Relevant Cost and Alternative Choice Decision

Prof. (Dr.) Gourav Vallabh XLRI JAMSHEDPUR

* Decision making is one of basic function of manager and in business decision cost is always a key and relevant factor. * Though the decision making process applied by managers in different situation may be different yet in most of the cases, the manager follow a method consisting of following stages (1) Define the problem and the objective to be accomplished. (2) Identifying the several alternative course of action (3) Obtaining, analysing and evaluating the relevant information and (4) Making the decision by selecting one option. * In management accounting, the decision model used is known as differential analysis or incremental analysis. For this manager must understand and distinguish between relevant and irrelevant cost.

Problem

XYZ Ltd. is considering the alternative of purchasing a component from outside supplier against the practice of manufacturing it. The estimated costs of production are Direct labour Rs. 100 per unit, Direct Material Rs. 300 per unit, Variable overheads of Rs. 10 per unit and Fixed overhead (allocated) of Rs. 20 per unit. The firm has a requirement of 400 units per annum and the supplier has quoted a price of Rs. 500 per unit for an order of 100 units. Analyze the relevant costs, given that the labour is a permanent pay roll.

Special sales order problem * In some situations, the firm has to decide about whether to accept or not a special sales order usually at a price lower than the normal selling price * So long as the increment sales revenue is more than the incremental cost, the firm will increase its shortened profits. * XYZ Co. has capacity to produce 1,20,000 units of a product per month and is producing and selling 90,000 units at present. The variable cost and the selling price are Rs.0.90 and Rs.2.50 respectively. It has received an export quality for 20,000 units @ Rs.1.80 per unit. Should the export order be accepted given that (i) the fixed cost at present is Rs. 1,11,000 per month. (ii) all the administrative expenses are fixed at Rs.15,000 per month. (iii) a special printing machine costing Rs.10,000 would be required to imprint a special label on the export units, and this machine can be used only for printing these labels.

To continue or shut down a product or Department

* Firms usually have to decide about which product or sales mix is better. * The same principal of relevance that applied to special order situation also applies to decision about adding or debating products or department.

Problem ABC Ltd. has three departments Maintenance, General and Marketing. Over the years, Maintenace is found showing losses, so there is a proposal to drop it. Departmental and Total Income Statements are presented as follows:
Departments Maintenace General Marketing Total Rs.10,00,000 Rs.8,00,000 Rs.1,00,000 Rs.19,00,000 8,00,000 5,60,000 60,000 Rs.14,20,000 2,00,000 2,40,000 40,000 4,80,000 60,000 1,50,000 -10,000 1,00,000 1,00,000 40,000 20,000 15,000 5,000 1,80,000 2,65,000 35,000

Sales -Variable Cost Contribution -Fixed Costs Unavoidable Avoidable Net Income

Make or Buy Decision A decision to produce a part internally rather than to buy externally from a supplier is often called a make or buy decision.

* In case the firm has both the production capacity and expertise to produce a given part, the decision to produce or buy externally must be based on the relevant cost of both options.

Problem Auto Well Ltd. is operating at 80% capacity to produce 20,000 Fuel Assemblies. For this purpose, a casket is being purchased at present at a price of Rs. 12 per casket. There is a proposal from the Production department that the casket can also be produced internally, based on the absorption costing the cost sheet has been prepared in respect of production of 20,000 caskets. Number of units Material Cost @Rs. 3.15 per Direct labour cost @ Rs. 5.50 per Variable Overheads Rs. 1.50 per Allocated Fixed Overheads 20,000 Rs. 63,000 1,10,000 30,000 82,000 2,85,000 Cost per unit Rs. 14.25

Problem Intel Axel Ltd. has received an order for a specialized product. This would be a one off order and is in excess of normal budgeted production. Following cost information is available for the product. Direct Material: Direct Labour: Steel (@Rs. 5 per sq. meter) Rs. Brass fitting Skilled (Rs. 8 x 25 hours) Semi-skilled (Rs. 5 x 10 hours) (35 hours x Rs. 10 per hour) 50 20 200 50 350 100 770 154 924 231 1,155 Continued

Overheads Other Expenses Production Cost Administrative Overheads (20% of Production Cost) Total Cost Profit (25% on Cost) Selling Price

Concluding Part You are required to find out the lowest quotation for the supply of the above specialised product on the basis of the following: (i) Steel is readily available in stock valued at Rs. 5 per square meter. However, the current market price of the steel is Rs. 5.50 per sq. meter. (ii) The skilled labour is currently employed by the firm @ Rs. 8 per hour. But in order to produce the specialized product, (i) the labour would be employed at overtime rate of Rs. 12 per hour, or (ii) the firm will reduce the proportion of another product which contributes Rs. 13 per hour. (iii) The semi-skilled labour currently has sufficient idle time to be able to do the job of specialised product. (iv) The overhead absorption rate of Rs. 10 per hour include power cost which is directly related to machine usage. The specialized product requires machine use of 10 hour only and the power cost is Rs. 0.75 per machine hour. There is no other overhead cost which can be identified with the specialized product (v) Other expenses, already being incurred by the firm, are allocated to this job.