The concept of relevant cost is very key in
making short term decisions
Any cost that is useful for decision making is
often referred to as a relevant cost.
Relevant costs are therefore future costs.
A decision is about the future; it cannot
alter what has been done already.
historic costs/sunk costs are irrelevant for
decision making.
Relevant costs are cash flows:
In essence, any cost or charge that fails to
reflect additional cash spending should be
excluded.
These include: Depreciation as a fixed
overhead incurred.
Relevant costs are incremental or
differential costs
A relevant cost is one which arises as a direct
consequence of a decision
Thus, only costs which will differ under some
or all of the available opportunities should
be considered.
This type of situation arises when a
manufacturer is faced with the decision as to
whether:
(a) to manufacture one of its components in-
house, or
(b) to buy such components from an outside
supplier.
qualitative factors will also be considered in
deciding whether or not to produce in-house:
(a) The quality of the product that will be
bought from outside;
(b) The reliability of the outside supplier;
(c) The possible problems of transport and
handling costs; and
(d) Government regulations, especially on
import from overseas.
(a) If the outside supplier’s quotation is
greater than the total variable cost of
producing the component in-house, then the
component should be manufactured in-
house.
(b) If the total variable cost of in-house
production is higher than the quotation of
the outside supplier, then it will be quite
discrete for the management to purchase the
component from the supplier.
Sky Heights Ltd manufactures components
for aircrafts. The following is the cost sheet
per unit of one of its component:
Prime cost 30
Variable costs 14
Fixed costs 8
Total cost 52
The same component is available at $46 in
the open market. Report to the management
of Sky Heights whether the firm should
manufacture the component or buy it.
Thevariable relevant cost of making a
component is $44 whereas its market price is
$46. Hence, it is economical to manufacture
the component in-house.
a firm is considering whether to
manufacture or purchase a particular
component 223.this would be in batches of
10 000 units and the buying price is 6.50 per
unit. The marginal cost of manufacturing this
component is 4.75 per unit.
The component would have to be made on a
machine which is currently working on a full
capacity. If it manufactured, it is estimated
that the sales of the finished product Z
would be reduced by 1000 units. Product Z
has a marginal cost of $60 per unit and sell
for $80 per unit.
Should
the firm manufacture or buy this
component.
Marginal cost of manufacture 47500
Lost contribution 20 000
67500
Buying price 65 000
A saving of 2500 per ever batch of 10 000
The general decision criteria, on financial
grounds, are that;
1.If a product or a division is making a positive
contribution towards common (general) fixed
costs, then it should not be closed.
2 If there are fixed costs specifically incurred
for a division or a product, then those fixed
costs become relevant costs and net
contribution should be calculated.
A Company produces three products for
which the following operating statements has
been produced.
X Y Z
SALES 32000 52 000 44 000
TOTAL COST 36 000 42 000 33 000
NET PROFIT (4000) 10 000 11 000
Totalcost comprise 2/3 variable ,1/3 fixed
The directors consider that as product X
shows a loss it should be discontinued.
Required:
Based on the above cost data, should product
X be dropped. Motivate your answer.
students to provide to work out
This type of situation arises when a company
receives an order from a customer at a price
lower than its normal selling price.
The company, if working below capacity, may
be advised to accept the offer after taking
into consideration the marginal cost of its
production.
Chaka Limited manufactures a special
product for ladies called ‘the slimming stick‟.
A stick sells for $0.20 per unit. Current
output is 400,000 sticks which represents 80%
level of activity. A customer Gwaya Stores
Limited, recently, placed an order for
100,000 sticks at $0.13 per unit. The total
cost for the period were $56,000 of which
$16,000 were fixed costs. This represents a
total cost of $0.14 per slimming stick.
Required:
(a) Based on the above information, advise
Chaka Limited whether to accept or not to
accept the offer.
Therefore if the answer to the following
questions are in affirmative, the special
price quoted by the customer should be
accepted:
(a) Does the price quoted by the special
customer cover the marginal cost of
production?
(b) Does the company have excess capacity?
Do we the capacity to take the order.
What is our marginal cost.
Does the offer price cover the marginal cost.
Current capacity-400 000 (80%)
Spare capacity- 100 000 (20%)
Total capacity -(500 00) (100%)
Marginal cost =(56000-16 000)
400 000
0.10 per stick
The offer price covers the marginal cost and
therefore should be accepted
The following information relates to G Ltd
Sales (100 000units @$2 each
Labour cost $80 000
Material cost $ 50 000
Fixed cost $30 000
An opportunity has risen to supply additional
units of 30 000 per year at price of $1.8
Acceptance of this order would incur extra
fixed cost of $8 100 per annum and payment
of extra overtime premium of 20% for the
extra direct labour required.
Determine the net profit using marginal cost
principles
Should this order be accepted?
The end
thank you
