Relevant Costing

(Incremental Analysis)

Professor: John Anthony M. Labay, CPA, MBA

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TITLE: Relevant Costing

I. Learning Outcomes
1. Definition and Concept of Relevant Cost
2. Definition and Concept of Avoidable and Unavoidable Costs
3. Typical Decision-Making Cases

II. Discussion

Relevant cost can be defined as a managerial accounting term that is used to describe and
explain the costs that are related to the management decisions. The main objective behind the
concept of the relevant cost is that management requires data and information to take important
decisions regarding the management and high-level authorities. However, the data and the
information are available in the bulk quantity and such a huge quantity of data can also make the
senior management or decision-making team confuse. In order to avoid this confusion, the only
relevant data or relevant cost is collected from the bulk data so that management can make
decisions on the basis of the selected data. Relevant costs are the actual decision-making costs
and are relevant in the case of decision making. This means that these costs may be irrelevant in
other cases except for the case where they are used for the decision making. Relevant costs
may also be termed as the future costs that differ between the alternate methods. It is important
to consider and calculate relevant costs as a lot of irreverent costs can lead to erroneous decisions
in the business. Moreover, discarding the irreverent data can also save time and efforts towards
the decision making. Irrelevant costs are costs that are not affected by the ultimate decision. In
other words, these are the costs which shall be incurred in all managerial alternatives being
considered. Since they are the same in all alternatives, they become irrelevant and need not be
considered in calculations made for managerial analysis.

Avoidable Costs and Unavoidable Costs

Avoidable costs are such costs which are incurred only when a product or activity is continued
and a decision to discontinue a product or activity will eliminate or reduce these costs.
Unavoidable Costs are costs which are immune to a decision in the sense that they are incurred
regardless a product or activity is continued or dropped.

Typical Decision-Making Cases

1. Make or Buy Decision
Make-or-Buy decision (also called the outsourcing decision) is a judgment made by management
whether to make a component internally or buy it from the market. While making the decision,
both qualitative and quantitative factors must be considered.

Examples of the qualitative factors in make-or-buy decision are control over quality of the
component, reliability of suppliers, impact of the decision on suppliers and customers, etc. The
quantitative factors are actually the incremental costs resulting from making or buying the
component. For example: incremental production cost per unit, purchase cost per unit, production
capacity available to manufacture the component, etc.

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2. Adding or Dropping Business Segment or Product Line

A decision whether or not to continue an old product line or department, or to start a new one is
called an add-or-drop decision. An add-or-drop decision must be based only on relevant
information.

Relevant information includes the revenues and costs which are directly related to a product line
or department. Examples of relevant information are sales revenue, direct costs, variable
overhead and direct fixed overhead. Such decision must not be based on irrelevant information
such as allocated fixed overhead because allocated fixed overhead will not be eliminated if the
product line or department is dropped.

3. Accept or Reject a Special Order

Special order pricing is a technique used to calculate the lowest price of a product or service at
which a special order may be accepted and below which a special order should be rejected.
Usually a business receives special orders from customers at a price lower than normal. In such
cases, the business will not accept the special order if it can sell all its output at normal price.
However, when sales are low or when there is idle production capacity, special orders should be
accepted if the incremental revenue from special order is greater than incremental costs.

This method of pricing special orders, in which price is set below normal price but the sale still
generates some contribution per unit, is called contribution approach to special order pricing. The
idea is that it is better to receive something above variable costs, than receiving nothing at all.

4. Utilization of a Constrained Resource

Scarce resource utilization (or allocation) decision is a judgment regarding the best use of scarce
resources so as to maximize the total net income of a business. Scarcity of different resources
puts constraints on the amount of product that can be produced using those resources. For
example, a business may have limited number of machine hours to utilize in production. Scarce
resource allocation decision is also called limiting factors decision.

When resources are abundant, products generating relatively higher contribution margin per unit
are preferred because it leads to highest net income. However, when resources are scarce, a
decision in this way is unlikely to maximize the profit. Instead the allocation of a scarce resource
to various products must be based on the contribution margin per unit of the scarce resource from
each product.

A simple scarce resource allocation decision involves the following steps:

a. Calculate the contribution margin per unit of the scarce resource from each product.
b. Rank the products in the order of decreasing contribution margin per unit of scarce resource.
c. Estimate the number of units of each product which can be sold.
d. Allocate scarce resource first to the product with highest contribution margin per unit of scarce
resource, then to the product with next highest contribution margin per unit of scarce resource.

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5. Sell or Process Further

A decision whether to sell a joint product at split-off point or to process it further and sell it in a
more refined form is called a sell-or-process-further decision. Joint products are two or more
products which have been manufactured from the same inputs and in a same production process
(i.e. a joint process). The point at which joint products leave the joint process is called split-off
point.

Some of the joint products may be in final form ready for sale, while others may be processed
further. In such cases managers have to decide whether to sell the unfinished goods at split-off
point or to process them further. Such decision is known as sell-or-process-further decision and
it must be made so as to maximize the profits of the business.

A sell-or-process-further analysis can be carried out in three different ways:

a. Incremental (or Differential) Approach calculates the difference between the additional
revenues and the additional costs of further processing. If the difference is positive the product
must be processed further, otherwise not.
b. Opportunity Cost Approach calculates the difference between net revenue from further
processed product and the opportunity cost of not selling the product at split-off point. If the
difference is positive, further processing will increase profits.
c. Total Project Approach (or the comparative statement approach) compares the profit
statements of both options (i.e. selling and further processing) separately for each product. The
option generating higher profit is chosen.

6. Retain or replace an old asset

Management often has to decide whether or not to repair/retain or replace an old asset. In a
decision to retain or replace asset, management compares the costs which are affected by the
two alternatives. Generally, these are variable manufacturing costs and the cost of the new
equipment. The book value of the old machine is a sunk cost which is a cost that cannot be
changed by any present or future decision. Sunk costs are not relevant in incremental analysis.
Any trade-in allowance or cash disposal value of the existing asset is relevant, however.

7. Continue or Shutdown Operation

Management will choose to implement a shutdown of operation when the revenue received from
the sale of the goods or services produced cannot even cover the fixed costs of production. In
that situation, the firm will experience a higher loss when it operates, compared to not operating
at all.

Shutdown occurs if revenue is below average variable cost at the profit-maximizing positive level
of output. Producing anything would not generate revenue significant enough to offset the
associated variable costs; producing some output would add losses (additional costs in excess of
revenues) to the costs unavoidably being incurred (the fixed costs). By not producing, the firm
loses only the fixed costs.

Shutdown point (SDP) is the level of sales where the loss from continuing the operations is equal
to the shut down costs (e.g., loss from discontinuing operations). Shutdown costs are those still
incurred during the shutdown period. (Depreciation, Property tax, Interest expense, Insurance of
facilities, Security of premises)

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III. Learning Exercises

1. Ros Corporation uses part A2 in one of its products. The company's Accounting Department
reports the following costs of producing the 4,000 units of the part that are needed every year.
Per Unit
Direct materials P 2.80
Direct labor 6.30
Variable overhead 8.50
Supervisor’s salary 2.60
Depreciation of special equipment 6.80
Allocated general overhead 6.10
An outside supplier has offered to make the part and sell it to the company for P32.30 each. If
this offer is accepted, the supervisor's salary and all of the variable costs, including direct labor,
can be avoided. The special equipment used to make the part was purchased many years ago
and has no salvage value or other use. The allocated general overhead represents fixed costs of
the entire company. If the outside supplier's offer were accepted, only P4,000 of these allocated
general overhead costs would be avoided. In addition, the space used to produce part A2 could
be used to make more of one of the company's other products, generating an additional segment
margin of P26,000 per year for that product.

Required:
a. Prepare a report that shows the effect on the company's total net operating income of buying
part A2 from the supplier rather than continuing to make it inside the company.

b. Which alternative should the company choose?

2. When Mr. Dong, president and chief executive of Dong, Inc., first saw the segmented income
statement below, he flew into his usual rage: "When will we ever start showing a real profit? I'm
starting immediate steps to eliminate those two unprofitable lines!"
Product Lines .
Total X Y Z
Sales P 250,000 P 100,000 P 75,000 P 75,000
Variable Expenses 119,000 37,000 35,000 47,000
Contribution Margin 131,000 63,000 40,000 28,000
Traceable fixed expenses* 98,000 31,000 37,000 30,000
Common expenses, allocated 32,900 18,000 10,500 4,400
Net operating income (loss) P 100 P 14,000 P (7,500) P (6,400)

*These traceable expenses could be eliminated if the product lines to which they are traced were
discontinued.

Required:
Recommend which segments, if any, should be eliminated. Prepare a report in good form to
support your answer.

3. Juls Company produces a single product. The cost of producing and selling a single unit of this
product at the company's normal activity level of 60,000 units per month is as follows:
Direct materials P 34.00
Direct labor 4.00
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Variable manufacturing overhead 2.00

Fixed manufacturing overhead 21.30
Variable selling and administrative expense 2.70
Fixed selling and administrative expense 7.00

The normal selling price of the product is P79.80 per unit.

An order has been received from an overseas customer for 2,000 units to be delivered this month
at a special discounted price. This order would have no effect on the company's normal sales and
would not change the total amount of the company's fixed costs. The variable selling and
administrative expense would be P0.30 less per unit on this order than on normal sales.
Direct labor is a variable cost in this company.

Required:
a. Suppose there is ample idle capacity to produce the units required by the overseas customer
and the special discounted price on the special order is P71.60 per unit. By how much would this
special order increase (decrease) the company's net operating income for the month?

b. Suppose the company is already operating at capacity when the special order is received from
the overseas customer. What would be the opportunity cost of each unit delivered to the overseas
customer?

c. Suppose there is not enough idle capacity to produce all of the units for the overseas customer
and accepting the special order would require cutting back on production of 700 units for regular
customers. What would be the minimum acceptable price per unit for the special order?

4. Gloss Company makes three products in a single facility. These products have the following
unit product costs:
Products .
A B C
Direct materials P 13.50 P 16.20 P 17.60
Direct labor 14.10 18.00 18.50
Variable mfg. overhead 3.10 3.60 3.60
Fixed mfg. overhead 11.60 16.60 8.50
Unit product cost P 42.30 P 54.40 P 48.20

Additional data concerning these products are listed below:

Products .
A B C
Mixing minutes per unit 3.30 3.80 5.10
Selling price per unit P 59.30 P 73.20 P 64.60
Variable selling cost per unit P 1.90 P 2.20 P 1.50
Monthly demand in units 1,000 1,000 4,000

The mixing machines are potentially the constraint in the production facility. A total of 27,400
minutes are available per month on these machines. Direct labor is a variable cost in this
company.

Required:
a. How many minutes of mixing machine time would be required to satisfy demand for all three
products?
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b. How much of each product should be produced to maximize net operating income? (Round off
to the nearest whole unit.)

c. Up to how much should the company be willing to pay for one additional hour of mixing machine
time if the company has made the best use of the existing mixing machine capacity?

5. Ico Company makes two products from a common input. Joint processing costs up to the split-
off point total P47,600 a year. The company allocates these costs to the joint products on the
basis of their total sales values at the split-off point. Each product may be sold at the split-off point
or processed further. Data concerning these products appear below:
Product X Product Y Total
Allocated joint processing costs P 23,800 P 23,800 P 47,600
Sales value at split-off point P 34,000 P 34,000 P 68,000
Costs of further processing P 20,900 P 21,800 P 42,700
Sales value after further processing P 53,600 P 60,100 P 113,700

Required:
a. What is the net monetary advantage (disadvantage) of processing Product X beyond the split-
off point?

b. What is the net monetary advantage (disadvantage) of processing Product Y beyond the split-
off point?

c. What is the minimum amount the company should accept for Product X if it is to be sold at the
split-off point?

d. What is the minimum amount the company should accept for Product Y if it is to be sold at the
split-off point?

IV. Assessment

1. Part F4 is used in one of Wil Corporation's products. The company's Accounting Department
reports the following costs of producing the 7,000 units of the part that are needed every year.
Per Unit
Direct materials P 7.00
Direct labor P 6.00
Variable overhead P 5.60
Supervisor’s salary P 4.70
Depreciation of special equipment P 1.50
Allocated general overhead P 5.40

An outside supplier has offered to make the part and sell it to the company for P28.30 each. If
this offer is accepted, the supervisor's salary and all of the variable costs, including direct labor,
can be avoided. The special equipment used to make the part was purchased many years ago
and has no salvage value or other use. The allocated general overhead represents fixed costs of
the entire company. If the outside supplier's offer were accepted, only P9,000 of these allocated
general overhead costs would be avoided.

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Required:
a. Prepare a report that shows the effect on the company's total net operating income of buying
part F4 from the supplier rather than continuing to make it inside the company.

b. Which alternative should the company choose?

2. Zacc Corporation makes a range of products. The company's predetermined overhead rate is
P14 per direct labor-hour, which was calculated using the following budgeted data:
Variable manufacturing overhead P 105,000
Fixed manufacturing overhead P 385,000
Direct labor hours 35,000

Management is considering a special order for 300 units of product D03C at P119 each. The
normal selling price of product D03C is P157 and the unit product cost is determined as follows:
Direct materials P 64.00
Direct labor 37.50
Manufacturing overhead applied 35.00
Unit product cost P 136.50

If the special order were accepted, normal sales of this and other products would not be affected.
The company has ample excess capacity to produce the additional units. Assume that direct labor
is a variable cost, variable manufacturing overhead is really driven by direct labor-hours, and total
fixed manufacturing overhead would not be affected by the special order.

Required:
If the special order were accepted, what would be the impact on the company's overall profit?

3. Hon Company makes three products in a single facility. Data concerning these products follow:
Products .
A B C
Selling price per unit P 74.90 P 90.80 P 71.00
Direct materials P 26.40 P 29.10 P 15.20
Direct labor P 25.50 P 37.80 P 38.00
Variable mfg. overhead P 2.20 P 2.20 P 1.60
Variable selling cost per unit P 3.80 P 2.50 P 3.00
Mixing minutes per unit 3.20 2.90 2.70
Monthly demand in units 4,000 4,000 1,000

The mixing machines are potentially the constraint in the production facility. A total of 24,500
minutes are available per month on these machines. Direct labor is a variable cost in this
company.

Required:
a. How many minutes of mixing machine time would be required to satisfy demand for all three
products?

b. How much of each product should be produced to maximize net operating income? (Round off
to the nearest whole unit.)

c. Up to how much should the company be willing to pay for one additional hour of mixing machine

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4. McBee Corporation purchases potatoes from farmers. The potatoes are then peeled, producing
two intermediate products-peels and depeeled spuds. The peels can then be processed further
to make a cocktail of organic nutrients. And the depeeled spuds can be processed further to make
frozen french fries. A batch of potatoes costs P35 to buy from farmers and P19 to peel in the
company's plant. The peels produced from a batch can be sold as is for animal feed for P24 or
processed further for P14 to make the cocktail of nutrients that are sold for P48. The depeeled
spuds can be sold as is for P34 or processed further for P29 to make frozen french fries that are
sold for P55.

Required:
a. Assuming that no other costs are involved in processing potatoes or in selling products, how
much money does the company make from processing one batch of potatoes into the cocktail of
organic nutrients and frozen french fries?

b. Should each of the intermediate products, peels and depeeled spuds, be sold as is or
processed further into an end product?