2016-17 Term 1

ACCT112 Management Accounting

Week 10

Relevant Costing

2016-17-T1-Aug to Dec 2016

Seminar Outline
Identify relevant and irrelevant costs and
benefits in decision-making
Prepare an analysis for the following decisionmaking:
Drop or Keep a product line
Make or Buy
Special order
Decision with constraints
Further processing of joint products

2016-17-T1-Aug to Dec 2016

The Concept of Relevance

Relevant Information has two
characteristics:
It occurs in the future; and
E.g.It Decision:
differs among
the alternative
what shall
Tom get forcourses of
o
action
lunch?
Fish &
Chicken
r
chips
rice

If cost of chicken rice = $7; cost of fish & chips

The
cost of the dishes is relevant as it differs between the
= $6?
2Ifalternatives
cost of chicken rice = $7; cost of fish & chips
The
= $7?
cost of the dishes is irrelevant as both alternatives
have
If Tom
hascost
spent $10 on a movie yesterday?
same
$10 is irrelevant as it has already been spent
2016-17-T1-Aug to Dec 2016
3
sunk cost

Opportunity Costs: Example

XYZ Ltd has produced a limited edition painting. It
has received offers from the 4 companies below:
Company A: $80,000
Company B: $85,000
Company C: $90,000
Biggest sacrifice if XYZ sells to
Company D: $95,000
Co E
Another customer, Company E, also wants to buy
the painting. What is the minimum price that XYZ
would require from Company E?
2016-17-T1-Aug to Dec 2016

Opportunity Costs
An opportunity cost is the maximum
benefit that is foregone as a result of
pursuing
ofthen
action.
E.g. If XYZsome
sellscourse
to Co E,
it cannot sell
to Co D. $95,000 offered by Co D is the
opportunity cost.
Opportunity
costs are not actual cash
outlays (i.e. not incurred yet) and are not$95,000
recorded in the formal accounts of aninfo not
E.g.
$95,000 offered by Co D is not
organization.
needed
recorded in the accounts because there isfor
sale yet.
no
Opportunity costs are relevant costs in Reporting
purpose
decision-making.
E.g.
In deciding whether to sell to Co $95,000
info
E, the relevant cost of the painting
needed for
= $95,000. To ensure profit 0,
Decisionselling price cost. Thus, Co Es
making
offer $95,000 2016-17-T1-Aug to Dec 2016
purpose
5

Avoidable and Non-Avoidable Costs

Avoidable costs are future costs that can be
eliminated (in whole or in part) by choosing one
alternative over another. They are differential
costs.
E.g. SIA started TigerAir Australia in 2007 with 5
aircraft and A$10 m. In 2014, Virgin offered to
buy TigerAir for A$1. SIAs reported loss would
be S$59.8 million if it agreed to sell.
Decision: Should SIA sell TigerAir Australia to
Virgin for A$1?

Avoidable and Non-Avoidable Costs

Dont
Sell

Sell

Proceeds from sale

of TigerAir
Australia (TAA)
Rev from flights by
TAA
Fuel
Staff: flight crew
eg. Cost SIA
$5m, CEO
useful life 5 yr.
Staff:
Alrdy dep 2 yrs. 3rd yr now
Depreciation of
aircraft
Lease of TAA office
Loss of disposal of
2016-17-T1-Aug to Dec 2016
biz S$59.8m

Total vs Differential Cost Approach

ABC Co sells its product for $40 per unit. Its current
manufacturing costs to produce 5,000 units are as
follows:
Direct materials
$14 per unit
Direct labour
$8 per unit
Variable overhead
$2 per unit
Fixed overhead
$62,000 per year
ABC is considering a new labour saving machine
that rents for $3,000 per year.
Direct labour would be reduced to $5 per unit.
Selling price and other costs are expected to
remain unchanged.
2016-17-T1-Aug to Dec 2016

Method 1: Total Approach

ABC Co will increase net operating income by

$12,000 if it rents the machine.
2016-17-T1-Aug to Dec 2016

Method 2: Differential Cost Approach

Alternative approach: look at differential costs
and revenues
The only costs that differ between the
alternatives are
(a) direct labor costs savings; and (b) increase in
fixed rental costs.
Benefits
Cost
s

2016-17-T1-Aug to Dec 2016

10

Keep or Drop a Product Line

Lovell Co. makes and sells digital watches and
smartbands. Due to the declining popularity of
digital watches, Lovells digital watch line has
not reported a profit for several years. Lovell is
considering dropping
this product
line.
Investigation
has revealed
that total
fixed
general factory overhead and general
administrative expenses would not be affected
if the digital watch line is dropped. The fixed
general factory overhead and general
administrative expenses assigned to this
product would be reallocated to the smartband
line.
The equipment used to manufacture digital
watches has no resale value or alternative
use.
2016-17-T1-Aug to Dec 2016
11

Digital Smartba
Lovell
Watches
nd Company
$500,000 $800,000 $1,300,000

Sales
Less: Variable Expenses
Variable manufacturing
costs
$120,000 130,000
Variable shipping costs
5,000
6,000
Commissions
75,000 105,000
Contribution margin
$300,000 $559,000
Less: Fixed Expenses
Allocated general factory
ovhd
$60,000
80,000
Salary of line manager
90,000
90,000
Depreciation of
equipment
50,000
45,000
Advertising - direct
100,000 120,000
Rent - factory space
70,000
80,000
Allocated genera admin
30,000
50,000
($100,00
2016-17-T1-Aug to Dec 2016 0) $94,000
12
Net Operating Profit/(Loss)

$250,000
$11,000
$180,000
$859,000
$140,000
$180,000
$95,000
$220,000
$150,000
$80,000
($6,000)

Keep or Drop a Product Line

DECISION RULE
Evaluate benefits vs costs from companys
perspective; not product lines perspective
Drop the product line only if company as a
whole benefits i.e.
Profit of company
AFTER
dropping product
o
Benefits
of
r
dropping
Cost savings if
line
was dropped

>
>

Profit of company
BEFORE
dropping product
Costs of
dropping
Lost contribution
margin

2016-17-T1-Aug to Dec 2016

13

Keep or Drop a Product Line: Total

Approach
Keep
Drop

Digital
Digital Difference
Watches Watches
if Drop
$1,300,000 $800,000 -$500,000

Sales
Less: Variable Expenses
Variable manufacturing
costs
Variable shipping costs
Commissions
Contribution margin
Less: Fixed Expenses
Allocated general factory
ovhd
Salary of line manager
Depreciation/Loss on
disposal
Advertising - direct
Rent - factory space
Allocated genera
admin
Company
is worse
off by
Net Operating Loss

$250,000
$11,000
$180,000
$859,000

$130,000
$6,000
$105,000
$559,000

$120,000
$5,000
$75,000
-$300,000

$140,000

$140,000

$0

$180,000
$95,000

$90,000
$95,000

$90,000
$0

Reallocated to
Smartband

Reallocated to Smartband

$220,000 $120,000 $100,000

$150,000
$80,000
$70,000
$80,000 if $80,000
$0
$40,000
the product
line
14
($6,000) ($46,000) ($40,000)

Keep or Drop a Product Line:

Incremental Approach
CM lost if digital watches are
dropped

- Costs of
$300,00dropping
0

Savings from fixed costs:

Salary of line
manager

$90,00
0

Advertising direct

Benefits of
dropping

100,00
From a quantitative perspective,
should not
0

drop
digitalspace
watch 70,000
product 260,000
line as the
Rentthe
factory
company will be worse off by $40,000.
Net disadvantage
Beware
of allocated fixed costs &-sunk costs
to relevant
Co.
$40,00 for company
not
costs; thus no savings
if segment is closed!0
But Note: not all fixed costs are irrelevant in all
cases
2016-17-T1-Aug to Dec 2016

15

Make or Buy
When a company is involved in more than one
activity in the entire value chain, it is vertically
integrated. A decision to carry out one of the
activities in the value chain internally, rather
than to buy externally from a supplier is called
a make or buy decision.
DECISION RULE:
Cost of Making

Buy if
>

Cost of

Buying
Or
Benefits

>

Costs
Avoidable costs >
buy externally 2016-17-T1-Aug to Dec 2016
(i.e. savings from

Cost to
16

Make or Buy - Example

Essex Company produces computers. It
currently manufactures part 4A, which is used in
the computer production.
The unit product cost of part A4 is:

2016-17-T1-Aug to Dec 2016

17

Make or Buy - Example

Other information:
a) The special equipment used to manufacture
part 4A has no resale value.
b) The total amount of general factory overhead,
which is allocated on the basis of direct labor
hours, would be unaffected by this decision
c) The $30 unit product cost is based on 20,000
parts produced each year.
d) An outside supplier has offered to provide the
20,000 parts at a cost of $25 per part.
Should Essex accept the suppliers offer?

2016-17-T1-Aug to Dec 2016

18

Make or Buy - Example

Cost
Per Unit

Outside purchase price

$ 25

Direct materials
Direct labor
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost

Cannot be
eliminated
i.e. Nonavoidable
costs

Cost of 20,000 Units

Buy
Make
$ 500,000

9
180,000
5
100,000
1
20,000
3 Sunk 2 cost40,000
10 Allocated
$ 30
$ 340,000
cost

BENEFIT
S OF
BUYING

Avoidab
le
Costs if
do not
make
$i.e.
500,000
if
COSTS
buy
OF
BUYING

DECISION
?

2016-17-T1-Aug to Dec 2016

19

Special Order
A special order is a one-time order that is not
considered part of the companys normal
ongoing business.
DECISION RULE
When analyzing a special order, only the
incremental costs and benefits are
relevant.
Accept order if incremental benefits >
incremental costs

2016-17-T1-Aug to Dec 2016

20

Special Order Example

a) Jet, Inc. makes a single product whose
normal selling price is $20 per unit.
b) A foreign distributor offers to purchase
3,000 units for $10 per unit. Jet, Inc. must
fulfil the order in full if it accepts the offer.
c) This is a one-time order that would not
affect the companys regular business.
d)Annual capacity is 10,000 units.
e) Fixed marketing costs are not affected by
the special order but variable marketing
costs must be incurred on the special order.

2016-17-T1-Aug to Dec 2016

21

Special Order Example (idle

If Jet, Inc. plans capacity)
to sell only 5,000 units
during the year.

$8 per unit

$12 per
unit

2016-17-T1-Aug to Dec 2016

22

Special Order Example (idle

capacity)

Annual capacity = 10,000 units

Planned production = 5,000 units excess capacity
5,000 units
Fixed manufacturing overhead cost will not increase if
Jet
produces
additional
3,000 units.
Also,
given (e)
Fixed marketing
costs are not
affected by the special order

If Jet accepts the offer, net operating income

will increase by $6,000.
2016-17-T1-Aug to Dec 2016

23

Special Order Example (no idle

If Jet Inc plans to capacity)
sell 8,000 units to regular
customers during the year.
If accept special order of 3,000 units,
Total production (regular + special order) =
11,000
Annual capacity
= 10,000
Thus, must
give
units of regular
Incremental
Approach
Relevant
costs
ofup 1,000
sales order
special
Opportunity cost (lost $12 CM x 1,000 units of regular
sales)
= $12,000
Incremental cost $8 to produce 3,000
units
=
$24,000
Total relevant costs
= $36,000
Incremental revenue from special order=
$10 x 3,000
= $30,000
REJECT Special
order because
company2016-17-T1-Aug
will beto worse
off by24
Dec 2016

Special Order Example (no idle

capacity)
Total
Approach
Alternative
analysis

Accept Special
3,000 spOrder
order + 7,000 reg

Reject Special
Order8,000 reg

Revenue

Variable
costs
CM

(3,000 x $10)
+ (7,000 x $20)
= $170,000

8,000 x $20
= $160,000

10,000 x $8
= $80,000

8,000 x $8
= $64,000

$90,000
$96,000
REJECT Special order because
company will be worse off by
$6,000
2016-17-T1-Aug to Dec 2016

25

Decision with Constraints

When a limited resource of some type
restricts the companys ability to satisfy
demand, the company is said to have a
constraint.
The machine or process that is limiting overall
output is called the bottleneck it is the
constraint.

2016-17-T1-Aug to Dec 2016

26

Decision with Constraints

When a constraint exists, a company should select
a product mix that maximizes Total Profit of the
company.
Profit = TCM FC. Thus, if fixed costs remain
unchanged, then maximising Total Contribution
Margin will maximise Total Profit.
Do not prioritise products based on highest
contribution margin per unit of product.
Rather, promote those products that earn the
highest contribution margin in relation to the
DECISION
RULEresource.
constraining
Choose the product mix that maximises Total
Profit. Where Fixed Cost is not relevant,
choose the products that have the highest
contribution margin per unit of the
2016-17-T1-Aug to Dec 2016
27
constraining resource.

Decision with Constraints - Example

Product
1
$60
$36
$24
1 min

Product
2
$50
$35
$15
0.5 min

Selling price per unit

Var expense per unit
CM per unit
Machine A1 time required
per unit
a)
Machine
A1 isdemand
the constrained
resource and
is
Current
market
per
2,000
2,200
being used at 100% of its capacity.
week
units
units

b)There is excess capacity on all other machines.

c) Machine A1 has a capacity of 2,400 minutes per
week.
What is the product mix to maximise profit?
2016-17-T1-Aug to Dec 2016

28

Decision with Constraints - Example

Step 1: Rank the products to
be produced
Product 1 Product 2
Contribution margin per unit
$24
$15
Machine A1 time per unit
1 min
0.5 min
Contribution margin per minute $241= $24
$150.5=$30
1 minute of Machine A1 can produce:
1 unit of Product 1 i.e. contribution margin =
$24 * 1 = $24
or
2 units of Product 2 i.e. contribution margin =
$15
Since
*2=
$30>$24,
$30
produce Product 2 first,
then Product 1.
2016-17-T1-Aug to Dec 2016

29

Decision with Constraints - Example

Step 2: Produce ranked products to meet
market
demand
Alloting Our Constrained Resource (Machine A1)
Weekly demand for Product 2
Time required per unit
Total time required to make
Product 2
Total time available
Time used to make Product 2
Time available for Product 1
Time required per unit
Production of Product 1

2016-17-T1-Aug to Dec 2016

2,200 units
0.50 min.
1,100 min.

2,400
1,100
1,300
1.00
1,300

30

min.
min.
min.
min.
units

Decision with Constraints - Example

According to the plan, we will produce 2,200
units of Product 2 and 1,300 of Product 1.

The total contribution margin is $64,200.

2016-17-T1-Aug to Dec 2016

31

Further Processing of Joint Products

In some industries, a number of end

products are produced from a single raw
material input.

Two or more products produced from a

common input are called joint products.

The point in the manufacturing process

where each joint product can be recognized
as a separate product is called the split-off
point.

2016-17-T1-Aug to Dec 2016

32

Further Processing of Joint Products

Oil
Input

Common
Production
Process
Gasoline
JOINT COSTS
$x incurred
to produce
products

Chemicals

Split-Off
Point
2016-17-T1-Aug to Dec 2016

For example, in
the petroleum
refining
industry, a
large number
of products are
extracted from
crude oil,
including
heating oil,
gasoline, and
various organic
chemicals.
33

Further Processing of Joint Products

Joint costs are
sunk costs
(incurred
before decision
Input
point)
Joint Costs
already
incurred in
the
common
production
process

Decisio
n
Proces
Making
Oil

Gasoline

Chemicals

s
Furthe
r?
Proces
s
Furthe
r?
Proces
s
Furthe
r?

Split-Off
Point
2016-17-T1-Aug to Dec 2016

34

Final
Sale
Final
Sale
Final
Sale

Further Processing of Joint Products

Joint costs are traditionally allocated among
different products at the split-off point for
balance sheet inventory reporting.
Allocated joint costs are not relevant in
decisions regarding what to do with a
product from the split-off point forward.
DECISION RULE

It will always be profitable to continue

processing a joint product after the split-off
point so long as the incremental revenue
exceeds the incremental processing costs
incurred after the split-off point.
2016-17-T1-Aug to Dec 2016

35

Further Processing of Joint Products a) Sawmill, Inc. cutsExample

logs from which unfinished
lumber and sawdust are the immediate joint
products.
b) Unfinished lumber is sold as is or processed
further into finished lumber.
c) Sawdust can also be sold as is to gardening
wholesalers or processed further into prestologs.
Per Log
d) Data about Sawmills joint products includes:
Lumbe Sawd
r
ust
Sales value at split-off point
$140
$40
Sales value after further
$270
$50
processing
Allocated joint product costs
$176
$24
2016-17-T1-Aug to Dec 2016
Cost of further processing
$5036
$20

Further Processing of Joint Products Example

Analysis of Sell or Process Further

Per Log
Lumber

Sales value after further processing

Sales value at the split-off point
Incremental revenue
Cost of further processing
Profit (loss) from further processing

270
140
130
50
80

Therefore,
Lumber: process further
Sawdust: do not process
further
Additional profit: $80
2016-17-T1-Aug to Dec 2016

37

Sawdust

50
40
10
20
(10)

More about Opportunity Costs

The company is planning to produce air purifiers,
which will require Mat A.
There is enough old stock of Mat A that was
bought for $12 per kg.
If the company doesnt use the old Mat A to
produce the air purifiers, it could use the old Mat
A to enhance the quality of the electric fans that
the company is currently producing and increase
the selling price
of thesell
electric
fanMat
from
Alternatively,
it could
the old
A $80
to ato
recycle
$100.
company
for $10/kg.
New Mat A could be bought for $18 per kg.
What is the relevant cost of Mat A for the
pricing decision of the air purifiers?
2016-17-T1-Aug to Dec 2016

38

More about Opportunity Costs

Use existing or new Mat A to produce air
purifiers?
Existing Mat A can be used as
follows:
Make Fans
Benefit:
Incr revenue
$20

Existing Mat A
Sell to Recycle
Co
Benefit: $10

Make air
purifiers

If the existing Mat A is used for the air

purifiers, the opportunity cost = max.
benefit sacrificed = $20
If use new Mat A, cost =
$18
So, is company better off if it uses existing
Mat A or new Mat A?
2016-17-T1-Aug to Dec 2016

39

Relevant cost of
using Mat A for Air $18 is also known as
the DEPRIVAL VALUE
Purifiers = $18,
which is the
LOWER of
Replacement
Cost of New
Mat A $18

Recoverable
Value of Existing
Mat A $20
Opportunity Cost:
Max. sacrifice; thus
HIGHER of:
Economic Value
Net Realizable
of Existing Mat
Value of
A (EV)
Existing Mat A
$20 (additional
(NRV)
rev if use Mat
$10
A for fans)
2016-17-T1-Aug to Dec 2016

40

More about Opportunity Costs

What is the relevant cost of Mat A for the
pricing decision of air purifiers?
Make Air Purifiers
If use Existing Mat A, relevant cost = $20
If use New Mat A, relevant cost = $18
To maximise profit, choose cheaper option.
Decision: Use New Mat A; relevant cost =
$18
The company will buy New Mat A to make air
purifiers; and use the Existing Mat A to make
What
willfans.
be the decision if the cost of buying New
electric
Mat A = $22?
2016-17-T1-Aug to Dec 2016

41

Some Qn that you can answer now

There are so much information but do you

know which info is relevant?

2016-17-T1-Aug to Dec 2016

42