By Zachary Mitchell,2014-05-20 17:42
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    Ch18 Relevant costing and decision making


    Relevant costs

    Choice of product product mix Make or buy

    decisions decisions

    Shut down decisions One-off contracts

    1.Relevant Costs

     1A relevant cost is a future cash flow arising as a direct consequence of a decision.

     2Decision making should be based on relevant costs.

     A.Relevant costs are future costs. A decision is about the future and it cannot alter what has been done already. Costs that have been incurred in the past are totally irrelevant to any decision n that is being made ‘now’.Such costs are past costs or sunk costs. Costs that have been incurred include not only costs that have already been paid, but also costs that have been committed. A committed cost is a future cash flow that will be incurred anyway, regardless of the decision taken now.

     B.Relevant costs are cash flows. Only cash flow information is required. This means that costs or charges which do not reflect additional cash spending such as

    depreciation and notional costs should be ignored for the purpose of decision


     C.Relevant costs are incremental costs.

     3Other terms are sometimes used to describe relevant costs.

     Avoidable cost: whether or not to discontinue a product

     Differential cost is‘the difference on in total cost between alternatives.’

     An opportunity cost is ‘The value of the benefit sacrificed when one course of action is chosen, in preference to an alternative’.

     A sunk cost is a past cost which is not directly relevant in decision making.The

    principle underlying decision accounting is that management decisions can only affect the future. In decision making, managers therefore require information about future costs and revenues which would be affected by the decision under review. They must not be misled by events, costs and revenues in the past, about which they can do nothing.

     Fixed and variable costs

     Variable costs will be relevant costs. Fixed costs are irrelevant to a decision.

     Controllable and uncontrollable costs


     Non-relevant variable costs

     1.12 There might be occasions when a variable cost is in fact a sunk cost and

    therefore a non-relevant variable cost.For example,suppose that a company has some

    units of raw material in stock.They have been paid for already,and originally cost

    2,000.They are now obsolete and are no longer used in regular production,and they have no scrap value.However,they could be used in a special job which the company is trying to decide whether to undertake.The special job is a ˊone-off ˊcustomer

    order,and would use up all these materials in stock.

     aIn deciding whether the job should be undertaken,the relevant cost of the materials to the special job is nil.Their original cost of 2,000 is a sunk cost,and

    should be ignored in the decision.

    bHowever,if the materials did have a scrap value of,say, 300,then their

    relevant cost to the job would be the opportunity cost of being unable to sell them for scrap,ie 300.

     Attributable fixed costs

     1.13 There might be occasions when a fixed cost is a relevant cost,and you must be aware of the distinction between ˊspecificˊor ˊdirectly attributableˊfixed

    costs,and general fixed overheads.

     1.14 Directly attributable fixed costs are those costs which,although fixed within a relevant range of activity level are relevant to a decision for either of the following reasons.

     aThey could increase if certain extra activities were undertaken.For example,it may be necessary to employ an extra supervisor if a particular order is accepted.The extra salary would be an attributable fixed cost.

     General fixed overheads

     1.15 General fixed overheads are those fixed overheads which will be unaffected by decisions to increase or decrease the scale of operations,perhaps because they are an apportioned share of the fixed costs of items which would be completely unaffected by the decisions.General fixed overheads are not relevant in decision making.

     Absorbed overhead is a notional accounting cost and hence should be ignored for decision making purposes. It is overhead incurred which may be relevant to a decision.

     1.16 Absorbed overhead is a notional accounting cost and hence should be ignored for decision-making purposes.It is overhead incurred which may be relevant to a decision.

     4The relevant cost of materials

     The relevant cost of raw materials is generally their current replacement cost, unless the materials have already been purchased and would not be replaced once used. In this case the relevant cost of using them is the higher of the following:

     Their current resale value

     The value they would obtain if they were put to an alternative use

     If the materials have no resale value and no other possible use, then the relevant cost of using them for the opportunity under consideration would be nil.

     Material B is used regularly by OˊReilly Ltd,and if units of B are required for

    this job,they would need to be replaced to meet other production demand.

     Materials C and D are in stock as the result of previous over-buying,and they have a restricted use.No other use could be found for material C,but the units of material D could be used in another job as substitute for 300 units of material E,which currently costs 5 per unitof which the company has no units in stock at the


     R equired

     Calculate the relevant costs of material for deciding whether or not to accept the contract.


     aMaterial A is not yet would have to be bought in full at the replacement cost of 6 per unit.

     bMaterial B is used regularly by the company.There are existing stocks 600

    unitsbut if these are used on the contract under review a further 600 units would be bought to replace them.Relevant costs are therefore 1,000 units at the replacement cost of 5 per unit.

     c1,000 units of material C are needed and 700 are already in stock.if used for

    4 each.The existing stocks of 700 the contract,a further 300 units must be bought at

    will not be replaced.if they are used for the contraci,they could not be sold at 2.50

    each.The realizable value of these 700 units is an opportunity cost of sales revenue forgone.

     dThe required units of material D are already in stock and will not be replaced.There is an opportunity cost of using D in the contract because there are alternative opportunities either to sell the existing stocks for 6 per unit ?!1,200 in

    total or avoid other purchasesof material E,which would cost 300×1,500.Since

    substitution for E is more beneficial, 1,500 is the opportunity cost.

     eSummary of relevant costs


     Material A1,000×6 6,000

     Material B1,000×5 5,000

     Material C300×4plus700×2.50 2,950

     Material D 1,500

     Total 15,450

     5Relevant cost of labor


     LW plc is currently deciding whether to undertake a new contract.15 hours of labour will be required for the contract.LW plc currently produces product L,the standard cost details of which are shown below.




     Direct materials10kg,!2 20

     Direct labour5 hrs ,!6 30


     Selling price 72

     Contribution 22

     aWhat is the relevant cost of labour if the labour must be hired from outside the organization?

     bWhat is the relevant cost of labour if LW plc expects to have 5 hours spare capacity?

    cWhat is the relevant cost of labour if labour is in short supply?

     1.20 SOLUTION

     aWhere labour must be hired from outside the organisation,the relevant cost of laboru will be the variable costs incurred.

     bIt is assumed that the 5 hours spare capacity will be paid anyway,and so if these 5 hours are used on another contract,there is no additional cost to LW plc.

     Relevant cost of labour on new contract


     Direct labour 10 hours ,!6 60

    5 hours ,!0 0 Spare capacity


     cContribution earned per unit of Product L produced=22

     If it requires 5 hours of labour to make one unit of product L,the contribution earned per labour hour=22/5=4.40.

     Relevant cost of labour on new coutract

     Direct labour 15 hours ,!6 90

     Contribution lost by not making product L?!4.40×15 hours



     1.21 It is important that you should be able to identify the relevant costs which are appropriate to a decision. In many cases,this is a fairly straightforward problem,but there are cases where great care should be taken.Attempt the following question.

     6The deprival value of an asset

     In simple terms, the deprival value of an asset represents the amount of money that a company would have to receive if it were deprived of an asset in order to be no worse off than it already is.


     A machine cost 14,000 tne years ago.It is expected that the machine will generate future revenues of 10,000.Alternatively,the machine could be scrapped

    for 8,000.An equivalent machine in the same condition would cost 9,000 to buy

    now.What is the deprival value of the machine?

     1.24 SOLUTION

     Firstly,let us think about the relevance of the costs given to us in the question.

     Cost of machine=14,000=past/sunk cost

     Future revenues=10,000=revenue expected to be generated

     Net realizable value=8,000=scrap proceeds

     Replacement cost=9,000

     When calculating the deprival value of an asset,use the following diagram.

     Therefore,the deprival value of the machine is the lower of the replacement cost

    10,000.The deprival value is therefore 9,000. and

    2.Choice of Product Product MixDecisions

     1A limiting factor is a factor which limits the organization’s activities.

    2It is assumed in limiting factor accounting that management wishes to

    maximize profit and that profit will be maximized when contribution is maximized given no change in fixed cost expenditure incurred. Marginal costing ideas are


     3Contribution will be maximized by earning the biggest possible contribution from each unit of limiting factor.

     4The limiting factor decision therefore involves the determination of the contribution earned by each different product from each unit of the limiting factor.


     In exam, five steps can be followed:

     Step 1 Identify the limiting factor

     Step 2 Calculate contribution per unit for each product

     Step 3 Calculate contribution per unit of limiting factor

     Step 4 Rank products make product with highest contribution per unit of

    limiting factor first

     Step 5 Make products in rank order until scare resource is used up optimal

    production plan


     AB Ltd makes two products,the Ay and the Be.Unit variable costs are as follows.

     Ay Be


     Direct materials 1 3

     Direct labour?!3 per hour 6 3

     Variable overhead 1 1

     8 7

     The sales price per unit is 14 per Ay and 11 per Be.During July 20X2 the

    available direct labour is limited to 8,000 hours.Sales demand in July is expected to be 3,000 units for Ays and 5,000 units for Bes.


     Determine the profit-maximising production mix,assuming that monthly fixed costs are 20,000,and that opening stocks of finished goods and work in progress are nil.

     2.7 SOLUTION

     Step1. Confirm that the limiting factor is something other than sales demand.

     Ays Bes Total

     Labour hours per unit 2 hrs 1hr

     Sales demand 3,000units 5,000units

     Labour hours needed 6,000hrs 5,000hrs 11,000hrs

     Labour hours available 8,000 hrs

     Shortfall 3,000 hrs

     Labour is the limiting factor on production.

     Step2. Identify the contribution eamed by each product per unit of limiting factor,that is per labour hour worked.

     Ays Bes


     Sales prict 14 11

     Variable cost 8 7

     Unit contribution 6 4

     Labour hours per unit 2 hrs 1 hr

     Contribution per labour hour=unit

     of limiting factor 3 4

     Although Ays have a higher unit contribution than Bes,two Bes can be made in the time it atkes to make one Ay.Because labour is in short supply is is more profitable to make Bes than Ays.

     Step3. Determine the optimum production plan.Sufficient Bes will be made to meet the full sales demand,and the remaining labour hours available will then be used to make Ays.

     Step 3. Determine the optimum production plan.Sufficient Bes will be made to meet the full sales demand,and the remaining labour hours available will then be used to make Ays.

     a Hours hours Priority of

     product Demand required available manufacture

     Bes 5,000 5,000 5,000 lst

     Ays 3,000 6,000 3,000bal 2nd

     11,000 8,000

     b Hours Contribution

     Product Units needed per unit Total


     Bes 5,000 5,000 4 20,000

     Ays 1,500 3,000 6 9,000

     8,000 29,000

     Less fixed costs 20,000

     Profit 9,000

     3.Make or Buy Decisions

     If an organization has the freedom of choice about whether to make internally or buy externally and has no scarce resources that put a restriction on what it can do itself, the relevant costs for the decision will be the differential costs between the two



     Buster Ltd makes four components,W,X,Y and Z,for which costs in the forthcoming year are expected to be as follows.

     W X Y Z

    units 1,000 2,000 4,000 3,000 Production

     Unit marginal costs

     Direct materials 4 5 2 4

     9 4 4 Direct labour 8

     Variable production overheads 2 3 1 2

     14 17 7 12

     Directly attributable fixed costs per annum and committed fixed costs are as follows.


     Incurred as a direct consequence of making W 1,000

     Incurred as a direct consequence of making X 5,000

     Incurred as a direct consequence of making Y 6,000

     Incurred as a direct consequence of making Z 30,000

     Other fixed costscommitted 50,000

     A subcontractor has offered to supply units of W,X,Y and Z for 12, 21,

    10 and 14 respectively.


     Decide whether Buster Ltd should make or buy the components.

     3.4 SOLUTION

     aThe relevant costs are the differential costs between making and buying,and they consist of differences in unit variable costs plus differences in directly attributable fixed costs.Subcontracting will result in some fixed cost savings.

     W X Y Z


     Unit variable cost of making 14 17 7 12

     Unit variable cost of buying 12 21 10 14

     2 4 3 2

     W X Y Z

     Annual requirementsunits 1,000 2,000 4,000 3,000


     Extra variable cost of

     buying(pre annum) (2,000) 8,000 12,000 6,000

     Fixed costs saved by buying (1,000)(5,000)(6,000) (8,000)

     Extra total cost of buying (3,000) 3,000 6,000 (2,000)


     bThe company would save 3,000 pa by subcontracting component W

    where the purchase cost would be less than the marginal cost per unit to make internallyand would save 2,000 pa by subcontracting component Z because of

    the saving in fixed costs of 8,000.

     cIn this example,relevant costs are the variable costs of in-house manufacture,the variable costs of subcontracted units,and the saving in fixed costs.

     In a situation where a company must subcontract work to make up a shortfall in its own production capability, its total costs are minimized if those components/products subcontracted are those with the lowest extra variable cost of buying per unit of limiting factor saved by buying.


     Green Ltd manufactures two components,the Alpha and the Beta,using the same machines for each.The budget for the next year calls for the production and assembly of 4,000 of each component.The variable production cost per unit of the final product,the gamma,is as follows.

     Machine hours Variable cost


     1 unit of Alpha 3 20

     1 unit of Beta 2 36

     Assembly 20


     Only 16,000 hours of machine time will be available during the year,and a sub-contractor has quoted the following unit prices for supplying components:Alpha 29;Beta 40.Advise Green Ltd.

     3.8 SOLUTION

     aThere is a shortfall in machine hours available,and some products must be sub-contracted.

     Product Units Machine hours

     Alpha 4,000 12,000

     Beta 4,000 8,000

     Required 20,000

    16,000 Available

     Shortfall 4,000

     bThe assembly costs are not relevant costs because they are unaffected by the make of buy decision.The units subcontracted should be those which will add least to the costs of Green Ltd.Since 4,000 hours of work must be sub-contracted,the cheapest policy is to subcontract work which adds the least extra coststhe least extra variable

    costsper hour of own-time saved.

     cAlpha Beta


     Variable cost of making 20 36

    29 40 Variable cost of buying

     9 4

     Machine hours saved by buying 3 hrs 2 hrs

     Extra variable cost of buying,

     per hour saved 3 2

     It is cheaper to buy Betas than to buy Alphas and so the priority for making the components in-house will be in the reverse order to the preference for buying them from a subcontractor.

     d Hrs per unit Hrs required Cumulative

     Component to make in-house in total hours

     Alpha 3hrs 12,000 12,000

     Beta 2hrs 8,000 12,000


     Hours available 16,000

     Shortfall 4,000

     There are enough machine hours to make all 4,000 units of Alpha and 2,000 units of Beta.4,000 hours production of Beta must be sub-contracted.This will be the cheapest production policy available

     e Number of Unit variable Total

     Component Machine hours units cost variable cost


     Alpha 12,000 4,000 20 80,000

     Betabalance4,000 2,000 36 72,000


     Buy Hours saved

     Betabalance4,000 2,000 40 80,000

     Total variable costs of components 232,000

     Assembly costs4,000×20 80,000

     Total variable costs 312,000

     4.Shut down decisions

     Shut down decisions involve thee following.

     a.Whether or not to shut down a factory, department, or product line either because it is making a loss or it is too expensive to run;

     b.If the decision is to shut down, whether the closure should be permanent or temporary.


     Suppose that a company manufactures three products, Corfus,Cretes and Zantes. The present net profit from these is as follows.

     Corfus Cretes Zantes Total


     Sales 50,000 40,000 60,000 150,000

    25,000 35,000 90,000 Variable costs 30,000

     Contribution 20,000 15,000 25,000 60,000

     Fixed costs 17,000 18,000 20,000 55,000

     3,000 3,000 5,000 5,000 Profit/loss

    The company is concerned about its poor profit performance,and is considering whether or not to cease selling Cretes.It is felt that selling prices cannot be raised or lowered without adversely affecting net income. 5,000 of the fixed costs of Cretes

    are attributable fixed costs which would be saved if production ceased.All other fixed costs would remain the same.

     4.3 SOLUTION

     aBy stopping production of Cretes,the consequences would be a 10,000 fall

    in profits.


     Loss of contribution 15,000

     Savings in fixed costs 5,000

     Incremental loss 10,000

     bSuppose,however,it were possible to use the resources realized by stopping production of Cretes and switch to produing a new item.Rhodes,which would sell for 50,000 and incur variable costs of 30,000 and extra direct fixed costs of

    6,000.A new decision is now required.

     Cretes Rhodes


     Sales 40,000 50,000

     Less variable costs 25,000 30,000

     Contribution 15,000 20,000

     Less direct fixed costs 5,000 6,000

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