RELEVANT COSTING

TOPICS

1.4.2. Relevant costing and differential analysis

1.4.2.1. Definition and identification of relevant costs

1.4.2.2. Concept of opportunity costs

1.4.2.3. Approaches in analyzing alternatives in non-routine decisions (total
and differential)
1.4.2.4. Types of decisions (make or buy, accept or reject special order,
continue or drop/shutdown, sell or process further, best product combination,
pricing decisions)
RELEVANT COSTS
DIFFERENTIAL COSTS
CHARACTERISTICS OF
RELEVANT COSTS
 Variable expenses such as direct
material and direct labor in most
GENERAL production related decisions.
EXAMPLES
OF Direct fixed costs which are avoidable in
RELEVANT case of a closure.
COSTS:
Opportunity cost of continuing a business
activity, accepting a business order,
producing instead of purchasing an item
 Non-cash expenses (e.g., depreciation)

GENERAL Sunk cost (e.g., cost of machinery, cost of defective

products already produced).
EXAMPLES
OF
IRRELEVANT
COSTS: Committed expenses which are unavoidable.

‘One-off’ revenues and expenses (e.g., sale of

machinery, redundancy payments) that do not
reflect the underlying profitability of the business.
RELEVANT
COSTING
 ASSUMPTIONS IN
RELEVANT COSTING
a) Cost behavior patterns are known, e.g. if a department closes
down, the attributable fixed cost savings would be known.
b) The amount of fixed costs, unit variable costs, sales price and
sales demand are known with certainty.
c) The objective of decision making in the short run is to maximise
'satisfaction', which is often known as 'short-term profit'.
d) The information on which a decision is based is complete and
reliable.
SUNK COSTS
Sunk costs are the result of past decisions
and cannot be changed by any current or
future decisions. Sunk costs are irrelevant to
current or future decisions.
OUT-OF-POCKET
COSTS
Out-of-pocket costs are future outlays of
cash associated with a particular decision.
Out-of-pocket costs are relevant to decisions.
 Opportunity costs are the potential
OPPORTUNITY benefits given up when one
alternative is selected over another.
COSTS Opportunity costs are relevant to
decisions.
 Avoidable costs are
eliminated (in whole or in
part) by choosing one
AVOIDABLE COSTS alternative over the other.
Avoidable costs are
relevant in making
decisions.
 Unavoidable costs are costs that
are incurred regardless of the
option chosen. Sunk costs are
unavoidable so they are irrelevant
UNAVOIDABLE to decisions. Future costs that do
COSTS not differ (meaning they are
incurred in equal amounts) in two
decision alternatives are
unavoidable so they are irrelevant.
COMMON COSTS
Common costs are costs which will be identical for all alternatives are
irrelevant, e.g. rent or rates on a factory would be incurred whatever
products are produced.
COMMITTE
D COSTS
A committed cost is a
future cash outflow that
will be incurred anyway,
whatever decision is
taken now, e.g. contracts
already entered into
which cannot be altered.
A committed cost is
irrelevant.
RELEVANT BENEFITS
Management must also consider relevant benefits. Incremental benefits or
profits (such as additional contribution margin) are relevant to decision
making in some decision alternatives.
APPROACHES IN ANALYZING ALTERNATIVES IN NON-ROUTINE
DECISIONS
 Entire costs of a decision are
considered and compared,
regardless of whether they are
relevant or not. Total analysis
TOTAL ANALYSIS assists in the determination of total
projected profit of each decision
alternative, not merely the better
decision between two alternatives.
TOTAL ANALYSIS

Pro-Forma Marginal Income Sales

Statement (Between 2
Less: Variable manufacturing costs
Alternatives)
Manufacturing margin
Less: Variable selling and administrative expenses
Contribution margin
Less: Controllable direct fixed costs and expenses
Controllable margin
Less: Non-controllable direct fixed costs and expenses
Segment (direct) margin
Less: indirect (allocated) fixed costs and expenses
Operating income
 Differential revenues and costs (also
called relevant revenues and costs or
incremental revenues and costs)
represent the difference in revenues and
DIFFERENTIAL costs among alternative courses of action.
ANALYSIS Analyzing this difference is called
differential analysis (or incremental
analysis).
INCREMENTAL PROFIT

Incremental Profit Incremental revenue

Less: Incremental costs
Incremental profit
TYPES OF DECISIONS (MAKE OR BUY,
ACCEPT OR REJECT SPECIAL ORDER,
CONTINUE OR DROP/SHUTDOWN, SELL
OR PROCESS FURTHER, BEST PRODUCT
COMBINATION, PRICING DECISIONS)
Incremental costs are important
in the decision to make a product
or purchase it from a supplier.

MAKE OR
The cost to produce
an item must
direct materials
direct labor
incremental
BUY
include: production
overhead DEICISION
S
Do not use the predetermined
overhead application rate to
determine product cost in the
decision.
SAMPLE PROBLEM:

Orchid Company produces fertilizers with the following cost per gram of output:

Direct materials P0.45

Direct labor 0.50
Factory overhead 0.50
Total cost to make P1.45
SAMPLE PROBLEM
Normal, predetermined overhead application rate is 100% of direct labor cost. Orchid
can purchase fertilizer from outside from a supplier for P1.20. How much overhead do we
have to eliminate before Orchid should buy from an outside supplier? (Assume management
computes an incremental overhead rate of P0.20 per unit if it produces the fertilizer.)
ANSWER

Make Buy
Direct materials P0.45 ----
Direct labor 0.50 ----
Overhead costs ? ----
Purchase price ---- P1.20
P0.95 P1.20
ANSWER
P1.20 - P0.95 = P0.25

If we eliminate P0.25 of overhead, the price to make and the price to buy would be
the same.
ANSWER
If we cannot eliminate more than P0.25 of overhead per unit, then the price to BUY
will be cheaper.
This means that at the current state, the BUY OPTION is better than the MAKE
OPTION.
SAMPLE PROBLEM
A company currently buys a key part for a product it manufactures. The company buys the
part for P5 per unit and believes it can make the part for P1.50 per unit for direct materials and
P2.50 per unit for direct labor. The company allocates overhead costs at the rate of 50% of
direct labor. Incremental overhead costs to make this part are P0.75 per unit. Should the
company make or buy the part?
ANSWER

(per unit) Make Buy

Direct materials P1.50 -
Direct labor 2.50 -
Overhead 0.75 -
Cost to buy the part ____ P5.00
Total cost per unit P4.75 P5.00
NOTES
WE DO NO T CONSIDER THE ALLOCATED FIXED OVERHEAD. ALLOCATED FIXED
OVERHEAD IS IRRELEVANT.
WE CONSIDER THE ACTUAL INCREMENTAL OVERHEAD.
ACCEPT OR REJECT SPECIAL ORDER

1. The decision to accept additional business should be based on incremental costs and
incremental revenues.

2. Incremental amounts are those that occur if the company decides to accept the new
business.

3. The Company should consider whether it has excess capacity or not.

FORMULA

With idle capacity AND no alternative use of capacity:

Incremental sales

Less: Incremental costs

Incremental profit (loss)

FORMULA
With idle capacity AND With alternative use of capacity:

Incremental sales

Less: Incremental costs

Incremental profit (loss)

Less: Opportunity costs (benefit lost) from the alternative use of capacity

Advantage (disadvantage) of accepting the special sales order

FORMULA
No idle capacity AND No alternative use of capacity:

Incremental sales

Less: Incremental costs

Incremental profit
FORMULA
No idle capacity AND With alternative use of capacity:

Incremental sales

Less: Incremental costs

Incremental profit (loss)

Less: Opportunity costs, net of best benefit foregone from alternative use of capacity

Advantage (disadvantage) of accepting the special sales order

 SAMPLE PROBLEM

COMBO currently sells 100,000 units of its product. They are operating at 80% of full
capacity. The company has per unit and annual total sales and costs as shown in the following
table.

A current buyer of COMBO’s products wants to purchase additional units of its product
and export them to another country. This buyer offers to buy 10,000 units of the product at
P8.50 per unit, or P1.50 less than the current price. The offer price is low, but COMBO is
considering the proposal because this sale would be several times larger than any single
previous sale and it would use idle capacity. Should COMBO accept the offer?
SAMPLE PROBLEM
PER UNIT TOTAL
SALES (10,000 U) 10.00 1,000,000
DIRECT MATERIALS 3.50 350,000
DIRECT LABOR 2.20 220,000
VAR. OH 0.50 50,000
VAR. SELLING EXPENSE 1.40 140,000
FIXED OH 0.60 60,000
FIXED ADMIN. EXPENSE 0.80 80,000
ANSWER
PER UNIT TOTAL
SALES (10,000 U) 8.50 85,000
DIRECT MATERIALS 3.50 (35,000)
DIRECT LABOR 2.20 (22,000)
VAR. OH 0.50 (5,000)
VAR. SELLING - -
CM 2.30 23,000
FX. OH - -
FX. ADMIN - -
INCREMENTAL INCOME 2.30 23,000
ANSWER
COMBO SHOULD ACCEPT THE SPECIAL ORDER.
SAMPLE PROBLEM
TOUCH company receives a special order for 200 units of Laptops that requires stamping the
buyer’s name on each unit, yielding an additional fixed cost of P400,000 to its normal costs.
Without the order, the company is operating at 75% of capacity and produces 7,500 units of
product at the costs below. The company's normal selling price is P22,000 per unit. The
sales price for the special order is P18,000 per unit.
 Variable costs per
Costs (7,500 Units) Fixed costs
unit

SAMPLE Direct materials

Direct labor
37,500,000
60,000,000
P5,000
P8,000

PROBLEM Overhead
variable)
(30%
20,000,000 P800 P14,000,000

Selling expenses
25,000,000 P2,000 P10,000,000
(60% variable)
SAMPLE PROBLEM
The special order will not affect normal unit sales and will not increase fixed overhead and
selling expenses. Variable selling expenses on the special order are reduced to one-half the
normal amount. Should the company accept the special order?
ANSWER
PER UNIT TOTAL
SALES (200 UNITS) 18,000 3,600,000
DM 5,000 (1,000,000)
DL 8,000 (1,600,000)
VOH 800 (160,000)
VSE 1,000 (200,000)
INC. COST 2,000 (400,000)
CM / INC. INCOME 240,000
ASSUME:
ASSUME THAT TOUCH IS OPERATING AT FULL CAPACITY.
ANSWER
COMPUTE OPPORTUNITY COST:
SELLING PRICE P22,000
VAR COSTS (15,800)
CM P6,200
X UNITS FOREGONE 200
OPPORTUNITY COST P1,240,000
ANSWER

TOTAL
INC. INCOME 240,000
OPPORTUNITY. COST (1,240,000)
CM / INC. LOSS (1,000,000)
SCRAP OR
REWORK
As long as rework costs are recovered
through sale of the product, and rework
does not interfere with normal
production, rework IS BETTER rather
than scrap.
SCRAP OR
Costs incurred in manufacturing units of
REWORK
product that do not meet quality
standards are sunk costs and cannot be
recovered so they are irrelevant.
SAMPLE PROBLEM
Fabulous Company has 10,000 defective units that cost P1.00 each to make. The units can be
scrapped now for P0.40 each or reworked at an additional cost of P0.80 per unit. If reworked,
the units can be sold for the normal selling price of P1.50 each. Reworking the defective units
will prevent the production of 10,000 new units already ordered that would also sell for P1.50.
Should Fabulous scrap or rework?
 ANSWER

Scrap Rework
Sale of scrapped/reworked units P0.40 P1.50
Less out-of-pocket costs to rework defects (0.80)
Less opportunity cost of not making new units _____ (0.50)
Incremental net income (per unit) P0.40 P0.20
ANSWER
FABULOUS SHOULD SCRAP.
SE L L OR P ROC E SS
F URT HE R
SELL OR
PROCESS
FURTHER
Process further only if
incremental revenues
exceed incremental
costs.
SAMPLE PROBLEM
NOVA CORP has 40,000 units of wooden blocks. Processing costs to date are P30,000. The
40,000 unfinished units can be sold as is, for P50,000 or they can be processed further to
produce finished products tables, chairs, and cabinets. Processing the units further will cost
an additional P80,000 and will yield total revenues of P150,000. NOVA CORP seeks your
advice whether to sell the wooden blocks or use them to create tables, chairs, and cabinets.
ANSWER

Sell as Product Q Process Further

Incremental revenue P50,000 150,000
Incremental cost ----0---- (80,000)
Incremental income P50,000 P70,000
ANSWER
NOVA CORP SHOULD
PROCESS FURTHER. THERE
IS AN INCREMENTAL
INCOME OF P20,000.00
 The P30,000 of previously incurred
manufacturing costs are excluded from
NOTES the analysis. These costs are sunk, and
they are not relevant to the decision.
CONTINUE OR SHUTDOWN
 Direct fixed costs are typically eliminated if
a product line is eliminated, and are
considered differential costs.

CONTINUE OR Allocated fixed costs are typically not

eliminated if a product line is eliminated,
SHUTDOWN and are not differential costs.

Managers compare sales revenue and costs

for each alternative (keep or drop), and
select the alternative with the highest profit.
 This point of the output and price
where the business earns just the
revenue enough to cover the total
variable costs. Shutdown point
SHUTDOWN POINT occurs exactly when the marginal
profit of the business reaches a
negative scale.
 SHUTDOWN POINT

a. It is the output and price point where a firm is able to just cover its total
variable cost.
b. The average variable cost (AVC) is at its minimum point.
c. It is where the marginal cost (MC) curve intercepts the average variable cost
(AVC) curve.
d. The firm is indifferent between shutting down and continuing production where
losses equal to the total fixed costs are incurred regardless of either decision.
SHUTDOWN POINT FORMULA
Loss from continuing = loss from discontinuing

Where:

Loss from continuing = (CM - FC)

Loss from discontinuing = (0 – Shutdown costs)

SHUTDOWN POINT
At shutdown point:

𝐶𝑀 − 𝐹𝐶 = 0 − 𝑆𝐷𝐶

𝑄𝑆 𝑈𝐶𝑀 − 𝐹𝐶 = 0 − 𝑆𝐷𝐶

𝑄𝑆 𝑈𝐶𝑀 = 𝐹𝐷𝐶 − 𝑆𝐷𝐶

SHUTDOWN POINT
Where:

CM = Contribution margin

FC = Fixed costs

SDC = Shutdown costs

UCM = Unit contribution margin

QS = Quantity sold
SHUTDOWN QUANTITY

𝐹𝐶 − 𝑆𝐷𝐶
𝑄𝑆 =
𝑈𝐶𝑀
 BARAKO ROBUSTA HAZELNUT
COFFEE COFFEE COFFEE
Sales 750,000 1,000,000 250,000
SAMPLE Variable Costs 320,000 550,000 100,000
PROBLEM Direct Fixed 390,000 320,000 70,000
Costs

Allocated Fixed 56,250 75,000 18,750

Abra Company has Costs
the following
segments:
SAMPLE PROBLEM
Abra Company is concerned about the losses associated with the Barako Coffee and is
considering dropping this product line. Allocated fixed costs are assigned to product lines
based on sales. If Abra Company eliminates a product line, total allocated fixed costs are
assigned to the remaining product lines. All variable costs and direct fixed costs are differential
costs.
TOTAL ANALYSIS
Barako Coffee Robusta Coffee Hazelnut Coffee TOTAL
Sales 750,000 1,000,000 250,000 2,000,000
Variable Costs 320,000 550,000 100,000 970,000
CM 430,000 450,000 150,000 1,030,000
Direct Fixed Costs 390,000 320,000 70,000 780,000
Allocated Fixed Costs 56,250 75,000 18,750 150,000
PROFIT (16,250) 55,000 61,250 100,000
WITHOUT BARAKO

Robusta Coffee Hazelnut Coffee TOTAL

Sales 1,000,000 250,000 1,250,000
Variable Costs 550,000 100,000 650,000
CM 450,000 150,000 600,000
Direct Fixed Costs 320,000 70,000 390,000
Allocated Fixed 120,000 30,000 150,000
Costs
PROFIT 10,000 50,000 60,000
 IT IS BETTER TO MAINTAIN BARAKO.
CONCLUSION BECAUSE OF ITS CONTRIBUTION MARGIN
TO THE ALLOCATED FIXED COSTS.
ASSUME
Assume Abra Company can
lease the warehouse space
currently being used by the
Barako Coffee Department
for P15,000 per year. How
does this affect the
company’s decision to keep
or drop the BARAKO COFFEE
product line?
ANSWER

WITH BARAKO WITHOUT DIFFERENCE

BARAKO
PROFIT 100,000 60,000 (40,000)
ADDITIONAL - 15,000 15,000
INCOME
TOTAL PROFIT 100,000 75,000 (25,000)
CONCLUSION
ADDITIONAL PROFITS CANNOT COVER THE LOSSES.
THEREFORE, IT IS STILL BETTER TO KEEP BARAKO COFFEE PRODUCT LINE.
ASSUME
THE ADDITIONAL LEASE INCOME OF P80,000 BUT ABRA COMPANY WILL INCUR
SHUT DOWN COSTS OF P20,000. SHOULD ABRA COMPANY CONTINUE WITH
BARAKO COFFEE OR SHUT IT DOWN?
ANSWER

WITH BARAKO WITHOUT DIFFERENCE

BARAKO
PROFIT 100,000 60,000 (40,000)
ADDITIONAL - (20,000) (20,000)
EXPENSE
ADDITIONAL - 80,000 80,000
INCOME
TOTAL PROFIT 100,000 120,000 20,000
CONCLUSION
IT IS BETTER FOR ABRA COMPANY TO CLOSE DOWN BARAKO COFFEE LINE FOR A
TOTAL INCREMENTAL PROFIT OF P20,000.
BEST PRODUCT
C O M B I N AT I O N
(SALES MIX)
Focus of selling efforts on more
profitable products.

If production facilities or other

factors are limited, producing OPTIMUM SALES
more of one product usually
means producing less of others. MIX

Focus on the contribution margin

per unit of scarce resource.
SAMPLE PROBLEM
COMFORT makes and sells two products, Pillows and Blankets using the same machines.
The following are the selling prices and variable costs per unit:

Product A Product B
Selling P500 750
price
Variable 350 550
costs
 SAMPLE PROBLEM
However, it takes one hour to produce one unit of Pillow, while it takes two hours to produce
one unit of Blanket. Which product has a higher contribution margin? Which product should
COMFORT produce more?
 ANSWER

Pillow Blanked
Selling price per unit P500 P750
Variable costs per unit 350 550
Contribution margin per unit (a) 150 200
DIVIDE: Machine hours per unit (b) 1.0 2.0
Contribution margin per unit P150 P100
CONCLUSION
Even though PILLOW’s unit contribution is less, it has a higher contribution margin per machine hour.

COMFORT SHOULD PRODUCE MORE PILLOWS THAN BLANKETS.

NOTES
CONSIDER CONTRIBUTION MARGIN PER SCARCE RESOURCE. NOT CONTRIBUTION
MARGIN ONLY.
SAMPLE PROBLEM
PINE TREE produces two products, Mini Scented Candles and Mini Perfumes. Scented
Candles sells for P10 per unit and Mini Perfumes sells for P12.50 per unit. Variable costs are
P7 per unit of Mini Scented Candles and P8 per unit of Mini Perfumes. The company has a
capacity of 5,000 machine hours per month. Mini Scented Candles uses 1 machine hour per
unit, and Mini Perfumes uses 3 machine hours per unit.

a. Compute the contribution margin per machine hour for each product.

b. Assume demand for Mini Scented Candles is limited to 3,800 units per month. How many
units of Mini Scented Candles and Mini Perfumes should the company produce, and what
will be the total contribution margin from this sales mix?
ANSWER

(per unit) SCENTED PERFUME

CANDLES S
Sales P10.00 P12.50
Variable costs (7.00) (8.00)
Contribution margin per unit P3.00 P4.50
Machine hours per unit 1 3
Contribution margin per machine hour P3.00 P1.50
ANSWER

Total machine hours available 5,000

Machine hours used for production of
3,800
Gamma (3,800 units x 1 MH per unit)
Machine hours available for production of
1,200
Omega
Machine hours used for production of Omega
1,200
(1,200 MHs / 3 MH per unit = 400 units)
Remaining machine hours 0
ANSWER

Contribution margin (calculated on a per unit basis)

CANDLES 3,800 units × P3.00 contribution margin per unit P11,400
PERFUMES 400 units × P4.50 contribution margin per unit 1,800
Total contribution margin P13,200
ANSWER

Contribution margin (calculated on a

per machine hour basis)
CANDLE 3,800 machine hours × $3.00 P11,400
contribution margin per machine hour
PERFUMES 1,200 machine hours × 1,800
$1.50 contribution margin per machine
hour
Total contribution margin P13,200
 PRICING DECISIONS

Target Costing
Target costing = Expected selling price – Desired profit
Cost-plus Pricing
Markup % =
Target profit + Fixed overhead costs + Fixed selling and
administrative costs
Total variable costs
THANK YOU