Chapter 4

Measuring relevant costs and

revenues for decision-making

Question 4.24
Make or buy decision
The management of Springer plc is considering next years production and purchase
budgets.
One of the components produced by the company, which is incorporated into
another product before being sold, has a budgeted manufacturing cost as follows:

()
Direct material 14
Direct labour (4 hours at 10 per hour) 40
Variable overhead (4 hours at 2 per hour) 8
Fixed overhead (4 hours at 5 per hour) 20
Total cost 82 per unit

Trigger plc has offered to supply the above component at a guaranteed price of
78 per unit.

Required:
(a) Considering cost criteria only, advise management whether the above
component should be purchased from Trigger plc. Any calculations should be
shown and assumptions made, or aspects which may require further
investigation should be clearly stated. (6 marks)
(b) Explain how your above advice would be affected by each of the two separate
situations shown below.

(i) As a result of recent government legislation if Springer plc continues to

manufacture this component the company will incur additional inspection
and testing expenses of 56 000 per annum, which are not included in the
above budgeted manufacturing costs. (3 marks)

(ii) Additional labour cannot be recruited and if the above component is not
manufactured by Springer plc the direct labour released will be employed
in increasing the production of an existing product which is sold for 146
and which has a budgeted manufacturing cost as follows:

()
Direct material 10
Direct labour (8 hours at 10 per hour) 80
Variable overhead (8 hours at 2 per hour) 16
Fixed overhead (8 hours at 5 per hour) 40
146 per unit

All calculations should be shown. (4 marks)

15 MEASURING RELEVANT COSTS AND REVENUES FOR DECISION-MAKING

(c) The production director of Springer plc recently said:
We must continue to manufacture the component as only one year ago we
purchased some special grinding equipment to be used exclusively by this
component. The equipment cost 100 000, it cannot be resold or used
elsewhere and if we cease production of this component we will have to
write off the written down book value which is 80 000.
Draft a brief reply to the production director commenting on his statement.
(4 marks)
(Total 17 marks)

Question 4.25
Calculation of minimum selling price
You have received a request from EXE plc to provide a quotation for the manufacture
of a specialized piece of equipment. This would be a one-off order, in
excess of normal budgeted production. The following cost estimate has already
been prepared:

Note ()
Direct materials:
Steel 10 m2 at 5.00
per sq. metre 1 50
Brass fittings 2 20
Direct labour
Skilled 25 hours at 10.00
per hour 3 200
Unskilled 10 hours at 8.00
per hour 4 80
Overhead 35 hours at 10.00
per hour 5 350
Estimating time 6 100
850
Administrative overhead
at 20% of
production cost 7 170
1020
Profit at 25% of
total cost 8 255
Selling price 1275

Notes:
1. The steel is regularly used, and has a current stock value of 5.00 per sq. metre.
There are currently 100 sq. metres in stock. The steel is readily available at a
price of 5.50 per sq. metre.
2. The brass fittings would have to be bought specifically for this job: a supplier
has quoted the price of 20 for the fittings required.
3. The skilled labour is currently employed by your company and paid at a rate of
10.00 per hour. If this job were undertaken it would be necessary either to
work 25 hours overtime which would be paid at time plus one half or to reduce
production of another product which earns a contribution of 13.00 per hour.
4. The unskilled labour currently has sufficient paid idle time to be able to
complete this work.
5. The overhead absorption rate includes power costs which are directly related
to machine usage. If this job were undertaken, it is estimated that the machine
time required would be ten hours. The machines incur power costs of 0.75 per
hour. There are no other overhead costs which can be specifically identified
with this job.
6. The cost of the estimating time is that attributed to the four hours taken by the
engineers to analyse the drawings and determine the cost estimate given above.

16 PART I: QUESTIONS
7. It is company policy to add 20% on to the production cost as an allowance
against administration costs associated with the jobs accepted.
8. This is the standard profit added by your company as part of its pricing policy.

Required:
(a) Prepare, on a relevant cost basis, the lowest cost estimate that could be used as
the basis for a quotation. Explain briefly your reasons for using each of the
values in your estimate. (12 marks)
(b) There may be a possibility of repeat orders from EXE plc which would occupy
part of normal production capacity. What factors need to be considered before
quoting for this order? (7 marks)
(c) When an organisation identifies that it has a single production resource which
is in short supply, but is used by more than one product, the optimum
production plan is determined by ranking the products according to their
contribution per unit of the scarce resource.
Using a numerical example of your own, reconcile this approach with the
opportunity cost approach used in (a) above. (6 marks)
(Total 25 marks)

Question 4.26
Price/output and key factor decisions
You work as a trainee for a small management consultancy which has been asked
to advise a company, Rane Limited, which manufactures and sells a single product.
Rane is currently operating at full capacity producing and selling 25 000 units
of its product each year. The cost and selling price structure for this level of activity
is as follows:

A new managing director has recently joined the company and he has engaged
your organization to advise on his companys selling price policy. The sales price of
60 has been derived as above from a cost-plus pricing policy. The price was viewed
as satisfactory because the resulting demand enabled full capacity operation.
You have been asked to investigate the effect on costs and profit of an increase in
the selling price. The marketing department has provided you with the following
estimates of sales volumes which could be achieved at the three alternative sales
prices under consideration.

Selling price per unit 70 80 90

Annual sales volume (units) 20 000 16 000 11 000

17 MEASURING RELEVANT COSTS AND REVENUES FOR DECISION-MAKING

You have spent some time estimating the effect that changes in output volume
will have on cost behaviour patterns and you have now collected the following
information.
Direct material: The loss of bulk discounts means that the direct material cost
per unit will increase by 15% for all units produced in the year if activity
reduces below 15 000 units per annum.
Direct labour: Savings in bonus payments will reduce labour costs by 10% for
all units produced in the year if activity reduces below 20 000 units per annum.
Sales commission: This would continue to be paid at the rate of 10% of sales
price.
Fixed production overhead: If annual output volume was below 20 000 units,
then a machine rental cost of 10 000 per annum could be saved. This will be
the only change in the total expenditure on fixed production overhead.
Fixed selling overhead: A reduction in the part-time sales force would result
in a 5000 per annum saving if annual sales volume falls below 24 000 units.
This will be the only change in the total expenditure on fixed selling and
distribution overhead.
Variable production overhead: There would be no change in the unit cost for
variable production overhead.
Administration overhead: The total expenditure on administration overhead
would remain unaltered within this range of activity.
Stocks: Ranes product is highly perishable, therefore no stocks are held.

Task 1
(a) Calculate the annual profit which is earned with the current selling price of 60
per unit.
(b) Prepare a schedule to show the annual profit which would be earned with
each of the three alternative selling prices.

Task 2
Prepare a brief memorandum to your boss, Chris Jones. The memorandum should
cover the following points:
(a) Your recommendation as to the selling price which should be charged to
maximize Rane Limiteds annual profits.
(b) Two non-financial factors which the management of Rane Limited should
consider before planning to operate below full capacity.
Another of your consultancys clients is a manufacturing company, Shortage
Limited, which is experiencing problems in obtaining supplies of a major
component. The component is used in all of its four products and there is a
labour dispute at the suppliers factory, which is restricting the components
availability.
Supplies will be restricted to 22 400 components for the next period and the
company wishes to ensure that the best use is made of the available
components. This is the only component used in the four products, and there
are no alternatives and no other suppliers.
The components cost 2 each and are used in varying amounts in each of the
four products.
Shortage Limiteds fixed costs amount to 8000 per period. No stocks are
held of finished goods or work in progress.
The following information is available concerning the products.

Maximum Product A Product B Product C Product D

demand 4000 units 2500 units 3600 units 2750 units
per period ( per unit) ( per unit) ( per unit) ( per unit)
Selling price 14 12 16 17
Component costs 4 2 6 8
Other variable costs 7 9 6 4

18 PART I: QUESTIONS
Task 3
(a) Prepare a recommended production schedule for next period which will
maximize Shortage Limiteds profit.
(b) Calculate the profit that will be earned in the next period if your recommended
production schedule is followed.

Question 4.27
Acceptance of a contract
JB Limited is a small specialist manufacturer of electronic components and much of
its output is used by the makers of aircraft for both civil and military purposes. One
of the few aircraft manufacturers has offered a contract to JB Limited for the supply,
over the next twelve months, of 400 identical components.
The data relating to the production of each component is as follows:
(i) Material requirements:
3 kg material M1 see note 1 below
2 kg material P2 see note 2 below
1 Part No. 678 see note 3 below
Note 1. Material M1 is in continuous use by the company. 1000 kg are currently
held in stock at a book value of 4.70 per kg but it is known that future
purchases will cost 5.50 per kg.
Note 2. 1200 kg of material P2 are held in stock. The original cost of this material
was 4.30 per kg but as the material has not been required for the last two years
it has been written down to 1.50 per kg scrap value. The only foreseeable
alternative use is as a substitute for material P4 (in current use) but this would
involve further processing costs of 1.60 per kg. The current cost of material P4
is 3.60 per kg.
Note 3. It is estimated that the Part No. 678 could be bought for 50 each.
(ii) Labour requirements: Each component would require five hours of skilled
labour and five hours of unskilled. An employee possessing the necessary
skills is available and is currently paid 12 per hour. A replacement would,
however, have to be obtained at a rate of 11 per hour for the work which
would otherwise be done by the skilled employee. The current rate for unskilled
work is 8 per hour and an additional employee could be appointed for
this work.
(iii) Overhead: JB Limited absorbs overhead by a machine hour rate, currently 20
per hour of which 7 is for variable overhead and 13 for fixed overhead. If this
contract is undertaken it is estimated that fixed costs will increase for the
duration of the contract by 3200. Spare machine capacity is available and each
component would require four machine hours.
A price of 220 per component has been suggested by the large company
which makes aircraft.

You are required to:

(a) State whether or not the contract should be accepted and support your
conclusion with appropriate figures for presentation to management;
(16 marks)
(b) comment briefly on three factors which management ought to consider and
which may influence their decision. (9 marks)
(Total 25 marks)

19 MEASURING RELEVANT COSTS AND REVENUES FOR DECISION-MAKING

Question 4.28
Preparation of a cost estimate involving the
identification of relevant costs
You are the management accountant of a publishing and printing company which
has been asked to quote for the production of a programme for the local village fair.
The work would be carried out in addition to the normal work of the company.
Because of existing commitments, some weekend working would be required to complete
the printing of the programme. A trainee accountant has produced the following
cost estimate based upon the resources as specified by the production manager:

()
Direct materials:
paper (book value) 5 000
inks (purchase price) 2 400
Direct labour:
skilled 250 hours at 12.00 3 000
unskilled 100 hours at 7 750
Variable overhead 350 hours at 4.00 1400
Printing press depreciation 200 hours at 2.50 500
Fixed production costs 350 hours at 6.00 2 100
Estimating department costs 00 400
15 500
You are aware that considerable publicity could be obtained for the company if you
are able to win this order and the price quoted must be very competitive.
The following are relevant to the cost estimate above:
1. The paper to be used is currently in stock at a value of 5000. It is of an unusual
colour which has not been used for some time. The replacement price of the
paper is 8000, while the scrap value of that in stock is 2500. The production
manager does not foresee any alternative use for the paper if it is not used for
the village fair programmes.
2. The inks required are not held in stock. They would have to be purchased in
bulk at a cost of 3000. 80% of the ink purchased would be used in printing the
programme. No other use is foreseen for the remainder.
3. Skilled direct labour is in short supply, and to accommodate the printing of the
programmes, 50% of the time required would be worked at weekends, for
which a premium of 25% above the normal hourly rate is paid. The normal
hourly rate is 12.00 per hour.
4. Unskilled labour is presently under-utilized, and at present 200 hours per week
are recorded as idle time. If the printing work is carried out at a weekend, 25
unskilled hours would have to occur at this time, but the employees concerned
would be given two hours time off (for which they would be paid) in lieu of
each hour worked.
5. Variable overhead represents the cost of operating the printing press and
binding machines.
6. When not being used by the company, the printing press is hired to outside
companies for 6.00 per hour. This earns a contribution of 3.00 per hour.
There is unlimited demand for this facility.
7. Fixed production costs are those incurred by and absorbed into production,
using an hourly rate based on budgeted activity.
8. The cost of the estimating department represents time spent in discussion with
the village fair committee concerning the printing of its programme.
Required:
(a) Prepare a revised cost estimate using the opportunity cost approach, showing
clearly the minimum price that the company should accept for the order. Give
reasons for each resource valuation in your cost estimate. (16 marks)
(b) Explain the relevance of opportunity costs in decision-making. (5 marks)

20 PART I: QUESTIONS
Question 4.29
Decision on whether to launch a new product
A company is currently manufacturing at only 60% of full practical capacity, in
each of its two production departments, due to a reduction in market share. The
company is seeking to launch a new product which it is hoped will recover some
lost sales.
The estimated direct costs of the new product, Product X, are to be established
from the following information:

Direct materials:
Every 100 units of the product will require 30 kilos net of Material A. Losses of 10%
of materials input are to be expected. Material A costs 5.40 per kilo before discount.
A quantity discount of 5% is given on all purchases if the monthly purchase
quantity exceeds 25 000 kilos. Other materials are expected to cost 1.34 per unit of
Product X.

Direct labour (per hundred units):

Department 1: 40 hours at 10.00 per hour.
Department 2: 15 hours at 11.00 per hour.

Separate overhead absorption rates are established for each production department.
Department 1 overheads are absorbed at 130% of direct wages, which is
based upon the expected overhead costs and usage of capacity if Product X is
launched. The rate in Department 2 is to be established as a rate per direct labour
hour also based on expected usage of capacity. The following annual figures for
Department 2 are based on full practical capacity:

Overhead, 5 424 000:

Direct labour hours, 2 200 000.

Variable overheads in Department 1 are assessed at 40% of direct wages and in

Department 2 are 1 980 000 (at full practical capacity).
Non-production overheads are estimated as follows (per unit of Product X):
Variable, 0.70
Fixed, 1.95

The selling price for Product X is expected to be 13.325 per unit, with annual sales of
2 400 000 units.

Required:
(a) Determine the estimated cost per unit of Product X. (13 marks)
(b) Comment on the viability of Product X. (7 marks)
(c) Market research indicates that an alternative selling price for Product X could
be 12.825 per unit, at which price annual sales would be expected to be 2 900 000
units. Determine, and comment briefly upon, the optimum selling price.
(5 marks)
(Total 25 marks)

21 MEASURING RELEVANT COSTS AND REVENUES FOR DECISION-MAKING

Question 4.30
Limiting key factors
PDR plc manufactures four products using the same machinery. The following
details relate to its products:

*Absorbed based on budgeted labour hours of 1000 per week.

There is a maximum of 2000 machine hours available per week.

Requirement:
(a) Determine the production plan which will maximise the weekly profit of PDR
plc and prepare a profit statement showing the profit your plan will yield.
(10 marks)
(b) The marketing director of PDR plc is concerned at the companys inability to
meet the quantity demanded by its customers.
Two alternative strategies are being considered to overcome this:
(i) to increase the number of hours worked using the existing machinery by
working overtime. Such overtime would be paid at a premium of 50%
above normal labour rates, and variable overhead costs would be expected
to increase in proportion to labour costs.
(ii) to buy product B from an overseas supplier at a cost of 19 per unit including
carriage. This would need to be repackaged at a cost of 1 per unit
before it could be sold.

Requirement:
Evaluate each of the two alternative strategies and, as management accountant,
prepare a report to the marketing director, stating your reasons (quantitative and
qualitative) as to which, if either, should be adopted. (15 marks)
(Total 25 marks)

22 PART I: QUESTIONS