RELEVANT COST

ANALYSIS
GROUP 1
 “
Managers must constantly make decisions.
In making these decisions, they must
estimate how each decision could affect
operating income.

2
MANAGERS AS DECISION-MAKERS

Vital role of managers–

utilize accounting
information and apply
analytical methods

3
DECISION-MAKING PROCESS

1. Problem Identification
2. Setting of criteria
3. Identification of alternatives
4. Choosing the best alternative
5. Implementation of the chosen alternative
6. Evaluating the results
4
COST CONCEPTS FOR DECISION-MAKING
⊳ Relevant Cost
-expected future cost that differ in every
decision made
⊳ Irrelevant Cost
-costs incurred that do not differ in each
alternative; does not affect management
decisions
⊳ Opportunity Cost
-benefit foregone as a result of rejecting one
opportunity in favor of another; a relevant
cost
⊳ Avoidable Cost
-can be eliminated by discontinuing or
shutting down an activity; a relevant cost
⊳ Out-of-pocket Cost
-cost that requires future expenditures of cash
or other resources; a relevant or irrelevant
cost
⊳ Sunk Cost
-result from past decisions that can’t be
anymore be changed; never relevant
5
COST CONCEPTS FOR DECISION-MAKING

⊳ Incremental Cost
-additional cost incurred as an effect of choosing an
alternative
⊳ Incremental Revenue
-additional revenue earned from choosing an alternative
⊳ Incremental Profit
-excess of incremental revenue over incremental cost

6
METHODS OF RELEVANT COSTING

TOTAL APPROACH DIFFERENTIAL APPROACH

⊳ total revenues and cost of each ⊳ only takes into account the differences
alternative are compared (increase or decrease) in revenues and
whether relevant or irrelevant costs
⊳ alternative result is increased in profit,
⊳ alternative that yields the most
then it is pursued
beneficial result of the
⊳ short-cut method in analysing the
organization is the one chosen
situation for decision-making
⊳ mostly used; put more emphasis on the
net effect 7
DECISION-MAKING SCENARIOS

a. Accept or Reject a Special Order

b. Make or Buy
c. Continuing or Discontinuing a Business Segment
d. Shutdown Point
e. Sell or Process further
f. Product Combination
8
 ACCEPT OR REJECT
1 A SPECIAL ORDER
Evaluate whether a special order should be
accepted, or rejected; if accepted, the price that
should be charged
ACCEPT OR REJECT A SPECIAL ORDER

⊳ Special Orders- one-time orders that do not affect the organization’s

normal sales; outside of company’s regular sales
⊳ Decision guideline:
Accept the order when the incremental revenue from the special
order exceeds incremental costs, provided the regular market or customers
will not be affected. In most cases, fixed production costs are irrelevant.
(NOTE: No idle capacity, opportunity costs should be included as part of
the incremental costs.)
10
PROBLEM 8-1

11
PROBLEM 8-1

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 of the overseas
customer and accepting the special order would require cutting back on production of
700 units for regular customer. What would be the minimum acceptable price per unit
for the special order?
12
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?

Differential Approach
Incremental Revenue: (2, 000 x 71.60) P 143, 200

Incremental Cost:

Variable Manufacturing Costs (2, 000 x 40) 80, 000

Variable Selling/Admin. Expenses (2, 000 x 2.40*) 4, 800

Incremental Profit P 58, 400**

* VSAE/unit= 2.70 – 0.30 = 2.40

**increase in the company’s net operating income

13
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?
Unit Sales (regular) P 79.80

Unit Variable Cost (regular) (42.70)

Unit Contribution Margin P 37.10*

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

Unit Variable Cost (special) P 42.30

Opportunity Cost [(700 x 37.10)/ 2, 000] 12.99

Minimum acceptable price P 55.39

14
2 MAKE OR BUY
Concerned whether an item/part for a certain
final product should be produced internally
or purchased from an outside supplier.
MAKE OR BUY

⊳ Items/parts are used as raw materials for a company’s

another product
⊳ Decision guideline:
Choose the option that involves the lower cost. In most
cases, fixed costs are irrelevant. Consider opportunity costs, if
any.
16
PROBLEM 8-2

17
PROBLEM 8-2

a. Prepare a report that shows the effect on the

company’s total net operating income of buying
part A55 from the supplier rather than continuing to
make it inside the company.
b. Which alternative should the company choose?

18
Total Approach
MAKE/PRODUCE BUY/PURCHASE

Direct Materials (2.8 x 4000) P 11 200

Direct Labor (6.3 x 4000) 25 200
Variable (8.5 x 4000) 34 000
Manufacturing
Overhead
Supervisor’s Salary (2.6 x 4000) 10 400
Depreciation of Special (6.8 x 4000) 27 200
Equipment
Allocated General (6.1 x 4000) 24 400 ( 24 400 – 4000) P 20 400
Overhead
Purchase Price ( 32.30 x 4000) 129 200
Total Relevant Cost P 132 400 P 149 600
Opportunity Cost 26 000
Total Cost P 158 400 P 149 600

19
Decision: The company should choose the alternative of buying the part from an
outside supplier.

20
 CONTINUE OR

3
DISCONTINUE A
BUSINESS SEGMENT
Review needed by the management when
business segment or product line become
unprofitable
CONTINUE OR DISCONTINUE A SEGMENT

⊳ Unavoidable costs
-costs that will still be incurred even if the segment is
discontinued
⊳ Avoidable costs
-costs that would no longer be incurred after discontinuing the
segment; relevant costs
⊳ Decision guideline:
Continue if lost contribution margin is greater than the fixed cost savings or
avoidable costs, otherwise discontinue. Allocated common fixed costs are irrelevant.
22
PROBLEM 8-3

23
⊳ Decision Guideline:

Lost contribution margin > cost savings/avoidable cost = continue

Lost contribution margin < cost savings/avoidable cost = discontinue

24
Recommend which segments, if any, should be eliminated.
Prepare a report in good form to support your answer.

25
26
Based on the decision rule, product line G must be discontinued, because the lost
contribution margin is less than the avoidable cost. In addition, based on the report using
the total approach, the net income will be P 2, 100 and using the differential approach,
there will be an increase in net income by P 2, 000 if product line G will be discontinued.
27
4 SHUTDOWN POINT
Product/services that are seasonal or under
certain industry cycle—shutdown
temporarily or continue its operations
SHUTDOWN POINT

⊳ Shutdown costs
-costs that will still be incurred even when there is no operation
⊳ Shutdown point
-indifference point; should be identified first
⊳ Decision guideline:
If current sales is greater than shutdown point, continue the operations
otherwise discontinue. Take note of shutdown costs which are relevant in this
decision-making scenario.

29
CASE 8-1

30
a. Which alternative, continuing or discontinuing the operations, is advisable and by
how much is its advantage? Prepare an analysis report of the net advantage?

31
32
 SELL OR
5 PROCESS FURTHER
Several end products from a common input;
profitable to continue processing or not
SELL OR PROCESS FURTHER

⊳ Joint products
-number of end products are produced from a common input
⊳ Split-off point
-stage in the production process at which the joint products are identifiable as
separate products
⊳ Decision guideline:
Process further if incremental revenue from processing further is greater than
incremental costs of processing, otherwise, sell at split-off point. Joint costs are
considered sunk costs after split-off point, thus, irrelevant.
34
PROBLEM 8-4

35
 PROBLEM 8-4

a. Prepare a segmented income statement for Island Princess, showing results

for rings, juice, fertilizer, and in total. Do not allocate joint costs individually.
b. Now suppose that Island Princess is considering the option of processing
the skins further into pet food which would sell for P1, 000. Additional costs
would be P450. Should this be done.

36
a. Prepare a segmented income statement for Island Princess, showing
results for rings, juice, fertilizer, and in total. Do not allocate joint
costs individually.

b. Now suppose that Island Princess is considering the option of processing the
skins further into pet food which would sell for P1, 000. Additional costs would
be P450. Should this be done?
Skins
Sales 1000
Further Processing Costs (450)
550 Yes. IR>IC; 550>450 37
 PRODUCT
6 COMBINATION
Sells more than one product and has limited
capacity for production of its products;
optimize its production to produce highest
net income possible
PRODUCT COMBINATION

⊳ Bottleneck
-constraint that is limiting overall output in a production process
⊳ Calculation of the contribution margin for each product is required
⊳ Decision guideline:
Identify and measure the constraint on the limited resource(s). Rank the
product(s) according to the highest contribution margin per unit of limited
resources.

39
PROBLEM 8-5

40
PROBLEM 8-5

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 time if the company has
made the best use of the existing mixing machine capacity?
(Round off to the nearest whole cent.)
41
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.)

42
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? (Round off to the
nearest whole cent.)

The Company should be willing to pay up to the contribution

margin /minute for the marginal job which is Php 4.59.

275.40 CM/hour

43
 Thank You!
GROUP 1

Bolandres-Collantes-Go-Medina-Menchavez-Nuñez-Reyes

44