Unit 9 - Relevant Costing for Decision Making
1 Introduction
Mgt decisions involves predictions of costs & revenues.
Only the costs and revenues that will differ among alternative actions are relevant to the decision.
The role of historical data is to aid the prediction of future data. But historical data may not be relevant to the management decision itself.
Qualitative factors may be decisive in many cases, but to reduce the number of such factors to be judged, accountants usually try to express manydecision factors as possible in quantitative terms.
2 Terminology Relating to Decision-Making
Relevant costs are costs appropriate to aiding the making of specific management decisions. Actually, to affect a decision a cost must be:
Future
Past costs are irrelevant as they are not affected them by future decisions & decisions should be made as to what is best now .
Incremental
This refers to add'l revenue or expenditure which may appear as a result of our decision-making. (A cash flow - Such charges as depreciation may be future but do not represent cash flows and, as such, are not relevant.)
Two other related terms:
Sunk costs
Past costs, not relevant for decision making
Committed costs
Costs which are futures in nature but which arise from past decisions, perhaps as the result of a contract.
3 Types of Decision Making
Besides the output volume decisions, there are applications for the variable costing technique in relation to the solution of ST problems.
a) Make-or-buy decisions -
A company is often faced with a decision as to whether it should manufacture a component or buy it outside. (Refer to )
B) Price-fixing decisions -
A company needs to fix a selling price for individual product in ST. (refer to )
c) Replacement of equipment -
It is a capital investment or long-term decision that requires the use of discounted cash flow procedures. (Refer to textbook)
4 Other Costing Techniques Aiding DM
Differential Costing
Differential costing - used for preparing ad hoc info in which only cost & income differences % alt courses of action are considered.
It looks at future, incremental costs, . relevant costs.
. a family considers buying a second car.
Opportunity costs
Opportunity cost - the max alt. earning which might have been obtained from an alt. use of the limited resource. This relates to possible alt. uses of specific resources of co. May be done by charging the opportunity cost' of these resources as the relevant cost. (Refer to )
Illustrated Examples
Example 1 (Make-or-Buy Decisions)
A Company is at present manufacturing a component. The annual quantity required is 10,000 units, and the annual cost at present is reported as:
$'000
Direct materials 200
Direct wages 50
Supervision 8
Floor space occupancy 7
The component could be purchased for $ each. Should the company continue to manufacture the component or buy it from the outside supplier?
Answer
The cost of floor space is irrelevant if this is merely the apportioned cost of part of a factory, since the cost will continue whether or not the particular component is manufactured; it is therefore a fixed cost. The marginal cost of production appears to be the cost of materials and the wages (ie. $25 per unit), but the costs of supervision, although presumably a fixed cost, are obviously relevant to the labor engaged in manufacturing this particular product. Immediate suggestion -Outside purchase would save marginal costs of $25 per unit, but would cost $ per unit.
At a required volume of 10,000 units, outside purchase would lose the company contribution (at $ per unit) of 5,000
but would save the relevant fixed cost of 8,000
Therefore outside purchase would be preferable asit would save 3,000
The above is the purely financial solution. Other factors would need to be taken into account, such as the reliability of the outside product, and the ability
of the supplier to deliver on time and the potential loss if he does the required volume had been 20,000 units per annum the answer would have been different,because:
Outside purchase would cost the company contribution (at per unit) of 10,000
yet it could still save the relevant fixed costs of only 8,000
Consequently continued manufacture would be cheaper by 2,000
Example 2 (Selling Price Decisions)
Consider producing an item with a total production cost of $ and a current selling price of $50. The company is working at about50% capacity and, because of high fixed overheads, is operating at a loss. An offer of a contract to sell 5,000 units at well below normal selling price (in fact $26 per unit) is received. The co has to decide whether to accept or reject the contract. It is probably fair to say that a businessman, approaching the problem from a total cost viewpoint, would reject the offer out of hand, assuming that acceptance of the offer would
only add to the existing loss-making situation.
The relevant costs to be considered here are the marginal costs of the product. Let us assume that the marginal cost per unit is made up as follows:
$
Direct materials
Direct wages
Variable overhead
Total
Answer
Acceptance of the contract will provide a unit contribution of $ ($ - $) thus producing a total contribution for the contract of $29,000 ($ x 5000), which would reduce the loss. The company should accept the contract, but it would be unwise to handle contracts for large quantities at that price since production of more profitable business may have to be replaced.
Note
In general terms any sale which yields a marginal contribution is, in the short run, better than no sale at all provided there is enough idle capacity (50% in our case).Also, in using marginal pricing it is important to be sure that:
(a) The sale at a low price does not displace other possible sales giving a higher rate of contribution;
(b) Price cutting in particular instances does not lead to a general reduction of prices, either because other customers demand comparable terms or because competitors enter into a price-cutting war.
Example 3 (Opportunity Costs)
In a firm, material A has no alternative uses and 200 units of which lie in stock. The information below has been collected. You are required to find the relevant price of 120 units and 250 units respectively.
Book value $2 per kg
Current price $3 per kg
Sale price obtainable $ per kg
(a) 120 units may be supplied from stock at best alterative earning of $
120 @ $ $336
(b) Only 200 of the 250 units may be so satisfied. The balance of 50 being bought at the current price:
200 @ $ $560
50 @ $3 $150
Total $710
Note particularly that book value is never relevant (sunk cost). Also because opportunity cost is the best alternative others may be ignored.
Example 4 (Differential and Relevant Costs)
A research project, which to date has cost the company $150,000 is under review. It is anticipated that, should the project be allowed to proceed, it will be completed in approximately one year when the results would be sold to a government agency for $300,000. Shown below are the additional expenses which the managing director estimates will be necessary to complete
the work.
Materials - $60,000
This material, which has just been received, is extremely toxic and if not used on the project would have to be disposed of by special means, at a cost of $5,000. Labor - $40,000
The men are highly skilled and very difficult to recruit. They were transferred to the project from a production department and, at a recent board meeting, the works director claimed that if the men were returned to him he could earn the
Company each year $150,000 extra sales. The accountant calculated that the prime cost of those sales would be $100,000 and the overhead absorbed (all fixed) would amount to $20,000.
Research staff - $60,000
A decision has already been taken that this will be the lost major piece of research undertaken, and consequently when work on the project ceases the staff involved will be made redundant. Redundancy and severance pay have been estimated at $25,000, and share of general building services at $35, managing director is not very sure what is included in this expense. He knows however that the accounts staff charge similar amounts every year to each department.
Required
Assuming the estimates are accurate, advice the managing director whether the project should be allowed to proceed. You must carefully and clearly explain the reasons for your treatment of each expense item.
Answer:
(1st approach : Differential cost approach)
Proceed Abort Difference
$ $ $
Materials - (5,000) 5,000
Labour: cost (40,000) - -
opp. cost (contr.) - 50,000
(90,000)
Research staff (60,000) - (60,000)
Revenue 300,000 - 300,000
------- ------ -------
200,000 45,000 155,000
Note: This answer shows relevant costs/revenues only.
(2nd approach: Costs and benefits relevant to decision to proceed)
Costs Benefits
Cost to date (sunk) - -
Mat. - Disposal cost avoided 5,000
Labour cost 40,000
Opp. costs lost contribution 50,000
90,000
Research salaries 60,000
Revenue 300,000
------ -------
150,000 305,000
(150,000)
-------
Net benefit 155,000
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