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TS Dec 2013 1
By the end of the session, you are expected to apply the
following cost and management accounting techniques:
A. Multiple break even analysis
B. Relevant Costs in Decision Making
i. Basic concept and application of relevant costs
ii. Special Pricing/Bidding Decisions
iii. Discontinuation of Business Segments
iv. In-House vs. Outsource
v. Simple limiting factor situations
TS Dec 2013 2
Reading:
Jones (Chapter 19)
Dyson (Chapter 18)
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Relevant costs (and revenues)
Sunk costs
Avoidable / non-avoidable costs
Opportunity cost / benefit
Incremental / differential costs
TS Dec 2013 3
A more realistic situation would involve a company with
multiple products. In this situation, an important input
would be an assumed sales mix i.e. the relative
proportion of each type of product sold.
In this situation, the sales mix will be used to evaluate
the weighted average unit contribution margin. Based on
this sales mix, the break even calculations will yield total
number of products to be sold.
TS Dec 2013 4
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TS Dec 2013 5
After discussions, the Charity has decided to sell three types of
tickets for the week
Premium () Box () Stall ()
Ticket Price 200 129 89
Variable Costs
Catering 30 10 5
Brochure/Gifts 15 5 -
Agent Commission 5 3 1
Capacity mix 20% 30% 50%
Fixed costs remain at 33,000
What is the break even point in number of tickets, particularly for
each class of ticket? How many tickets are needed to achieve an
overall surplus of 15,000?
TS Dec 2013 6
After discussions, the Charity has decided to sell three types of
tickets for the week
Premium () Box () Stall ()
Contribution 150 111 83
Capacity mix 20% 30% 50%
Weighted average contribution = (150 x 0.20) + (111 x 0.30) + (83 x
0.50) = 104.8
BEP = 33,000 / 104.80 = 315 tickets in total (63 for Premium, 95 for
Box,.)
Surplus of 15,000 = 48,000 / 104.80 = 459 tickets, again split on the
basis of the capacity mix.
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TS Dec 2013 7
The focus is on identifying relevant costs i.e. costs relevant to the
decision at hand.
Relevant costs have two important characteristics:
They are future costs i.e. costs not yet incurred. Costs that have been
already incurred or committed are not relevant. The usual term is sunk
costs.
They are differential costs i.e. They are different under the alternative
courses of action. Incremental costs are costs incurred if a particular
alternative is selected.
Key feature of relevant costing
net profit no longer key criterion but contribution is
Focuses on extra cost of an extra unit (incremental or marginal cost)
Replacement value or disposal value relevant but not historic cost.
Opportunity cost matters what would be gained or lost by not
selecting the next best alternative
TS Dec 2013 8
Materials or other components
Is the material already in stock or committed for purchase or is
the company about to buy it? What price could it be purchased
for?
Does the firm use the material consistently or not?
Also, if not used, can it be sold to a third party?
Labour
Is the required labour idle or not? If not, does the existing work
need to be abandoned to do the job (opportunity cost)? Or can
specialised labour be brought in to do the job (incremental
cost)?
Overheads (indirect cost) and other costs
Allocation of existing overheads - not relevant, since it will
have to be paid anyway). But any other incremental costs
have to be included.
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TS Dec 2013 9
In a special order decision, managers are faced with deciding
whether or not to supply a customer with a single, one off order
for goods or services, at a special/bidding price.
(i) Identify the incremental costs (i.e. In most cases, the
variable costs to be incurred + any additional cost i.e. Hire
of a specific asset).
(ii) Identify the incremental revenue price of special order and
compare to incremental costs.
(iii) In case there is no excess capacity, the company must
forego part of its normal sales to meet the order. Hence, the
opportunity cost = contribution lost from normal sales in
accepting the special sales.
Caledonian Ltd manufactures sweaters, selling them on
average at 37 wholesale price. Current output is 35,000 per
month, representing 70% of capacity. The company has the
opportunity to utilize their surplus capacity by bidding for a
one-off contract of 10,000 sweaters for a client.
(a)Total costs for 35000 units were 1,155,000, of which
385,000 were fixed costs. There is an additional 1.50 cost
per sweater for printing the clients logo. It is believed the
cheapest competitor will bid at around 25. Can Caledonian
Ltd company outbid this competitor?
(b)What additional implications would Caledonian Ltd have to
consider if the client eventually doubles its order i.e. 20,000
sweaters.
TS Dec 2013 10
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(a) Order of 10,000 sweaters is within the maximum capacity
(35,000 / 0.70 = 50,000 units)
Total costs = 1,155,000
Variable cost per unit = 1,155,000 385,000 = 770,000 /
35,000 = 22 per unit.
Incremental cost for the order = 22 + 1.50 23.50
Yes the company can bid below the 25 threshold.
(b) Order is above capacity and to be fulfilled, existing sales
must be reduced by 5,000 units (55,000 50,000)
Incremental cost = 23.50 + contribution from lost sales [ (37-
22 x 5,000) / 20,000] = 27.25
In this case, bid must be increased to at least 27.25 but this
not competitive compared to the other bid of 25
TS Dec 2013 11
The decision could involve discontinuing a product line, a
service, or a branch
A product (or service) line or branch is discontinued only
after considering whether there is no positive contribution
from that product. A positive contribution, however low it
may be, still contributes towards fixed costs. Also, focus on
contribution margin ratio (%) if having to choose between
several product lines or departments
In both cases, one important point to bear in mind is that
some of the present (unavoidable) fixed costs will have to be
borne by the remaining product lines or branches (typical
example for branches head office costs), whilst the
segment-specific (avoidable) fixed costs would be eliminated.
TS Dec 2013 12
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Consider the following data for an integrated oil & gas company:
Upstream Midstream Downstream
Revenue 120,000 50,000 30,000
Variable Costs 50,000 22,000 18,000
Fixed Costs* 20,000 10,000 5,000
Overhead allocated
From head office** 60% 25% 15%
* Wholly avoidable, and relating to specific administrative support for
each department
** Additional fixed business expenses (total 50,000) for the head
office, absorbed by, or allocated to, each segment according to the %
provided above.
What is the profit per segment? Should one segment in particular be
discontinued?
Construct a basic income statement for each division:
Upstream Midstream Downstream
Revenue 120,000 50,000 30,000
Variable Costs 50,000 22,000 18,000
Contribution Contribution Contribution Contribution 70,000 70,000 70,000 70,000 28,000 28,000 28,000 28,000 12,000 12,000 12,000 12,000
Fixed Costs 20,000 10,000 5,000
Overhead allocation
for Practice 30,000 12,500 7,500
Net profit Net profit Net profit Net profit 20,000 20,000 20,000 20,000 5,500 5,500 5,500 5,500 (500) (500) (500) (500)
Even if the downstream division is loss making, closing it down will not Even if the downstream division is loss making, closing it down will not Even if the downstream division is loss making, closing it down will not Even if the downstream division is loss making, closing it down will not
result in all of its cost to become avoidable. Whilst the variable costs and result in all of its cost to become avoidable. Whilst the variable costs and result in all of its cost to become avoidable. Whilst the variable costs and result in all of its cost to become avoidable. Whilst the variable costs and
fixed costs are considered to be avoidable, the overheads for head office fixed costs are considered to be avoidable, the overheads for head office fixed costs are considered to be avoidable, the overheads for head office fixed costs are considered to be avoidable, the overheads for head office
will remain and will have to be re will remain and will have to be re will remain and will have to be re will remain and will have to be re- -- -allocated to other divisions. Overall, the allocated to other divisions. Overall, the allocated to other divisions. Overall, the allocated to other divisions. Overall, the
firms profit will decline if the division is closed. firms profit will decline if the division is closed. firms profit will decline if the division is closed. firms profit will decline if the division is closed.
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TS Dec 2013 15
In an in-house or outsource decision, an organization is faced with
the choice of whether to particular goods or services itself, or source
these products/services from an external supplier.
(i) Identify the relevant costs of manufacturing the product i.e. The
costs that can be avoided (generally, variable costs) if the product is
not manufactured. Fixed costs absorbed in the product cost will still
need to be incurred, even if the production is outsourced. Hence,
such fixed costs are deemed to be non-relevant or unavoidable.
(ii) Compare the costs to the price, tendered by the outsourcing firm
(iii) If the decision to outsource releases additional internal capacity,
the company could, in some cases, use this free capacity to generate
additional revenue.
TS Dec 2013 16
Elppa plc has an annual production of 10,000 memory sticks for
inclusion in its new Ephone product. The components unit cost
structure is provided as follows: Materials 12, Labour 10,
Variable Expenses 2, and Fixed Expenses 13. The manager has
an offer from a supplier, willing to provide Elppa plc with the
component for 30. There will be no redundancy costs for the labour.
Should the component be purchased and production stopped?
If the above outsourcing was possible, assume now that Elppa plc
can use the available resources to manufacture another new product
(Ewatch) at a selling price of 34. In this case, the material price will
be 13, labour costs will be 7 per unit and variable expenses 1.50
per unit. 8,000 Ewatches could be sold annually, with the existing
overheads and equipment. Would it be advisable to produce and sell
this new product and hence, contract out the manufacture of the
memory sticks?
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TS Dec 2013 17
Should the component be purchased and production stopped?
Compare avoidable costs (12+10+2 = 24) with outsourcing price
(30). Not beneficial to stop manufacturing since only saving
24.
Would it be advisable to produce and sell this new product and
hence, contract out the manufacture of the motor component?
Contribution if manufacturing / selling new product = (34-13-7-
1.50) x 8000 units = 100,000.
If outsourcing, extra cost for component = 10,000 x (30 24) =
60,000
Net effect of outsourcing = +40,000 but this is conditional on
several factors
TS Dec 2013 18
The company may have constraints to attain full or
optimal capacity due to the lack of (or delay in the supply
of) resources e.g. labour, materials, direct expenses
Assuming ample demand for all products, the existence of
a limiting factor of production would imply a decision on
which products to give priority.
In this case, the decisive criteria would be to compare the
contribution of each product per unit of scarce resource.
The product generating the highest contribution/scarce
resource ratio will normally have priority.
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Parts F G H
Demand units 2000 2000 2000
Unit Price () 150 200 225
Machine
hours per unit
2 4 5
Variable
Costs ():
Materials
Labour
50
50
80
60
40
125
TS Dec 2013 19
Beaufort manufactures
the following parts. The
three products use the
same raw materials and in
the next period, the
available machine hours
will be restricted to 10,000
hours. Total fixed costs
are estimated at 60,000.
How should one allocate
the machine hours to
maximize profit?
TS Dec 2013 20
F G H
Contribution per unit 50 60 60
Contribution per scarce resource 50/2 60/4 60/5
=25 =15 =12
Prioritise product with highest ratio (limiting factor: 10,000 machine hours)
since demand cannot be met for all products
i.e. F (2000 units x 2 hours) = 4,000 hours
Remaining number of machine hours = 6,000
Production for G = 6,000/4 = 1,500 units
Hence, Gs level of production will be limited to 1500 and there are no hours
left for H.
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There is a large number of situations and decisions, where
financial implications would come into play. The key
notions are contribution and relevant cost.
It does not mean that the cheapest or more profitable
option is the wisest one, since the techniques implicitly
adopt a short term perspective. Hence, at the very least,
non-financial factors remain of equal importance.
Advances in information systems, quality management have
also provided new ways to use financial data, beyond the
traditional financial cost accounting system
TS Dec 2013 21