DEPARTMENT OF ACCOUNTING AND FINANCE COST AND

MANAGEMENT ACCOUNTING II

INDIVIDUAL ASSIGNMENT I

Cost Management and Accounting II

Prepared by:

ID:
Contents
1. Differentiate relevant costs and revenues from irrelevant costs and revenues in any decision. In
special decisions what is the role of accountants?...........................................................................................2
2. Distinguish between quantitative factors and qualitative factors in decision?........................................9
3. Recognize how to make special order decision and Show the analysis of make or buy decisions?.....10
Cost of the Item.........................................................................................................................................13
Required Capacity.....................................................................................................................................13
Required Expertise....................................................................................................................................14
Required Funding......................................................................................................................................14
Impact on Company Bottleneck................................................................................................................14
Availability of Drop Shipping...................................................................................................................14
Strategic Importance..................................................................................................................................14
4. Describe the key concept in choosing which among multiple products to produce when there are
capacity constraints?......................................................................................................................................15
5. Discuss the key factor managers must consider when adding or dropping product lines and segments?
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6. Explain why the book value of equipment is irrelevant in equipment replacement decisions?...16

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 1. Differentiate relevant costs and revenues from irrelevant costs and
revenues in any decision. In special decisions what is the role of
accountants?
Let’s have a detailed view of this scenario by taking different decision circumstances.
I. Special Order Decision
Special order decisions are typically one-time only orders and/or orders below the prevailing
market price.
Example
(A short-term order) Monthly capacity for a department within a company = 50 000 units
Expected monthly production and sales for next quarter at normal selling price of £40 = 35 000
units
Estimated costs and revenues (for 35 000 units):

 The excess capacity is temporary and a company has offered to buy 3 000 each month for

the next three months at a price of £20 per unit. Extra selling costs for the order would be
£1 per unit.
 The excess capacity is temporary and a company has offered to buy 3 000 each month for
the next three months at a price of £20 per unit. Extra selling costs for the order would be £1
per unit.

 A study of the cost estimates, however, indicates that for the next quarter DL will remain
unchanged – as the excess capacity is temporary
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  Only variable costs, the extra selling costs and sales revenues differ between alternatives
are relevant costs/revenues.
 Two approaches presenting relevant costs — Present only columns 1 and 2 or just column
3.
Since relevant revenues exceed relevant costs the order is acceptable subject to t the following
assumptions:
1. Normal selling price of £40 will not be affected.
2. No better opportunities will be available during the period – no opportunity cost
3. The resources have no alternative uses - no opportunity costs
4. The fixed costs are unavoidable for the period under consideration. – irrelevant in decision
making
Note that the identifications of relevant cost depend on circumstances
II. Optimal Use of Scarce Resources Decisions (Product Mix Decisions)
 Factors that restrict output.
 The objective is to concentrate on those products/ services that yield the largest
contribution per limiting factor.

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Example:

Components X Y Z
Contribution per
£12 £10 £6
unit
Machine hours per unit 6 2 1
Estimated sales demand (units) 2 000 2 000 2 000

Required machine hours 12,000 4 000 2 000

Contribution per machine hour £2 £5 £6

Ranking per machine hr 3 2 1

 Capacity for the period is restricted to 12,000 machine hours

Profits are maximized by allocating scarce capacity according to ranking per machine hour as
follows:

Production used hours available

2 000 units of Z 2 000 10 000
2 000 units of Y 4 000 6000
1 000 units of X 6 000 –
The production will result in the
following: 2 000 units of Z at £6 per 12 000
unit contribution
2 000 units of Y at £10 per unit contribution 20 000
1 000 units of X at £12 per unit contribution 12 000
Total contribution 44 000
 Note that qualitative factors should be taken into account.

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  However, applies only to those situations in which capacity constraint cannot be
removed in the short-term.
 In the long-term, additional resources should be acquired if, contribution from the extra
capacity > cost of acquisition.

III. Keep or Drop a Product/Segment

Routine periodic profitability analysis by cost objects provides attention-directing information

that highlights those potential unprofitable activities that require more

detailed (special studies). Assume the periodic profitability analysis of sales territories
reports the following:
Southern Northern Central Total
£000 £000 £000 £000
Sales 900 1000 900 2800
Variable 1592 466 528 598
Fixed 942 266 318 358
Profit/loss 56 266 168 154

 Assume that special study indicates that £250 000 of Central fixed costs and all variable
costs are avoidable and
 The relevant financial information is as follows:
Keep central Discontinue Difference
open central open
£000 £000 £000

Sales 2 800 1 900 900

Less: Variable costs 1 592 994 598
Less: Fixed costs 942 692 250
Reported profit 266 214 52

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Columns 1 and 2 can be presented or just column 3 which shows that the relevant revenues
arising from keeping the territory open are £900 000 and the relevant (incremental) costs are £848
000.Therefore Central provides a contribution of £52 000 towards fixed costs and profits.

Relevant Costs and Benefits

 Contribution Margin (CM) lost if dropped.

 Fixed Costs avoided if dropped.
 CM lost/gained on other products/segments

Irrelevant Costs

 Allocated Common Costs

 Sunk Costs

Decision Rule

 Keep if - CM lost (all products/segments) > Fixed Costs avoided + CM gained (other
products/segments)
 Drop if - CM lost (all products/segments) < Fixed Costs avoided + CM gained (other
products/segments)

IV. Make or Buy (In source or out sourcing) decision

Involves obtaining goods or services from outside suppliers instead of getting them from the
organization itself.
Example:-
A division currently manufactures 10 000 components per annum.
The costs are as follows:
Total (£) Per unit (£)
Direct materials 120 000 12
Direct labor 100 000 10
Variable manufacturing overhead costs 10 000 1
Fixed manufacturing overhead costs 80 000 8

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Share of non-manufacturing overheads 50 000 5
Total costs 360 000 36
 Supplier has offered to supply 10 000 components per annum at a price of £30 per unit for
a minimum of three years. If the components are outsourced the direct labor will be made
redundant.
 Direct materials and variable overheads are avoidable and fixed manufacturing overhead
would be reduced by £10 000 per annum but non-manufacturing costs would remain
unchanged.
 The capacity has no alternative use.
Assuming there is no alternative use of the released internal capacity arising from outsourcing;
annual costs will be as follows:

Make Buy Difference

Direct materials 120 000 120000 Relevance cost
Direct labor 100000 100000 of making
Variable MOH 10000 10000
Fixed MOH 80000 70000 10000 Relevance cost
buying
Non-manufacturing costs 50000 50000
Outside purch. incurred/(saved) 300000 300000
Total costs incurred/(saved) 360,000 420,000 60000

 Outsourcing is a more expensive alternative

 Columns 1 and 2 can be presented or just column 3 which shows that the relevant costs of
making are £240 000 compared with £300 000 from outsourcing (buying).
 Where the released internal capacity arising from outsourcing can be used to generate
rental income or a profit contribution, the lost income or profit contribution represents an
opportunity cost associated with making the components.

Assume that the released capacity from outsourcing enables a profit contribution of £90000 to be
generated. The relevant costs of making will now be:

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Relevant costs (described above) £240 000

Opportunity cost (Lost profit contribution) 90 000

Total relevant costs of making 330 000

 Outsourcing is now the cheaper alternative.

V. Product Line Decisions

Routine periodic profitability analysis by cost objects provides attention-directing information

that highlights those potential unprofitable activities that require more detailed (special studies).

Assume the periodic profitability analysis of sales territories reports the following:

Southern Northern Central Total

£000 £000 £000 £000
Sales 900 1000 900 2800
Variable 466 528 598 1592
Fixed 266 318 358 942
Profit/loss 266 168 154 56

 Assume that special study indicates that £250 000 of Central fixed costs and all variable
costs are avoidable and
 The relevant financial information is as follows:
Keep central open Discontinue central Difference
open
£000 £000 £000

Sales 2 800 1 900 900

Less: Variable costs 1 592 994 598

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 Less: Fixed costs 942 692 250
Reported profit 266 214 52

 Columns 1 and 2 can be presented or just column 3 which shows that the relevant

revenues arising from keeping the territory open are £900 000 and the relevant

(incremental) costs are £848 000.Therefore Central provides a contribution of £52 000
towards fixed costs and profits.
Thus, the primary role of cost accountant in decision process is to: decide what information is
relevant to each decision problem, and provide accurate and timely information (data).

2. Distinguish between quantitative factors and qualitative factors in

decision?
Quantitative factors are rates of return, financial ratios, and cash flows in our decision model to
guide our ultimate decision. Qualitative factors are pending state and federal legislation, new
technological breakthroughs, and the outcome of an upcoming election.

Quantitative Factors

 Provide a numerical basis for decision making – reduces decisions to looking at a

monetary value placed on different choices, e.g. –Forecasted sales figures for the next 3
years –The cost of a series of redundancies against the longer term financial benefits to the
firm of this process
 such data provides only part of the story Other factors need to be taken into account,
particularly the effects of decisions on stakeholder groups and their response to such
decisions, e.g. –The takeover of Manchester United by Malcolm Glazer might make
financial sense but the reaction of the supporters might make the move unworkable

Qualitative Factors

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 Qualitative factors look to take account of these other issues that may influence the
outcome of a decision Can be wide ranging and especially need to consider the impact on
human resources and their response to decisions
 SWOT decisions (for example, investment in a new production plant) could be considered
not only in financial terms but also to apply other techniques of decision making to look at
wider issues: A SWOT analysis might be part of this: –Strengths –Weaknesses –
Opportunities –Threats
 PEST might also need to factor in other external issues that might influence the decision
making process which can be summarised as: –Political –Economic –Social –
Technological Political could be in its widest sense, e.g. the internal politics of a firm as
well as the national and international political effect
 The decision to site a series of wind turbines in a coastal area might be justified on
financial grounds but: –What is the reaction of the local community? –Does government
policy support such planning developments? –Are there social impacts – e.g. noise
pollution, damage to eco-systems, etc? Such factors may make the difference between
success and failure
 Human Resources Management Impact on a firm’s human resources is essential to
consider, in particular the effects on: Motivation Morale Recruitment and Retention May
be difficult to assess and measure May need to distinguish between short term effects and
long term
 Stakeholder Analysis Wider impacts on stakeholder groups may also be necessary, such
stakeholders include: –Employees –Shareholders –Managers –Environment –Local
Community –Suppliers –Government –Consumers
 Decision Making Eventual decision may rest on the balance between the perceived effects
of quantitative and qualitative If the long term effect on the workforce for example was to
reduce productivity or increase absence because of the impact on motivation and morale,
the fact that a decision makes financial sense may be shelved! Qualitative by its nature,
therefore, is very subjective

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 3. Recognize how to make special order decision and Show the analysis of
make or buy decisions?
How to make special order decision

This is one of those decisions that affect output level. In general, a special order is profitable as
long as the incremental revenue from the special order exceeds the incremental costs of the order.
Two conditions need considering about special order decisions.

(i) Customers must be from markets not ordinarily served by the company, and
(ii) The company must operate below it maximum productive capacity

Let’s take deep look into the following example

Example: Consider the following details of the income statement, on absorption costing basis
(that is, both variable and fixed manufacturing costs are included in inventoriable costs and cost
of goods sold), of Samson Company for the year just ended December 31, 2014

Total per unit Sales (1,000,000 units) Br 20,000,000 Br 20

Cost of Goods Sold 15,000,000 15
Gross Margin Br 5,000,000 Br. 5
Selling and Administrative Expenses 4,000,000 4
Operating Income Br. 1,000,000 Br. 1

Samson’s fixed manufacturing costs were Br 3 million and fixed selling and administrative
expenses were Br 2.9 million. Near the end of the year, Ethio Company offered Samson Br 13 per
unit for 100,000 unit special order. The special order would not affect Samson‘s regular business
in any way. Furthermore, the special sales order would not affect total fixed costs and would not
require any additional variable selling and administrative expenses. Required:

a) Should Samson accept or reject the special order?

b) Could the special order affect Samson’s regular business?

Let’s have a look to the solution

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If there is a need to make correct analysis for the above problem, employing contribution
approach to the income statement employs,

15,000,000−3,000,000
 Variable manufacturing cost per unit ═ ═ 12 per unit
1000000

Here we need to note that we should not employ the absorption or financial approach that treats
fixed costs, i.e., fixed manufacturing costs as if it were variable.

 Total Variable manufacturing cost ═ Br. 12 x 1,000,000 ═ Br.12,000,000

4,000,000−2,900,000
 Variable selling and administrative cost per unit =
1000,000
= 1.1 per unit
 Total Variable selling and administrative cost ═ Br. 1.1 x 1, 000, 0000 ═ Br. 1,100,000
(the special order does not affect this cost)

The analysis would be as follows on comparative contribution income statement

Without special With special order Difference: relevant

order 1,000,000 units 1,100,000 units to be amount for the
to be sold sold 100,000 units of
special order
Sales Br. 20,000,000 Br. 21,300,00 Br. 1,300,000
Variable Expenses:
Manufacturing Br. 12,000,000 Br.13,200,000 Br.1,200,000
Selling and Adm. 1,100,000 1,100,000
Total Variable Exp. Br. 13,100,000 Br. 14,300,000 Br.1,200,000
Contribution Margin Br. 6,900,000 Br. 7,000,000 Br.100,000
Fixed Expenses:
Manufacturing Br. 3,000,000 Br. 3,000,000
Selling and Adm. 2,900,000 2,900,000
Total Fixed Expenses Br.5,900,000 Br. 5,900,000
Operating Income Br.1,000,000 Br.1,100,000 Br. 100,000

Comparative income statement table above shows analysis relevant revenues for decision:

(1) Distinguish relevant costs and revenues from irrelevant ones and

(2) Use the contribution income statement to focus on whether each variable cost and each fixed
cost is affected by the alternatives (i.e. reject or accept) under consideration.

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In this case, the relevant revenues and costs are the expected future revenues and costs that differ
as a result of accepting the special offer sales of Br 1,300,000(Br 13 per unit X 100,000 units) and
variable manufacturing costs of Br. 1,200,000 (Br 12 per units X 100,000 units). The fixed
manufacturing costs and selling and Administration costs (including variable costs) are irrelevant.
That is because these costs will not change in total whether the special order is accepted or
rejected. Based on the relevant data analyzed above, Samson would gain an additional Br. 100,
000 (relevant revenues, Br 1,300,000 less relevant costs Br 1,200,000) in operating income by
accepting the special order.

In this example, comparing total amounts for 1,000,000 units versus 1,100,000 units or focusing
only on the relevant amounts in the difference column in comparative income statement avoids
misleading implication the implication that would result from comparing the Br 13 per unit
selling price against the manufacturing cost per unit of Br 15 (from Samson’s income statement
on absorption costing basis) which includes both Variable and fixed manufacturing costs.

From the relevant data analyzed above, Samson Company should accept the special order because
it brings an additional income of Br. 100,000 for the company as:

Income with special order Br. 1,100,000

Income without special order 1,000,000

Additional income if the order had been accepted Br. 100,000

b) Yes. Unless Samson Company has effectively segments its market so that the special order to
the Ethio Company does not affect the regular business.

The analysis of make or buy decisions

The make or buy decision involves whether to manufacture a product in-house or to purchase it
from a third party. The outcome of this analysis should be a decision that maximizes the long-
term financial outcome for a company. There are a number of factors to consider when making
this decision, including the following items.

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Cost of the Item
Which alternative presents the lowest total out-of-pocket cost? Businesses tend to include fixed
costs when adding up their internal costs, which is incorrect. Only direct costs should be included
in the compilation of the internal cost to manufacture a product in-house. This amount should be
compared to the quoted price of a supplier.

Required Capacity
Will the company have sufficient capacity to produce the product in-house? Alternatively, is the
supplier reliable enough to be able to produce the goods in sufficient quantities and in a timely
manner? If the company is a relatively minor customer, it is possible that it will receive minimal
deliveries from the supplier during high-demand periods.

Required Expertise
Does the company have sufficient expertise to make the goods in-house? In some cases, a
business has experienced such a high rate of product failure that it has no choice but to outsource
the work to a supplier. In this case, the real debate is whether there is any chance of being able to
enhance the in-house production capability.

Required Funding
Does the company have enough cash to purchase the equipment needed for in-house production?
If the equipment is already on site, could outsourcing the work allow the equipment to be sold, so
that the cash can be used elsewhere? This is a major concern for startup companies, which have
little excess cash available to invest in facilities.

Impact on Company Bottleneck

Will shifting production to a supplier ease the burden on the company's bottleneck operation? If
so, this can be an excellent reason to buy the goods. If the bottleneck is elsewhere (such as in the
sales department), then this is not a consideration.

Availability of Drop Shipping

A supplier may offer to store the goods at its facility and then ship them directly to the company's
customers as they place orders. This approach shifts the burden of investing in inventory to the

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supplier, which can represent a substantial reduction in working capital. However, doing so also
gives the supplier the names and addresses of the company’s customers.

Strategic Importance
How important is the product to the corporate strategy? If it is very important, then it could make
more sense to manufacture the product, in order to maintain complete control over it. This option
is most likely to be taken if the company has proprietary production technology that it does not
want to share with a supplier. Conversely, something having little importance can more easily be
shifted to a supplier.

4. Describe the key concept in choosing which among multiple products to

produce when there are capacity constraints?

Likewise other short-term decisions, a company must consider the relevant costs and revenues
when making decisions when resources are constrained. Whether the organization facing a
constraint is a merchandising, manufacturing, or service organization, the initial step in allocating
scarce or constrained resources is to determine the unit contribution margin, which is the
selling price per unit minus the variable cost per unit, for each product or service. The company
should produce or provide the products or services that generate the highest contribution margin
first, followed by those with the second highest, and so forth. The total contribution margin will
be maximized by promoting those products or accepting those orders with the highest
contribution margin in relation to the scarce resource. In other words, products or services should
be ranked based on their unit contribution margin per production restraint, which is the unit
contribution margin divided by the production restraint.

5. Discuss the key factor managers must consider when adding or dropping
product lines and segments?
Decisions to replace usable plants assets should be based on studies of relevant costs. The
relevant costs are the future costs of continuing to use the equipment versus replacement.

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In general, in deciding whether to replace or keep existing equipment, four commonly
encountered factors considered in relevance:
a) Book value of old equipment: irrelevant, because it is a past (historical) cost.
Therefore, depreciation on old equipment is irrelevant.
b) Disposal value of old equipment: relevant, because it is an expected future inflow that
usually differs among alternatives.
c) Gain or loss on disposal: this is the algebraic difference between book value and
disposal value. It is therefore, a meaningless combination of irrelevant and relevant
items. Consequently, it is best to think of each separately.
d) Cost of new equipment: relevant, because it is an expected future outflow that will
differ among alternatives. Therefore, depreciation on new equipment is relevant.

6. Explain why the book value of equipment is irrelevant in equipment

replacement decisions?
The book value of fixed assets like machinery, equipment, and inventory is another example of
irrelevant sunk costs. The book value of a machine is a sunk cost that does not affect a decision
involving its replacement.

The book value of existing equipment in equipment-replacement decisions represents past

(historical) cost and therefore is irrelevant.

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