Unit 6: Relevant costs for decision making

LEARNING OUTCOMES
LO1 Distinguish between relevant and irrelevant costs in
decisions
LO2 Prepare an analysis showing whether to keep or replace
old equipment
LO3 Prepare an analysis showing whether a product line or
other organizational segment should be dropped or
retained
LO4 Prepare a well-organized make or buy analysis
LO5 Prepare an analysis showing whether a special order
should be accepted
LO6 Determine the most profitable use of constrained
resources
LO7 Prepare an analysis showing whether joint products
should be sold at the split-off point or processed further
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Cost Concepts for Decision Making

A relevant cost is a cost that

differs between alternatives.

DIFFERENTIAL
AVOIDABLE

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Identifying Relevant Costs
Costs that can be eliminated (in whole or in part) by
choosing one alternative over another are avoidable
costs. Avoidable costs are relevant costs.

Unavoidable costs are never relevant and include:

Sunk costs.
Future costs that do not differ between the
alternatives.

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Identifying Relevant Costs

Sunk cost - a cost that has already

been incurred and that cannot be
avoided regardless of what a manager
decides to do.

5
Identifying Relevant Costs

Future costs - costs that will not

differ between alternatives. Cost that
are unavoidable

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Sunk Costs are not Relevant Costs
Let’s look at
the White
Company
example.

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Sunk Costs are not Relevant Costs
A manager at White Co. wants to replace an old
machine with a new, more efficient machine.

Old Machine New Machine

Original cost R72 000 R90 000

Remaining book value R60 000 R90 000
Remaining/expected useful life 5 5
Disposal value now/five years 15 000 0
Annual variable expenses 100 000 80 000
Annual revenue sales 200 000 200 000
Annual fixed costs (excl. depreciation) 70 000 70 000
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Sunk Costs are not Relevant Costs

Should the manager purchase the new

machine?

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Incorrect Analysis
The manager recommends that the company
not purchase the new machine since disposal
of the old machine would result in a loss:

Remaining book value R 60 000

Disposal value (15 000)
Loss from disposal R 45 000

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 Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales R 1 000 000
Variable expenses (500 000)
Other fixed expenses
Depreciation - new
Depreciation - old
Disposal of old machine
Total operating profit

R200 000 per year × 5years

R100 000 per year × 5 years 11
 Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales R 1 000 000
Variable expenses (500 000)
Other fixed expenses (350 000)
Depreciation - new
Depreciation - old
Disposal of old machine
Total operating profit

R70 000 per year × 5 years

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 Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales R 1 000 000
Variable expenses (500 000)
Other fixed expenses (350 000)
Depreciation - new
Depreciation - old (60 000)
Disposal of old machine
Total operating profit R 90 000

The remaining book

value of the old machine.
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Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales R 1 000 000 R 1 000 000 R0
Variable expenses (500 000) (400 000) 100 000
Other fixed expenses (350 000)
Depreciation - new
Depreciation - old (60 000)
Disposal of old machine
Total operating profit R 90 000

R80 000 per year × 5 years

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 Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales R 1 000 000 R 1 000 000 R0
Variable expenses (500 000) (400 000) 100 000
Other fixed expenses (350 000) (350 000) -
Depreciation - new (90 000) (90 000)
Depreciation - old (60 000)
Disposal of old machine
Total operating profit R 90 000

The total cost will be depreciated

over the five year period.

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 Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales R 1 000 000 R 1 000 000 R0
Variable expenses (500 000) (400 000) 100 000
Other fixed expenses (350 000) (350 000) -
Depreciation - new (90 000) (90 000)
Depreciation - old (60 000) (60 000) -
Disposal of old machine 15 000 15 000
Total operating profit R 90 000 R 115 000 R 25 000

The remaining book value of the old

machine is a sunk cost and is not
relevant to the decision. 16
Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales R 1 000 000 R 1 000 000 R0
Variable expenses (500 000) (400 000) 100 000
Other fixed expenses (350 000) (350 000) -
Depreciation - new (90 000) (90 000)
Depreciation - old (60 000) (60 000) -
Disposal of old machine 15 000 15 000
Total operating profit R 90 000 R 115 000 R 25 000

Would you recommend purchasing the new

machine even though we will show a R45 000
loss on the old machine?
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Correct Analysis

Let’s look at a
more efficient
way to analyse
this decision.

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Correct Analysis
Relevant CostAnalysis
Savings in variable expenses
provided by the new machine
(R20 000 × 5 yrs) R 100000

Net advantage

R100 000 - R80 000 = R20 000 variable cost savings

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Correct Analysis

Relevant CostAnalysis
Savings in variable expenses
provided bythenewmachine
(R20000×5yrs) R 100000
Costof thenew machine (90000)
Disposal value ofold machine 15000
Netadvantage R25000

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LO3 Prepare an analysis showing whether a product line or
other organizational segment should be dropped or retained

Adding/Dropping Segments
One of the most important decisions
managers make is whether to add or drop a
business segment such as a product or a
store.

Let’s see how relevant costs should

be used in this decision.
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 Adding / Dropping Segments
Due to the declining popularity of digital
watches, Lovell Company’s digital
watch line has not reported a profit for
several years. A statement of profit or
loss for last year is shown on the next
screen.

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Adding / Dropping Segments

Segment statement of profit or loss

Digital Watches
Sales R 500 000
Less: variable expenses
Variable mfg. costs R 120 000
Variable shipping costs 5 000
Commissions 75 000 200 000
Contribution margin R 300 000
Less: fixed expenses
General factory overhead £60 000
Salary of line manager 90 000
Depreciation of equipment 50 000
Advertising - direct 100 000
Rent - factory space 70 000
General admin. expenses 30 000 400 000

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 Adding / Dropping Segments
Segment statement of profit or loss
Digital Watches
If the digital watch line is dropped,Rthe
Sales 500 000
fixed
Less:general factory overhead and general
variable expenses
administrative
Variable mfg. costsexpenses will
R 120 be
000 allocated
Variable shipping costs 5 000
to other product lines because they
Commissions 75 000 200 000
are not avoidable.
Contribution margin R 300 000
Less: fixed expenses
General factory overhead R 60 000
Salary of line manager 90 000
Depreciation of equipment 50 000
Advertising - direct 100 000
Rent - factory space 70 000
General admin. expenses 30 000 R 400 000
Operating loss -R 100 000 24
Adding / Dropping Segments
Segment statement of profit or loss
Digital Watches
Sales R 500 000
Less: variable expenses
The equipment
Variable mfg. costs used toRmanufacture
120 000
digital
Variable watches
shipping costs has no5 resale
000
value or alternative75use.
Commissions 000 200 000
Contribution margin R 300 000
Less: fixed expenses
General factory overhead R 60 000
Salary of line manager 90 000
Depreciation of equipment Should Lovell retain or drop
50 000
Advertising - direct the100
digital
000 watch segment?
Rent - factory space 70 000
General admin. expenses 30 000 400 000
Operating loss -R 100 000
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A Contribution Margin Approach

DECISION RULE
Lovell should drop the digital watch segment
only if its fixed cost savings exceed lost
contribution margin.

Let’s look at this solution.

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A Contribution Margin Approach
Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped -R 300 000

Less fixed costs that can be avoided

Salary of the line manager R 90 000
Advertising - direct 100 000
Rent - factory space 70 000 260 000
Net disadvantage -R 40 000

Remember, depreciation on equipment with no resale

value is not relevant to the decision since it is a sunk
cost and is not avoidable.
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Comparative Profit Approach

The Lovell solution can also be obtained

by preparing comparative statements of
profit or loss showing results with and
without the digital watch segment.

Let’s look at this second approach.

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 ComparativeProfitApproach
Solution
Keep Drop
Digital Digital
Watches Watches
Difference
Sales R500000 £0 -R500000
Lessvariable expenses: -
Mfg.expenses 120000 - 120000
Freightout 5000 - 5000
Commissions 75000 - 75000
Total variable expenses 200000 - 200000
Contributionmargin 300000 - (300000)
Lessfixed expenses:
General factoryoverhead 60000 60000 -
Salary of line manager 90000 - 90000
Depreciation 50000 50000 -
Advertising -direct 100000 - 100000
Rent- factoryspace 70000 - 70000
General admin.expenses 30000 30000 -
Total fixedexpenses 400000 140000 260000
Beware of Allocated Fixed Costs
Why should we keep
the digital watch
segment when it’s
showing a loss?

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 Beware of Allocated Fixed Costs
Part of the answer lies
in the way we allocate
common fixed costs
to our products.

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Beware of Allocated Fixed Costs
Our allocations can
make a segment
look less profitable
than it really is.

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LO4 Prepare a well-organized make or buy analysis

The Make or Buy Decision

A decision concerning whether an item should be
produced internally or purchased from an outside
supplier is called a “make or buy” decision.

Let’s look at the Essex Company example.

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The Make or Buy Decision
•Essex manufactures part 4A that is currently
used in one of its products.
•The unit cost to make this part is:

Direct m a t e r i a l s R 9
Direct l a b o u r 5
Variable overhead 1

D e p r e c i a t i o n of special e q u i p . 3
Supervisor's salary 2
G e n e r a l factory o v e r h e a d 10
Total cost p e r unit R 30

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The Make or Buy Decision
•The special equipment used to manufacture part
4A has no resale value.
•General factory overhead is allocated on the basis
of direct labour hours.
•The R30 total unit cost is based on 20,000 parts
produced each year.
•An outside supplier has offered to provide the
20,000 parts at a cost of R25 per part.
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Should we accept the supplier’s offer?

 The Make or Buy Decision

Cost Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price R 25 R 500 000

Direct materials R9 180 000

Direct labour 5 100 000
Variable overhead 1 20 000
Depreciation of equip. 3 -
Supervisor's salary 2 40 000
General factory overhead 10 -
Total cost R 30 £ 340 000 R 500 000

20 000 × R9 per unit = R180 000

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The Make or Buy Decision
Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price R 25 R 500 000

Direct materials R9 180 000

Direct labour 5 100 000
Variable overhead 1 20 000
Depreciation of equip. 3 -
Supervisor's salary 2 40 000
General factory overhead 10 -
Total cost R 30 R 340 000 R 500 000

The special equipment has no resale

value and is a sunk cost. 37
The Make or Buy Decision
Cost Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price R 25 R 500 000

Direct materials R9 180 000

Direct labour 5 100 000
Variable overhead 1 20 000
Depreciation of equip. 3 -
Supervisor's salary 2 40 000
General factory overhead 10 -
Total cost R 30 R 340 000 R 500 000

Not avoidable and is irrelevant. If the product is

dropped, it will be reallocated to other products.
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The Make or Buy Decision
Cost Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price R 25 R 500 000

Direct materials R9 180 000

Direct labour 5 100 000
Variable overhead 1 20 000
Depreciation of equip. 3 -
Supervisor's salary 2 40 000
General factory overhead 10 -
Total cost R 30 R 340 000 R 500 000

Should we make or buy part 4A?

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The Make or Buy Decision

DECISION RULE
In deciding whether to accept the
outside supplier’s offer, Essex isolated
the relevant costs of making the part
by eliminating:
• The sunk costs.
• The future costs that will not differ
between making or buying the parts.
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The Matter of Opportunity Cost

The economic benefits that are foregone as a

result of pursuing some course of action.
Opportunity costs are not actual monetary
outlays and are not recorded in the accounts of
an organisation.

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End of Chapter 9

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