CHAPTER 11 part 2

RELEVANT COSTS FOR

NON-ROUTINE DECISION MAKING

TYPES OF DECISIONS

These decisions that commonly occur in all business activities are as follows:

1. Make or Buy
2. Add or Drop a product or other Segments
3. Sell now or Process Further
4. Special Sales Pricing
5. Utilization of Scarce Resources
6. Shut-down or Continue Operations
7. Pricing

Make or Buy Decision

Differential cost analysis is appropriate for short-run make-or-buy decisions involving the
construction of plant assets or component parts of the finished product on the company premises
rather than acquiring them outside.

The make-or-buy decision is a management decision about whether an item should be made
internally or bought from an outside supplier. To put idle capacity to use, firm often consider
manufacturing a part or subassembly they are currently purchasing. For example, a watch
company might use its idel capacity to produce its own watch bands or bracelet. Or a company
that manufactures cars might use its idle capacity to manufacture its own stock absorbers instead
of buying them from an outside supplier.

When these opportunities arise, the managerial accountant is often asked to compare the cost of
manufacturing a part internally with the cost of purchasing it.

Illustrative Problem 11-3: Make or Buy decision

Assume that KLM Company is purchasing 2,000 parts from an outside suppliers for P170 a part.
If a company makes the part internally, costs will be assigned to the part as follows:

Direct Materials P120,000

Direct Labor 100,000
Variable Overhead 60,000
Fixed Overhead 80,000
Manufacturing costs per unit will amount to P180 (P360/2,000).

Should the company manufacture the parts or buy them from an outside supplier?

If KLM managers simply com,pare the total manufacturing costs of P360,000 with total
purchase costs of P340,000, they will in most probability decide to buy the part.
 But looking more closely at the individual cost components, we will find the inclusion of
overhead which will be incurred regardless of whether or not it makes or buys the part.
Hence, these costs are not relevant.

For 2,000 units, the relevant costs under “make” alternative will be as follows:

Direct material P60 P120,000

Direct Labor 50 100,000
Variable overhead 30__ 60,000
Total P140 P360,000

While the relevant purchase costs remain at P170 per unit or a total of P340,000.

All things being equal therefore, it would be advisable for the KLM Company to manufacture the
part internally because the company will realize cost savings of P60,000.

Before making the final decision, the company should consider other factors, both quantitative
and qualitative.

The other quantitative factor to be considered is the effect on the company’s required production
level. The analysis done was based on a 2,000-part level. What if the company feels that the
needed production level is different? To gujide management in making decision should the
production requirement be different from the 2,000 units originally used, the accountant can
determine the point of indifference cost volume. This is the production level at which the cost of
buying an item equals the cost of making it. In KLM Company’s case the point of indifference
cost volume is calculated as follows

Total Cost to make = Total Cost to buy

40,000 + 140X = 170X

Where X representing the production volume

X = 1,333 units

The indifference cost volume is 1,333 units. If expected production volume is below 1,333,
purchasing the part will be advisable because it is the least costly alternative. If expected
production volume is above 1,333, making the part is less costly.

Opportunity costs or earnings the company could have made if it had applied the capacity to
some alternative use are relevant and should therefore be added to the relevant costs of “make”
alternative. Examples are rent offered for the use of the facilities, avoidable fixed costs if parts
are purchased from outside suppliers.

Adding of Dropping Products/Segments

Over time, consumers’ preferences change. Some products become obsolete and are dropped
from product lines, others are developed to replace them . When management is considering
dropping a product line or customer group, the only relevant costs are those that a company
would avoid by dropping the product or customer, An important factor in deciding whether to
add or drop a product is the decision’s effect on operating income.

Illustrative Problem 11-4: Eliminate or Retain a Product Line:

Suppose a company furnishes the following recent recent operating statement for its three
product lines, A, B, and C.

A B C Total
Sales P400,000 P360,000 P300,000 P1,060,000
Variable Expenses 280,000 (70%) 216,000 (60%) 240,000 (80%) 736,000
Fixed Expenses:
Salaries of product
line supervisors 30,000 32,000 40,000 102,000
Marketing cost allocated
to product lines on
basis of sales 8,000 7,200 6,000 21,200
Administrative costs
allocated equally 22,000 22,000 22,000 66,000
Total expenses 340,000 277,200 308,000 925,000
Operating income (loss) P60,000 P 82,800 P (8,000) P 134,800

Management is considering discontinuing Product C operations.

The company can sell assets used in Product C operations at book value. They would lay off the
Product C supervisor with no termination pay.

a. Assuming no other changes are expected, should the company drop Product C?

Analysis: Product C has a positive contribution to indirect costs of P20,000 (P300,000-

P240,000) and therefore should not be eliminated. Overall income will decrease by
P20,000 if the company will drop Product C.

b. Assuming that in addition to the data given, the following changes are expected:
1. Sales of Product A and Product B increase by 10% and 15%, respectively
2. Marketing costs will remain unchanged.
3. Salaries of Product A and B’s product line supervisors would increase by 8% and
10% respectively due to the increased sales.
4. No increase in total assets is required.
Should the company drop Product C?

Analysis: The following schedule shows the projected operating statement assuming the
company discontinued Product C operations.

Product Lines
_______________________________
 A B Total__
Sales P440,000 P414,000 P854,000
Variable Expenses 308,000 248,400 556,400
Fixed Expenses:
Salaries of product line
supervisors 32, 400 35,200 67,600
Marketing costs 10,923 10,277 21,200
Administrative costs 33,000 33,000 66,000
Total 384,323 326,877 711,200
Operating income (loss) before taxes P 55,677 P 87,123 P142,800

Based on the computations, the company may decide to drop Product C.

As shown above, overall net income will be P142,800. This is slightly higher than the present
overall income of P134,800 with no increase in total assets required. However, management
should consider other factors, such as the future sales of product C and whether the increased
sales of Product A and B will continue or would occur without eliminating Product C
operations.

Sell Now or Process Further

In some industries, a number of end products are produced from a single or common raw
materials input. For example, in the meat-packaging industry, a great variety of products – ham,
bacon, spare ribs, pork roasts, and so on are produced from a common are referred to as joint
products. Firms that produce several end products from a common input are faced with the
problem of deciding how the joint product cost of that input is going to be divided among the
joint products. Joint product costs is used to describe those manufacturing costs that are incurring
in producing the joint products up to the split-off point. The split off point is that point in the
manufacturing process at which the joint product can be recognized as separate products.

Joint product costs are irrelevant in decisions regarding what to do with a product from the split
off point forward because they have already been incurred and therefore are sunk costs. Costs
incurred after the split-off point for the benefit of only one particular product are called
separable costs. They are relevant costs in the sell-or-process-further decision.

In sell-or-process-further decision, it will always be profitable to continue processing a joint

product after the split-off so long as the incremental revenue from such processing exceeds the
incremental processing costs.

Illustrative Problem 11-5: Sell Now or Process Further

Assume that three products are derived from a single raw material input. Cost and revenue data
relating to the products are presented before (along with an analysis of which products should be
sold at the split-off point and which should be processes further).

Product
_______________________________
A B C___
Sales value at the split-off point P 60,000 P 75,000 P 30,000
Sales value after further processing 80,000 120,000 45,000
Allocated joint product costs 40,000 50,000 20,000
Cost of further processing 25,000 30,000 5,000

Which of the product lines should be processed further and which should be sold at the split-off
point?

Analysis: The following evaluation should be made using the relevant data:

Product Lines
_______________________________
A B C___
Incremental revenue from
Further processing* P 20,000 P 45,000 P 15,000
Incremental cost of further
processing 25,000 30,000 5,000
Profit (loss) from further
processing P ( 5,000) P 15,000 P 10,000

 Sales value after further processing minus Sales value at the split-off point.

As shown in the ablve schedule, Product B and C should be processed further; Product A should
be sold at split-off point.

SPECIAL SALES PRICING

Managers must evaluate whether a special order should be accepted, or if the order is accepted,
the price that should be charged. A special order is one time order that is not considered part of
the company’s ongoing business. Managers may be asked to consider accepting a special order
for their product at a reduced price to make use of the excess, or idle facilities. Such orders are
worth considering, provided they will not affect regular sales of the same products.

UTILIZATION OF SCARCE RESOURCES

Choosing which products to manufacture and sell is a common managerial decision. Managers
are routinely faced with the problem of deciding how scarce resources are going to be utilized.
For example, a department store has a limited amount of flow space and therefore cannot stock
every product that may be available. A small CPA firm, due to shortage of personnel may have
to choose between performing work for client A or B. A manufacturing firm has a limited
number of machine hours and a limited number of direct labor-hours at its disposal.

When capacity becomes pressed because of a scarce resource, the firm is said to have a
constraint. Because of the constrained scarce resource, the company cannot fully satisfy
demand, so the manager must decide how the scarce resource should be used. Fixed costs are
usually unaffected by such choices, so the manager should select the course of action that will
maximize the firm’s total contribution margin. This is based on the assumption that the product
choices as a short-run decisionsbecause we have adopted the definition that in the short run,
capacity is fixed, while in the long-run, capacity can be changed.

Contribution in Relation to Scarce Resources

To maximize total contribution margin, a firm should not necessarily promote those products that
have the highest contribution margins per unit. With a single constrained resource, the important
measure of profitability is the contribution margin per unit of scarce resource used.

The Problem of Multiple Constraints

If a firm is operating under several scarce resource constraints, what should it do? Constraints
may refer to limited availability of raw materials, limited direct labor-hours available, limited
capital available for investments and many more. As more constraints and products are added,
solving product mixes becomes more complex. Although it is possible to solve these problems
by hand, they are typically solved by computer. The optimal proper combination of product
“mix” can be found by use of quantitative method known as linear programming.