SHORT-TERM DECISIONS

1. Relevant Costs : Definition, Criteria & Its

Usefulness

 Management needs sufficient and relevant information make the correct decisions.
 Hence, the need to understand relevant costs.
 A relevant cost relates to future expected costs that will differ with each alternative used.
 Because of the difference amongst alternative, hence it has a bearing on the decision to be made.
 Irrelevant costs simply are costs that will not affect the decision. By analyzing these type of
irrelevant costs, management will be wasting their time and efforts as these costs do not affect
the decision they are going to make.

FEATURES or CRITERIA of Relevant Costs:

Relevant cost is a cost that will be incurred in the future. Historical costs are sunk costs which has no
relevancy in the decision making.
The costs must differ between alternatives. If a cost is the same whether we choose alternative A or B
then this is an irrelevant cost. A good example is factory rental which remains the same irrespective
of management wanting to manufacture product A or B.
Only CASH flow item And Incremental fixed costs are relevant. Non cash item like depreciation and
absorbed fixed overheads are not relevant costs as they do not involve any additional cash flow.
  Questions:

Question No:1

ABC Ltd wishes to know the relevant cost of material X for a special contract. The contract will need 200 litres of

Q.

Currently in stock 150 litres

Original cost of Q in stock $2 per litre

Current purchase price of Q $4 per litre

If not used on the contract stocks of Q would be scrapped for proceeds of $1 per litre

Answer:

Relevant costs:-

Cost of purchasing 50 litres of Q=(50x$4) =$200 plus Opportunity cost of scrap(150 litres x$1) =$150 =$350

Question No.2:

ABC Ltd requires 400kg of material D for a job it is about to start. 300 kgs are currently in stock which cost $5

per kilogram three months ago. The current purchase price of material D is $4 per kilogram. If the material D

that the company currently holds is not used in the job in question it will be scrapped a cost of $0.50 per kilo

gram. What is the relevant cost of the 400 kgs of material D?

Answer:

Relevant costs=300x$0.50 + 100x$4=$550

  Costs Used For Alternative Decision – Making Techniques

The following are some other cost techniques which are useful to management’s decision makings:

OPPUTUNITY COST
 Represents the opportunities which have been forgone by following one course of action
rather than an alternative course.
 The opportunity cost in this case is the profit foregone by utilizing scarce resources for one
particular course of action.

ILLUSTRATION :

Company A may either manufacture or buy a component from an outside supplier.

If it buys from outside, the spare capacity can be rented out to another manufacturer for $20,000.
The opportunity cost of making the component would be to lose the opportunity to earn the $20,000
Note that the opportunity cost does not involve cash transaction but it is relevant• to decision
making.

INCREMENTAL OR DIFFERENTIAL COST

 Incremental cost is used interchangeably with differential cost.

 Incremental cost is the additional cost and revenue that may result from each degree of
change in the level or nature of activity.
 Whilst Differential cost is the difference in the cost and revenue between two alternatives.

ILLUSTRATION :

Company A need to consider whether or not to accept a special order.

One relevant piece of information will be the variable cost.
The relevant cost before taking this special order is $25,000 and after taking the order it is $35,000.
Therefore the differential or incremental cost is $35,000-$25,000 which is $10,000
AVOIDABLE COST

 Is cost that can be avoided if a given alternative is not adopted.

ILLUSTATION :

Assuming that a manufacturer decides not to proceed with a new product line which enable total
savings in direct material, labor, direct expenses and variable costs of $10,000.
In this case, the differential cost of $10,000 can be avoided. The $10,000 is the avoidable cost.
  Limiting Factor

 One part of managerial accounting is the need to understand limiting factor for short term
decision. As a result of limited supply of resources constraint, a company normally
cannot produce as many products as it wish.
 The limited supply of resources can be in many forms like limited cash, labour time,
material/machine availability and others.
 In line with the limited resources, the production manager therefore needs to plan the
production mix in order to maximize its profit.
 To establish the proper production mix, the rule is to rank the products according to the :

CONTRIBUTION PER LIMITING FACTOR

 Whichever product that gives the highest UCM per LF will given the highest rank.
 The highest rank will be given the highest priority to be produced using the available
resources.
 The remaining resources will then be used to produce the next ranking products until
all the resources are used up.
ILLUSTRATION :

The below illustration assumes a shortage of direct labour as the limiting resource constraint.
The details of the company three product lines are as follows:
Products A B C
Selling price : $50 $40 $30
Variable costs : $20 $20 $20
Unit Contribution: $30 $20 $10
Expected demand : 1,000 units; 500units; 600units
To produce 1 unit of product, the direct labour hours for each product is:
Product A : 10 hours Product B : 5 hour Product C: 1 hour
Due to unavailability of labour supply, for the forth coming period, it is assumed that the
overall shortage of labour hours is 1,100 hours.

QUESTION : Determine the production mix to maximize the company’s profit.

SOLUTION :

(1) Compute the Contribution per limiting factor

Contribution per Limiting Factor
= Unit Contribution/ No of hour to make the product
Product A : Unit Contribution $30 /10 hours = 3
Product B : Unit Contribution $20/5 hour = 4
Product C : Unit Contribution $10/1 hour =10

(2) Rank the Contribution per limiting factor ( highest ratio of contribution per limiting
factor)
Product A =Rank No 3
Product B =Rank No 2
Product C =Rank No 1
(3) Determine the overall total hours to produce ALL products A,B & C and what is the
shortage:
= Expected demand x No of hours
Product A = 1,000 units x 10hours =10,000 hours
Product B = 500 units x 5 hour = 2,500 hours
Product C = 600 units x 1 hour = 600 hours
Total Direct Hours to produce All products =13,100
Total Available hours due to constraint =12,000
Shortage of (1,100) hours

(4) Using the Rank as per item 2 ,do the allocation of the available 12,000 ( 1,100 hours
shortage) :
Total labour available = 12,000

Less:
Rank No 1: Product C = (600)hours =600 units
Rank No.2 :Product B =(2,500)hours =500 units
Rank No 3: Product C =(8,900)hours =8,900/10=890 units

Therefore the appropriate production mix is:

Product C: 600 units
Product B: 500 units
Product A: 890 units
  Make or Buy
 At times, management needs to decide whether to manufacture the product or to buy the
ready made from other companies
 The following are some reasons to buy from other companies :

REASONS TO BUY FROM OTHER COMPANIES

 Flexibility to meet urgent demand of customers;

 Overcome limiting factor problem ( Part 1);
 Concentrate on its own core competencies;
 Take advantage of the specialist skill and expertise of the outsiders;
 Overcome production bottleneck and
 Solve seasonal demand problem

So, what should management do in a Make or Buy Decisions? The suggested approach is to :

COMPARE BETWEEN THE RELEVANT COST OF MAKE OR BUY

 If it is cheaper to make, the company should manufacture internally and

 If it cheaper to buy then the company should buy from the outsiders
 The relevant costs involve the following:
RELEVANT COSTS OF MAKING
=
Variable Cost of Manufacturing like direct materials, direct labours and variable production
overheads
+
Any increase in specific Fixed costs
+
Any Opportunity cost involved

RELEVANT COSTS OF MAKING

=
Purchase price
+
Any direct costs relating to purchasing

ILLUSTRATION :

Company A has to decide whether to manufacture internally or to buy or contract from outsiders.
Company A is able to contract with another company to supply them ready make at $5 each.
The details of Company A internal production costs are as follows:
Direct material/unit $2.00
Direct labour/unit $3.00
Variable production overhead $0.50
Fixed production overhead $0.50
Total production per unit cost $6.00
The company also need to pay for transport charges of $5,000 for the delivery of 3,000 units of
the product.

QUESTION : Should Company A make or buy the product?

SOLUTION :

Relevant cost of Making

=Direct material + Direct Labour + Variable Production OH
=($2 + $3 + 0.50) x 3,000 units
=$16,500

Relevant cost of Buying:

= Purchase cost + Transport cost
= ($5 x 3,000) + $5,000
=$20,000

Therefore, it is better for Company A to manufacture internally.

SALIENT POINTS TO MAKE

In a Make or Buy situation, there are certain factors to consider:

 The quality of the products been purchased externally;

 Whether delivery time is able to be met and
 Customer loyalty might be affected if sales are forgone due to cases of full capacity
Q : MAKE OR BUY
Snazzy Jazzi Footware manufactures a variety of athletic shoes. The company has always
produced all necessary parts for its shoes, including the laces. An outside supplier has offered to
produce and sell laces to Snazzy Jazzi Footware at a cost of $0.20 per lace.

To evaluate this offer, Snazzy Jazzi Footware has gathered the following information relating to
its own cost of producing laces internally:

Per Unit ($) 26 000 Laces Per Year

($)
Direct Materials 0.06 1 560
Direct Labour 0.07 1 820
Variable Manufacturing Overhead 0.02 520
Fixed Manufacturing Overhead (Traceable) 0.03 780
Fixed Manufacturing Overhead (Allocated) 0.06 1 560
Total Cost 0.24 6 240

One-third of the traceable fixed manufacturing overhead relates to supervisory salaries. The
supervisor would be fired if Snazzy Jazzi chose to purchase from the outside supplier. Two-
thirds of the traceable fixed manufacturing overhead relates to depreciation of lace-making
equipment that has no resale value.

Required

1.) Assuming that the company has no alternative use for the facilities that are now being
used to produce the laces, should the outside supplier’s offer be accepted? (Show your work).
(3)

2.) Suppose that if the laces were purchased, the company could use the freed capacity to
make a new product. The segment margin of the new product is expected to be $1,000 per year.
Should the company accept the offer to buy the laces for $0.20 per lace? (Show your work). (2)
  CVP ANAYLIS QUESTION

ABC Company’s projected contribution format income statement for the upcoming year is on
below.

ABC Company
Income Statement
for the year ended 31 December 20X3
$
Sales (60 000 units) 3 000 000
Variable Costs 1 200 000
Contribution Margin 1 800 000
Fixed Costs 1 300 000
Net Operating Income 500 000

Required :

a) Calculate the sales price per unit and the variable costs per unit.

b) Compute the company’s contribution margin ratio.

c) Compute the company’s break-even point in units.

d) Calculate the company’s margin of safety in dollars ($)

e) Assume that next year management wants the company to earn a profit of $1 500 000. How many
units must be sold to reach this target profit?

f) The president has an idea. He believes that increasing marketing expenses by $400 000 and
offering an extra $2 per unit commission will increase the number of units sold by 20 000. Should
the company do it?

g) Refer to the original data. Next year there will be increased industry competition and the
company projects that it must decrease its selling price by 10% (use your answer from part (a)).
Management wants to maintain the same net operating income next year ($500 000). Assuming
all other costs remain constant, how many units must the company sell to meet management’s
goal?