Relevant Costing

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Relevant Costing
process of analyzing whether a cost is relevant or not

not all costs are useful in decision making

refer to those that will

future costs

cashflows → cash flow information is required (depreciation and notional costs

should be ignored)

incremental costs → incrase in costs and revenue that occurs as a direct result
of a decision taken that is relevant

avoidable costs

opportunity costs

Irrelevant costs are those that will not cause any difference

sunk costs → does not affect the future cash flows of a business

past costs

committed costs → future costs that cannot be avoided are not relevant

non-cash expenses

general overhead → general and administrative overheads which are not

affected by the decisions under consideration should be ignored

Relevant Costing 1
 Application of Relevant Costing

List of Short-Term Non-Routine Scenarios With Corresponding Decision

Guidelines

Tactical Decision Making

Choosing among alternative with an immediate or limited end in view

Objective is to use idle productive capacity to increase short-run profits

Involves small-scale actions that serve a larger purpose

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 Tactical Decision Making-Process
 Recognize and define the problem

 Identify alternatives as possible solutions to the problem, and eliminate any

unfeasible alternatives

 Identify the costs and benefits associated to the feasible alternative. Eliminate
the costs and benefits that are not relevant to the decisions.

 Compare the relevant costs and benefits for each alternative

 Assess qualitative factors

 Select the alternative with the greated overall benefit

Relevant Costs and Revenues

Relevant costs (revenues): are future costs (revenues) that differ accross
alternatives.

In choosing between two alternatives, only the costs and revenues relevant to
the decision should be considered.

If a future cost is the same for more than one alternative, it has no effect on
the decision

Frequently variable costs - called flexible resources

Past costs
Depreciation represents an allocation of a cost already incurred

Sunk costs: a past cost - a cost already incurred that cannot be affected by
future actions.

always irrelevant

The acquisition cost of the machinery and its associated depreciation should
not be a factor in the make-or-buy decision.

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 Activity resource usage model
A model that classifies resources according to their nature, which allows the
assessment of changes in resources supply (and thus resource spending) as
activity demand for the resource changes.

Focuses on the use of resources and has two categories:

 Flexible resources

 Committed resources

Make-or-Buy Decisions
A decision that focuses on whether a component (service) should be made
(provided) internally or purchased externally.

Outsourcing: the payment by a company for a business function that was formerly
done in-house.

Illustration:
Talmadge Company produces 100,000 units of Part 34B, used in one of its snow-
blower engines, each year. An outside supplier has offered to supply the part for
$4.75. The unit cost is:

Overhead is applied on the basis of machine hours; Part 34B requires 30,000
machine hours per year.

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 Required:

 What are the alternative for Talmadge Company?

The alternatives are to make the part in house or buy the part externally.

 Assume that none of the fixed cost is avoidable. List the relevant cost(s) of
internal production and of external purchase.

The relevant costs of making the part are direct materials, direct labor, and
variable factory overhead.

The relevant cost of buying the part is the purchase price.

 Which alternative is more cost effective and by how much?

Because the fixed overhead is not relevant, the analysis shows a $95,000
advantage in favor of making the part in house.

Name Make Buy Difference

Direct materials $50,000 0 $50,000

Direct labor 240,000 0 240,000

Variable overhead 90,000 0 90,000

Purchase price 0 475,000 475,000

Totals $380,000 $475,000 95,000

 What if $60,000 of fixed overhead is supervision for Part 34B that is

avoided if the part is purchased? Which alternative is more cost effective
and by how much?
Solution:

Name Make Buy Difference

Direct materials $50,000 0 $50,000

Direct labor 240,000 0 240,000

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 Name Make Buy Difference

Variable overhead 90,000 0 90,000

Supervision 60,000 0 60,000

Purchase price 0 475,000 475,000

Totals $440,000 $475,000 $35,000

Now, supervision (part of fixed overhead) is relevant; the analysis shows a

$35,000 advantage in favor of making the part in house.

Keep-or-Drop
A relevant costing analysis that focuses on keeping or dropping a segment of
a business

Illustration:

Dexter Company makes three types of GPS devices. The Basic GPS model is an
entry-level automotive GPS device; it is sold through discounters and
Amazon.com. The Runner's GPS is a miniaturized model that allows the runner to
track mileage, steps, and heart rate while running; it is sold through athletic stores
and on sports gear websites. The Chart Plotter is a specialized GPS device for
sailors; it can be customized with maps of the sea floor and specific geographic
areas of coast line and deep water. It is sold via the Web on dedicated GPS sites.
Dexter Company is considering dropping the Basic GPS line and keeping the
Runner's GPS and Chart Plotter. The segmented income statement is presented
below.

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 Required:

 List the relevant benefits and costs for each alternative.

The relevant benefits and costs of keeping the Basic GPS line include
sales of $450,000, variable costs of $324,000, advertising cost of
$85,000, and supervision cost of $60,000. All common fixed costs are
irrelevant. None of the relevant benefits and costs of keeping the Basic
GPS line would occur under the drop alternative.

 Which alternative is more cost effective and by how much?

Basic GPS

Name Keep Drop Differential Amount to Keep

Sales $450,000 0 $450,000

Less variable costs 324,000 0 324,000

Contribution margin 126,000 0 $126,000
Less direct fixed costs:

Advertising 85,000 0 85,000

Supervision 60,000 0 60,000
Product margin 19,000 0 $19,000

 What if dropping the Basic GPS line would mean a 10 percent loss of volume
for the Runner's GPS device and a 2 percent loss in volume for the Chart

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 Plotter? Which alternative would be more cost effective and by how much?

Basic Runner's Chart

Name Total
GPS GPS Plotter

Sales $0 $882,000 $1,636,600 $2,518,600

Less variable costs 0 334,800 589,568 924,368
Contribution margin $0 $547,200 $1,047,032 $1,594,232

Less direct fixed costs

Advertising 0 124,000 130,000 254,000
Supervision 0 115,000 135,000 250,000

Product margin $0 $308,200 $782,032 $1,090,232

Less common fixed
915,000
expenses

Operating income $175,232

Difference in income = Income with all three lines - Income with only two lines

= $238,400 - $175,232 = $63,168

The analysis shows that dropping the line will actually decrease income by
$63,168. Therefore, the Basic GPS line should be kept.

Special-Order Decisions
Decisions that focus on whether a specially priced order should be accepted
or rejected.

Example of tactical decisions with a short-term focus.

Illustration:

Polarcreme, Inc., an ice-cream company, is operating at 80 percent of its

productive capacity, 10 million one-quart units. An ice-cream distributor from a

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 different geographic region has offered to buy 2 million units of premium ice
cream at $1.75 per unit, provided its own label can be attached to the product.
Normal selling price is $2.50 per unit. Cost information for the premium ice cream
follows:

The special order will not require commissions or distribution (the buyer will pick
up the order at Polarcreme's factory). The order will require 10,000 purchase
orders, 20,000 receiving orders, and 13 setups. In addition, a one-time cost for
the special order's label template will be required at $24,500.

Required:

 List the relevant benefits and costs for each alternative

The relevant benefits and costs of accepting the order include revenue, direct
materials, direct labor, packaging, other variable costs, purchasing, receiving,
setting up, and the cost of the label template. No fixed costs will be affected.
If the order is rejected, the net benefit is zero.

 Which alternative is more cost effective and by how much?

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 Differential Amount to
Name Accept Reject Accept

Sales 2M x $1.75 $3,500,000 $0 $3,500,000

Direct materials 2M x $0.95 1,9000,000 0 1,9000,000
Direct labor 500,000 0 500,000

Packaging 400,000 0 400,000

Other variable costs 100,000 0 100,000
Purchasing 80,000 0 80,000

Receiving 120,000 0 120,000

Setting up $8,000 x 13 set
104,000 0 104,000
ups)
Fixed costs 24,500 0 24,500
Total costs $271,500 0 $271,500

There is a $271,500 increase in operating income if the special order is

accepted.

 What if accepting the special order upset a regular customer who was
considering expanding into the new geographical region and decided, then,
to take their regular annual order of 2 million units of premium ice cream to
another company? Which alternative would be better?

In this case, the regular order, at $2.50 per unit, would be better than the
special order at $1.75 per unit and the company would be better off rejecting
the special order. Even though the special order avoids the commission and
distribution charge, those total only $0.05 per unit, and the company would be
better off making the additional $0.75 in price with the regular customer, not
to mention avoiding the $24,500 for the special label template.

Decisions to Sell or Process Further

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 Sell or process further: relevant costing analysis that focuses on whether or not a
product should be processed beyond the split-off point.

Illustration:
Delrio Company grows and sells fresh and canned food products. The San Juan
farm grows and harvests tomatoes. Each plot yields 1,500 pounds of tomatoes,
referred to as a load; of the 1,500 pounds, 1,000 pounds are Grade A tomatoes
and 500 are Grade B. The cost of growing and harvesting the tomatoes is $200
per load. Delrio can sell the 1,000 pounds of Grade A tomatoes in a load to grocers
for $0.40 per pound. Alternatively, the tomatoes could be processed into hot
sauce. Each bottle of hot sauce sells for $1.50 and requires one pound of
tomatoes. The cost of additional processing averages $1 per bottle; this amount
includes the remaining ingredients, bottles, labor, and needed processing
activities.

Required:

 List the relevant benefits and costs for each alternative.

The relevant benefits and costs of selling at split-off versus processing the
tomatoes further include revenue from sale to grocers and revenue from
selling the hot sauce less the additional (further) processing costs. The $200
per load cost of growing and harvesting the tomatoes is sunk and need not be
considered.

 Which alternative is more cost effective and by how much?

Sell at Process Differential Amount to

Name
Split-Off Further Process Further

Sales 1,000 x
$400 $1,500 $1,100
$0.40
Further
0 1,000 1,000
processing cost
Total $400 $500 $100

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 There is a $100 per load advantage to processing the Grade A tomatoes into
hot sauce.

 What if the best of the Grade A tomatoes, Premium A's, could be sold to
grocers for $0.80 per pound? Of the 1,000 pounds of Grade A tomatoes in a
load, about 30 percent are Premium A's. The grocers, however, will not buy
the Premium A's unless they are also sold the regular Grade A tomatoes.
They will deal with another supplier instead.) It will cost an additional $50
per load to separate the Premium A's from the regular Grade A's. Which
alternative would be better?
Solution:
1,000 pounds x 30% = 300
300 x 0.80 = 240
700 x 0.40 = 280

Sell at Process Differential Amount to

Name
Split-Off Further Process Further
Sales 240 + 280 $520 $1,500 $980
Further
50 1,000 950
processing cost
Total $470 $500 $30

There is a $30 per load advantage to processing the Grade A tomatoes into
hot sauce.

Decision Model

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 set of procedures that, if followed, will lead to a decision

Tactical cost analysis

use of relevant cost data to identify the alternative that provides the greated
benefit to the organization

Includes predicting costs, identifying relevant costs, and comparing relevant

costs

Activity Resource Usage Model

focuses on the use of resource

Categories

 Flexible resources

purchased in the amount needed and at the time of use

 Committed resources

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 acquired in advance of usage through implicit contracting

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 In drop, there is no benefit nor loss

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 May 2 percent decrease

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 Ans: A

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