University of San Jose – Recoletos

School of Business and Management

Accountancy and Finance Department

Cost Accounting and Control

Mr. Jun Brian Alenton, CPA, CMA, CAT, RCA, MICB, MBA

Module 12
Relevant Costing and Short-term Decision Making

CAVEATS
CONCEPT REVIEW:  The financial figures are only part of the
MANAGERS MUST MAKE DECISIONS ABOUT THE USE
information needed for a fully informed
OF ORGANIZATIONAL RESOURCES THAT WILL YIELD
UTMOST BENEFIT TO THE OWNERS decision.
 Consider relevant non-financial factors
when making a decision.
Steps in Decision-Making
1. Identify and define the problem, and assign
responsibility KEY CONCERN:
2. Specify the criterion Managers must be able to distinguish between
RELEVANT and NON-RELEVANT ITEMS
3. Determine and evaluate possible courses of
actions (alternatives)
4. Identify and estimate the costs and benefits
TWO PITFALLS TO AVOID IN MAKING DECISIONS
associated with each feasible alternative
5. Assess qualitative factors •Not able to identify sunk
6. Make a decision Sunk Cost cost
•Sunk cost still considered in
7. Review results of the decision Fallacy decision

Competitor price
•Not able to identify relevant
cuts
Hidden costs
•Opportunity cost not
Cost Fallacy considered in decision

The
Challenge
of
Changing Qualifications for a Cost or Revenue to be Relevant
Markets  Future Cost or Revenue
New products Changing
customer  Cost or Revenue will differ between or among
by competitor preferences alternatives

Relevant Costs
 Differential/incremental costs – the difference
WITH A FIXED SET OF RESOURCES, MANAGERS MUST in total cost between alternatives
MAKE SHORT-RUN DECISIONS TO REACT TO THE  Avoidable costs – the specific costs of an
CHANGING MARKETPLACE activity or sector of a business which would be
avoided if that activity or sector did not exist
 Opportunity costs – the value of the benefit
The company must sacrificed when one course of action is taken
Goal of Relevant
choose between
Costing alternatives
Non-Relevant Costs
 Sunk or past costs
Choose alternative  Absorbed FxOH that will not change as a result
ST Profit with lowest cost of a decision
Maximization  Cost to be incurred in the future but will not
or Maximizing Choose alternative differ between or among alternatives
ROI with highest  Historical cost depreciation
revenue

Module 12 ACCTG201 Page 1 of 8

Relevant Revenues
 Differences in revenues between the Decisions
alternatives Involving • Outsourcing
Cost • Replacement
Information

• Disinvestment
Consider only Disregard Non- Decisions • Further Processing
Relevant Items Relevant Items Involving • Product Mix
Cost and
• Lease or Sell
Revenue
Information • Additional Business
• Pricing
REMINDER
 VC sometimes does not change under SUMMARY OF POINTS TO REMEMBER
alternatives FOR EACH DECISION TYPE
 FxC sometimes changes between
I. Make or Buy Product or Component
alternatives
 Incremental analysis not the same as Backdrop: Company has existing facilities to make
product or component (vertical integration), and an
CVP analysis
option to purchase it elsewhere

 Efficient use of available resources; those that

Differential Analysis are produced least efficiently should be
1. Eliminate costs and benefits that do not differ
outsourced (or capacity should be expanded)
between or among alternatives
 Support services may be outsourced
2. Use the remaining costs and benefits that
domestically or internationally (computer
differ between or among alternatives in
processing, legal work, accounting, training)
making the decision
 Must factor in opportunity cost for freed up
facilities
Decision Types  Quality control (Make) vs. Economies of scale
1. Make or Buy Product or Component (Buy)
(Outsourcing Decision)
2. Retain or Replace Equipment*
Relevant Cost of Making
(Replacement Decision) vs.
3. Keep or Drop Segment or Product Relevant Cost of Buying
(Shutdown or Disinvestment Decision)
4. Sell as is or Process Further
(Further Processing Decision) II. Keep or Drop Segment or Product
5. Utilization of Constrained Resource
(Best Product Combination / Product Mix Backdrop: Existence of an unprofitable segment or
decision) product line
6. Lease or Sell Asset*
7. Accept or Reject a Special Order  Opposite of Capital Budgeting Decision
(Special pricing Decision / Additional Business)  Relevant: Revenue and costs that will be lost
8. Pricing Decisions by dropping the segment or product
 Irrelevant: Unavoidable Cost or costs that will
Note:
* These decision types are normally classified to be remain to be incurred even if the segment or
part of capital budgeting decisions, not short-term product will be dropped
decisions.  Excess capacity may exist, unless another
project uses this capacity immediately
DECISION TYPES BASED ON INFORMATION  Temporary vs. Permanent/Final
NEEDED
CM or Loss of Keeping
vs.
CM or Loss of Dropping

Module 12 ACCTG201 Page 2 of 8

III. Sell as is or Process Further

Backdrop: The company makes products that go through a

joint process, producing joint products Incremental revenue must be greater than incremental
cost
 Company has the option to sell at split-off, or to sell
after further processing VI. Pricing Decisions
 Relevant: Revenue at split-off; Revenue after
incremental processing cost Backdrop: The pricing policy of the company will have
 Irrelevant: Joint cost an impact on profit; the pricing policy of the company
will depend on whether the company is a price-setter
Net profit of selling after processing further or a price taker
vs.
Net profit of selling at split-off  Price-setters: Firms that have discretion over
setting the selling prices of their products and
IV. Utilization of Constrained Resource services
 Price-takers: Firms that have little control over
Backdrop: Company has a limited or constrained the prices of their products and services
resource, and several product lines are utilizing this
 Firms may be price-setters for some of their
resource
products, and price-takers for other products
 Company cannot fully accommodate demand
 Common Approaches:
due to constraint imposed by the scarce
o Cost-Based Price
resource
 Full Cost
 Maximize constrained resource by ranking the
 Variable Cost
products according to the CM per unit of
o Market-Based Price
constrained resource (or CM per limiting
o Profit-Maximizing Price
factor)
o Time-and-Material Pricing
Prioritize making the product with the highest CM per  Other Approaches:
unit of constrained resource, or satisfy product o Competition-Based Pricing
demand according to ranking
o New Product Pricing
o Pricing by Intermediaries
Additional Concerns
o Price Adjustments
 Managing constraints:
o Working overtime o Product Mix Pricing
o Subcontracting some work
o Investing in additional machines SUPPLEMENTARY NOTES
o Shifting workers from non-bottleneck processes
to the bottleneck
Qualitative Factors
 Government pricing regulations, if any
o Business process improvements on bottleneck
o Reducing defective units processed through  Effect of special order on regular sales
bottleneck  Possible reaction of regular sales customers to
 Complicating factor: Multiple constraints special order arrangements
 Disinvestment – dropping a product line may
V. Accept or Reject a Special Order affect sales of other product lines
 Quality of outsourced product and reliability of
supplier
Backdrop: The company has opportunity for additional
 Employee morale – layoffs, extra working
business; one-time order that is not part of the
company’s normal ongoing business; additional sale at hours, lesser working hours
a substantially lower price
External Factors
 Basic assumption: Regular sales will not be  Market condition: Pure Competition, Monopoly,
affected by the special order; Company is not Monopolistic Competition, Oligopoly
operating at full capacity (there is excess
Behavioral and Implementation Issues
capacity to accommodate the special order)
 Keep the firm’s strategic objectives in the
 Negotiations and arrangements regarding the
forefront
special order must be discreet, so as not to
 Maximize CM, minimize FxC
unsettle the existing customer base
 Careful not to include irrelevant costs in
 Company must ascertain that this one-time
decision making
customer is not currently operating in a market
where the customer is a player
 If company is operating at full capacity, lost
CM will be spread over the units
accommodated for the special order

Module 12 ACCTG201 Page 3 of 8

 SHORT-TERM DECISIONS // DIFFERENTIAL ANALYSIS
SUMMARY

Decision Nature Assumption(s) Relevant Items Non-Relevant Items Decision Rule

Relevant cost to make;
Company has the option to Company has existing Make if the avoidable cost of
Make or Buy Relevant cost to buy;
buy or to make a product or facilities to make product or Unavoidable costs making is lesser than the
(Outsourcing) Opportunity cost of freed up
component component incremental cost of buying
facilities

Keep or Drop Company is thinking about Avoidable costs; Benefits Keep if the CM lost by
There is an unprofitable
Segment or dropping a segment or from alternative use of freed Undavoidable costs dropping is greater than the
segment or product line
Product product up facilities costs avoided by dropping

Revenue from processing Sell as is if Net Profit of

Products may be sold at split-
Sell as is or Several products go through further minus cost of selling at split-off is greater
off or processed further and Joint costs
Process Further a joint process processing further; Revenue than Net Profit of selling
sold later
from selling at split-off after processing further
Company has a constrained Cost of making the products
Utilization of Prioritize product with highest
Maximizing constrained or resource, and several product Ranked CM per unit of that cannot be
Constrained CM per unit of constrained
limited resource lines are utilizing this constrained resource accommodated by the
Resource resource
resource constrained resource
Accept if the price of the
Accept or Reject There is idle or excess Revenue from special order; special order is higher than
Special Order One-time additional sale capacity; regular sales will not Incremental cost of making Unavoidable costs the incremental relevant costs
(Special Pricing) be affected units (including any opportunity
cost)

Module 12 ACCTG201 Page 4 of 8

Discussion Problems:

Problem 1. The following costs relate to a variety of decision settings:

Cost Decision
1. Allocated corporate overhead Closing a money-losing department
2. Cost of an old car Vehicle replacement
3. Direct materials Make or buy a product
4. Salary of marketing manager Project discontinuance; manager to be transferred elsewhere
in the firm
5. Home theater installation Purchase of a new home
6. Unavoidable fixed overhead Plant closure
7. Research expenditures incurred last year, related Product introduction to marketplace
to new product
8. P4 million advertising program Whether to promote product A or B with the P4 million
program
9. Manufactured cost of existing inventory Whether to discard the goods or sell them to a third-world
country

Required: Consider each of the nine costs listed and determine whether it is relevant or irrelevant to the
decision cited.

Problem 2. Mindsqueeze Corporation manufactures a product that has two parts, A and B. It is currently considering
two alternative proposals related to these parts.

The first proposal is for buying Part A. This would free up some of the plant space for the manufacture of more of Part B
and assembly of the final product. The product vice president believes the additional production of the final
product can be sold at the current market price. No other changes in manufacturing would be needed.

The second proposal is for buying new equipment for the production of Part B. The new equipment requires fewer
workers and uses less power to operate. The old equipment has a net disposal value of zero.

Required: Tell whether the following items are relevant or irrelevant for each proposal. Treat each
proposal independently.
Proposal Proposal
1 2
a Total variable manufacturing overhead, Part A
b Total variable manufacturing overhead, Part B
c Cost of old equipment for manufacturing Part B
d Cost of new equipment for manufacturing Part B
e Total variable selling and administrative costs
f Sales revenue of the product
g Total variable costs of assembling final products
h Total direct manufacturing materials, Part A
i Total direct manufacturing materials, Part B
j Total direct manufacturing labor, Part A
k Total direct manufacturing labor, Part B

Problem 3. Test your understanding of relevant and non-relevant costs by seeing if you can identify which of the
following costs are relevant:
_____ a. The salary to be paid to a market researcher who will oversee the development of a new product. This is
a new post to be created especially for the new product but the P12,000 salary will be a fixed cost. Is this cost
relevant to the decision to proceed with the development of the product?
_____ b. The P2,500 additional monthly running costs of a new machine to be purchased to manufacture an
established product. Since the new machine will save on labor time, the fixed overhead to be absorbed by the
product will reduce by P100 per month. Are these costs relevant to the decision to purchase the new machine?
_____ c. Office cleaning expenses of P125 for next month. The office is cleaned by contractors and the contract
can be cancelled by giving one month’s notice. Is this cost relevant to a decision to close the office?
_____ d. Expenses of P75 paid to the marketing manager. This was to reimburse the manager for the cost of
travelling to meet a client with whom the company is currently negotiating a major contract. Is this cost relevant
to the decision to continue negotiations?

Module 12 ACCTG201 Page 5 of 8

Problem 4. TGIF Inc. manufactures party games. Most games are played on boards that are purchased from an outside
supplier at the cost of P1 each. The company uses 50,000 boards a year. Management requests that an analysis be
made to determine the profitability of producing the boards internally.
The materials required to manufacture each board cost P.15 per board. To print the game pattern and to glue the
pattern to the board includes a direct labor cost of P.20 per board. The company would also have to lease a board press
costing P20,000 for a four-year lease. Presently, there is adequate space in the Producing Department for the
manufacture of 20,000 boards per year.
If the company were to produce all of its boards internally, it would be necessary to cease its manufacture of checkers
and to purchase these pieces from the outside, resulting in an additional P25,000 cost. Also, a checker caster costing
P8,000 with a P4,000 book value would have to be scrapped without a salvage value.

Required: Prepare a recommendation to management to aid in the make-or-buy decision for the game
boards; use an analysis of the differential costs required for the manufacture of 20,000 and then 50,000
boards vs. the cost of purchasing each quantity from an outside supplier.

Problem 5. Hobbies Company has three product lines in its retail stores: books, videos, and music. The allocated fixed
costs are based on units sold and are unavoidable. Demand of individual products is not affected by changes in other
product lines. Results of the fourth quarter are presented below:

Books Music Videos Total

Units sold 1,000 2,000 2,000 5,000
Revenue P24,000 P48,000 P32,000 P104,000
Variable departmental costs 15,000 22,000 23,000 60,000
Direct fixed costs 3,000 6,000 4,000 13,000
Allocated fixed costs 4,400 8,800 8,800 22,000
Net income (loss) P 1,600 P11,200 P (3,800) P 9,000

Required: Prepare an incremental analysis of the effect of dropping the Video product line.

Module 12 ACCTG201 Page 6 of 8

Problem 6. Citronella Chemical Corporation produces a water-based pest control chemical which it sells to pest companies
to manufacture as an anti-mosquito oil. In 2019, the company incurred P140,000 of costs to produce 14,000 gallons of the
chemical. The selling price of the chemical is P21.00 per gallon. The costs per unit to manufacture a gallon of the chemical
are presented below:

Direct materials P 3.50

Direct labor 3.00
Variable manufacturing overhead 2.00
Fixed manufacturing overhead 1.50
Total manufacturing costs P10.00

With the rising cases of dengue in the country, the company is considering manufacturing the anti-mosquito oil itself. If the
company processes the chemical further and manufactures the anti-mosquito oil itself, the following additional costs per
gallon will be incurred: Direct materials P1.00, Direct labor P.50, Variable manufacturing overhead P1.00. No increase in
fixed manufacturing overhead is expected. The company can sell the pesticide at P25.00 per gallon.

Required: Determine the incremental per gallon increase in net income and the total increase in net income
if the company manufactures the anti-mosquito oil.

Problem 7. Bready Bunch Company manufactures Gahibread and Humokbread in a joint process. The joint costs amount
to P80,000 per batch of finished goods. Each batch yields 20,000 liters, of which 40% are Gahi and 60% are Humok. The
selling price of Gahi is P8.75 per liter, and the selling price of Humok is P15.00 per liter.

Required:

A. If the joint costs are allocated on the basis of the products' sales value at the split-off point, what
amount of joint cost will be charged to each product?

B. Breadside has discovered a new process by which G can be refined into Product GG, which has a sales
price of P12 per liter. This additional processing would increase costs by P2.10 per liter. Assuming
there are no other changes in costs, should the company use the new process?

Module 12 ACCTG201 Page 7 of 8

Problem 8. Markham Modems, Inc. recently received a special order to manufacture 10,000 units for a Brazilian company.
This order specified that the selling price per unit should not exceed P50. Because the order was received without the
effort of the Sales Department, no commission would be paid. However, an export-handling charge of P2 per unit would
be incurred. Management anticipates that acceptance of the order will have no effect on other sales.
The company is operating at 80% of capacity, or 80,000 units, and expects to continue at this level for the coming year,
without the Brazilian order. Unit selling price and costs, based on estimated actual capacity for the coming year, are:

Selling price ....................................................................................................................... P65.00

Expenses
Direct materials ............................................................................................................ P15.00
Direct labor .................................................................................................................. 20.00
Variable factory overhead ............................................................................................. 7.50
Fixed factory overhead ................................................................................................. 3.00
Sales commissions ........................................................................................................ 5.00
Other marketing expenses (75% variable) ..................................................................... 2.00
General expenses (25% fixed) ...................................................................................... 4.00
Total..................................................................................................................... P56.50

Required:
a. Prepare an analysis showing the effect on profits if the company accepts the special order.
b. What qualitative factors must the company include before making the decision to accept or reject the order?

Problem 9. Cottage Company has budgeted sales of P300,000 with the following budgeted costs:

Direct materials P60,000

Direct manufacturing labor 40,000
Factory overhead
Variable 30,000
Fixed 50,000
Selling and administrative expenses
Variable 20,000
Fixed 30,000

Compute the average markup percentage for setting prices as a percentage of:
a. The full cost of the product

b. The variable cost of the product

c. Variable manufacturing costs

d. Total manufacturing costs

Module 12 ACCTG201 Page 8 of 8