RELEVANT COSTING
DECISION MAKING- the process of choosing a course of action, preferably the most advantageous to the organization,
from at least two alternatives.
Types of Management Decisions:
Short Term Cases
a. Accept or reject a special order
b. Sell or process further a product line
c. Make or buy a part of product line
d. Continue operating or drop a business segment
e. Product combination
f. Utilization of scarce resources
g. Change in profit factors
Long Term Cases- Capital Investment decisions by Capital Budgeting
The Decision-Making Process
1. Defining the problem.
2. Specifying the objective and criteria.
3. Identifying the alternative courses of action.
4. Determining and evaluating the possible consequences of the alternative.
5. Choosing the best alternative and making the decision.
6. Evaluating the results of the decision.
Approaches in Solving Problems that Involve Decision Making:
Total Project Analysis/ Comparative Statement Approach- total revenues and costs are determined for each
alternative and the results are compared to serve as basis for making decisions. It considers the relevant and
irrelevant costs prepared at contribution margin format.
Differential/ Incremental/ Relevant Analysis- it considers only the differences or changes in costs and revenues.
(Relevant cost only).
TYPES OF COSTS USED IN DECISION MAKING
RELEVANT COSTS Future cost expected to be different between or among alternatives.
DIFFERENTIAL COSTS Increases (increment) or decreases (decrements) in total costs that
result from selecting one alternative instead of another.
AVOIDABLE COSTS (Relevant) costs that will be saved or those that will not be incurred
if a certain decision is made
SUNK COSTS (Irrelevant) costs incurred already and cannot be avoided regardless
of what a manager decides to do.
OUT-OF-POCKET Costs that require expenditure of cash or incurrence of a liability as
COSTS a result of management decision.
OPPORTUNITY COSTS (Relevant) income or benefit sacrificed or forgone when an
alternative is chosen over another.
JOINT COSTS (Irrelevant) costs incurred in simultaneously manufacturing two or
more products that are difficult to identify individually as separate
types of products until the products reach a certain processing stage
known as the split-off point.
FURTHER PROCESSING (Relevant) costs to be incurred after the split-off point if product is
COSTS processed further.
SPLIT-OFF POINT The point in the manufacturing process where some of all of joint
product can be recognized as individual product.
NATURE OF DECISION
ALTERNATIVES DESCRIPTION TECHNIQUE GUIDELINES
Should a part or product Compute the total relevant cost Choose the option (make
be manufactured or in making a product, then or buy) that involves the
bought from outside compare it from the offer of lower cost. In most cases,
MAKE OR BUY supplier? outside supplier. fixed costs are irrelevant.
*Variable cost per unit Consider opportunity cost,
if any.
*Unavoidable fixed cost
*Opportunity Cost
Should a special order Use incremental analysis. If the Accept the order when the
that usually requires a incremental revenues exceed additional revenue from
price lower than the the incremental costs, then the special order exceeds
ACCEPT OR REJECT a regular selling price be accept. additional cost, provided
special order accepted? the regular market will not
be affected. In most cases,
fixed production costs are
irrelevant.
Should a business Prepare a comparative income Continue if avoidable
segment, which may be statement in CM format with revenue of the segment
CONTINUE OR DROP a product line, a the segment data and without involved is greater than its
a business segment department or a branch the segment data. avoidable costs; otherwise,
be continued or consider dropping the
discontinued? segment.
Should a product, after Use incremental analysis: (SP Process further if
undergoing the joint at split-off point after additional revenue from
SELL NOW OR process, be sold at the processing further > additional processing further is
PROCESS FURTHER a split off point or be processing costs) greater than further
product processed further? processing costs. Joint
cost, since already incurred
are irrelevant.
Which product(s) should 1. Determine the CM per hour. Identify the constraint or
be emphasized when 2. Rank products according to limitation on the scarce
PRODUCT there is a limited #1. resources. Emphasize by
COMBINATION: capacity? 3. Consider market limitation if ranking the product(s) with
Utilization of Scarce any. the highest contribution
resources
4. Compute profitability of each margin per unit of scarce
product line. resources.
Should a business Identify Shut Down Point= You should SHUT DOWN
operation be shut down (Fixed Cost of Continued if the drop in level of
or still continue for Operations Less the Estimated production is below the
SHUTDOWN OR
some moment? Shut Down Cost) DIVIDED by shutdown point. Or
CONTINUE Operations
CM per unit. CONTINUE of the drop in
level of production is
above the shutdown point.
Is the price affordable Target Selling Price= (Cost +
and economical and Markup); wherein Cost based
PRICING PRODUCTS high enough to cover may be: Absorption Approach
AND SERVICES ALL Traceable and or Contribution Approach
Common Cost plus
Return on Capital?
TOTAL AND INCREMENTAL APPROACH
Carlota Company currently produces 6,000 units of its major product per month. Financial data for the last month are:
Sale P240,000
Variable Costs P144,000
Fixed Costs P 60,000
The company would like to expand its operation to 7,000 units per month. Fixed costs would increase P10,000 because of
the expansion.
REQUIRED: Prepare both a total analysis approach and an incremental analysis approach to evaluate the decision.
WARM-UP PROBLEM:
Because of a monumental error committed by its purchasing department, King’s Grocery received 1,000 heads of
cabbage rather than the 100 that were actually ordered. The company paid P25 per head for the cabbage. Although the
management is confident that 200 units can be sold through its regular sales, the market is not large enough to absorb the
other 800 heads. Management has identified two ways to dispose of the excess heads. First, a wholesaler has offered to
purchase them for P12 each. Second, a restaurant chain has offered to purchase the heads if King’s will agree to convert
the heads into packaged coleslaw salad. This option would require King’s to additional cost of P10,000 for conversion and
the heads could be sold for P24 each.
REQUIRED:
1. Which costs are sunk in this decision?
2. There are three alternatives King’s can consider. Describe the alternative that in not mentioned in the story.
3. what are the relevant costs of each decision alternative and what should the company do?
PROBLEM 1: MAKE OR BUY
DINGLE Technology manufactures a particular computer component. Currently, the costs per unit are as follows:
Direct materials, P50; Direct labor, P500; Variable overhead, P250; Fixed overhead, P400 (Total: P1,200). SAM Inc. has
obtained DINGLE with an offer to sell 10,000 units of the component for P1,100 per unit. If DINGLE accepts the
proposal, P2,500,000 of the fixed overhead will be eliminated. Should DINGLE make or buy the component? Why?
a) Make due to savings of P3M
b) Buy due to savings of P2.5M
c) Buy due to savings of P1M
d) Make due to savings of P500,000
PPROBLEM 2: ACCEPT OR REJECT SPECIAL ORDERS
Given the following target selling price for a unit of product:
A foreign distributor has offered to purchase 5,000 units at a special price of P38 per unit. The company is selling
only 20,000 units per year through regular channels and so it has idle capacity. Variable selling costs associated with the
special order would be P2 per unit. If the special order is accepted, the company’s overall net income will
a. Increase by P40,000
b. Decrease by P10,000
c. Increase by P50,000
d. Decrease by P70,000
PROBLEM 3: CONTINUE OR DROP A SEGMENT
ABC Company plans to discontinue a department that has a P48,000 contribution margin and P96,000 of fixed costs. Of
these fixed costs, P42,000 cannot be eliminated. What would be the effect of this discontinuance on ABC profit?
a. Increase by P48,000
b. Decrease by P48,000
c. Increase by P6,000
d. Decrease by P6,000
PROBLEM 4: SELL NOW OR PROCESS FURTHER
DELVIN Company produces three products from a joint process costing P100,000. The following
information is available:
Which of the products should be processed further?
a. A only
b. A and B
c. B and C
d. A, B and C
PROBLEM 5: PRODUCT COMBINATION (Utilization of Scarce resources)
RST Co. produces three products: A, B and C. One machine is used to produce the products. The contribution
margin, sales demand and time on the machine (in minutes) are as follows:
Products Demand (units) Contribution Margin Minutes on Machine
A 100 20 10 per unit
B 80 18 5 per unit
C 150 25 10 per unit
There are 2,400 minutes available on the machine during the week. How many units should be produced and sold to
maximize the weekly contribution?
a. A, 100; B, 80; C, 150
b. A, 50; B, 80; C, 150
c. A, 90; B, 0; C, 150
d. A, 100; B, 80, C, 100
ADDITIONAL EXERCISES IN RELEVANT COSTING
EXERCISES 1:
Hec Company is selling 80,000 units of a product at P10 per unit. The variable cost is P6 per unit, and the annual
cost is P120,000. A discount house has offered to buy 10,000 additional units of the product which would slightly be
modified, but the modification would not affect production cost. The discount house will pay P7 per unit.
REQUIRED:
If the two markets can be distinguished, should the order be accepted (assuming capacity exists and has no other use)?
The manager feels that the two markets might not be distinguished and that the lower price would cause regular sales to
fall by 5,000 units. Should Hec accept the discount house offer?
If the discount house offer is raised to P9 per unit and competition resulting from the special sale causes the regular price
to drop to P9.50 to maintain the same regular sales volume, should Hec accept the discount house offer?
EXERCISES 2:
The Kanal Bowling Center was asked to host a bowling tournament for the Pins Company. The tournament would
require the center to be closed to normal business for one day. This would be feasible since the tournament is on Monday
and the center is not heavily used on Mondays. The Pins Company has offered a flat fee of P3,000. Additional expenses
for the day are estimated by the center manager to be P1,000, the cost of hiring some additional casual workers to help
clean up the center after the tournament. The manager has estimated that the loss of fees due to the closing of the center to
normal business would be about P1,400. There would be some cost savings (estimated at P400) because several hourly-
paid employees would not work that day. The manager feels that there would be no loss of future business as a result of
closing for one Monday.
REQUIRED:
What is the opportunity cost of closing the Bowling Center to normal business?
Calculate the additional profit or loss from hosting the tournament.
EXERCISES 3:
Samsang Company sells 5G, a special model of smart phone, at a price of P13,500 per unit. Samsang’s costs per
unit are:
Materials P3,000
Labor 1,500
Variable FO 2,400
Fixed FO 5,100
TOTAL COST 9,600
A special order for 1,000 units was received from IS, a well known school in the country. Additional shipping costs on the
sale are P900 per unit.
REQUIRED:
If Samsang is operating at full capacity, what is the minimum price per unit that should be set for the IS order?
If Samsang has excess capacity, what is the minimum price per unit?
EXERCISES 4:
Emil R., president of Mwah Department Store, thinks that the Paint Department should be dropped. He wants to add a
Peanut Department boutique in the same space. Data for 2021 in thousands are:
Allocated expenses are common costs and are assigned by a mathematical formula.
REQUIRED: Ignoring your attitude toward peanut butter, what should Emil do to maximize profit? Explain.
EXERCISES 5:
Data concerning four product lines are as follows:
Total Fixed Cost P100,000
Total Hours Available
96,000 hours
REQUIRED: Based on these data, choose the best product combination.
How would the answer change if the company were required to deliver 2,000 units of each product line to a major
distributor?
