RELEVANT COSTING

Management Advisory Services

I. OVERVIEW

Basics of decision making

● Information is essential to arrive at a sound decision
● Information is gathered from internal and external sources.

Note:
Information like past data and current data are analysed as basis for estimation of costs, to
forecast and the basis of decision analysis. There must be a combination of quantitative and
qualitative information.

Internal sources- company records

External sources- supplier (for make or buy) or competitors (for accept or reject special
order)

II. THE DECISION MAKING PROCESS

1. Define the Problem

- For each problem there is different relevant information. It always changes based on
the problem at hand. Know the problem to solve whether to make or buy, accept or
reject, continue or discontinue, sell or process further.
2. Obtain Information
- Information must be relevant in the decision analysis.
3. Identify Alternatives
- What are the possible solutions to the situation/problem? Identify atleast two
alternatives like to make or buy, and accept or reject etc.
4. Determine possible consequence of the alternatives
- Quantitative side- what are the effect of each alternative on revenue, cost and profit
- Qualitative side- it will determine the long term effect of each alternative.
5. Choose the best alternative and implement the decision
6. Evaluate performance
- Evaluate if desired objectives are met.

III. APPROACHES IN ANALYZING ALTERNATIVES

Total Approach
- Analyzes information by preparing complete set of financial reports for each
alternative
 - Reports include all revenues and expenses whether relevant or not.
- This approach is not advisable because it tends to become misleading
because of the inclusion of irrelevant costs.

Differential Approach
- Analyzes only information that changes between alternatives
- Costs that will remain the same are excluded
- This method is preferred over the Total Approach because it is simple and
easy to analyze

IV. DEFINITION AND IDENTIFYING RELEVANT COSTS

Definition
Relevant Cost is a FUTURE COST that changes between two alternatives.

Identifying Relevant cost

A cost that changes between two alternatives is highly dependent on the
decision situation.
Note: What is relevant in one situation might not be relevant in another situation.

Examples of Relevant Cost

a. Variable cost
b. Avoidable / Incremental fixed cost
c. Imputed cost
d. Opportunity Cost
e. Savings

Identifying Relevant Cost

SAMPLE PROBLEM 1

Laurel Corporation has its own cafeteria with the following annual costs:

Food P100,000
Labor 75,000
Overhead 110,000
TOTAL P285,000

The overhead is 40% fixed. Of the fixed overhead, P25,000 is the salary of the cafeteria
supervisor. The remainder of the fixed overhead has been allocated from total company
overhead. Assuming the cafeteria supervisor will remain and that laurel will continue to pay
his/her salary. Identify the relevant costs.

Solution:
 Food P100,000
Labor 75,000
Overhead- Variable 66,000
TOTAL 241,000

Note: Salary of supervisor is unavoidable therefore it is an irrelevant cost.

SAMPLE PROBLEM 2

Power Systems Inc. manufactures jet engine for the United States armed forces on cost plus
basis. The cost of a particular jet engine the company manufactured is shown below.

Direct Materials P200,000

Direct Labor 150,000
Overhead:
Supervisor’s salary 20,000
Fringe’s Benefit on direct labor 15,000
Depreciation 12,000
Rent 11,000
TOTAL COST 408,000

If production of this engine were discontinued, the production capacity would be idle, and the
supervisor would be laid off. Identify the relevant costs.

Solution:
DIrect materials P200,000
Direct labor 150,000
Overhead :
Supervisor’s salary 20,000
Fringe benefits on direct labor 15,000
TOTAL P385,000

Note:
Depreciation is a sunk cost. A sunk cost is already incurred in the past and no longer relevant in
decision making.

Rent is a committed cost that will be incurred regardless of what will happen.
An example of a committed cost is a contract of lease. When you enter into a contract of lease, you
are obligated to pay rent during the given period of time. Hence, not relevant for decision making.

V. IRRELEVANT COSTS

Discretionary Cost
- Discretionary cost is inherent to the operation. It can be delayed in the current
period but eventually will be incurred.
 Examples are repairs and maintenance expense , training and development
costs, advertising expense, etc.

Committed Cost
- Commited cost is a cost that the company is obligated to incur and cannot get
out of it.

Example is rent expense in a contract of lease.

Sunk Cost
- Is a historical cost that will no longer change between two alternatives.

Examples are Joint Costs in Sell-as-is or Process further, cost of obsolete

inventories, and cost of old equipment in replacement decisions.

VI. DECISION MAKING GUIDE

General Rule

Quantitative Approach
- Deals with analyzing factors that are measurable in terms of peso impact on
profits. The basic rule is choose the alternative that will increase profits.
- Most quantitative approaches deal with short term costs
-

Qualitative Approach
- Deals with analyzing not financial factors that will indirectly affect profitability.
- The guide is to choose the alternative that will possibly increase company
profitability in the long run.

Indifference point
- The point wherein the cost of alternatives are the same
- Under these conditions the decision maker will heavily rely on qualitative
information to determine the best alternative.

Indifference point example:

JJ Motors Inc. employs 45 sales personnel to market its line of luxury automobiles.
The average car sells for P23,000 and a 6% commission is paid to the sales person.
JJ motors is considering a change to commission arrangement that would pay each
salesperson a salary of P2,000 per month plus a commission of 2% of the sales
made by that salesperson. The amount of total monthly car sales at which JJ Motors
would be indifferent as to which plan to select?

Solution:
 Old New
Commission 6% 2%
Salary - 2,000

Therefore 2,000 =4%

Indifference point per person = 2,000/4%
= 50,000
Indifference point in total sales = 50,000 X 45
= P2,250,000

Proof:
Old
2,250,000 x 6% = 135,000

New
2,250,000 x 2% = 45,000
2,000 sal. X 45 = 90,000
= 135,000

Algebraic Approach

X = indifference point of sales per person

.06x = .02x + 2,000

-.02x+.06x = 2,000
.04x = 2,000
.04 .04
X = 50,000

Indifference point in total sales = 50,000 x 45 salesperson

= 2,250,000

Under what situation will I need to analyze?

When analyzing alternatives, identify the alternative that will create a change in net
income.

VII. MAKE OR BUY

Make or buy is basically an analysis of avoidable cost. If you make you will avoid the cost of
buying, and if you buy you will avoid the cost of making. Choose the option that involves the
lowest cost.
Relevant costs to make usually include variable costs whether manufacturing, selling or
administrative costs, avoidable fixed cost, and opportunity cost . Opportunity cost arises if
there are alternative uses of facilities used to make the component .

Relevant costs to buy usually include acquisition price and incidental costs related to the
purchase such as freight in, inspection costs, and set-up costs of components.

Qualitative factors include employee morale if the component was purchased and the quality
of component if purchased.

1. Garfield Company manufactures Part G for use in its production cycle. The cost per unit
for 10,000 units for Part G are as follows:

Direct materials P3
Direct labor 15
Variable overhead 6
Fixed overhead 8

Odie Company has offered to sell Garfield 10,000 units of Part G for P30 per unit. If Garfield
accepts Odie’s offer, the released facilities could be used to save P45,000 in relevant costs
in the manufacture of Part H. In addition P5 per unit of the fixed overhead applied to Part G
would be totally eliminated. What alternative is more desirable and by what amount is it more
desirable?

Solution- Total Approach

Make Buy
Direct materials P3 Acquisition Price P30
Direct labor 15
Variable OH 6
Avoidable fixed OH 5
Savings on Part H 4.50
Total P33.50

Cheaper to buy, 3.50 / unit or 35,000 in total.

Solution- Net Approach

Make Buy
Direct materials P3 Acquisition Price P30
Direct labor 15 Savings on Part H (4.50)
Variable OH 6 Total P25.50
Avoidable fixed OH 5
Total P29
 Cheaper to buy, 3.50 / unit or 35,000 in total.

2. Regis Company manufactures plugs used in its manufacturing cycle at a cost of P36 per
unit that includes P8 of fixed overhead. Regis needs 30,000 of these plugs annually, and
Orlan Company has offered to sell these units to Regis at P33 per unit. If Regis decides to
purchase the plugs, P60,000 of the annual fixed overhead applied will be eliminated and the
company may be able to rent the facility previously used for manufacturing the plugs.

If Regis Company purchases the plugs but does not rent the unused facility, how much will
be the per unit savings/loss?

Solution:

Make Buy
Acquisition Price P33
Variable OH P28
Avoidable fixed OH 2
Total P30

P3 unit loss or 90,000 loss

If the plugs are purchased and the facility rented, Regis Co. wishes to realize 100,000 in
savings annually. To achieve this goal, how much is the minimum annual rent on the facility?

Incremental Revenue _190,000_ Incremental loss (90,000)

Net Advantage, P100,000

VIII. ACCEPT OR REJECT A SPECIAL ORDER

This involves a situation where the company should accept a special order which usually
requires a price much lower than the regular selling price.

Accept the special order provided that incremental revenues are greater than incremental
costs of accepting the special order.

Only relevant cost incurred are relevant. Avoidable Cost is not relevant

The minimum price includes variable costs incurred plus incremental fixed costs of the
special order and opportunity costs if any.

Qualitative factors include reaction of existing customers and potential future profitability of
the new customer.
1. Stephen Company manufactures men’s caps. The projected income statement for
the year before any special order is as follows:

Amount Per unit

Sales P400,000 P20
COGS 320,000 16
Gross Margin 80,000 4
Selling expenses 30,000 3
Operating income P50,000 P1

Fixed costs included in the above projected income statement are 80,000 in COGS and
9,000 in selling expenses.

A special order offering to buy 2,000 caps for P17 each was made to Stephen. No additional
selling expenses will be incurred if the special order is accepted. Stephen has the capacity to
manufacture 2,000 more caps. As a result of the special order, how much would the
operating income increase?

Solutions:

Selling price of special order P17

Less: Incremental cost of special order 12*
(320k-80k)/20,000 units
Incremental profit per unit P5
Special Order quantity x 2,000

Incremental profit of accepting P10,000

● 20,000 units = P400,000/ P20

2. Woods Co. is approached by a new customer to fulfill a large one-time only special order
for a product similar to one offered to regular customers. The following per unit data apply for
sales to regular customers:

Direct materials P 100

Direct labor 125
Variable manufacturing OH 60
Fixed manufacturing support 75
Total manufacturing costs 360
Mark up (60%) 216
Targeted selling price 576

Woods Co. has excess capacity. The customer wants the product to use a higher grade
material, so direct material costs will increase by P30 per unit.
What is the minimum acceptable price of this one-time only special order?

Solution:
Direct materials P 100
Direct labor 125
Variable manufacturing OH 60
Incremental Direct materials 30
Minimum price P315

Other than price, what other items Woods Co. consider before accepting this one-time
only special order?

What is the minimum price if there is no idle capacity?

Solution:

Original selling price P 576

Incremental direct materials 30
Minimum Price P606

OR

Variable manufacturing P 315

Opportunity Cost 291
Minimum Price P 606

3. Kator Inc. manufactures industrial components. One of its products that is used as a
sub-component in auto manufacturing is KB-96. The selling price and cost per unit data for
KB-96 is as follows:

Per Unit Data

Selling price P150
Direct materials 20
Direct labor 15
Variable manufacturing overhead 12
Fixed manufacturing overhead 30
Variable selling 3
Fixed selling and administrative 10
Total costs 90
Operating Margin P 60

Kator Inc. received a special, one-time order for 1,000 KB-96 parts. Assuming Kator has
excess manufacturing capacity, the minimum unit price for this special one-time order should
not be lower than?
 Solution:

Direct materials 20
Direct labor 15
Variable manufacturing overhead 12
Variable selling 3
Minimum Price P50

Kator Inc. received a special, one-time order for 1,000 KB-96 parts. Kator has an alternative
use of its capacity to produce an LB-64 part, which would produce a contribution of P10,000
using the same amount of capacity. The minimum unit price for this special, one-time KB-96
part order should not be lower than?

Solution:

Variable cost P50

Opportunity cost 10
Minimum Price P60

IX. CONTINUE OR DROP/SHUTDOWN A BUSINESS SEGMENT OR PRODUCT LINE

Continue vs Discontinue

Involves an analysis if a business segment, which may be a product line, a

department, or a branch be discontinued.

Continue provided that the contribution margin is positive if there are no avoidable
fixed costs. (short-run test)

Continue if the segment income is positive. (long-run test)

Qualitative factors include reaction of customers if a product is discontinued, and

effect on employees if discontinued.

1. ABD Realty manages five apartment complexes in a three-state area. Shown below are
summary income statements for each apartment complex

Summary Income Statements

(In thousands)

One Two Three Four Five

Rental Income P1000 P1,210 P2,347 P1,878 P1,065
Expenses 800 1,300 2,600 2,400 1,300
Profit P 200 P (90) P(253) P(522) P(235)

Included in the expenses is P1,200,000 of corporate overhead allocated to the apartment

complexes based on rental income.

Solution:
One Two Three Four Five
Profit P 200 P (90) P(253) P(522) P(235)
Allocated FC 160 194 376 300 170
Segment NI P360 P104 P123 P(222) P(65)

2. The Silk Company has two divisions North and South . The Divisions have the following
revenues and expenses.

North South
Sales P720,000 P350,000
Less: Costs and expenses
Variable costs 370,000 240,000
Traceable fixed costs 130,000 80,000
Allocated common corporate costs 120,000 50,000
Operating income/loss P100,000 P(20,000)

Traceable fixed cost is avoidable if a division is closed.

How much is the company’s net income if division South was discontinued?

Solution:
Net income of north P100,000
Less: Allocated cost of South 50,000
Overall NI w/o South P50,000

3. Zorro Company produces and sells 8,000 units of Product X each year. Each unit of
Product X sells for P10 and has a contribution margin of P6. It is estimated that if Product X
is discontinued, P51,000 of the 60,000 in fixed costs charged to product X could be
eliminated.

What is the overall increase or decrease in income if Product X was discontinued ?

Solution:
Total CM P48,000
Less: Avoidable fixed 51,000
Segment net loss P (3,000)
 Compute for the shutdown point in pesos and in units

Solution:

Units Pesos
= P51,000 / P6 = P51,000/60%
= 8,500 units = P85,000

Sales P85,000
Less: Variable cost 34,000
CM 51,000
Less: Avoidable fixed costs 51,000
Segment Net Income P -0-

X. SELL AS IS OR PROCESS FURTHER

The situation analyzes the profitability of a joint product if it is sold as is at the split-off
point or processed further.

Decide to process further only if incremental revenue is greater than further processing
cost or cost incurred beyond the split-off point.
IGNORE JOINT COSTS, regardless if allocated or not, because it is sunk cost.

Joint costs-
cost incurred in simultaneously manufacturing two or more products that are difficult
to identify individually as separate types of products until the products reach a certain
processing stage known as the “split-off point”

Split-off point
A point in the manufacturing process where some or all of joint products can be
recognized as distinct and separate products.

Further processing costs

costs incurred beyond the split-off point as separated joint products are to be
processed further.

1. Cole Co. owns a large processing line which segregates coconuts into its components
upon contact with the breaker of the machine. Presently it sells the coconut meat, juice,
shell, and husk to various manufacturers. A feasibility study is being made to process its
components into “buko pies'’ for the meat, “biko juice” for the juice flower pots for the shells,
and fuel briquets for the husk.

At the segregation point, you gathered the following data per unit:
 Meat Juice Shell Husk
Selling price P4.00 P2.00 P1.00 P1.00
Allocated joint cost 0.13 0.06 0.03 0.03
Profit(loss) P3.87 P1.94 P0.97 P0.97

The study shows that after further application of additional manufacturing process, the
following is projected:

Selling price P12.00 P4.00 P2.00 P2.00

Additional Processing cost 3.80 2.90 1.95 1.95

Fixed cost of the plant amounts to P500,000. Interest rate is 12%.

Which product should go through the additional manufacturing process?

Solution:
Incremental Revenue - Incremental cost = Incremental P/L

Meat (P12 - 4) - P3.80 = P4.20 process further

Juice (P4 - 2) - P2.90 = P (0.90) sell as is
Shell (P2 - 1 ) - P1.95 = P(0.95) sell as is
HUsk (P2 - 1 ) - P1.95 = P(0.95) sell as is

XI. BEST PRODUCT COMBINATION AND OPTIMIZATION OF SCARCE RESOURCES

Best Product Combination

This situation involves a company producing multiple products but is faced with one
limited or scarce resource.

The decision guide is to prioritize the product with the highest contribution margin per
limited resources. If there is idle capacity, the decision would be to prioritize the product
that has the highest contribution margin per unit.

1. Homes Company produces three products, with costs and selling prices as shown
below:

A B C
Selling price per unit P30 100% P20 100%
P15 100%
Variable cost per unit 18 60% 15 75% 6
40%
Contribution Margin P12 40% P5 25% P9
60%
 A particular machine is a bottleneck. On that machine, 3 machine hours are
required to produce each unit of Product A, 1 hour is required to produce each unit
of Product B, and 2 hours are required to produce each unit of Product C. In what
order should it produce its products?

Solution:
A B C
Contribution margin P12 P5 P9
Production hours 3 hrs 1 hr 2hrs
CM/ hour P4 P5 P4.50

Hence, BCA

2. Nortons Mufflers manufactures three different product lines, Model X, Model Y, and Model
Z. Considerable market demand exists for all models. The following per unit data apply:

Model X Model Y Model Z

Selling Price P80 P90 P100
Direct materials 30 30 30
Direct labor (P10/ hr) 15 15 20
Variable support costs
(P5/ machine hr) 5 10 10
Fixed Support costs 20 20 20

For each model compute the contribution margin per unit.

Solution:

Model X Model Y Model Z

Selling Price P80 P90 P100
Direct materials 30 30 30
Direct labor (P10/ hr) 15 15 20
Variable support costs
(P5/ machine hr) 5 10 10
CMU P30 P35 P40

For each model compute the contribution margin per machine hour.

Solution:
Model X Model Y Model Z
Variable support costs
(P5/ machine hr) 5 10 10
CMU P30 P35 P40
Required machine hours 1 hr 2 hrs 2 hrs
CMU/ hr = P30 =P17.50 =P20
 END OF SLIDE

ADDITIONAL NOTES- FORMULAS AND GUIDELINES

A. MAKE OR BUY DECISIONS

Guideline: Compare the cost to make with the cost to buy and choose the least costly
option. The possible cost for each are provided below:

Cost to Make

Avoidable variable costs:

Direct materials
Materials handling
Direct labor
Variable manufacturing OH

Avoidable fixed costs

Opportunity cost

Cost to Buy

Purchase price

Materials handling

B. ACCEPT OR REJECT A SPECIAL ORDER

Guideline: Accept the order when the incremental revenue exceeds the incremental cost.
Incremental cost would depend whether the company has excess capacity to satisfy the
special order or not ( the latter would incur opportunity costs). The formula is as follows:

Incremental Revenue Php XXX

Less: Incremental costs:
Direct materials Php xxx
 Direct labor xxx
Variable manufacturing overhead xxx
Variable selling expenses xxx
Opportunity Costs xxx
Additional Fixed costs xxx (XXX)
Incremental Profit Php XXX

C. CONTINUE OR SHUTDOWN A BUSINESS SEGMENT PRODUCT LINE OR

BRANCH

Guideline 1: Continue if avoidable revenue is greater than its avoidable cost.

AVOIDABLE REVENUES

Sales Revenue

Opportunity Costs

AVOIDABLE COSTS

Variable costs

Traceable fixed costs

Avoidable common fixed costs

Other avoidable costs

Guideline 2 : Look for the segment margin. If it is positive, better to continue. If the company
has no choice but to drop a segment, drop the one with the least segment margin. You will
recall the computation of segment margin:

Sales Php XXX

Less: Variable expenses (XXX)
Contribution Margin XXX
Less: Traceable fixed expenses (XXX)
Segment Margin XXX
Less: Common fixed Expenses XXX
Net Income XXX
 D. SELL OR PROCESS FURTHER A PRODUCT

Guideline: Compare the additional revenue to additional costs. Additional revenue is the
difference between the revenue (or selling price) after processing further while additional
costs mainly pertain to the cost of processing further. Note that joint manufacturing costs are
irrelevant for these are costs incurred in the past and would not differ in the two decision
alternatives ( whether to sell at a split off or process further).

Suggested Formula:

Revenue or selling price after processing further Php XXX

Less: revenue or selling price at split-off (XXX)
Additional Revenue XXX
Less: Cost of processing further (XXX)
Incremental Revenue XXX

E. PRODUCT COMBINATION

Guideline: Compute for the contribution margin per constrained resource and rank
them from highest to lowest. The suggested formula is presented below:

Product A Product B
Selling Price Php XXX Php XXX
Less: Variable cost per unit (XXX) (XXX)
Contribution margin per unit XXX XXX
Divide: Constrained resource per unit
e.g. “ it takes 2 machine hours to produce 1 unit”

OR

Multiply : Number of units produced per XXX XXX

constrained resource (u/CR)
e.g. “ 2 units are produced per machine hour”

Contribution margin per constrained resource Php XXX Php XXX