WEEK 7 - RELEVANT COSTING

Making decisions is one of the basic functions of a manager.

To be successful in decision making, managers must be able to perform

differential analysis, which focuses on identifying the costs and benefits that
differ between alternatives. Identify relevant costs and revenue.

The purpose of this chapter is to develop these skills by illustrating their use
in a wide range of decision-making situations

Q1) What is RELEVANT COSTS vs NOT RELEVANT COSTS ?

You have an old mobile phone bought for $1,000 two years ago. You can
trade-in for $150. Alternatively, you can repair it for $40 and sell it for
$200.

What will you do?

Trade-In Repair Difference

(RELEVANT)
Sales revenue 150 200 +50
Costs 0 -40 -40
Profit 150 160 +10

Recommend to repair because $10 more cash.

RELEVANT NOT RELEVANT (ignore)

1 Differ among alternative options Fixed costs in general(cannot avoid)
2 Involve cash inflow or outflow Non-cash, eg, depreciation expense
3 Expected future costs & revenue Sunk costs (past)
4 Avoidable costs (fixed costs) Not avoidable
5 Opportunity cost Allocated corporate (HQ) cost

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Relevant Costs

To be relevant a cost (revenue) item must meet the following criteria:

1. NOT Historic (sunk) costs

l Sunk costs are past costs (i.e. have been incurred prior to a
decision point). You cannot avoid it.

2. MUST BE DIFFERENT it must be an expected future cost (or

revenue) –
l it must differ among alternative courses of action
l if they do not differ, then they will not matter and will have no
bearing on the decision making
l Additional costs incurred as a consequence of a decision
between two or more alternative courses of action.
l Variable costs are relevant costs, unless given an indication to
the contrary

3. Avoidable Costs
Costs that can be identified with an activity or sector of a business and
which can be avoided if that activity or sector did not exist. Costs that
would not be incurred if the activity to which they relate did not exist

4. Opportunity Costs
The potential benefit given up when one alternative is selected over
another. These do not appear in the profit and loss account, but they are
very real for decision making

NOT Relevant Costs

Ignore everything else e.g. sunk costs and future costs and benefits that do not
differ between the alternatives and non-cash items such as depreciation.

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Q2) How to MAKE SHORT-TERM BUSINESS DECISIONS?

5 short-term decision-making problems

1. Special selling price decisions (special order)

2. Product-mix decisions when capacity constraints exist

3. Decisions on replacement of equipment

4. Outsourcing (Make or buy) decisions

5. Discontinuation decisions.

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(1) Special pricing decisions (Special order)

REQUIRED:

(1) The excess capacity is temporary. A hotel in Queensland has offered

to buy 3,000 towels at a price of $20 per unit. Extra selling costs for
the order = $1 per unit.

Should Victoria Corp accept the special order from the hotel in
Queensland?

(2) In (1) above example, it was assumed that the spare capacity is
temporary. Assume now spare capacity is long term.

a. Also assume that an opportunity for a contract of 15,000 units per

month at $25 special price emerges involving extra selling cost of $1
per unit. No other opportunities.

b. If this contract is not accepted:

i. direct labour will be reduced by 30%,
ii. manufacturing non-variable costs will be reduced by $70,000
per month,
iii. marketing costs will be reduced by $20 000,
iv. Unutilised facilities can be rented out at $25,000 per month
Should Victoria Corp accept the special order?

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Recommendation : Accept the special because profit will increase by $27,000.

Recommendation : Reject the special because profit will decrease by -$31,000.

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(2) Product mix decisions with limited productivity capacity
(Constraint resources)

REQUIRED:

How should the company allocate its limiting factor to maximise profit?

The main decision is to direct limited resources (machine

hours) to products that gives you the largest contribution per
unit of limiting resource (machine hour).

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 (3) Equipment replacement

REQUIRED:

Should the Company retain the old machine OR buy the new machine?

Recommendation : Buy the new machine because the overall costs is lower by $30,000.

1. Variable (operating) costs is relevant

2. Disposal value of the old equipment (+cash flow)
3. Original cost, carrying value , depreciation expense of the old equipment is NOT
relevant.

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(4) Outsourcing (make or buy decisions)

l A supplier has offered to supply 10,000 components per annum at a

price of $30 per unit for a minimum of three years.
l If the components are outsourced the direct labour will be made
redundant.
l Direct materials and variable overheads are avoidable and
l fixed manufacturing overhead would be reduced by $10,000 per
annum but non-manufacturing costs would remain unchanged. The
capacity has no alternative uses

REQUIRED:

(1) Should the Company manufacture or outsource the components?

(2) Assuming the released internal capacity arising from outsourcing

can be used to generate rental income or profit contribution of
$90,000. Will your decision change? Should the Company now
manufacture or outsource the components?

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The main decision criteria is which option is cheaper. Need consider any opportunity, if
any.

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(5) Discontinuation decisions

Periodic profitability analysis ($000):

Assume that special study indicates that $250,000 of Central fixed costs
and ALL variable costs are avoidable and $108,000 fixed costs are
unavoidable if the Central territory is discontinued.

358 – 108 = 250 is avoidable fixed cost!!!!

REQUIRED:

Should the Company discontinue Central territory?

Managers should consider what cost items can be eliminated

and what cannot be eliminated if we discontinue the operation
(central) or product.

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Challenging Questions

10.25 Closing and opening stores

Thompson Ltd runs two convenience stores, one in Ballarat and one in Bendigo. Operating
profit for each store in 2017 is as follows:

Ballarat Bendigo store

store
Revenues $1 070 000 $ 860 000
Operating costs
Cost of goods sold 750 000 660 000
Lease rent (renewable each year) 90 000 75 000
Labour costs (paid on an hourly basis) 42 000 42 000
Depreciation of equipment 25 000 22 000
Utilities (electricity, heating) 43 000 46 000
Allocated corporate overhead 50 000 40 000
Total operating costs 1 000 000 885 000
Operating profit (loss) $70 000 $(25 000 )

The equipment has a zero disposal value. In a senior management meeting, Maria Lopez,
the management accountant at Thompson Ltd, makes the following comment,
‘Thompson can increase its profitability by closing down the Bendigo store or by adding
another store like it.’

Required
1. By closing down the Bendigo store, Thompson can reduce overall corporate
overhead costs by $44 000. Calculate Thompson’s operating profit if it closes the
Bendigo store. Is Maria Lopez’s statement about the effect of closing the Bendigo store
correct? Explain.

2. Calculate Thompson’s operating profit if it keeps the Bendigo store open and
opens another store with revenues and costs identical to the Bendigo store (including
a cost of $22 000 to acquire equipment with a one-year useful life and zero disposal
value). Opening this store will increase corporate overhead costs by $4000. Is Maria
Lopez’s statement about the effect of adding another store like the Bendigo store
correct? Explain.

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Recommend: Open new store because profit increase
by $11,000. Maria is correct.

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 10.22 Relevant costs, contribution margin, product emphasis (week 9)

The Beach Shack is a take-away food store at a popular beach. Susan Pratt, owner of
the Beach Shack, is deciding how much refrigerator space to devote to four different
drinks. Pertinent data on these four drinks are as follows:

Cola Lemonade Flavoured Natural

milk orange juice
Selling price $18.80 $20.00 $27.10 $39.20
per case
Variable cost $14.20 $16.10 $20.70 $30.20
per case
Cases sold per 25 24 4 5
metre of shelf
space per day

Susan has a maximum front-shelf space of 12 metres to devote to the four drinks. She
wants a minimum of 1 metre and a maximum of 6 metres of front-shelf space for each
drink.

Required
1. Calculate the contribution margin per case of each type of drink.

2. A co-worker of Susan’s recommends that she maximise the shelf space devoted
to those drinks with the highest contribution margin per case. Evaluate this
recommendation.

3. What shelf-space allocation for the four drinks would you recommend for the
Beach Shack? Show your calculations.

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Q10-22 Flavoured Orange
1 Cola Lemonade milk Juice
Selling price
Deduct variable cost per case
Contribution margin per case

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1. The argument fails to recognise that shelf space is the constraining factor. There are
only 12 metres of front shelf space to be devoted to drinks. Pratt should aim to get the highest
daily contribution margin per metre of front shelf space:
3 Flavoured Orange
Cola Lemonade milk Juice
Contribution margin per case
Sales (number of cases) per metre
off shelf space per day ´
Daily contribution per metre

1. The allocation that maximises the daily contribution from drink sales is:
Daily Total
Metres of
Contribution Contribution
Shelf Margin per
per Metre of
Space Day
Front Shelf
Space
Cola
Lemonade
Natural orange juice
Flavoured milk
Total

The maximum of six metres of front shelf space will be devoted to Cola because it
has the highest contribution margin per unit of the constraining factor. Four metres
of front shelf space will be devoted to Lemonade, which has the second highest
contribution margin per unit of the constraining factor. No more shelf space can be
devoted to Lemonade since each of the remaining two products, Natural orange juice
and Flavoured milk (that have the second lowest and lowest contribution margins per
unit of the constraining factor) must each be given at least one metre of front shelf
space.

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REVIEW BELOW QUESTION ON YOUR OWN

7.27 Life-cycle costing

Top Notch Ltd (TNL) has been producing home furniture for over 40 years. Charles Strong,
the owner, has decided he would like to manufacture an executive desk that contains
space for not only a laptop dock but also an MP3 player dock. Based on his experience
with furniture, he believes that the desk will be a popular item for four years, and will then
be obsolete because technology will have changed again.
TNL expects the design phase to be very short, maybe four months. There is no R&D cost
because the idea came from Charles, without any real research. Also, fixed production
costs will not be high because TNL has excess capacity in the factory. The TNL accountants
have developed the following budget for the new executive desk:
Fixed Variable
Months 1–4 Design costs $700 000 __
Months 5–36 Production $9 000 $225 per desk
Marketing 3 000 __
Distribution 2 000 $20 per desk
Months 37–52 Production $9 000 $225 per desk
Marketing 1 000 __
Distribution 1 000 $22 per desk

The design cost is for the total period of four months. The fixed costs of production,
marketing and distribution are the expected costs per month.
Required
Ignore the time value of money.
1. Assume that TNL expects to make and sell 16 000 units in the first 32 months
(months 5–36) of production (500 units per month) and 4800 units (300 per month)
in the last 16 months (months 37–52) of production. If TNL prices the desks at $500
each, how much profit will TNL make in total and on average per desk?
2. Suppose that TNL is wrong about the demand for these executive desks and after
the first 36 months stops making them altogether. It sells 16 000 desks for $400
each with the costs described for months 5–36 and then incurs no additional costs
nor generates additional revenues. Will this have been a profitable venture for
TNL?
3. Will your answer to requirement 2 change if TNL must nevertheless incur the
estimated fixed production costs for the whole period to month 52, even if TNL
stops making executive desks at the end of 36 months?

Solution: (25-30 min.)

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Life-cycle costing
1.
Projected Life Cycle Income Statement
Revenues [A$500 ´ (16 000 + 4 800)] A$10 400 000
Variable costs:
Production [A$225 ´ (16 000 + 4 800)] 4 680 000
Distribution [(A$20 ´ 16 000) + (A$22 ´ 4 800)] 425 600
Contribution margin 5 294 400
Fixed costs:
Design costs 700 000
Production (A$9 000 ´ 48 months) 432 000
Marketing [(A$3 000 ´ 32 months) + (A$1 000 ´ 16
months)] 112 000
Distribution [(A$2 000 ´ 32 months) + (A$1 000 ´ 16
months)] 80 000
Life cycle operating profit A$ 3 970 400

A$3 970 400

Average profit per desk = = A$190.88
(16 000+ 4800)

2.
Projected Life Cycle Income Statement
Revenues (A$400 ´ 16 000) A$6 400 000
Variable costs:
Production (A$225 ´ 16 000) 3 600 000
Distribution (A$20 ´ 16 000) 320 000
Contribution margin 2 480 000
Fixed costs:
Design costs 700 000
Production (A$9 000 ´ 32 months.) 288 000
Marketing (A$3 000 ´ 32 months.) 96 000
Distribution (A$2 000 ´ 32 months.) 64 000
Life cycle operating income A$1 332 000

The new desk design is still profitable even if TNL drops the product after only 32
months of production. However, the operating income per unit falls to only
A$83.25
(A$1 332 000 ÷ 16 000 desks) per desks.

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3.
Life cycle operating income (requirement 2) A$1 332 000
Additional fixed production costs (A$9 000 ´ 16
months.) 144 000
Revised life cycle operating income A$1 188 000

No, the answer does not change even if TNL continues to incur the fixed production
costs for the full 48 months. The revised operating income for the new executive
æ A$1 188 000 ö
desk becomes A$1 188 000, which translates into A$74.25 ç ÷ operating
è 16 000 desks ø
income per desk.

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