lecture 10 relevant costing.pdf

7/27/2019 Lecture 10 Relevant Costing.pdf

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BU8101 Accounting: A User Perspective

Lecture 10Relevant Costs, Incremental Analysis

Recommended Reading:

WHB 16th edition

Chapter 21

Other Reference:Financial and Managerial Accounting: Information for Decisions

John J Wild, Barbara Chiapetta

Chapter 23

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Lecture Date: 25 March 2013


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Lecture Outline

Relevant Costs

Definition

Relevant cost and decision-making

Total vs. incremental approach

Incremental Analysis Types of Business Decisions

1. Special Order Decisions

2. Production Constraint (Product Mix) Decisions

3. Make or Buy Decisions

4. Sell, Scrap or Rebuild Decisions

5. Joint Product Decisions

Non-Financial Considerations

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Relevant Costs for Decision Making

A relevant cost is a cost that differs between

alternatives.

A relevant cost is likely to have a bearing on

the future.

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Relevant Irrelevant

Differential Cost (aka Relevant Cost) Allocated Cost -- a common cost that

-- will differ according to alternative has been arbitrarily assigned to a

activities being considered. product or activity.

Likely a future cost.

Opportunity Cost -- benefits foregone Sunk Cost -- has already been incurred

by choosing one alternative over and will not change.

another.

Cost Concepts for Decision Making

Lets take a closer look at

Opportunity Cost &

Sunk Cost

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Opportunity Cost (Benefits Forgone )

The benefit that could have been attained bypursuing an alternative course of action.

Example: If you are not attending college, youcould be earning $20,000 per year. Your

opportunity cost of attending college for oneyear includes the $20,000 salary foregone.

Opportunity costs are not recorded in theaccounting records, but are relevant to decisions

because they are a real sacrifice.

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Sunk Cost10-6

Costs that have already been incurred.They do not affect any future cost and cannot be

changed by current or future action.

Sunk costs are irrelevant to decisions.

Example: You bought a car that cost $10,000 two years

ago. The $10,000 cost is sunk because whether youdrive it, park it, trade it, or sell it, you cannot change the$10,000 cost.


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Cost = $10,000

two years ago

Cost = $25,000

today

Trade ?

Sunk Cost

Whats the trade-in value for the old car?

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The dealer will trade for $20,000 plus your car.What amount is relevant to your decision,

the $10,000 sunk cost of your car or the$20,000 out-of-pocket cash differential?

OLD CAR NEW CAR


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Relevant Cost and Decision Making

Decision making involves 5 steps:

Define the problem.

Identify the alternatives.

Collect information on alternatives.

Eliminate irrelevant information.

Make a decision with the remaining relevant

information.

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Relevant Cost Example10-9

1. Going to Florida for spring break.

2. Alternatives: Will you drive or fly to Florida for spring break?

3. You have gathered the following information to help you withthe decision.

Motel cost is $80 per night.

Meal cost is $20 per day.

Your car insurance is $100 per month.

Kennel cost for your dog is $5 per day.

Round-trip cost of gasoline for your car is $200.

Round-trip airfare and rental car for a week is $500.

Driving requires two days, with an overnight stay, cutting yourtime in Florida by two days.


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Florida Spring Break

Drive/Fly Analysis

Cost Drive Fly

Motel 640$ 640$

Eating out costs 160 160

Kennel cost 40 40

Car insurance 100 100

Gasoline 200 -

Airfare/rental car - 500

8 days @ $80

8 days @ $20

8 days @ $5



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Drive/Fly Analysis

Cost Drive Fly

Motel 640$ 640$


Kennel cost 40 40

Car insurance 100 100

Gasoline 200 -


4. Irrelevant informationCosts do not differ,

so they areirrelevant to decision

Also, car insuranceis irrelevant to

the decision as itis a past/sunk cost.



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5. Relevant InformationTransportation

costs differ betweenthe two alternatives,so they are relevant

to the decision

Are the extra twodays in Floridaworth the $300

extra cost to fly?


Drive/Fly Analysis

Cost Drive Fly

Motel 640$ 640$


Kennel cost 40 40

Car insurance 100 100Gasoline 200 -



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Total and Incremental Cost Approach

The management of a company is considering a new labor-saving

machine that rents for $3,000 per year. Data about the companysannual sales and costs with and without the new machine are:

Current

Situation

Situation

With New

Machine Variance

Sales (5,000 units @ $40 per unit) 200,000$ 200,000$ -Less variable expenses:

Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -

Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000

Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -

Total variable expenses 120,000 105,000 -

Contribution margin 80,000 95,000 15,000Less fixed expense:

Other 62,000 62,000 -

Rent on new machine - 3,000 (3,000)

Total fixed expenses 62,000 65,000 (3,000)

Net operating income 18,000$ 30,000$ 12,000

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TOTAL APPROACH

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The only costs that differ between the two alternatives are the directlabor cost savings and the increase in machine rental costs.

We can efficiently analyze the decision bylooking at the differential costs and benefits

and arrive at the same solution.

Decrease in direct labor costs (5,000 units @ $3 per unit) 15,000$Increase in machine rental expenses (3,000)

Net annual cost savings from renting the new machine 12,000$

Net Advantage to Renting the New Machine

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Total and Incremental Cost Approach

INCREMENTAL APPROACH

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(1) Special Order Decisions

The decision to accept additional business shouldbe based on

incremental costs and incremental revenues.

Incremental amounts are those that occur only if

the company decides to accept the new business.

differ between alternatives

Special consideration:

Does the company have excess capacity?

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Special Order Decisions

Victory Co. currently sells 100,000 units of a product. The companyhas revenues and costs as shown below:

Per Unit Total

Sales 10.00$ 1,000,000$

Direct materials 3.50 350,000

Direct labor 2.20 220,000

Factory overhead 1.10 110,000

Selling expenses 1.40 140,000Administrative expenses 0.80 80,000

Total expenses 9.00$ 900,000$

Operating income 1.00$ 100,000$

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Victory Co. is approached by an overseas company that offers topurchase 10,000 units at $8.50 per unit.

If Victory Co. accepts the offer, total factory overhead willincrease by $5,000; total selling expenses will increase by$2,000; and total administrative expenses will increase by

$1,000.

Victory Co. has a production capacity of 120,000 units.

Should Victory accept the offer?

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Our cost is $9.00per unit. I cant sellfor $8.50 per unit.

Special Order Decisions10-18

First, lets look at incorrect reasoningthat leads to an incorrect decision.

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Current

Business

Additional

Business Combined

Sales 1,000,000$ 85,000$ 1,085,000$Direct materials 350,000$ 35,000$ 385,000$

Direct labor 220,000 22,000 242,000

Factory overhead 110,000 5,000 115,000

Selling expenses 140,000 2,000 142,000Admin. expenses 80,000 1,000 81,000

Total expenses 900,000$ 65,000$ 965,000$

Operating income 100,000$ 20,000$ 120,000$

10,000 new units $8.50 selling price = $85,000


10,000 new units $3.50 = $35,000

10,000 new units $2.20 = $22,000

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Has excess capacity

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Current

Business

Additional

Business Combined

Sales 1,000,000$ 85,000$ 1,085,000$

Direct materials 350,000$ 35,000$ 385,000$

Direct labor 220,000 22,000 242,000Factory overhead 110,000 5,000 115,000

Selling expenses 140,000 2,000 142,000

Admin. expenses 80,000 1,000 81,000

Total expenses 900,000$ 65,000$ 965,000$Operating income 100,000$ 20,000$ 120,000$

Even though the $8.50 selling price is less than thenormal $10 selling price, Victory Co. should accept the

offer because net income will increase by $20,000.

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DECISION RULE

Accept the special order when theres incremental benefits forthe company.

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We can also look at this decisionusing the contribution margin method

Per Unit

10,000

units

Special order revenue 8.50$Direct materials 3.50

Direct labor 2.20

Contribution margin 2.80$ 28,000$

Increase in fixed costs:

Factory overhead 5,000$

Selling expenses 2,000

Administrative expenses 1,000

Special order profit 20,000$

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Special Order DecisionsVictory Co. has a production capacity of 100,000 units.

Should Victory accept the offer?Per Unit Total

10,000 units

Special order revenue 8.50$

Direct materials 3.50

Direct labor 2.20Contribution margin 2.80$ 28,000$

Increase in fixed costs:

Factory overhead 5,000$

Selling expenses 2,000

Administrative expenses 1,0008,000

Loss of CM on regular sales 43,000

10,000 units x CM $4.30 ($10 - $3.50 - $2.20)

Special order loss (23,000)$

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No excess capacity

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Managers often face the problem of deciding how scarceresources are going to be utilized.

Usually, fixed costs are not affected by this particular

decision, so management can focuson maximizing total contribution margin.

Lets look at the Kaiser Company example.

(2) Production Constraint Decisions

How to maximize contribution margin when onefactor limits production capacity?

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Production Constraint Decisions

Kaiser Company produces two products and selected datais shown below:

Products

A B

Selling price per unit $ 60 $ 50Less: variable expenses per unit 36 35Contribution margin per unit 24$ 15$

Current demand per week (units) 2,000 2,200

Contribution margin ratio 40% 30%

Processing time (per unit)required on Machine X 1.00 min. 0.50 min.

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Machine X is the scarce resource because there is

excess capacity on other machines. Machine X is

being used at 100% of its capacity.

Machine X capacity is 2,400 minutes per week.

Should Kaiser focus its efforts on Product A or B?

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Products

A BContribution margin per unit $ 24 $ 15

Time required to produce one unit 1.00 min. 0.50 min.

Contribution margin per minute 24$ 30$

Lets calculate the contribution margin per unit of the scarce

resource, machine X.

Product B should be emphasized. It makes more valuable useof the scarce resource (Machine X), yielding a highercontribution margin of $30 per minute as opposed to $24 forProduct A.

If there are no other considerations, the best plan would beto produce to meet current demand for Product B and thenuse any capacity that remains to make Product A.

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Allotting Scarce Resource (Machine X)

Weekly demand for Product B 2,200 units

Time required per unit 0.50 min.

Total time required to makeProduct B 1,100 min.

Total machine time available 2,400 min.

Time used to make Product B 1,100 min.

Time available for Product A 1,300 min.Time required per unit 1.00 min.Production of Product A 1,300 units


Lets see how this plan would work.

Current demand for A is 2,000 units

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According to the plan, we will produce 2,200 units of Product

B and 1,300 units of Product A.

Product A Product B

Production and sales (units) 1,300 2,200

Contribution margin per unit 24$ 15$Total contribution margin 31,200$ 33,000$

DECISION RULE

Priority is given to the product with the highestcontribution margin per unit of scarce resource

The total contribution margin for Kaiser is $64,200.

Any other combination would result in a lesser CM.

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Should Icontinue to makethe part, or should

I buy it?

I suppose Ishould compare

the outside purchaseprice with the additional

costs to manufacturethe part.

What will Ido with my

idle facilities if

I buy the part?

(3) Make or Buy Decisions

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Make or Buy Decisions

OutsourcingOutsourcing - Definition

The decision to buy or subcontract a component product or servicerather than produce it in-house.

May lead to reduced control over delivery time or product quality.

Outsourcing is a regular feature of companies with limited resources.

Why Outsource?

Cost savings.

Focus on core business.

Knowledge: access to intellectual property, wider experience.

Access to talent.Factors to Consider:

Reliability of supplier delivery, quality, price etc.

Flexibility to adapt to changing conditions.

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Incremental costs are also important in the decisionto make a product or buy it from a supplier.

The cost to produce an item must include

(1) direct materials (usually avoidable VC)

(2) direct labor (avoidable VC)

(3) incremental overhead (unavoidable v. avoidable F.C.)

We should NOT use the predetermined overhead rateto determine product cost.

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Unit Costs

Direct Materials 9.00$

Direct Labor 5.00

Variable Overhead 1.00

Fixed Overhead 13.00

Total 28.00$

Excel makes computer chips used in

one of its products. Unit costs, based on production of20,000 chips per year, are:

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An outside supplier has offered to provide the20,000 chips at a cost of $25 per chip. Fixed

overhead costs will not be avoided if the chipsare purchased.

Excel has no alternative use for the facilities.

Should Excel accept the offer?

Irrelevant cost: same under both alternatives

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Make Buy

Direct Material 9.00$ -$

Direct Labor 5.00 -

Variable Overhead 1.00 -

Purchase costs - 25.00Total 15.00$ 25.00$

Incremental costs = $10

DECISION RULE

Outsource if there is incremental benefits

Excel should not pay $25 per unit to an outside supplier toavoid the $15 per unit differential cost of making the part.Unavoidable fixed costs are irrelevant.

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A id bl Fi d C t


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Make Buy

Direct Material 9.00$ -$Direct Labor 5.00 -


Purchase costs - 25.00

Avoidable Fixed Overhead - (3.00)

Total 15.00$ 22.00$

Avoidable Fixed Cost

Fixed Overhead $13, out of which $3 is avoidable.


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A id bl Fi d C t


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Make Buy

Direct Material 9.00$ -$Direct Labor 5.00 -


Purchase costs - 25.00

Avoidable Fixed Overhead 3.00 -

Total 18.00$ 25.00$


Avoidable Fixed Cost

Fixed Overhead $13, out of which $3 is avoidable.

QUESTION

What is the maximum price that the company can paythe external supplier for the outsourced part?

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(4) Sell, Scrap, or Rebuild Decisions

Costs incurred in manufacturing units of productthat do not meet quality standards are sunk costs

and cannot be recovered.

As long as rebuild costs are recovered

through sale of the product, andrebuilding does not interfere with normalproduction, we should rebuild.

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Sell, Scrap, or Rebuild Decisions

Servo has 10,000 defective units that cost $1.00 each tomake. The units can be scrapped now for $.40 each or

rebuilt at an additional cost of $.80 per unit.If rebuilt, the units can be sold for the normal selling price

of $1.50 each. Rebuilding the 10,000 defective units willprevent the production of 10,000 new units that would

also sell for $1.50.

Should Servo scrap or rebuild?

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Scrap

Now Rebuild

Sale of defects 4,000$ 15,000$Less rebuild costs -

Less opportunity cost -

Net return 4,000$

Sell, Scrap, or Rebuild Decisions

10,000 units $0.40 per unit

10,000 units $1.50 per unit

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ScrapNow Rebuild

Sale of defects 4,000$ 15,000$

Less rebuild costs - (8,000)

Less opportunity cost - (5,000)

Net return 4,000$ 2,000

Sell, Scrap, or Rebuild Decisions10,000 units $0.80 per unit

Benefits foregone: CM for 10,000 new products10,000 units (Selling Price $1.50 Cost $1.00)

Servo should scrap the units now.

DECISION RULE

Choose the option with the highest incremental

benefits

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Product 2Joint Costs

Product 1

Product 3

(5) Joint Product Decisions

Joint costs arethe costs ofprocessing prior tothe split-off point

Two or more products produced from acommon input are called joint products

The split-off point is the point in a process wherejoint products can be recognized as separate products

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Further

Processing

Further

Processing

Final

Sale

Final

Sale

Final

Sale

Joint

Input

Common

ProductionProcess

Split-Off

Point

Oil

Gasoline

Chemicals

Joint costsare incurred

up to the

split-off point

p , p g y, g

products are extracted from crude oil, including gasoline, jet fuel, home heating

oil, lubricants, asphalt, and various organic chemicals.

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Joint Product Decisions

Businesses are often faced with the decision to sellpartially completed products at the split-off point or to

process them to completion.

DECISION RULEProcess further if

incremental revenues > incremental costs

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Ames Co. produces two products, A and B, from this process.

Should the products besold at split-off or

process further?

CommonProduction

Process

FinalSale

$120,000

Split-Off

Point

JointCost

$100,000

Revenue$70,000

AdditionalProcessing

Cost$40,000A

B

AdditionalProcessing

Cost$20,000

FinalSale

$65,000

Revenue$50,000


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Incremental Incremental

Product Revenue Cost DifferenceA 50,000$ 40,000$ 10,000$

B 15,000 20,000 (5,000)

Product A incremental revenue = $120,000 - $70,000 = $50,000Incremental revenue $50,000 > Incremental cost $40,000

Product B incremental revenue = $65,000 - $50,000 = $15,000Incremental revenue $15,000 < Incremental cost $20,000


Joint costs are not relevant in decisions regarding what to do with a

product after the split-off point.

Joint costs are really common costs incurred to simultaneously produce a

variety of end products.

Process product A, but sell product B at the split-off point.

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Non-financial Considerations

It would be irresponsiblefor me to base my

decision entirely on revenue

and cost figures.

Reputation

Environmentalimpacts

Legalissues

Ethical

implications

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(1)Specialorder

decisions

(2)Productionconstraintdecisions

(3)Makeor buy

decisions

(5)Joint

productdecisions

Non-Financial Considerations

Impact onregularcustomers

Undercuttingby special-ordercustomers

High CM butlow demand

ComplementaryProducts

Productquality /availability

Supplierrelationship

(4)Sell, Scrapor Rebuilddecisions

MarketDemand

Cannibalizeotherproducts

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Review Questions

1. Which of the following is true?

a. Fixed costs are always irrelevant.b. Variable costs are always relevant.c. Joint costs are always irrelevant.d. All of the above.

2. In the sell-or-process further decision,a. Joint costs are always relevant.b. Total costs of joint processing and further processing are

relevant.c. All costs incurred prior to the split-off point are relevant.d. The most profitable outcome can be to further process some

separately identifiable products beyond the split-off point, butsell others at the split-off point.

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Check List

Do you have a good understanding of: Types of relevant cost

Five types of decisions and the decision rules

Non-financial factors to consider when makingdecisions

lecture 10 relevant costing.pdf

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