 20% increase in fixed factory costs, and a 10% increase in administrative fixed costs. The variable costs would be P4.00 per unit sold.
Enter into a long-term contract with another company who will serve the area's customers. This company will pay Dynamics a royalty of P2.00 per unit based upon an estimate of 30,000 units being sold.
Close the Naga plant and not expand the operations of the Laguna plant. The total home office costs of P250,000 will remain the same under each situation.
Estimated Net Profit from Total Operations
Expansion of Laguna plant (Alternative 1): P618, Negotiation of long-term contract on a royalty basis (Alternative 2): P560, Shutdown of Naga plant with no expansion of other locations (Alternative 3): P330,
JKL Company - Machine Replacement
Decision
JKL Company is considering replacing a machine with the following details: - Book value: P100,000 - Remaining useful life: 4 years - Annual straight-line depreciation: P25,000 - Current market value: P80,
The replacement machine would: - Cost: P160,000 - Useful life: 4 years - Save P50,000 per year in cash operating costs - Be depreciated using the straight-line method
Assuming a tax rate of 40%, the increase in annual income taxes if the company replaces the machine would be P20,000.
Sampaguita Steam Laundry - Truck
Replacement Decision
The Sampaguita Steam Laundry bought a laundry truck that can be used for 5 years. The cost of the truck is P225,000 with a salvage value of P35,000. The estimated net returns of the truck for 5 years is P150,000. If the truck is sold, management can only recover P175,000.
Net Gain (Loss) if the Company Decides to Sell the Truck
P(50,000)
Net Gain (Loss) if the Company Decides to Keep the Truck
P(75,000)
Arlene Inc. - Machine Purchase Decision
Arlene Inc. is considering the purchase of a new machine costing P1,200,000 per year. The new machine would: - Increase revenues to P2,900,000 - Increase operating costs to P2,050,000 - Increase depreciation to P500,000 per year
Assuming a 35% income tax rate, Arlene's annual incremental after-tax cash flows from the machine would be P292,500.
Julius International - Joint Product Processing
Decision
Julius International produces weekly 15,000 units of Product JI and 30, units of JII for which P800,000 common variable costs are incurred. These two products can be sold as is or processed further. To maximize Julius' manufacturing contribution margin, the total separate variable costs of further processing that should be incurred each week are P190,000.
Table Top Model Corp. - Product Line
Reduction Decision
The Table Top Model Corp. produces three products: Tic, Tac, and Toc. The owner desires to reduce production load to only one product line due to the prolonged absence of the production manager. The sales, variable costs, and fixed operating expenses (including depreciation) are provided.
To maximize profits, the product that must be retained is "Tac", and the opportunity cost of selecting such product line is P3.14 million.
Hermo Company - Power Supply Decision
Hermo Company has just completed a hydro-electric plant at a cost of $21,000,000. The plant will provide the company's power needs for the next 20 years, and Hermo will use only 60% of the power output annually.
Quigley Company currently purchases its power from MP Electric at an annual cost of $1,200,000. Hermo could supply this power, thus increasing output of the plant to 90% of capacity. This would reduce the estimated life of the plant to 14 years.
