Relevant Costing Decision Making

Introduction to Relevant Costing and Decision Making

The title of this topic focuses on two aspects - (a) relevant costs, and (b) decision-making.

Relevant costs are those costs, which arises as a direct consequence of a decision among alternatives. Thus, an
important criterion of relevant costs is that they are future costs and changes as a result of the decision taken to
choose a particular alternative.

Other terms to describe relevant costs are incremental or differential costs, avoidable costs and opportunity costs.
Non-relevant costs therefore are either not a future cost or they are future costs, which will be incurred anyway,
regardless of the decision that is taken. A number of terms are used to describe these costs i.e. sunk cost, committed
costs and historical costs. Unless there are indications to the contrary, it should be assumed that variable costs would
be relevant whilst fixed costs are non-relevant.

Decision in this topic refers to the non-routine decisions i.e. decision that is not routinely made at frequent intervals.
Careful categorizing of decisions is needed because different category of decision requires costs (and revenue)
information relevant to the decision. It is helpful to mention that the different category of decision includes routine
planning decisions, investment (divestment) decisions, control decisions etc.

This topic therefore specifically relates to the measuring of costs (and benefits) for non-routine decisions. Since
business decision involves a choice from among at least two alternatives, only the costs and benefits relevant to the
alternatives should be compared when making the decision. Careful consideration of costs and benefits and the
probable effects of the decision on future returns is crucial because we are to assume that the organization is always
operating under the environment of scare resources where every dollar spent must lead to the maximum possible
return.

Specifically, in this topic, the non-routine decision refers to decision that relates to:

1. Make or buy
2. Limiting factor – Constrained Resources
3. Deleting a segment (shutdown problems)
4. Accepting or rejecting orders.

Throughout this topic, attention must be given to the process of identifying and classifying costs to determine the
relevant costs for each decision-making model and the application of Contribution (not profit) as a measurement of
maximum return. Therefore, it is important that working on this topic should not begin until you are completely
satisfied in understanding the topics that relate to cost classification and marginal costing.

In this part of the Lesson, we will learn the following:

1. The cost objective and the possible methods of cost classifications.

2. The decision-making process and the types of cost information relevant for decision-making.
3. An analysis showing the most profitable use of a constrained resources.
4. An analysis showing the make or buy decision.
5. An analysis showing whether a product line or other segments should be dropped or retained.
6. An analysis showing whether a special order should be accepted.

1
 Relevant Costing Decision Making

Cost Objective and the Possible Methods of Cost Classifications

Costs Objective Possible Methods of costs classification

a. period costs and product costs

b. manufacturing costs and non-manufacturing costs
c. direct and indirect costs
d. direct material, direct labor and manufacturing
Cost for Stock Valuation
overheads
e. manufacturing and non-manufacturing overheads
f. prime costs
g. conversion costs
a. Fixed costs and variable costs
b. Relevant and non-relevant costs
Costs for Decision Making c. Sunk costs
d. Opportunity costs
e. Marginal and incremental costs

The Decision-making Process and the Types of Course Information Relevant for Decision-making

One of the basic functions of a manager is making decisions. Making decisions involves choosing among
alternatives. Constantly, managers are faced with the problems of deciding what product to make and sell, what
production method to use, whether to make or buy the components, given the restricted resources which
components is to be manufactured first, whether to accept special orders at a discounted prices, and so forth.

Since decision involves the process of choosing among at least two alternatives, managers require information on
the cost and benefits of one alternative as compare to the costs and benefits of other alternatives. Based on this,
one of the important purposes of management accounting is to provide managers with information – relevant
information, for decision making.

This topic focuses on short-term decisions. By this it means that the decision involves a period (arbitrarily) of one year
and these decisions are easily reversed. The economic criterion of making short-term decisions is simple: given the
alternatives, choose the one that bring in the highest income; if both alternatives incur losses, minimize the losses.

Although the criterion is simple, there are several points to focus to apply this rule: Managers must be able to tell the
difference between relevant and irrelevant cost and benefit data when analysing alternatives. Only those costs and
benefits that differ in total between alternatives are relevant in a decision. If the cost remains the same regardless of
the alternative selected, then the decision has no effect on the cost and thus the costs and benefits can be ignored.
Relevant costs are thus costs that will be incurred at some future time; and they differ for each option available to
the decision-maker. The decision rule is that only future costs that differ among options are relevant for the decision.
These relevant costs are called differential revenues and costs; incremental revenues and costs; and avoidable
revenues and costs.

Relevant costs can be either variable costs or fixed costs. Variable costs are generally relevant because the total
variable costs differ among alternatives. In contrast, fixed costs often are irrelevant, since typically they remain
constant among alternatives. However, beyond certain relevant range, fixed costs change and thus are relevant in
the decision-making.

Several cost terms are particularly applicable to this topic. The terms are:

a. cost behavior – fixed and variable.

b. differential costs – the amount of increase or decrease in costs that is expected from a course of action
as compared with an alternative.

2
 Relevant Costing Decision Making

c. increment costs – the increase in revenues and costs.

d. avoidable costs – a cost that can be eliminated in whole or part by choosing one alternative over
another.
e. opportunity costs – is the benefit lost by taking one action as opposed to another. It is considered as
relevant cost.
f. sunk costs – a cost that has already been incurred and therefore will be the same no matter which
alternative is selected. This cost is never relevant in decisions.

An Analysis Showing the Most Profitable Use of a Constrained Resources

When resources of some types restrict the company’s ability to satisfy demands, the company is said to have a
constraint. Because of this constraint, the company cannot fully satisfy demand, so the managers must decide how
the constrained resource should be utilized.

A company might be faced with just one constraint factor or several factors putting an effective limit on the level of
activity that can be achieved. The constraint factor may change from time to time for the same company or
product. Examples of constraint factors are:

a. Sales – there may be limit to sales demand.

b. Labor – there may be limit either in term of total quantity of labor, or of particular skills.
c. Materials – insufficient availability of materials to produce enough units to satisfy demands.
d. Manufacturing capacity – insufficient machine capacity for production required to meet sales demand.
e. Financial resources – not enough cash to pay for the necessary production.

When facing with constrained labor supply, material availability, machine capacity or cash flow which limits
production to less than the volume which could be sold, management is faced with the problem of deciding which
product to produce and which product should not be produced because of the insufficient resources to make
everything.

It is assumed that the basic criterion of short-term decision making is the maximization of profit; and since in the short-
term, fixed costs are usually unaffected by such choice, managers would maximize profit by selecting a product mix
(or service mix) with maximum (highest possible) contribution. Since fixed costs are assumed to be constant, the only
relevant costs in a decision for the utilization of constrained resources are the variable costs.

By applying Variable Costing (Marginal Costing) technique, total contribution to the company will be maximized by
ensuring that the company is earning the highest possible contribution per unit of constraint factor used for the
product sold or service rendered. This involves the determination of (i) the contribution earned by each product
(service); and (ii) the product (service) per unit usage of constraint factor, and (iii) ranking the product in order of
profitability based on the contribution per constrained factor.

Illustration 1:

Oriental Resources produces three products and is reviewing the production and sales budgets for the next
accounting period. The following information is available for the three products:

Product A2 Product X8 Product K4

Sales Demand 200 units 200 units 200 units
Selling Price RM22 RM25 RM14
Variable costs RM10 RM15 RM8
Required machine hour
Per unit 6 hours 2 hours 1 hours

Machine capacity is limited to 1320 hours. Fixed costs are RM2000. You have been asked to determine the
production budget that will maximize profit.

3
 Relevant Costing Decision Making

Solution for Illustration 1:

STEP 1: Determine whether the company’s facing a situation of constraint factors

Product A2 Product X8 Product K4 TOTAL

Sales Demand 200 units 200 units 200 units
Required machine hour
Per unit 6 hours 2 hours 1 hours
Machine hours needed 1200 hrs 400 hrs 200 hrs 1800 hrs
Machine Capacity 1320 hrs
Shortfall (480 hrs)

Step 2: Determine the contribution earned by each product per unit of constraint factor

Product A2 Product X8 Product K4

Selling Price RM22 RM25 RM14
Variable costs RM10 RM15 RM8
Contribution Margin RM12 RM10 RM6

Required machine hour

Per unit 6 hours 2 hours 1 hours

Contribution Margin per

Constrained factor RM2/MacHr RM5/MacHr RM6/MacHr
(RM12/6 MacHr) (RM10/5 MacHr) (RM6/1 MacHr)

STEP 3: Rank the product for production according to contribution earned by each product per unit of constraint
factor

Product A2 Product X8 Product K4

Selling Price RM22 RM25 RM14
Variable costs RM10 RM15 RM8
Contribution Margin RM12 RM10 RM6

Required machine hour

Per unit 6 hours 2 hours 1 hours

Contribution Margin per

Constrained factor RM2/MacHr RM5/MacHr RM6/MacHr
(RM12/6 MacHr) (RM10/5 MacHr) (RM6/1 MacHr)

RANKING 3 2 1

STEP 4: Prepare the budget for production according to the ranking

Ranking Product Sales Machine Hours Balance of

Demand Required Machine Hours
(1320 MacHrs)
1 Product K4 200 units 200 x 1 MacHrs = 200 MacHrs 1120
2 Product X8 200 units 200 x 2 MacHrs = 400 MacHrs 720
3 Product A2 120 units* 120 x 6 MacHrs = 720 MacHrs 0

4
 Relevant Costing Decision Making

• *720 MacHrs available. Machine hours required to produce one unit of Product A2 is 6 hours. Thus, the
maximum production is 120 units (720 MacHrs/6 MacHrs per unit).

STEP 5: Determine the total contribution earned and profit recorded

Product A2 Product X8 Product K4 TOTAL

Selling Price RM22 RM25 RM14
Variable costs RM10 RM15 RM8
Contribution Margin RM12 RM10 RM6

Production 120 units 200 units 200 units

Contribution RM1440 RM2000 RM1200 RM4640
(Contribution Margin x Production units)
Fixed Costs (RM2000)
Profit RM2640

Assumptions on Constraint Factor Analysis:

1. Fixed costs in total remain constant regardless of the production decision made.
2. Variable cost per unit remain constant regardless of the production decision made
3. Sales demand estimates for each product and the resources required to produce each product is known with
certainty.
4. Units of output are divisible and profit-maximizing solutions might include fractions of units as the optimum level
of output.

An Analysis Showing the Make or Buy Decision

A make or buy decision making is about whether a company should make a product (carry out an activity
itself utilizing its own resources), or whether it should acquire from an outside organization to produce/carry out the
product/activity.

As an example, in the automobile industry, there are many parts to assemble. The company may produce
some parts such as the engine while other parts like the tires, spark plugs, nuts and bolts may be purchased from
outside suppliers. Organization must determine what they can do themselves and what they should pay other
organizations to do. The make or buy decision often raises strategic issues. An organization may find that other firm can
more profitably perform certain activities. The practice of choosing to have an outside firm to provide certain function
is called outsourcing.

The analytical process of the make-buy decision requires isolating the costs relevant to the decision of
making or buying. The relevant cost information for making the component consists of short-term cost to manufacture
it, ordinarily the variable manufacturing costs, which would be saved if the part is purchased. These costs are
compared to the purchase price for the part or component to determine the appropriate decision. Costs that will not
change whether the organization makes the part or buy from outside supplier are ignored.

Other factors are also important with the make-buy decision. The effect of using outside supplier is that the
organization will have less control over quality and timely delivery. But outside suppliers often have the benefit of
specialized skill and expertise in the work to produce the product at a relatively lower cost than the organization.
Make-buy decision should certainly not be based exclusively on cost considerations.

5
 Relevant Costing Decision Making

Illustration 2:

BlueTune Sdn. Bhd. manufactures three components, W2E, W3R and W6H, for which the costs in the fourth coming
year are expected to be as follows:
W2E W3R W6H
Production (units) 1500 2200 4800
Cost to manufacture, per unit (RM):

Direct materials 5 4 3
Direct labor 7 8 9
Variable Production Overhead 2 8 3
Fixed Production Overhead* 6 1 3
Total Costs 20 21 18

Cost to buy the component (RM) 16 19 18

*Allocated/common fixed costs

Assess whether BlueTune should make or buy the component.

Solution for Illustration 2:

a. The wrong way of calculating – comparing the total costs with the cost of buying.

W2E W3R W6H

Production (units) 1500 2200 4800
Cost to manufacture, per unit (RM):

Direct materials 5 4 3
Direct labor 7 8 9
Variable Production Overhead 2 8 3
Fixed Production Overhead 6 1 3
Total Costs of Making 20 21 18

Cost to buy the component (RM/unit) 16 19 18

Extra costs of buying (4) (2) 0

Decision buy buy indifference

b. The correct way of calculating - comparing the relevant costs of making and the purchase price.

W2E W3R W6H

Production (units) 1500 2200 4800
Cost to manufacture, per unit (RM):

Direct materials 5 4 3
Direct labor 7 8 9
Variable Production Overhead 2 8 3
Fixed Production Overhead - - -
Relevant Costs 14 20 15

Cost to buy the component (RM/unit) 16 19 18

Extra Cost of buying (saving) 2 (1) 3

Decision make buy make

6
 Relevant Costing Decision Making

Illustration 3:

BlueTune Sdn. Bhd. manufactures three components, W2E, W3R and W6H, for which the costs in the fort coming year
are expected to be as follows:

W2E W3R W6H

Production (units) 1500 2200 4800
Cost to manufacture, per unit (RM):

Direct materials 5 4 3
Direct labor 7 8 9
Variable Production Overhead 2 8 3
Fixed Production Overhead* 6 1 3
Total Costs 20 21 18

Cost to buy the component (RM/unit) 16 19 18

*40% of the fixed costs will be eliminated if the company buys from outside firm.

Assess whether BlueTune should make or buy the component.

Solution for Illustration 3:

W2E W3R W6H

Production (units) 1500 2200 4800
Cost to manufacture, per unit (RM):

Direct materials 5 4 3
Direct labor 7 8 9
Variable Production Overhead 2 8 3
Fixed Production Overhead – 40% 2.4 0.4 1.2
Relevant Costs 16.4 20.4 16.2

Cost to buy the component (RM/unit) 16 19 18

Decision buy buy make

An Analysis Showing the Decision Process of Deleting (or discontinuing) a Segment or Product

Not all products and services are a success. Even previously successful ones may no longer be popular with customers.
At some point, managers must decide when to drop these products or services. The decision whether to
drop/eliminate old (or nonprofitable) product or department, branch or division and in turn new ones added is one of
the most difficult decisions a manager has to make. It is often assumed, sometimes in error, that the total income from
operation of the company would increase if the operating losses of those losing products/segment were eliminated.
Eliminating the product or segment will eliminate all of the product or segment variable costs (direct materials, direct
labor, commissions and so on); however, if the operations of the loosing product are small as compare to the entire
operation of the business, the fixed costs may not decrease by discontinuing it. It is possible that the total operating
income of the company reduces rather than increases due to eliminating a product or segments.

Even though the decisions to drop a segment and add a new one involve many quantitative and qualitative factors,
the final decision to drop a segment and add a new one is going to depend on the impact the decision have on net
operating income. To access the impact, it is necessary to make a careful analysis of the incremental costs with
incremental revenues.

7
 Relevant Costing Decision Making

Illustration 4:

Mitrajaya Synergy makes four products, A23, N51, F43 and K75. The income statement for Mitrajaya for the financial
year ending June 2003 is as follow:

A23 N51 F43 K75 TOTAL

Sales (RM) 20000 15000 14000 20000 69000

Direct materials 5000 6000 4000 8000 23000

Direct labor 4000 8000 6000 4000 22000
Variable overheads 1000 2000 1500 1000 5500
Subtotal (10000) (16000) (11500) (13000) (50500)

Contribution Margin 10000 (1000) 2500 7000 18500

Direct Fixed costs (400) (100) (200) (300) (1000)
Allocated Fixed costs (4000) (4000) (4000) (4000) (16000)
Profit (Loss) 5600 (5100) (1700) 2700 1500

Determine whether Mitrajaya Synergy should produce all four products or drop product N51 and F43.

Solution for Illustration 4:

A. If both product N51 and F43 was abandoned

A23 N51 F43 K75 TOTAL

Sales(RM) 20000 - - 20000 40000

Direct materials 5000 - - 8000 13000

Direct labor 4000 - - 4000 8000
Variable overheads 1000 - - 1000 2000
Subtotal (10000) - - (13000) (23000)

Contribution Margin 10000 - - 7000 17000

Direct Fixed Costs (400) - - (300) (700)
Allocated Fixed costs - - - - (16000)
Profit (Loss) - - - - 300

It would be a wrong decision if both products N51 & F43 were discontinued. The total profit for the company drop
from RM2500 to RM300. The allocated fixed costs will remain at RM16000 while RM300 direct fixed costs was
eliminated.

B. Drop Product N51 only because the segment contribution margin of N51 is not enough to cover the variable
costs and direct fixed costs i.e. negative segment contribution margin.

i. Redo the income statement to calculate segment contribution margin:

8
 Relevant Costing Decision Making

A23 N51 F43 K75 TOTAL

Sales(RM) 20000 15000 14000 20000 69000

Direct materials 5000 6000 4000 8000 23000

Direct labor 4000 8000 6000 4000 22000
Variable overheads 1000 2000 1500 1000 5500
Subtotal (10000) (16000) (11500) (13000) (50500)

Direct Fixed costs (400) (100) (200) (300) (1000)

Segment Contribution Margin 9600 (1100) 2300 6700 17500

Allocated Fixed costs - - - - (16000)

Profit (Loss) 1500

ii. Drop the product with a negative segment contribution margin – in this case product N51only. Product k43
has a positive segment contribution margin.

A23 N51 F43 K75 TOTAL

Sales(RM) 20000 - 14000 20000 54000

Direct materials 5000 - 4000 8000 17000

Direct labor 4000 - 6000 4000 14000
Variable overheads 1000 - 1500 1000 3500
Subtotal (10000) - (11500) (13000) (34500)

Direct Fixed costs (400) - (200) (300) (900)

Segment Contribution Margin 9600 - 2300 6700 18600

Allocated Fixed costs - - - - (16000)

Profit (Loss) 2600

Total company profit increases to RM2600 i.e. by RM1100. Thus, when a product has a negative segment contribution,
discontinuing such product will result in total company profit increases by the same amount. In this case Product N51
has a negative RM1100 segment contribution margin. By discontinuing producing this N51, the total company profit
increases to RM2600 i.e. increase by RM1100 from the current position of RM1500.

iii. By the same argument, product F43 should be allowed to continue. Product F43 has a positive segment
contribution margin i.e.RM2300. If product F43 was discontinued (because decision is based on the product
loss of RM1700), the total company profit will go down by the same amount i.e. RM2300. As in (A), when both
product N51 and F43 were discontinued, the total profit is only RM300 (RM2600 less positive segment
contribution margin of product F43 of RM2300).

9
 Relevant Costing Decision Making

An Analysis Showing the Whether a Special Order Should be Accepted

Differential analysis should also be used in deciding whether to accept (or reject) special order. Special order is
described as additional order at a special discounted price. Differential analysis would involve the process of
comparing differential revenue that would be provided by the additional order at the discounted price to the
differential cost of producing and delivering the product. Special focus must be given to the differential costs; if the
company is operating at full capacity, then additional order will increase both variable and fixed costs of production
but if the company is operating below full capacity (excess capacity available), additional order will only effect
variable costs of production. Therefore, if excess capacity is available, then differential costs are only the variable
costs.

The decision to accept special order at a discounted price will therefore be:

a. if differential revenue > differential costs, accept the special order

b. if differential revenue < differential costs, reject the order.
c. If differential revenue = differential costs = indifference point

Illustration 5:

Matrix First produces sporting goods called BeyBlade. Its production capacity is 14000 units per month. Currently
production and sales are 12500 BeyBlades per month. The current manufacturing cost is RM10.00 consisting of
material, labor and variable overheads of RM8.50 and a fixed cost of RM1.50. The BeyBlade is sold at RM15.00 each.

Matrix First receives its first foreign order of 1000 BeyBlades from Macassar but at a discounted price of Malaysian
equivalent of RM9.00. Should the order be accepted?

Solution 5:

a. If the differential revenue of RM9.00 were compared with the production costs of RM10.00, the offer would
be rejected since there will a loss of RM1.00 per BayBlades (RM9.00 discounted price less production costs of
RM10.00 per unit). This would be the wrong approach.

b. If differential analysis is applied, the differential revenue is RM9.00, but the differential cost is only RM8.50
(restricted to variable costs due to the existence of extra capacity; fixed costs remain constant). Thus, differential
revenue exceeds differential cost by RM0.50 and the order should be accepted. In total the Matrix First will earn an
additional contribution of RM0.50 x 1000 BeyBlades = RM500

c. What would be the lowest price accepted for this additional order? The answer would be equivalent to the
differential costs i.e. RM8.50 variable costs. At this discounted price, the differential revenue is equal to differential
costs thus ‘no gain no loss’ situation.

- End of this topic -

10