Ch6-ShortTermDM

7/25/2019 Ch6-ShortTermDM

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Chapter 6 Relevant Cost Concepts in Decision Making

LEARNING OBJECTIE!

1. Define relevant costs, opportunity costs, sunk costs, and out-of-pocket costs.

2. Explain the above costs in the context of decision making.

3. onsider the various business decisions in!

"a# acceptance of special order$

"b# add or drop a product line or segment$

"c# make or buy decision$ and

"d# further processing decision.

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' e a n i n g

' a c h i n e r y( s e r o s t s

) a b o u r

o s t s

' a t e r i a l

o s t s

* p p o r t u n i t y

o s t s

+ u n k

o s t s

* u t - o f - p o c k e t

o s t s

, v o i d a b l e

( n a v o i d a b l e

o s t s

. e l e v a n t

o s t s

, c c e p t a n c e

o f + p e c i a l

* r d e r

, d d o r D r o pa / r o d u c t

) i n e

' a k e o r

0 u y

D e c i s i o n s

1 u r t h e r

/ r o c e s s i n g

D e c i s i o n s

, p p l i c a t i o n s

+ h o r t - t e r m

D e c i s i o n ' a k i n g

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"# I$enti%&ing Relevant Costs

"#" Meaning o% relevant costs

1.1.1 Relevant Costs

Relevant costs are %'t're cash %lo(sarising as a direct conseuence of a decision.

"a# elevant costs are %'t're costs.

"b# elevant costs are cash %lo(s.

"c# elevant costs are incre)ental costs.

"d# elevant costs are opport'nit& costs.

"#* Machiner& 'ser costs

1.2.1 *nce a machine has been bought its cost is a s'nk cost. Depreciation is not a

relevant cost, because it is not a cash %lo(. o4ever, using machinery may involve

so)e incre)ental costs. 5hese costs might be referred to as 'ser costs and they

include hire chargesand any %all in resale val'eof o4ned assets, through use.

"#+ La,o'r

1.3.1 *ften the la,o'r %orce (ill ,e pai$ irrespective o% the $ecision )a$eand the costs

are therefore not incre)ental. 5ake care, ho4ever, if the labour force could be p't to

an alternative 'se, in 4hich case the relevant costs are the varia,le costs o% the

la,o'rand associated variable overheads plus the contribution forgone from not being

able to put it to its alternative use.

"#- Materials

1.6.1 5he relevant cost of ra4 materials is generall& their c'rrent replace)ent cost,

'nlessthe materials have alrea$&been p'rchase$and 4ould not ,e replace$ once

'se$.

1.6.2 7f materials have already been p'rchase$ ,'t (ill not ,e replace$, then the relevant

cost of using them is either"a# their c'rrent resale val'eor "b# the val'e the& (o'l$

o,tain i% the& (ere p't to an alternative 'se, if this is greater than their current

resale value.

1.6.3 5he higher o% .a/ or .,/ is then the opport'nit& cost o% the )aterials . 7f the

materials have no resale value and no other possi,le 'se, then the relevant cost of

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using them for the opportunity under consideration 4ould be nil.

1.6.6 5he flo4chart belo4 sho4s ho4 the relevant costs of materials can be identified,

provi$e$ that the materials are not in short s'ppl&, and so have no internal

opport'nit& cost.

"#0 Opport'nit& costs

1.8.1 Opport'nit& Costs

*pportunity cost is the ,ene%it sacri%ice$by choosing one opportunity rather than

the next best alternative. 9ou 4ill often encounter opportunity costs 4hen there are

several possible uses for a scarce resource.

"#6 !'nk costs

1.&.1 !'nk Costs

+unk costs are the cost of resources 4hich have alrea$& ac1'ire$4here the total

4ill be 'na%%ecte$ ,& the choicebet4een various alternatives and are usually created

by the past decision.

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1.&.2 E2a)ple "

+uppose that a company is 4ondering 4hether to sell a ne4 product as part of its

summer season range. 7t has spent :1;,;;; on market research, 4hich has sho4n that

if the product is sold for :1; per unit "variable costs of sale < := per unit#, thecompany 4ill sell 6,;;; units. 5he money spent on market research is a sunk cost

and is irrelevant to the product for a variable cost of := in order to sell 6,;;; units at

:1; each. ontribution and profit 4ould increase by :=,;;;.

"#3 O't4o%4pocket costs .

/

1.>.1 O't4o%4pocket costs

5hey are defined as the act'al cash o'tla&s that exist currently. or example,

salaries, advertising, other operating expenses. Depreciation (o'l$ not ,e incl'$e$

as out-of-pocket as it has no c'rrent cash o'tla&.

"#5 Avoi$a,le an$ 'navoi$a,le costs

1.=.1 Avoi$a,le an$ 'navoi$a,le costs

Avoi$a,le costs are those costs that may be save$ by not adopting a givenalternative, 4hereas 'navoi$a,le costs cannot ,e save$. 5herefore onl& avoi$a,le

costs are relevantfor decision-making purposes. or example, the material costs are

avoidable for production 4hile factory rent is unavoidable.

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*# Acceptance o% !pecial Or$er

.Dec "/

2.1 !pecial Or$er

"a# +pecial order decision is defined as 4hen companies receive reuests to supply

products or services under special conditions and terms 4hile they have to

consider such non-routine decision.

"b# 'anagement has to consider several factors before taking or leaving the terms

of such orders. 7n deciding 4hether or not to confirm the order, management

has to determine if there are sufficient resources or excess capacity to handle

the special order and 4hether the relevant revenues are greater than the

relevant costs.

2.2 E2a)ple *

0 )td manufactures special purpose gauges to customers? specifications. 5he

highly-skilled labour force is al4ays 4orking to full capacity and the budget for the

next year is as follo4s!

: :

+ales 6;,;;;

Direct materials 6,;;;

Direct 4ages "3,2;; hours @ :8# 1&,;;;

ixed overhead 1;,;;; 3;,;;;

/rofit 1;,;;;

n enuiry is received from A9 )td for a gauge 4hich 4ould use :&; of direct

materials and 6; labour hours.

Re1'ire$7

"a# Bhat is the minimum price to uote to A9 )tdC

"b# Bould the minimum price be different if spare capacity 4as available but

materials 4ere subect to a uota of :6,;;; per yearC

!ol'tion7

"a# 5he limiting factor is 3,2;; hours and the budgeted contribution per hour is

:2;,;;; 3,2;; hours < :&.28 hour. 'inimum price is therefore!

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:

'aterials &;

Bages "6; hours @ :8# 2;;2&;

dd! ontribution "6; hours @ :&.28# 28;

ontract price 81;

t the above price the contract 4ill maintain the budgeted contribution "check

by calculating effect of devoting the 4hole 3,2;; hours to A9 )td#.

%ote, ho4ever, that the budget probably represents a mixture of orders, some

of 4hich earn more than :&.28 per hour and some less. cceptance of the A9

order must displace other contracts, so the contribution rate of contracts

displaced should be checked.

"b# 7f the limiting factor is materials, budgeted contribution per : of materials is

:2;,;;; 6,;;; < :8.

'inimum price is therefore!

:

'aterials and 4ages "as above# 2&;

ontribution ":&; x 8# 3;;

ontract price 8&;

0ecause materials are scarce, odd-obs must aim to earn the maximum profit

from its limited supply.

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+# A$$ or Drop a 8ro$'ct Line or !eg)ent

.J'n ""/

3.1 A$$ or Drop

/art of a business may appear to be unprofitable. 5he segment may, for example, be a

product, a department or a channel of distribution. 7n evaluating closure the cost

accountant should identify!

"a# loss of contribution from the segment$

"b# savings in specific fixed costs from closure$

"c# penalties, e.g. redundancy, compensation to customers$

"d# alternative use for resources released$

"e# other non-uantifiable effects.

"i# Bhat impact 4ill a shutdo4n decision have on employee moraleC

"ii# Bhat signal 4ill the decision give to competitorsC o4 4ill they reactC

"iii# o4 4ill customers reactC Bill they lose confidence in the company?s

productsC

"iv# o4 4ill suppliers be affectedC 7f one supplier suffers

disproportionately there may be a loss of good4ill and damage to

future relations.

3.2 E2a)ple +

00 fashion store comprises three department F 'en?s Bear, )adies? Bear and

(nisex. 5he store budget is as follo4s!

Men9s La$ies9 :nise2 Total

: : : :

+ales 6;,;;; &;,;;; 2;,;;; 12;,;;;

Direct cost of sales 2;,;;; 3&,;;; 18,;;; >1,;;;

Department costs 8,;;; 1;,;;; 3,;;; 1=,;;;pportioned store costs 8,;;; 8,;;; 8,;;; 18,;;;

/rofitG"loss# 1;,;;; H,;;; "3,;;;# 1&,;;;

7t is suggested that (nisex be closed to increase the siIe of 'en?s and )adies? Bear.

Bhat information is relevant or reuiredC

!ol'tion7

/ossible ans4ers are as follo4s!

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"a# (nisex earns :2,;;; net contribution "store costs 4ill be re-apportioned to

'en?sG)adies?#.

"b# /ossible increase in 'en?sG)adies? sales volume.

"c# Bill (nisex staff be dismissed or transferred to 'en?sG)adies?C"d# eorganiIation costs, e.g. repartitioning, stock disposal.

"e# )oss of custom because (nisex attracts certain types of customer 4ho 4ill not

buy in 'en?sG)adies.

Case "

/0E 7ndustries )td "/0E# produces t4o types of mini-motors! '12 and '26. '12 motor is

for simple electrical appliances and '26 is for more complicated electrical appliances. 5he

cost data for these mini-motors are as follo4s!

M"* M*-

'achine hours reuired per unit 2.;; 2.8;

+tandard cost per unit! ; ;

Direct material 2.8; 6.;;

Direct labour 8.;; 6.;;

'anufacturing overhead!

Jariable 3.;; 2.8;

ixed 6.;; 8.;;

5otal

5he variable manufacturing overhead is applied on the basis of direct labour hours. ixed

manufacturing overhead is applied on the basis of machine hours. 5he company needs to

produce =,;;; units of '12 and 11,;;; units of '26 in order to meet the demand of the

markets. 54o 4eeks ago, senior management decided to spend additional machine time on

other products. s a result, only 3;,;;; machine hours per year can be used in the

production of mini-motors. n external customer offers to buy both types of mini-motors at:16.

0esides manufacturing, /0E has a small retail outlet in the reception area in the

manufacturing plant and directly sells mini-motors to individual customers. 5he outlet is

manned by some disabled employees. fter revie4ing the financial statements of the outlet

by the ne4 chairman, 'r. 5homas 9an, suggested to close this outlet and use the resources

some4here else. 'r. 9an is an expert in supply chain and value chain. 5he financial figures

for the year ust ended are as follo4s!

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:

evenues H;;,;;;

Jariable costs 3;;,;;;5raceable fixed costs &=;,;;;

llocated corporate overhead 18;,;;;

7f the retail outlet is closed, =;K of the traceable fixed cost 4ill be eliminated. 7n addition,

the company 4ill incur one-time closure costs of :8;,;;;.


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.a/ Calc'late the pro%it or loss o% the retail o'tlet# .* )arks/

.,/ Deter)ine i% the retail o'tlet sho'l$ ,e close$# !ho( &o'r reasoning# .0 )arks/

.c/ ?hat T?O 1'alitative %actors sho'l$ senior )anage)ent consi$er regar$ing theclos're@ .- )arks/

.$/ >inancial o,ective is o'r onl& goal clai)s the ne( chair)an# !'ggest other

)eas're)ents partic'larl& %ro) the vie( o% sharehol$ers in )eas'ring the

per%or)ance o% 8BE In$'stries Lt$# .- )arks/

.FIAAT 8BE 8aper II Manage)ent Acco'nting an$ >inance J'ne *""/

-# Make or B'& Decisions

.Dec "* J'n "+/

6.1 Make or B'& .O'tso'rcing/

7n a make or buy decision 4ith no limiting factors, the relevant costs are the

$i%%erential costsbet4een the t4o options.

6.2 E2a)ple -

)td makes four components, B, A, 9 and L for 4hich costs in the forthcoming

year are expected to be as follo4s.

? H

/roduction "units# 1,;;; 2,;;; 6,;;; 3,;;;

(nit marginal costs : : : :

Direct materials 6 8 2 6

Direct labour = H 6 &

Jariable production overheads 2 3 1 2

16 1> > 12

Directly attributable fixed costs per annum and committed fixed costs!

:

7ncurred as a direct conseuence of making B 1,;;;

7ncurred as a direct conseuence of making A 8,;;;

7ncurred as a direct conseuence of making 9 &,;;;

7ncurred as a direct conseuence of making L =,;;;

*ther fixed costs "committed# 3;,;;;

8;,;;;

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sub-contractor has offered to supply units of B, A, 9 and L for :12, :21, :1; and

:16 respectively. +hould )td make or buy the componentsC

!ol'tion7

"a# 5he relevant costsare the differential costs bet4een making and buying, and

they consist of $i%%erences in 'nit varia,le costs pl's $i%%erences in $irectl&

attri,'ta,le %i2e$ costs. +ubcontracting 4ill result in some %i2e$ cost

savings.

B A 9 L

: : : :

(nit variable cost of

making

16 1> > 12

(nit variable cost of

buying

12 21 1; 16

"2# 6 3 2

nnual reuirements

"units# 1,;;; 2,;;; 6,;;; 3,;;;

: : : :

Extra variable cost ofbuying "per annum# "2,;;;# =,;;; 12,;;; &,;;;

ixed costs saved by

buying "1,;;;# "8,;;;# "&,;;;# "=,;;;#

Extra total cost of

buying "3,;;;# 3,;;; &,;;; "2,;;;#

"b# 5he company 4ould save :3,;;; pa by sub-contracting component B "4here

the purchase cost 4ould be less than the marginal cost per unit to makeinternally# and 4ould save :2,;;; pa by subcontracting component L

"because of the saving in fixed costs of :=,;;;#.

"c# 7n this example, relevant costs are the variable costs of in-house manufacture,

the variable costs of sub-contracted units, and the saving in fixed costs.

"d# urther considerations

"i# 7f components B and L are sub-contracted, the company 4ill have

spare capacity. o4 should that spare capacity be profitably usedC re

there hidden benefits to be obtained from sub-contractingC Bould the

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companyMs 4orkforce resent the loss of 4ork to an outside sub-

contractor, and might such a decision cause an industrial disputeC

"ii# Bould the sub-contractor be reliable 4ith delivery times, and 4ould he

supply components of the same uality as those manufacturedinternallyC

"iii# Does the company 4ish to be flexible and maintain better control over

operations by making everything itselfC

"iv# re the estimates of fixed cost savings reliableC 7n the case of /roduct

B, buying is clearly cheaper than making in-house. 7n the case of

product L, the decision to buy rather than make 4ould only be

financially beneficial if it is feasible that the fixed cost savings of

:=,;;; 4ill really be MdeliveredM by management. ll too often in

practice, promised savings fail to materialiseN

6.3 A$vantages an$ $isa$vantages o% o'tso'rcing .Dec "*/

A$vantages!

"a# 5he company can concentrate on its core ,'siness or other areas.

"b# Reso'rcescan be p't into other pro$'ct lines.

Disa$vantages!"a# 5he uality and punctuality in delivery may be difficult to control.

"b# 7t may affect the company?s reputation.

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0# >'rther 8rocessing Decisions

.Dec "+/

8.1 >'rther 8rocessing

oint product should be processe$ %'rtherpast the split-off point if sales val'e

)in's post4separation "further processing# costs is greater than sales val'e at

split4o%% point.

8.2 E2a)ple 0

5he /oison hemical ompany produces t4o oint products, lash and /ottum from

the same process. Ooint processing costs of :18;,;;; are incurred up to split-off

point, 4hen 1;;,;;; units of lash and 8;,;;; units of /ottum are produced. 5he

selling prices at split-off point are :1.28 per unit for lash and :2.;; per unit for

/ottum.

5he units of lash could be processed further to produce &;,;;; units of a ne4

chemical, lashplus, but at an extra fixed cost of :2;,;;; and variable cost of 3;c

per unit of input. 5he selling price of lashplus 4ould be :3.28 per unit. +hould the

company sell lash or lashplusC

!ol'tion7

5he only relevant costsGincomes are those 4hich compare selling lash against

selling lashplus. Every other cost is irrelevant! they 4ill be incurred regardless of

4hat the decision is.

7t is :2;,;;; more profitable to convert lash into lasshplus.

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E2a)ination !t&le


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Ch6-ShortTermDM