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8/10/2019 Lesson 2 dm budget costing
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Relevant cost and short termdecision making
In this chapter, we will be looking in details tovarious possible short term decision making.We will look into each of the followings:
1. Acceptance or rejection of a contract2. Minimum price quotation3. Limiting factor – Single constraint & Multi
constraint4. Make or buy decision5. Shut-down decisions6. Further processing decisions
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Relevant cost and short termdecision making
Example: A company has been making a machine to order for acustomer, but the customer has since gone intoliquidation, and there is no prospect that any money willbe obtained from the winding up of the company. Costsincurred to date in manufacturing the machine areRM50,000 and progress payments of RM15,000 hadbeen received from the customer prior to the liquidation.The sales department has found another company willingto buy the machine for RM34,000 once it has been
completed.To complete the work, the following costs would beincurred:
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Relevant cost and short termdecision making
1. Materials: these have been bought at a cost of RM6,000.They have no other use, and if the materials is not finished,they would be sold for scrap for RM2,000.
2. Further labour costs would be RM8,000. Labour is in shortsupply, and if the machine is not finished, the work forcewould be switched to another job, which would earnRM30,000 in revenue, and incur direct costs of RM12,000and absorbed (fixed) overhead of RM8,000.
3. Consultancy fees RM4,000. If the work is not completed, theconsultant’s contract would be cancelled at a cost ofRM1,500.
4. General overheads of RM8,000 would be added to the cost of
the additional work
Required: Should the customer’s offer be accepted?
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Relevant cost and short termdecision making
Solution RM Note
Materials 1
Labour costs 2
Consultancy fees 3
General overheads 4
Total
Note
1) The relevant cost for material is related theopportunity costs which is the scrap income to beforgone.
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Relevant cost and short termdecision making
Note:
2) The relevant cost of labor is the total of further labour cost andthe opportunity cost of forgoing the contribution to be earnedfrom the other job.
3)4)
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Relevant cost and short termdecision making
Minimum price quotation
The minimum price for a once off job is its total relevantcosts: this is the price at which the company would makeno incremental loss from undertaking the work, but would
just achieve an incremental cost breakeven point
Example:
You have received a request from EXE to provide aquotation for the manufacture of a specialized piece ofequipment. This would be a one-off order, in excess ofnormal budgeted production. The following cost estimatehas already been prepared:
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Relevant cost and short termdecision making
Note RMDirect materials:Steel 10m²@ RM5 per m² 1 50Brass fittings 2 20Direct labour
Skilled 25 hours @ RM8 per hour 3 200Semi-skilled 10 hours @ RM5 per hour 4 50Overhead 35 hours @ RM10 per hour 5 350Estimating time 6 100
770
Administration overhead @ 20% of production cost 1547 924
Profit @ 25% of production cost 8 231Selling price 1155
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Relevant cost and short termdecision making
Notes1. The steel is regularly used and has a current stock value
of RM5 per square meter. There are currently 100 squaremeters in stock. The steel is readily available at a price ofRM5.50 per square meter.
2. The brass fittings would have to be brought specificallyfor this job: a supplier has quoted the price of RM20 forthe fittings required.
3. The skilled labour is currently employed by your companyand paid at a rate of RM8 per hour. If this job wereundertaken it would be necessary either to work 25 hours’overtime which would be paid at time plus one half, OR inorder to carry out the work in normal time, reduceproduction of another product that earns a contribution ofRM13 per hour.
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Relevant cost and short termdecision making
Notes4. The semi –skilled labour currently has sufficient paid idle
time to be able to complete this work.5. The overhead absorption rate includes power costs
which are directly related to machine usage. If this job
were undertaken, it is estimated that the machine timerequired would be ten hours. The machines incur powercosts of RM0.75 per hour. There are no other overheadcosts that can be specifically identified with this job.
6. The cost of the estimating time is that attributed to thefour hours taken by the engineers to analyse thedrawings and determine the cost estimate given above.
7. It is the company policy to add 20% to the productioncost as an allowance for administration costs associatedwith the jobs accepted.
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Notes
8. This is the standard profit added by your companyas part of its pricing policy.
Required:Prepare on a relevant cost basis, the lowest costestimate that could be used as the basis for aquotation.
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Relevant cost and short termdecision making
Solution RMDirect materials:SteelBrass fittings
Direct labourSkilledSemi-skilledOverhead
Estimating time Administration overhead @ 20% of production costProfit @ 25% of production costSelling price
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Relevant cost and short termdecision making
Limiting Factor Analysis
Limiting factor or key factor is ‘Anything whichlimits the activity of an entity. An entity seeks tooptimize the benefit it obtains from the limiting
factor’. It is assumed that in limiting factor analysis,
management would optimize its profit byproducing the product mix that gives the highestpossible profit and profit is maximized when
contribution is maximized. Hence, products thatgive the highest possible contribution per unit oflimiting factor would be given production priority.
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Relevant cost and short termdecision making
Make or buy decision
An option is to be made whether to buy externally orproduced internally
If an organization has the freedom of choice to make
internally or purchase externally under the followingconditions:
1. No scarce resources – relevant costs will be thedifferential cost between the two options
2. Insufficient internal resources – comparison betweenthe purchase price of the said product with thevariable cost of making plus the opportunity cost ofusing the scarce resource is to be made.
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Relevant cost and short termdecision making
Example (no scarce resources):
Pixie Pharmaceuticals is a research-basedcompany which manufactures a wide variety of
drugs for use in hospitals. The purchasingmanager has recently been approached by anew manufaturer based in a newly industrialisedcountry who have offered to produce three of the
drugs at their factory. The following unit costand unit price information has been provided.
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Relevant cost and short termdecision making
Drug Fairyoxide Spriteolite Goblinex
Production (units) 20,000 40,000 80,000
$ $ $
Direct material cost 0.80 1.00 0.40
Direct labour cost 1.60 1.80 0.80Direct expense cost 0.40 0.60 0.20
Fixed cost 0.80 1.00 0.40
Selling price each 4.00 5.00 2.00
Imported price 2.75 4.20 2.00
Required:
(a) Recommend to the management whether any drugs should bepurchased on the basis of cost only.
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Relevant cost and short termdecision making
Solution
Drug Fairyoxide Spriteolite Goblinex
Unit variable costs:
Direct material 0.80 1.00 0.40
Direct labour 1.60 1.80 0.80Direct expenses 0.40 0.60 0.20
Total cost of making 2.80 3.40 1.40
Imported price 2.75 4.20 2.00
Saving/(Loss) from 0.05 (0.80) (0.60)Buying
Decision
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Relevant cost and short termdecision making
Shut down decision/ Discontinuing a product
Shut down decision involves the following decisions:
Whether to shut down a factory, a department or aproduct line either due to it making a loss or tooexpensive to run
If the decision is to shut down, whether the closure ispermanent or temporary
If the decision is to shut down a product line, should anew product line be set up to replace ceased productline.
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Relevant cost and short termdecision making
Approach
Method 1: Comparing the contribution/profit beforeand after the closure
Method 2: Considering the relevant cost (for eg the
contribution forgone from the ceased operation withthe savings obtained from closure)
Note: Students will most likely be required to use
the marginal costing approach to prepare thecontribution earned from a particular segment ofbusiness to determine whether that segment ofbusiness should cease operation or to continue.
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Relevant cost and short termdecision making
Example: Ayeco with a head office in Ayetown, has threemanufacturing units. One in Beetown, the second inCeetown and the third in Deetown. The companymanufactures and sells an air-conditioner under the brand-
name of Ayecool at a price of RM200. It is unable to utilizefully its manufacturing capacity. The management of thecompany has to decide whether or not to renew the leaseof the property at Beetown, which expires next year. Thecompany has been offered an extension to the lease at anadditional cost of RM50,000 per annum. This situation
concerning the lease has been known for some time, so theaccountant has collected relevant information to aid thedecision. It is estimated that the cost of closing downBeetown would be offset by the surplus obtained by thesale of plant, machinery and inventories.
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Relevant cost and short termdecision making
Beetown Ceetown Deetown Total
RM'000 RM'000 RM'000 RM'000
Costs
Direct Materials 200 800 400 1,400
Direct Wages 200 900 350 1,450
Production overhead: Variable 50 300 150 500
Fixed 200 600 300 1,100Subtotal 650 2,600 1,200 4,450
Selling overhead:Variable 25 200 100 325
Fixed 75 250 150 475
Administration overhead 100 450 200 750
Subtotal 850 3,500 1,650 6,000
Head office costs 50 200 100 350
Total 900 3,700 1,750 6,350Profit 100 300 250 650
Sales 1,000 4,000 2,000 7,000
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Relevant cost and short termdecision making
If Ayeco does not renew the lease of the Beetown property ithas two alternatives:a) Accept an offer from Zeeco, a competitor, to take over the
manufacture and sales in the Beetown area and pay to Ayeco a commission of RM3 for each unit sold.
b) Transfer the output at present made in Beetown to eitherCeetown or Deetown. Each of these units has sufficientplant capacity to undertake the Beetown output butadditional costs in supervision, salaries, storage andmaintenance would be incurred. These additional costsare estimated as amounting yearly to RM250,000 at
Ceetown and to RM200,000 at Deetown.If the Beetown sales are transferred to either Ceetown orDeetown, it is estimated that additional transport costswould be incurred in delivering to customers in the r
egion of Beetown, and that these would amount to RM15per unit and RM20 per unit respectively.
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Relevant cost and short termdecision making
Required:
Present a statement to the board of directors of Ayecoto show the estimated annual profit which would arisefrom the following alternative course of action.
a) Continuing production at all three sitesb) Closing down production at Beetown and
accepting the offer from Zeeco
c) Transferring Beetown sales to Ceetown
d) Transferring Beetown sales to Deetown
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Relevant cost and short termdecision making
SolutionBeetown Ceetown Deetown Total
Quantity sold 5000 20000 10000 35000
Sales 1000 4000 2000 7000
Less:-Variable Cost
Direct Materials 200 800 400 1400Direct Wages 200 900 350 1450
V. Production Overhead 50 300 150 500
V. Selling Overhead 25 475 200 2200 100 1000 325
Contribution 525 1800 1000 3325
Less:- Directly Attributable Fixed
CostFixed Production Overhead 200 600 300 1100
Fixed Selling Overhead 75 250 150 475
Administration Overhead 100 375 450 1300 200 650 750
Attributable Profit 150 500 350 1000
Less:- Head Office Cost 50 200 100 350
Profit 100 300 250 650
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Relevant cost and short termdecision making
Solution
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Solution
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Further processing decision Further processing decision involve the selection of
the joint products whether to sell it after further
processing it or immediately after split-off point. In such a case, the joint cost incurred before the
split off point would not be considered as this costwould have to be incurred regardless of whetherthe product is sold at split off point or after furtherprocessing.
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Relevant cost and short termdecision making
Example:
Rustam Ali Sdn Bhd produces two products from a singleprocess. During one period in which the process costs areexpected to be RM150,000, the following outputs areexpected:
Output Unit selling(litres) Price (RM)
Product X 5,000 15.00
Product Y 15,000 10.00
Each product can be further processed using skilled labour,costing RM10 per hour, to create superior products; Super Xand Super Y.
R l d h
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Further modifications will result in the following increases inlabour hours and amended selling prices:
Skilled Labour Unit SP (RM)
Product Super X 75hrs per lit 25 per lit
Product Super Y 40hrs per lit 13 per lit
Required:
Advise Rustam Ali Sdn Bhd whether Product X and Product Y
should be further processed before it is being sold.
R l t t d h t t
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Solution
R l t t d h t t
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Relevant cost and short termdecision making
Qualitative factors
Before any decisions is made, the management wouldneed to consider other factors which may not bequantifiable but represents an important aspects in
coming up with the conclusion. Below are someexamples which may affect a particular decision:
R l t t d h t t
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FactorsAvailability of resources such ascash, materials, labours etc
Inflation
DetailsAn opportunity might exists for acompany, but such an opportunitycan only be taken when there is noconstraints on taking up theopportunity
The effects on inflation on the prices of various items may need to be considered especially fixed pricecontract that may require years tocomplete should be taken into
account as the contracts profitabilitymay be affected if there is costoverrun
R l t t d h t t
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Relevant cost and short termdecision making
Employees
Customers
The company must consider theeffects of a particular decision on
the employees in terms of
motivation, morale, possible
resistance etc
Decisions involving undertaking a
once off job, product abandonment,
shutting down, make or buy will
inevitably affects the customers
loyalty.
R l t t d h t t
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Relevant cost and short termdecision making
Competitors
Suppliers
Every decision made by a companywill indirectly result in competitorsreacting to safeguard its own
profitability and survival. Forexample, before a company decidesto reduce its products’ selling price,the management will need to
consider its effectiveness as theremay be a possibility that a price warmay arise.
Certain decisions may affect thesuppliers such as the possible shut
down of a particular product line ormay result in the loss of goodwill ofthe company due to the negative
perception it has on the companyreducing its scale of operations.