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Topic 3Topic 3
Relevant Costing andContribution Analysis
Learning Objective 1Learning Objective 1
Use the seven-step decisionprocess to make decisions.
Information and theDecision Process
Information and theDecision Process
A decision model is a formal methodfor making a choice, often involvingquantitative and qualitative analysis.
Seven-Step Decision ProcessSeven-Step Decision Process
identify objectives
Search for alt. course of action
Gather data on alternatives
Implement the Decision
Compare actual vs planned outcomes
Step 1.
Step 2.
Step 3.
Step 5.
Step 6.
Make Specific Predictions
Feed
back
Step 7. Respond to divergences from plan
Step 4. Select alt. course of action
Historical CostsOther Information
Learning Objective 2Learning Objective 2
Differentiate relevant from irrelevant
costs and revenues indecision situations.
The Meaning of RelevanceThe Meaning of Relevance
Relevant costs and relevant revenues areexpected future costs and revenues thatdiffer among alternative courses of action.
Historical costs Sunk costs
Differential income Differential costs
Learning Objective 3Learning Objective 3
Distinguish between quantitativeand qualitative factors in decisions.
Quantitative and QualitativeRelevant Information
Quantitative and QualitativeRelevant Information
Quantitative factors
Financial Nonfinancial
Qualitative factors
Quantitative and QualitativeQuantitative and QualitativeRelevant InformationRelevant Information
Generally, relevant-cost analysis emphasises quantitative factors that can be expressed financially.But qualitative and quantitative non-financial factors are also important, and managers must at times give more weight to these factors.
Quantitative and QualitativeQuantitative and QualitativeRelevant InformationRelevant Information
Key features of relevant information:•Past (historical) costs may be helpful as basis for making predictions, but, in themselves are always irrelevant when making decisions.•Different alternatives can be compared in examining differences in expected total future revenues and costs.•Not all expected future revenues and costs are relevant. Those that do not differ among alternatives are irrelevant, hence can be eliminated from the analysis (key question is always: what difference will an action make?).•Appropriate weight must be given to qualitative and quantitative non-financial factors.
Example:One-Time-Only Special Order
Example:One-Time-Only Special Order
The Bismark Co. manufacturing plant has aproduction capacity of 44,000 towels each month.
Current monthly production is 30,000 towels.
Costs can be classified as either variable or fixedwith respect to units of output.
Relevance: Choosing output levels
One-Time-OnlySpecial Order Example
One-Time-OnlySpecial Order Example
Variable costs per
unit
Fixed costs per unit
Direct materials TShs. 6.50 TShs. - 0 - Direct labour 0.50 1.50Manufacturing costs 1.50 3.50Total TShs. 8.50 TShs. 5.00
One-Time-OnlySpecial Order Example
One-Time-OnlySpecial Order Example
Total fixed direct manufacturing labour is TShs. 45,000.
Total fixed overhead is TShs. 105,000.
Marketing costs per unit are TShs. 7(TShs. 5 of which is variable).
What is the full cost per towel?
One-Time-OnlySpecial Order Example
One-Time-OnlySpecial Order Example
A hotel in San Juan has offered to buy5,000 towels from Bismark Co. atTShs. 11.50 per towel for a total of TShs. 57,500.
No marketing costs will be incurred.
Variable (TShs. 8.50 + TShs. 5.00): TShs. 13.50Fixed: 7.00Total (full cost) TShs. 20.50
One-Time-OnlySpecial Order Example
One-Time-OnlySpecial Order Example
TShs. 8.50 × 5,000 = TShs. 42,500 incremental costs
What are the incremental revenues ?
What are the relevant costs of making the towels ?
TShs. 57,500 – TShs. 42,500 = TShs. 15,000
Learning Objective 4Learning Objective 4
Beware of two potentialproblems in
relevant-cost analysis.
Two Potential Problems inRelevant-Cost Analysis
Two Potential Problems inRelevant-Cost Analysis
Incorrect generalassumptions:
All variable costsare relevant.
All fixed costsare irrelevant.
1 2Misleadingunit-cost data:
Includeirrelevant costs.
Use same unitcosts at differentoutput levels.
Outsourcing versus InsourcingOutsourcing versus Insourcing
Outsourcing ispurchasing goodsand services fromoutside suppliers.
Insourcing isproducing goods
or providing serviceswithin the organisation.
Make-or-Buy Decisions ExampleMake-or-Buy Decisions Example
Bismark Co. also manufactures bath accessories.
Management is considering producing a part itneeds (#2) or buying a part producedby Towson Co. for TShs. 0.55.
Make-or-Buy Decisions ExampleMake-or-Buy Decisions Example
Bismark Co. has the following costs for150,000 units of Part #2:
Direct materials TShs. 28,000Direct labour 18,500Mixed overhead 29,000Variable overhead 15,000Fixed overhead 30,000Total TShs. 120,500
Make-or-Buy Decisions ExampleMake-or-Buy Decisions Example
Mixed overhead consists of material handlingand setup costs.
Bismark Co. produces the 150,000 units in 100batches of 1,500 units each.
Total material handling and setup costs equal fixedcosts of TShs. 9,000 plus variable costs of TShs. 200per batch.
Make-or-Buy Decisions ExampleMake-or-Buy Decisions Example
What is the cost per unit for Part #2?
TShs. 120,500 ÷ 150,000 units = TShs. 0.8033/unit
Should Bismark Co. manufacture the part or buy itfrom Towson Co.?
Make-or-Buy Decisions ExampleMake-or-Buy Decisions Example
Bismark Co. anticipates that next year the150,000 units of Part #2 expected to besold will be manufactured in 150 batchesof 1,000 units each.
Make-or-Buy Decisions ExampleMake-or-Buy Decisions Example
Variable mixed costs per batch are expected todecrease to TShs. 100.
Bismark Co. plans to continue to produce150,000 next year at the same variablemanufacturing costs per unit as this year.
Fixed costs are expected to remain the same asthis year.
Make-or-Buy Decisions ExampleMake-or-Buy Decisions Example
What is the variable manufacturing cost per unit?
TShs. 61,500 ÷ 150,000 = TShs. 0.41 per unit
Direct material TShs. 28,000Direct labour 18,500Variable overhead 15,000Total TShs. 61,500
Make-or-Buy Decisions ExampleMake-or-Buy Decisions Example
Expected relevant cost to make Part #2:
Cost to buy: (150,000 × TShs. 0.55) TShs. 82,500
Manufacturing TShs. 61,500Material handling and setups 15,000*Total relevant cost to make TShs. 76,500*150 × TShs. 100 = TShs. 15,000
Bismark Co. will save TShs. 6,000 by making the part.
Make-or-Buy Decisions ExampleMake-or-Buy Decisions Example
Now assume that the TShs. 9,000 in fixed clerical salariesto support material handling and setup will not beincurred if Part #2 is purchased from Towson Co.
Should Bismark Co. buy the part or make the part?
Make-or-Buy Decisions ExampleMake-or-Buy Decisions Example
Relevant cost to make:
Variable TShs. 76,500Fixed 9,000Total TShs. 85,500
Cost to buy: TShs. 82,500
By buying the part, Bismark would save: TShs. 3,000
Learning Objective 5Learning Objective 5
Explain the opportunity-costconcept and why it is
used in decision making.
Opportunity Costs,Outsourcing, and Constraints
Opportunity Costs,Outsourcing, and Constraints
Assume that if Bismark buys the part from Towson,it can use the facilities previously used tomanufacture Part #2 to produce Part #3 forKrista Company.
The expected additional future operating incomeis TShs. 18,000.
What should Bismark Co. do?
Opportunity Costs,Outsourcing, and Constraints
Opportunity Costs,Outsourcing, and Constraints
Bismark Co. has three options regarding Krista:
1. Make Part #2 and do not make Part #3.
2. Buy Part #2 and do not make Part #3.
3. Buy the part and use the facilities to produce Part #3.
Opportunity Costs,Outsourcing, and Constraints
Opportunity Costs,Outsourcing, and Constraints
Expected cost of obtaining 150,000 parts:
Buy Part #2 and do not make Part #3: TShs. 82,500
Buy Part #2 and make Part #3:TShs. 82,500 – TShs. 18,000 = TShs. 64,500
Make Part #2: TShs. 76,500
Opportunity Costs,Outsourcing, and Constraints
Opportunity Costs,Outsourcing, and Constraints
Opportunity cost is the contribution toIncome that is forgone (rejected) by notusing a limited resource in its next-bestalternative use.
Opportunity Costs,Outsourcing, and Constraints
Opportunity Costs,Outsourcing, and Constraints
Assume that annual estimated Part #2requirements for next year is 150,000.
Cost per purchase order is TShs. 40.
Cost per unit when each purchase is 1,500 units= TShs. 0.55.
Cost per unit when each purchase is equal to orgreater than 150,000 = TShs. 0.54.
Opportunity Costs,Outsourcing, and Constraints
Opportunity Costs,Outsourcing, and Constraints
Average investment in inventory is either:
(1,500 × .55) ÷ 2 = TShs. 412.50 or
(150,000 × TShs. 0.54) ÷ 2 = TShs. 40,500
Annual interest rate for investment ingovernment bonds is 6%.
TShs. 412.50 × .06 = TShs. 24.75
TShs. 40,500 × .06 = TShs. 2,430
Opportunity Costs,Outsourcing, and Constraints
Opportunity Costs,Outsourcing, and Constraints
Option A: Make 100 purchases of 1,500 units:Purchase order costs: (100 × TShs. 40) TShs. 4,000.00
Purchase costs: (150,000 × TShs. 0.55) TShs. 82,500.00
Annual interest income: TShs. 24.75
Relevant costs: TShs. 86,524.75
Opportunity Costs,Outsourcing, and Constraints
Opportunity Costs,Outsourcing, and Constraints
Option B: Make 1 purchase of 150,000 units:Purchase order costs: (1 × TShs. 40) TShs. 40
Purchase costs: (150,000 × TShs. 0.54) TShs. 81,000
Annual interest income: TShs. 2,430
Relevant costs: TShs. 83,470
Learning Objective 6Learning Objective 6
Know how to choose whichproducts to produce when there
are capacity constraints.
Product-Mix DecisionsUnder Capacity Constraints
Product-Mix DecisionsUnder Capacity Constraints
Per unit Product #2 Product #3Sales price TShs. 2.11 TShs. 14.50Variable expenses 0.41 13.90Contribution margin TShs. 1.70 TShs. 0.60Contribution margin ratio 81% 4%
Bismark Co. has 3,000 machine-hours available.
Product-Mix DecisionsUnder Capacity Constraints
Product-Mix DecisionsUnder Capacity Constraints
One unit of Prod. #2 requires 7 machine-hours.
One unit of Prod. #3 requires 2 machine-hours.
What is the contribution of each product permachine-hour?
Product #2: TShs. 1.70 ÷ 7 = TShs. 0.24Product #3: TShs. 0.60 ÷ 2 = TShs. 0.30
Learning Objective 7Learning Objective 7
Discuss what managersmust consider when
adding or discontinuing customers and segments.
Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based Costing, and Relevant Costs
Mountain View Furniture supplies furniture to two localretailers – Stevens and Cohen.
The company has a monthly capacity of 3,000machine-hours.
Fixed costs are allocated on the basis of revenues.
Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based Costing, and Relevant Costs
Stevens CohenRevenues TShs. 200,000 TShs. 100,000Variable costs 70,000 60,000Fixed costs 100,000 50,000Total operating costs TShs. 170,000 TShs. 110,000Operating income TShs. 30,000 TShs. (10,000)Machine-hours required 2,000 1,000
Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based Costing, and Relevant Costs
TotalRevenues TShs.
300,000Variable costs 130,000Fixed costs 150,000Total operating costs TShs. 280,000Operating income TShs. 20,000Machine-hours required 3,000
Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based Costing, and Relevant Costs
Should Mountain View Furniture drop the Cohenbusiness, assuming that dropping Cohen woulddecrease its total fixed costs by 10%?
New fixed costs would be:TShs. 150,000 – TShs. 15,000 = TShs. 135,000
Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based Costing, and Relevant Costs
Stevens AloneRevenues TShs. 200,000Variable costs 70,000Fixed costs 135,000Total operating costs TShs. 205,000Operating income TShs. (5,000)Machine-hours required 3,000
Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based Costing, and Relevant Costs
Cohen’s business is providing a contribution marginof TShs. 40,000.
TShs. 40,000 decrease in contribution margin– TShs. 15,000 decrease in fixed costs= TShs. 25,000 decrease in operating income.
Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based Costing, and Relevant Costs
Assume that if Mountain View Furniture drops Cohen’sbusiness it can lease the excess capacity to thePerez Corporation for TShs. 70,000.
Fixed costs would not decrease.
Should Mountain View Furniture lease to Perez?
Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based Costing, and Relevant Costs
Steven Perez Total
Revenues 200,000 70,000 270,000
Variable costs 70,000 0 70,000
Fixed costs 135,000 0 135,000
Total operating costs 205,000 0 205,000
Operating income (5,000) 70,000 65,000
Learning Objective 8Learning Objective 8
Explain why the book valueof equipment is irrelevant in
equipment-replacement decisions.
Equipment-Replacement Decisions Example
Equipment-Replacement Decisions Example
Existing ReplacementMachine Machine
Original cost TShs. 80,000 TShs. 105,000Useful life 4 years 4 yearsAccumulated depreciation TShs. 50,000Book value TShs. 30,000Disposal price TShs. 14,000Annual costs TShs. 46,000 TShs. 10,000
Equipment-Replacement Decisions Example
Equipment-Replacement Decisions Example
Ignoring the time value of money and income taxes,should the company replace the existing machine?
The cost savings over a 4-year period will beTShs. 36,000 × 4 = TShs. 144,000.
Investment = TShs. 105,000 – TShs. 14,000= TShs. 91,000
TShs. 144,000 – TShs. 91,000 = TShs. 53,000advantage of the replacement machine.
Learning Objective 9Learning Objective 9
Explain how conflicts can arisebetween the decision modelused by a manager and the
performance evaluation modelused to evaluate the manager.
Decisions andPerformance Evaluation
Decisions andPerformance Evaluation
What is the journal entry to sell the existing machine?
Cash 14,000Accumulated Depreciation 50,000Loss on Disposal 16,000Machine 80,000
Decisions andPerformance Evaluation
Decisions andPerformance Evaluation
In the real world would the manager replace themachine?
An important factor in replacement decisions is themanager’s perceptions of whether the decisionmodel is consistent with how the manager’sperformance is judged.
Decisions andPerformance Evaluation
Decisions andPerformance Evaluation
Top management faces a challenge – that is, makingsure that the performance-evaluation model ofsubordinate managers is consistent with thedecision model.
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