FSUU-JPIA: Counting to Accounting Triumph

Management Services
Module 1: Relevant Costing

Key Terms:
• Relevant information – the expected future data that differ among alternative courses of
action
• Decision making – process of studying and evaluating two or more available alternatives
leading to a final choice.
• Avoidable cost – a cost that can be eliminated as a result of choosing one alternative
over another in a decision making situation.
• Relevant Cost – expected future cost which differs between the decision alternatives.
• Sunk or historical cost – never relevant in decisions because they are not avoidable and
therefore they must be eliminated from manager’s decision.
• Opportunity Cost - economic benefits given up when an alternative is rejected.
• Out-of-pocket cost – either an intermediate or near-future cash outlay; they are usually
relevant to decisions.

Key Concepts:
• Any cost that is avoidable is relevant.
• Sunk cost and future costs that do not differ between alternatives are irrelevant.

Theory Questions:
1. Which of the following best describes relevant information?
a. Focused on past and differs between the alternatives under consideration
b. Focused on the past and not related to the decision under consideration
c. Focused on the future and differs between the alternatives under consideration
d. Focused on the future and not related to the decisions under consideration

2. A fixed cost is relevant if it is

a. future cost b. sunk
c. avoidable d. product cost

3. Relevant cost are

a. all fixed and variable costs
b. all cost that would be incurred within the relevant range of production
c. past costs that are expected to be different in the future
d. anticipated future costs that will differ among various alternatives

4. Sunk cost are

a. costs that increase due to a higher volume of activity or the performance of an
additional activity
b. costs that a company must incur to perform an activity at a given level, but will not be
incurred if a company reduces or discontinues the activity
c. the profits that a company forgoes by following a particular course of action
d. costs that were incurred prior to making a decision
5. The best characterization of an opportunity cost is that it is
a. relevant to decision making but is not usually reflected in the accounting
records
b. not relevant to the decision making and is not usually in the accounting records
c. relevant to decision making and is usually reflected in the accounting records
d. not relevant to decision making and usually reflected in the accounting records

TYPES OF DECISIONS
• Make or Buy
• Accept or Reject Special Orders
• Drop or Retain a Product or Segment
• Sell as-is or Process Further

MAKE OR BUY DECISION

- A management decision about whether an item should be made internally or bought
from an outside supplier. To put idle capacity to use, firms often consider
manufacturing a part or sub-assembly they are currently purchasing.

Exercise 1:
Assume that Relapse Incorporated is purchasing 2,000 parts from Delulu Company for
₱170 each. If a company makes the part internally, costs will be assigned to the part as follows:
Direct materials ₱ 120,000
Direct Labor 100,000
Variable Overhead 60,000
Fixed Overhead 80,000

Should the company manufacture the parts of buy them from outside supplier?

Solution:
Manufacturing cost per unit will amount to ₱180 (360,000/2,000), which is greater than the ₱170
pesos purchase price if bought from Delulu Company. But looking more closely at the individual
cost component, we will find the inclusion of fixed overhead which will be incurred regardless of
whether or not, the company makes or buys the part.

Incremental Analysis:

Cost to Buy from Delulu Company ₱170.00

Cost to Make Internally

Direct Materials ₱ 120,000
Direct Labor 100,000
Variable Overhead 60,000
280,000/2,000 units ₱140.00
Cost Savings from Making the Part Internally:

Cost to Buy ₱170.00

Cost to Make 140.00
Cost Savings 30.00
Number of units 2,000
Total Cost Savings ₱60,000

Comprehension Check: Make or Buy Decisions

1. In a make or buy decision, an opportunity cost that should be considered is the

a. income that could be generated from the idle production space
b. total cost to produce the item
c. variable cost to produce the item
d. fixed cost to produce the item

2. A company should decide to make rather than buy a part required for their production if the
a. company’s production facility is a full capacity
b. relevant cost per unit of making the part exceeds the per-unit relevant costs of
purchasing the part
c. supplier of the part can produce a higher-quality part
d. supplier of the part has questionable reliability

3. Which of the following qualitative factors favors the buy choice in a make or buy decision for a
component?
a. maintaining a long-term relationship with suppliers
b. quality control is critical
c. utilization of idle capacity
d. the component is critical to product

4. Epektibo Company is considering whether to make 2,000 units of product Haplasi which
costs ₱16 a unit or buy it from outside for ₱15 a unit. Further analysis shows that if the product
Haplasi is outsourced, fixed cost of ₱8,000 attributable to this product will be reduced by 25%. If
the product is outsourced, Epektibo Company will
a. decrease profit by ₱2,000
b. decrease profit by ₱4,000
c. increase profit by ₱2,000
d. increase profit by ₱4,000

Purchase Cost (2,000 x ₱15) ₱ 30,000

Relevant cost to make:
Variable Cost (2,000 x ₱16) – 8,000 ₱ 24,000
Avoidable Fixed Cost (8,000 x 25%) 2,000 26,000
Net Difference ₱ 4,000
ACCEPT OR REJECT SPECIAL ORDERS
- The entity is to check whether it will be beneficial for them to accept or reject a
special order at a certain one-time special selling price or just reject it.

Exercise 2: Bida-bida Manufacturing has an annual plant capacity to produce 2,500 units. Its
operations data are as follows:
Sales revenue 2,000 units at ₱40
Variable Mfg Cost at ₱24 per unit
Fixed Mfg cost ₱17,000
Variable Selling and Administrative Expenses at ₱2.50 per unit
Fixed Selling and Administrative Expenses ₱2,500

Assuming there will be no effect on regular sales at regular prices and that variable selling and
administrative expenses for the special order will go down by half, should the entity accept or
reject a special order for 400 units at a selling price of ₱32?

Incremental Revenue from special order

400units x ₱32 ₱ 12,800
Less: Incremental Costs
Variable Mfg (400units x ₱24) ₱9,600
Variable SAE (400units x ₱1.25) 500 10,100
Incremental Profit in accepting special order ₱ 2,700

Therefore, the entity should accept the special order since it will increase profit by ₱2,700

Exercise 3: Bida-bida Manufacturing has an annual plant capacity to produce 2,000 units. Its
operations data are as follows:
Sales revenue 2,000 units at ₱40
Variable Mfg Cost at ₱24 per unit
Fixed Mfg cost ₱17,000
Variable Selling and Administrative Expenses at ₱2.50 per unit
Fixed Selling and Administrative Expenses ₱2,500

Assuming there will be an effect on regular sales at regular prices and that variable selling and
administrative expenses but an additional fixed manufacturing cost of ₱5,000 will be incurred,
should the entity accept or reject a special order for 500 units at a selling price of ₱45?

Incremental Contribution Margin due to special order:

500units (₱45 - ₱26.50) ₱ 9,250.00
Less: Lost CM for dropping 500 regular units
500units (₱40 – 26.60) ₱6,750
Additional Fixed Cost 5,000 11,750.00
(₱ 2,500.00)
Comprehension Check: Accept or Reject Special Orders

1. An opportunity cost commonly associated with a special order is

a. the contribution margin on lost sales
b. the variable cost of the orders
c. additional fixed cost that is related to the increased output
d. any of the given choices

2. If there is an excess capacity, the minimum acceptable price for a special order must cover
a. variable cost associated with the special order
b. variable and fixed manufacturing costs associated with the special order
c. variable and incremental fixed costs associated with the special order
d. variable costs and incremental fixed costs associated with the special order plus
foregone contribution margin on regular units not produced.

3. Which of the following factors should be considered in deciding whether to accept a special
order?
a. the sales price of the product or service
b. the production capacity of the company
c. the impact on regular customers
d. all of the above

4. The Bagsakan Company has received a special order of 300 units of Product X for ₱6 a unit.
It usually sells for ₱9.50 a unit with a cost of ₱7.50 a unit inclusive of 75-centavos a unit as
sales commission that will not be paid on this order. The cost also includes ₱3 in manufacturing
overhead, two-third of which is for the fair share of depreciation, rent, utilities and supervisor’s
salary. The latter’s (supervisor’s salary) accounts for one-half of this amount. Assuming that
excess capacity is available, and this order requires a mold that costs ₱150, accepting the order
will increase
a. loss by ₱225 b. gain by ₱225
c. loss by ₱375 d. gain by ₱375

Incremental Revenue for special order ₱6.00

Incremental Cost
Regular cost per unit ₱ 7.50
Less: Commission 0.75
Fixed overhead (₱3 x 2/3) 2.00 4.75
Additional fixed cost for special order (₱150/300) 0.50 5.25
Net advantage per unit ₱0.75
Number of units 300
Increase in profit ₱ 225
DROP OR RETAIN A PRODUCT OR SEGMENT
- When management is considering dropping a product line, the only relevant costs
are those that a company would avoid by dropping the product. An important factor
in deciding whether to add or drop a product is the decision’s effect on net income

Exercise 4
Suppose a company furnishes the following recent operating statements for its three
product lines – X, Y, and Z

Product X Product Y Product Z Total

Sales ₱ 400,000 ₱360,000 ₱300,000 ₱1,060,000
Variable Exp. 280,000 216,000 240,000 736,000
Fixed Expenses
Salaries of
30,000 32,000 40,000 102,000
Supervisors
Allocated
8,000 7,200 6,000 21,200
Marketing Cost
Allocated Admin
22,000 22,000 22,000 66.000
Cost
Total Expenses 340,000 277,200 308,000 925,200
Operating
₱60,000 ₱ 82,800 ₱ (8,000) 134,800
Income (Loss)

Management is considering discontinuing Product Z operations. The company can sell assets
used in Product Z operations at book value. They would lay off the supervisor with no
termination pay. Assuming no changes are expected, should the company drop Product Z?

Product X Product Y Product Z Total

Sales ₱ 400,000 ₱360,000 ₱760,000
Variable Exp. 280,000 216,000 496,000
Fixed Expenses
Salaries of
30,000 32,000 62,000
Supervisors
Allocated
8,000 7,200 6,000 21,200
Marketing Cost
Allocated Admin
22,000 22,000 22,000 66.000
Cost
Total Expenses 340,000 277,200 645,200
Operating
₱60,000 ₱ 82,800 ₱ 114,800
Income (Loss)

Comprehension Check: Drop or Retain a Product or Segment

1. The decision to keep or drop products or services involves a strategic consideration of the
a. potential impact on remaining products or services
b. impact on employee morale
c. growth potential of the firm
d. all of the above
2. Which of the following should not be considered in a decision of whether to drop a product
line?
a. Unavoidable costs
b. Avoidable costs
c. Revenue that would be lost
d. Nonfinancial impacts of the decision

3. Kapoy Na Incorporated mines three products – Gold Ore sells ₱1,000,000 per ton, variable
costs are ₱600,000 per ton and fixed mining costs are ₱6,000,000. The segment margin for
2021 was ₱1,200,000. The management of Kapoy Na was considering dropping the mining of
Gold Ore. Only one-half of the fixed expenses are direct and would be eliminated if the segment
was dropped. If the Gold Ore were dropped, net income would
a. Increase by ₱2,000,000 b. Increase by ₱1,200,000
c. Decrease by ₱2,000,000 d. Decrease by ₱1,200,000

The amount of direct fixed expenses that would be eliminated were previously deducted from
segment margin and therefore not considered in the determination of the effect in income.

SELL AS-IS OR PROCESS FURTHER

- Joint product costs are irrelevant in decisions regarding what to do with a product
from the split off point forward because they have already been incurred.
- Cost incurred after split off point for the benefit of only one particular product are
called separable costs. They are relevant costs in the sell-or-process further
decision.
- In sell-process further decision, it will always be profitable to continue processing
further a joint product after the split-off so long as the incremental revenue exceeds
the incremental processing cost

Exercise 5
Assume that three products – M, N, O, are derived from a single raw materials input. Cost and
revenue data relating to the products are presented below:
Product M Product N Product O
Sales value at split-off ₱ 60,000 ₱ 75,000 ₱ 30,000
point
Sales value after 80,000 120,000 45,000
further processing
Allocated joint cost 40,000 50,000 20,000
Cost of further 25,000 30,000 5,000
processing

Which of the product lines should be processed further and which should be sold at split-off
point?
 Product M Product N Product O
Sales value at split-off ₱ 60,000 ₱ 75,000 ₱ 30,000
point
Sales value after 80,000 120,000 45,000
further processing
Incremental Revenue 20,000 45,000 15,000
from further
processing
Incremental cost of 25,000 30,000 5,000
further processing
Profit/Loss (5,000) 15,000 10,000

Product N and O should be processed further while product M should be sold at split off point.

Comprehension Check: Sell as-is or process further

1. Which of the following is relevant in deciding whether to sell joint products at split-off or
process them further?
a. the unavoidable costs of further processing
b. the additional cost of further processing
c. the variable costs of operating the joint process
d. the cost of materials used to make the joint products

2. Last Nalang Company produces a product that can be sold for ₱250,000 at an intermediate
stage. If the company finishes the product, they will incur ₱75,000 of additional material costs
and another ₱15,000 in labor and overhead costs. When finished, the company will be able to
sell the product for ₱350,000. Which of the following is correct?
a. Sell now
b. Finish the product because profits will increase by ₱25,000
c. Finish the product because profits will increase by ₱12,500
d. Finish the product because profits will increase by ₱10,000

Additional Sales (₱350,000 - ₱250,000) ₱100,000

Additional Cost (₱75,000+15,000) 90,000
Additional Profit 10,000