STRATEGIC COST MANAGEMENT: MODULE 5

RELEVANT COSTING

Decision Making

● Decision Making- it is the determination of a specific action among alternatives which is considered to be the best option

○ Routine Decisions- ones that is being made on a regular basis. Usually, these are pertaining to normal operating cycle of
an entity which occurs on a daily basis, hence there are already set of policies addressing such situation minimizing the
discretion of the decision maker.

■ Examples: What to sell, how much to sell, what to buy, how much to buy, etc

○ Nonroutine Decisions- these are pertaining to situations that are uncommon and will be made under the discretion of the
decision maker. Usually nonroutine decisions arise from events that managers have never dealt with before.

Scientific Approach in Decision Making

1. Set the objective: Usually it is to minimize the benefits and/or minimize the cost

2. Identify the Alternatives: the different options available in order to attain the objectives

a. Make or Buy (Outsourcing Decision)

b. Accept or Reject (Special Orders)

c. Drop or Maintain (Segments)

d. Sell or Process Further (Joint Processing of Products)

e. Constrained Resources (Environment with bottlenecks)

3. Gather Data

a. Relevant Data- those that should be considered in the decision making process

b. Irrelevant Data- those that should be ignored and not included in the analysis

4. Evaluate alternatives based on data gathered: Determination of the advantages and disadvantages for each alternative

5. Make a Conclusion: Select the alternative that will best achieve the objectives

Relevant VS Irrelevant

1. Relevant Revenues and Costs- those expected future revenues and costs that differ among alternatives

a. Differential Revenue and Costs- those that differ between two alternatives

i. Incremental Revenue and Costs are incurred additionally as a result of an activity

ii. Avoidable Revenue and Costs - a cost that can be avoided if a particular option is selected. It is a cost that
would go away

b. Opportunity Costs - the contribution to income that is foregone by not using a limited resource in its best alternative use.

2. Irrelevant Revenues and Costs- those that will not differ no matter what alternative will be chosen

a. Sunk Costs- past costs that have already been incurred and nothing can be done to change it
 b. Committed Costs- those future costs and revenues that will remain the same regardless of the decision to be made

Make or Buy (Minimize Cost)

● Also called outsourcing decision

● General Objective: Whichever of the two options results in the lower cost

● Consideration: the relevant cost to make versus the relevant cost to buy

● Issue: The total cost per unit of a product or service includes a unitized portion of fixed cost, a cost that may continue even if the item
or service is purchased elsewhere at a lower price

● Computation of Costs

Accept or Reject

● A special order is one-time order that is not considered part of the company’s normal ongoing business

● General Objective: Incremental Revenue (Special selling price) should always be higher than the incremental costs

● Consideration: Discounted selling price versus relevant cost to make and sell

● Issue: Since the existing fixed manufacturing overhead costs would not be affected by the order, they are not relevant

● Computation

Drop or Maintain

● General Objective: As long as the segment can contribute in covering common costs, it should not be closed

● Consideration: The contribution margin lost from the activity to be dropped versus avoidable costs

● Issues:
 ○ The key is to proper handling of fixed costs, particularly allocated common costs, and determination if such amounts are
avoidable or unavoidable

○ Mutually exclusive decisions- a segment will be affected by decisions made regarding another segment

● Computation

Segment Revenue (Sales) XX

Less: Variable Cost (XX)

Segment Contribution Margin XX

Less: Direct/Traceable Fixed Costs (XX)

Segment Margin (if positive=Maintain, if Negative= drop) XX

● Incremental Approach with consideration to additional items:

Loss Segment Margin (XX)

Increase in Contribution Margin of other segment XX

Decrease in Contribution Margin of other segment (XX)

Cost incurred in closing the segment (XX)

Increase/Decrease in over-all Operating income XX

Shutdown Point

● Objective: to choose the alternative that will result to the lower loss (choosing the lesser evil)

● This is applicable for companies with products that have seasonal, cyclical or random variation in demand. It is also applicable to
those companies that are in the process of restructuring its operation

● Consideration: Indifference point when to close and to stay open

● Computation: Shutdown point (in units to be sold)

Shutdown Point= (Avoidable Fixed Cost- Shutdown Cost)/Contribution Margin per unit

Sell or Process Further

● A joint production process results in the commingled manufacture of two or more products, called joint products. The product
become identifiable from each other at the split-off point

● Objective: When deciding to process a product the goal is always to maximize profit

● Consideration: The correct decision is made by comparing the separable cost incurred against the amount of increased sales
revenue

● Issue: Joint Costs incurred prior to split-off are not relevant when making the sell-at-split off or process further decision, because
these costs will be incurred regardless of the alternative selected

● Computation:

Sales after further processing XX

Sales at split off point (XX)

Cost to be incurred when process further (incremental cost) (XX)

Net incremental Profit=if positive XX

Constrained Resources

● Constraints- limitations or bottlenecks under which a company must operate, such as limited available machine time or raw
materials, which restrict the company’s ability to satisfy demand

● Objective: To maximize profit in a constrained environment by prioritizing products that will yield the highest

● Consideration: When only one limited resource is present, a company should focus on products that have the greatest amount of
contribution margin per unit of the scarce resource

● Computation Guide:

○ Identify the constraint

○ Compute the CM/unit for each of the product line

○ Compute the Contribution margin per constrained resources

○ Highest CM/constraint would be prioritize or rank 1

● Effect of Market Limitations

○ If the product line with the highest contribution margin has a maximum market demand limit, other resources may be
devoted to the other product line

○ If all the product line has a minimum requirement, this should be prioritized regardless of the ranking, then proceed to the
ranking based on the contribution margin per constrained resource

Sample Problem: Identify whether the ff costs are relevant or irrelevant

● Research and development costs incurred in the prior months

● Contribution Margin of the decrease in regular sales for accepting a special order

● Alternative usage of plant space (rentals to others for a fee, production of new products)

● Cost of inventory acquired several years ago

● Joint production cost incurred

● Depreciation of equipment used in production

● Salary of a manager of a product line that is being considered to be dropped

● Rental costs of additional space for the production of a new product

● Cost of special device that is necessary if a special order is accepted

● Direct Materials, direct labor, and variable overhead incurred on units produced last period

● Further processing costs

● Allocated main office expenses to different departments

● Current market value of old equipment being considered for disposal

● Rental of factory used by the company for regular production in which special orders will likewise be produced

Sample Problem: Make or Buy

Reebok Company manufactures 18,000 units of a certain component per year. This component is used in the production of a main product.
The following are the costs per unit to make the component:

Direct Materials (exclusive of freight charges of 1%) P10

Direct Labor 15

Variable Overhead 7.50

Fixed Overhead 9.50

If the company buys the component from an outside supplier, the company can rent out the released facilities for P24,000 a year. The cost of
the component per unit as quoted by the supplier is P34.00 exclusive of freight charges of 1%

70% of the fixed overhead applied to the component will be continue regardless of what decision is made

1. How much is the relevant cost to make?

2. How much is the relevant cost to buy?

3. How much is the differential cost?

Sample Problem: Accept of Reject a Special Order

At normal capacity, Kuh Company manufactures and sells 80,000 units of product per month. Selling price is P26 per unit. The costs at normal
capacity are as follows:

Direct Materials P720,000

Direct Labor 480,000

Variable Mfg overhead 144,000

Fixed Mfg overhead 220,000

Variable Expenses 96,000

Fixed Expenses 125,000

For the past several months, the company has been operating at 90% capacity. The company has an opportunity to sell 9,000 units from a
special customer at a price of only P21 per unit.

What would be the effect on the overall profit if this special order is accepted?

Sample Problem: Drop or Maintain

A summary statement of profits by operating branches has been prepared by the accountant of SAWI Company showing the results for typical
year (000 omitted
 Manila Pasay San Juan Taguig Total

Sales 8000 20000 15000 7000 50000

Cost and Exp 7000 12000 16000 10000 45000

Net Income 1000 8000 (1000) (3000) 5000

Included in the total costs and expenses of all the branches are some of the costs of the home office (located in QC) that have been allocated
in proportion to sales revenue in the amount of P20,000. All branch costs and expenses can be eliminated if the branch is eliminated.

Which departments should be maintain or drop?

Sample Problem: Shutdown Point

Under normal conditions, Suman Company manufactures 90,000 units of a product line in 6-month period. Selling price is P25 per unit and the
unit variable costs are P15. Fixed costs per annum (incurred uniformly throughout the year) are P360,000. Labor difficulties being experienced
by one of the company’s major customers will decrease total sales volume to only 2,400 units per month. Management plans to close their
plant for 6 months anticipating that the market will normalize after 6 months. Avoidable fixed costs if the company continues operations for 6
months are 70% of fixed costs to be incurred during the 6 month period. Additional costs of P6,000 howeer, will be incurred if the company
resumes operations.

1. What is the net profit or loss if the company continues operations?

2. What is the net profit or loss if the company will shutdown its operations?

3. Compute the shutdown point (in units) for 6 months.

Sample Problem: Sell or Process Further

Bigo Company uses a joint process to produce products N, S and A. Each product may be sold at its split off point or can be processed further
before they are sold. The joint production costs are P85,000 and are allocated using the sales value at split off point.

Product Production (units) SV at split off SV if processed Addtl Cost

N 25,000 50,000 60,000 4,000

S 15,000 75,000 95,000 11,000

A 40,000 30,000 36,000 9,000

What products should be processed further? If all products are processed further, what would be the overall differential profit? How much is the
relevant costs and irrelevant cost?