MANAGEMENT ACCOUNTING - Solutions Manual

CHAPTER 19

RELEVANT COSTS FOR DECISION MAKING

I. Questions
1. Quantitative factors are those which may more easily be reduced in terms
of pesos such as projected costs of materials, labor and overhead.
Qualitative factors are those whose measurement in pesos is difficult and
imprecise; yet a qualitative factor may be easily given more weight than
the measurable cost savings. It can be seen that the accountant’s role in
making decisions deals with the quantitative factors.
2. Relevant costs are expected future costs that will differ between
alternatives. In view of the definition of relevant costs, historical costs are
always irrelevant because they are not future costs. They may be helpful
in predicting relevant costs but they are always irrelevant costs per se.
3. The differential costs in any given situation is commonly defined as the
change in total cost under each alternative. It is not relevant cost, but it is
the algebraic difference between the relevant costs for the alternatives
under consideration.
4. Analysis:

Future costs: Replace Rebuild

New Truck P10,200
Less: Proceeds from
disposal, net 1,000
P 9,200 P8,500
Advantage of rebuilding P700

The original cost of the old truck is irrelevant but its disposal value is
relevant. It is recommended that the truck should be rebuilt because it
will involve lesser cash outlay.

5. No. Variable costs are relevant costs only if they differ in total between the
alternatives under consideration.

6. Only those costs that would be avoided as a result of dropping the product
line are relevant in the decision. Costs that will not differ regardless of
whether the product line is retained or discontinued are irrelevant.

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7. Not necessarily. An apparent loss may be the result of allocated common

costs or of sunk costs that cannot be avoided if the product line is
dropped. A product line should be discontinued only if the contribution
margin that will be lost as a result of dropping the line is less than the
fixed costs that would be avoided. Even in that situation the product line
may be retained if its presence promotes the sale of other products.

8. Allocations of common fixed costs can make a product line (or other
segment) appear to be unprofitable, whereas in fact it may be profitable.

9. In cost-plus pricing, prices are set by applying a markup percentage to a

product’s cost.

10. The price elasticity of demand measures the degree to which a change in
price affects unit sales. The unit sales of a product with inelastic demand
are relatively insensitive to the price charged for the product. In contrast,
the unit sales of a product with elastic demand are sensitive to the price
charged for the product.

11. The profit-maximizing price should depend only on the variable

(marginal) cost per unit and on the price elasticity of demand. Fixed costs
do not enter into the pricing decision at all. Fixed costs are relevant in a
decision of whether to offer a product or service, but are not relevant in
deciding what to charge for the product or service. Because price affects
unit sales, total variable costs are affected by the pricing decision and
therefore are relevant.

12. The markup over variable cost depends on the price elasticity of demand.
A product whose demand is elastic should have a lower markup over cost
than a product whose demand is inelastic. If demand for a product is
inelastic, the price can be increased without cutting as drastically into unit
sales.

II. Exercises

Exercise 1 (Identifying Relevant Costs)

Case 1 Case 2
Not Not
Item Relevant Relevant Relevant Relevant

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a. Sales revenue................................... X X
b. Direct materials............................... X X
c. Direct labor...................................... X X
d. Variable manufacturing
overhead.......................................... X X
e. Book value – Model E7000
machine........................................... X X
f. Disposal value – Model E7000
machine........................................... X X
g. Depreciation – Model E7000
machine........................................... X X
h. Market value – Model F5000
machine (cost)................................. X X
i. Fixed manufacturing
overhead.......................................... X X
j. Variable selling expense.................. X X
k. Fixed selling expense...................... X X
l. General administrative
overhead.......................................... X X

Exercise 2 (Identification of Relevant Costs)

Requirement 1

Fixed cost per mile (P3,500* ÷ 10,000 miles)..........................................................

P0.35
Variable operating cost per mile...............................................................................
0.08
Average cost per mile...............................................................................................
P0.43

* Depreciation............................................................................................................
P2,000
Insurance.................................................................................................................
960
Garage rent.............................................................................................................
480
Automobile tax and license.....................................................................................
60
Total........................................................................................................................
P3,500

Requirement 2

The variable operating costs would be relevant in this situation. The

depreciation would not be relevant since it relates to a sunk cost. However,
any decrease in the resale value of the car due to its use would be relevant.
The automobile tax and license costs would be incurred whether Ingrid decides
to drive her own car or rent a car for the trip during summer break and are
therefore irrelevant. It is unlikely that her insurance costs would increase as a
result of the trip, so they are irrelevant as well. The garage rent is relevant
only if she could avoid paying part of it if she drives her own car.

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Requirement 3

When figuring the incremental cost of the more expensive car, the relevant
costs would be the purchase price of the new car (net of the resale value of the
old car) and the increases in the fixed costs of insurance and automobile tax
and license. The original purchase price of the old car is a sunk cost and is
therefore irrelevant. The variable operating costs would be the same and
therefore are irrelevant. (Students are inclined to think that variable costs are
always relevant and fixed costs are always irrelevant in decisions. This
requirement helps to dispel that notion.)

Exercise 3 (Make or Buy a Component)

Requirement 1

Per Unit
Differential
Costs 15,000 units
Make Buy Make Buy
Cost of purchasing P200 P3,000,000
Direct materials P 60 P 900,000
Direct labor 80 1,200,000
Variable manufacturing overhead 10 150,000
Fixed manufacturing overhead, traceable1
20 300,000
Fixed manufacturing overhead, common
0 0 0 0
Total costs P170 P200 P2,550,000 P3,000,000

Difference in favor of continuing to make

the parts P30 P450,000
1
Only the supervisory salaries can be avoided if the parts are purchased. The
remaining book value of the special equipment is a sunk cost; hence, the P3 per
unit depreciation expense is not relevant to this decision. Based on these data, the
company should reject the offer and should continue to produce the parts internally.

Requirement 2

Make Buy
Cost of purchasing (part 1)...................................................................................................
P3,000,000
Cost of making (part 1)........................................................................................................
P2,550,000
Opportunity cost—segment margin forgone on a 650,000

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potential new product line................................................................................................

Total cost...............................................................................................................................
P3,200,000 P3,000,000
Difference in favor of purchasing from the outside
supplier..............................................................................................................................
P200,000

Thus, the company should accept the offer and purchase the parts from the outside
supplier.

Exercise 4 (Evaluating Special Order)

Only the incremental costs and benefits are relevant. In particular, only the
variable manufacturing overhead and the cost of the special tool are relevant
overhead costs in this situation. The other manufacturing overhead costs are
fixed and are not affected by the decision.

Per Total
Unit 10 bracelets
Incremental revenue P3,499.50 P34,995.00
Incremental costs:
Variable costs:
Direct materials 1,430.00 14,300.00
Direct labor 860.00 8,600.00
Variable manufacturing overhead 70.00 700.00
Special filigree 60.00 600.00
Total variable cost P2,420.00 24,200.00
Fixed costs:
Purchase of special tool 4,650.00
Total incremental cost 28.850.00
Incremental net operating income P 6.145.00
Even though the price for the special order is below the company’s regular
price for such an item, the special order would add to the company’s net
operating income and should be accepted. This conclusion would not
necessarily follow if the special order affected the regular selling price of
bracelets or if it required the use of a constrained resource.

Exercise 5 (Utilization of a Constrained Resource)

Requirement 1

X Y Z
(1) Contribution margin per unit................................................................................................
P18 P36 P20
(2) Direct labor cost per unit.......................................................................................................
P12 P32 P16
(3) Direct labor rate per hour......................................................................................................
8 8 8

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(4) Direct labor-hours required per unit (2) ÷ (3).......................................................................

1.5 4.0 2.0
Contribution margin per direct labor-hour (1) ÷ (4).............................................................
P12 P 9 P10

Requirement 2

The company should concentrate its labor time on producing product X:

X Y Z
Contribution margin per direct labor-hour
P12 P9 P10
Direct labor-hours available × 3,000 × 3,000 × 3,000
Total contribution margin P36,000 P27,000 P30,000

Although product X has the lowest contribution margin per unit and the
second lowest contribution margin ratio, it has the highest contribution margin
per direct labor-hour. Since labor time seems to be the company’s constraint,
this measure should guide management in its production decisions.

Requirement 3

The amount Jaycee Company should be willing to pay in overtime wages for
additional direct labor time depends on how the time would be used. If there
are unfilled orders for all of the products, Jaycee would presumably use the
additional time to make more of product X. Each hour of direct labor time
generates P12 of contribution margin over and above the usual direct labor
cost. Therefore, Jaycee should be willing to pay up to P20 per hour (the P8
usual wage plus the contribution margin per hour of P12) for additional labor
time, but would of course prefer to pay far less. The upper limit of P20 per
direct labor hour signals to managers how valuable additional labor hours are
to the company.

If all the demand for product X has been satisfied, Jaycee Company would
then use any additional direct labor-hours to manufacture product Z. In that
case, the company should be willing to pay up to P18 per hour (the P8 usual
wage plus the P10 contribution margin per hour for product Z) to manufacture
more product Z.

Likewise, if all the demand for both products X and Z has been satisfied,
additional labor hours would be used to make product Y. In that case, the
company should be willing to pay up to P17 per hour to manufacture more
product Y.

Exercise 6 (Sell or Process Further)

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Product A Product B Product C

Sales value after further processing P80,000 P150,000 P75,000
Sales value at split-off point 50,000 90,000 60,000
Incremental revenue 30,000 60,000 15,000
Cost of further processing 35,000 40,000 12,000
Incremental profit (loss) P(5,000) 20,000 3,000

Products B and C should be processed further, but not Product A.

Exercise 7 (Identification of Relevant Costs)

Requirement 1

The relevant costs of a fishing trip would be:

Fuel and upkeep on boat per trip............................. P25

Junk food consumed during trip*............................. 8
Snagged fishing lures............................................... 7
Total........................................................................ P40

* The junk food consumed during the trip may not be completely relevant.
Even if Shin were not going on the trip, he would still have to eat. The
amount by which the cost of the junk food exceeds the cost of the food he
would otherwise consume would be the relevant amount.

The other costs are sunk at the point at which the decision is made to go on
another fishing trip.

Requirement 2

If he fishes for the same amount of time as he did on his last trip, all of his
costs are likely to be about the same as they were on his last trip. Therefore, it
really doesn’t cost him anything to catch the last fish. The costs are really
incurred in order to be able to catch fish and would be the same whether one,
two, three, or a dozen fish were actually caught. Fishing, not catching fish,
costs money. All of the costs are basically fixed with respect to how many fish
are actually caught during any one fishing trip, except possibly the cost of
snagged lures.

Requirement 3
In a decision of whether to give up fishing altogether, nearly all of the costs
listed by Shin’s wife are relevant. If he did not fish, he would not need to pay

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for boat moorage, new fishing gear, a fishing license, fuel and upkeep, junk
food, or snagged lures. In addition, he would be able to sell his boat, the
proceeds of which would be considered relevant in this decision. The original
cost of the boat, which is a sunk cost, would not be relevant.
These three requirements illustrate the slippery nature of costs. A cost that is
relevant in one situation can be irrelevant in the next. None of the costs are
relevant when we compute the cost of catching a particular fish; some of them
are relevant when we compute the cost of a fishing trip; and nearly all of them
are relevant when we consider the cost of not giving up fishing. What is even
more confusing is that CG is correct; the average cost of a salmon is P167,
even though the cost of actually catching any one fish is essentially zero. It
may not make sense from an economic standpoint to have salmon fishing as a
hobby, but as long as Shin is out in the boat fishing, he might as well catch as
many fish as he can.

Exercise 8 (Dropping or Retaining a Segment)

Requirement 1
No, the housekeeping program should not be discontinued. It is actually
generating a positive program segment margin and is, of course, providing a
valuable service to seniors. Computations to support this conclusion follow:

Contribution margin lost if the housekeeping program

is dropped............................................................................................
P(80,000)
Fixed costs that can be avoided:
Liability insurance...............................................................................
P15,000
Program administrator’s salary...........................................................
37,000 52,000
Decrease in net operating income for the organization
as a whole...........................................................................................
P(28,000)

Depreciation on the van is a sunk cost and the van has no salvage value since
it would be donated to another organization. The general administrative
overhead is allocated and none of it would be avoided if the program were
dropped; thus it is not relevant to the decision.

The same result can be obtained with the alternative analysis below:

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Difference:
Total If Net Operating
House- Income
Current keeping Is Increase or
Total Dropped (Decrease)
Revenues......................................................................
P900,000 P660,000 P(240,000)
Variable expenses.........................................................
490,000 330,000 160,000
Contribution margin....................................................
410,000 330,000 (80,000)
Fixed expenses:
Depreciation*..........................................................
68,000 68,000 0
Liability insurance...................................................
42,000 27,000 15,000
Program administrators’ salaries............................ 115,000 78,000 37,000
General administrative overhead............................ 180,000 180,000 0
Total fixed expenses.....................................................
405,000 353,000 52,000
Net operating income (loss).........................................
P 5,000 P(23,000) P  (28,000)

*Includes pro-rated loss on disposal of the van if it is donated to a charity.

Requirement 2

To give the administrator of the entire organization a clearer picture of the

financial viability of each of the organization’s programs, the general
administrative overhead should not be allocated. It is a common cost that
should be deducted from the total program segment margin. Fol lowing the
format for a segmented income statement, a better
income statement would be:
Home Meals on House-
Total Nursing Wheels keeping
Revenues........................................................
P900,000 P260,000 P400,000 P240,000
Variable expenses..........................................
490,000 120,000 210,000 160,000
Contribution margin......................................
410,000 140,000 190,000 80,000
Traceable fixed expenses:
Depreciation..............................................
68,000 8,000 40,000 20,000
Liability insurance....................................42,000 20,000 7,000 15,000
Program administrators’
salaries..................................................
115,000 40,000 38,000 37,000
Total traceable fixed expenses....................... 225,000 68,000 85,000 72,000
Program segment margins............................ 185,000 P 72,000 P105,000 P  8,000
General administrative overhead.................. 180,000
Net operating income (loss)..........................P  5,000

Exercise 9 (Special Order)

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Requirement 1

Monthly profits would be increased by P9,000:

Total for
Per Unit 2,000 Units
Incremental revenue.........................................................................
P12.00 P24,000
Incremental costs:
Variable costs:
Direct materials........................................................................
2.50 5,000
Direct labor..............................................................................
3.00 6,000
Variable manufacturing overhead.............................................0.50 1,000
Variable selling and administrative...........................................
1.50 3,000
Total variable cost........................................................................
P 7.50 15,000

Fixed costs:
None affected by the special order............................................ 0
Total incremental cost...................................................................... 15,000
Incremental net operating income.....................................................P 9,000

Requirement 2

The relevant cost is P1.50 (the variable selling and administrative costs). All
other variable costs are sunk, since the units have already been produced. The
fixed costs would not be relevant, since they would not be affected by the sale
of leftover units.

Exercise 10 (Make or Buy a Component)

The costs that are relevant in a make-or-buy decision

are those costs that can be avoided as a result of
purchasing from the outside. The analysis for this
exercise is:
Per Unit
Differential Costs 20,000 Units
Make Buy Make Buy
Cost of purchasing....................................................... P23.50 P470,000
Cost of making:
Direct materials.......................................................
P 4.80 P 96,000
Direct labor..............................................................
7.00 140,000
Variable manufacturing overhead........................... 3.20 64,000
Fixed manufacturing overhead................................ 4.00 * 80,000

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Total cost..................................................................
P19.00 P23.50 P380,000 P470,000
* The remaining P6 of fixed manufacturing overhead cost would not be relevant, since
it will continue regardless of whether the company makes or buys the parts.

The P150,000 rental value of the space being used to

produce part R-3 represents an opportunity cost of
continuing to produce the part internally. Thus, the
completed analysis would be:
Make Buy
Total cost, as above..........................................................................................
P380,000 P470,000
Rental value of the space (opportunity cost)...................................................
150,000
Total cost, including opportunity cost.............................................................
P530,000 P470,000
Net advantage in favor of buying....................................................................
P60,000

Profits would increase by P60,000 if the outside supplier’s offer is accepted.

Exercise 11 (The Economists’ Approach to Pricing)

Requirement (1)

Cecile makes more money selling the ice cream cones at the lower price, as
shown below:

P17.90 Price P13.90 Price

Unit sales........................................................ 860 1,340

Sales...............................................................P15,394.00 P18,626.00
Cost of goods sold @ P4.10............................ 3,526.00 5,494.00
Contribution margin........................................ 11,868.00 13,132.00
Fixed expenses................................................ 425.00 425.00
Net operating income...................................... P11,443.00 P12,707.00

Requirement (2)

The price elasticity of demand is computed as follows:

d = In(1 + % change in quantity sold)
In(1 + % change in price)
1,340 – 860
In(1 + 860 )
=
13.90 – 17.90
In(1 + 19-11 )
17.90
In(1 + 0.55814)
=
In(1 – 0.22346)

In(1.55814)
=
In(0.77654)

0.44349
= = –1.75
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Chapter 19 Relevant Costs for Decision Making

Requirement (3)

The profit-maximizing price can be estimated using the following formulas:

Profit-maximizing –1
=
markup on variable cost 1 + d
–1
= = 1.333
1 + (–1.75)

Profit-maximizing Profit-maximizing Variable cost

= 1 + x
price markup on variable cost per unit

= (1 + 1.3333) x P4.10 = P9.60

This price is much lower than the prices Cecile has been charging in the past.
Rather than immediately dropping the price to P9.60, it would be prudent to
drop the price a bit and see what happens to unit sales and to profits. The
formula assumes that the price elasticity is constant, which may not be the
case.

Exercise 12 (Target Costing)

Sales (50,000 batteries × P65 per battery).....................................P3,250,000

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Less desired profit (20% × P2,500,000)........................................ 500,000

Target cost for 50,000 batteries.....................................................P2,750,000

Target cost per battery = (P2,750,000 ÷ 50,000 batteries)

= P55 per battery

Exercise 13 (Pricing a New Product)

The selling price of the new amaretto cappuccino product should at least cover
its variable cost and its opportunity cost. The variable cost of the new product
is P4.60 and its opportunity cost can be computed by multiplying the
opportunity cost of P34 per minute of order filling time by the amount of time
required to fill an order for the new product:

Selling price of Variable cost of

the new product  the new product +

Opportunity cost Amounts of the constrained

per unit of the resource required by a unit
x
constrained resource of the new product

Selling price of 45 seconds

the new product  P4.60 + P34 per minute + 60 seconds per minute

Selling price of
the new product  P4.60 + P34 per minute + 0.75 minute

Selling price of
the new product  P4.60 + P25.50 = P30.10
Hence, the selling price of the new product should at least cover both its variable
cost of P4.60 and its opportunity cost of P25.50, for a total of P30.10.

III. Problems

Problem 1 (Accept or Reject an Order)

Product A Product B
Selling price per unit P1.20 P1.40
Less Variable costs/unit:

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Materials 0.50 0.70

Labor 0.20 0.24
Factory overhead (25%) 0.10 0.14
0.80 1.08
Contribution margin/unit P0.40 P0.32
Multiplied by number of units to be sold 21,000 units 30,000 units
Total contribution margin P8,400 P9,600

Product B should be accepted because its total contribution margin is higher

than that of Product A.

Problem 2 (Eliminate or Retain a Product Line)

Requirement 1

No, production and sale of the round trampolines should not be discontinued.
Computations to support this answer follow:

Contribution margin lost if the round trampolines

are discontinued............................................. P(80,000)
Less fixed costs that can be avoided:
Advertising – traceable.................................. P41,000
Line supervisors’ salaries............................... 6,000 47,000
Decrease in net operating income for the
company as a whole....................................... P(33,000)

The depreciation of the special equipment represents a sunk cost, and

therefore it is not relevant to the decision. The general factory overhead is
allocated and will presumably continue regardless of whether or not the round
trampolines are discontinued; thus, it is not relevant.

Requirement 2

If management wants a clear picture of the profitability of the segments, the

general factory overhead should not be allocated. It is a common cost and
therefore should be deducted from the total product-line segment margin. A
more useful income statement format would be as follows:

Trampoline

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Total Round Rectangular Octagonal

Sales...................................... P1,000,000 P140,000 P500,000 P360,000
Less variable expenses.......... 410,000 60,000 200,000 150,000
Contribution margin............. 590,000 80,000 300,000 210,000
Less fixed expenses:
Advertising – traceable..... 216,000 41,000 110,000 65,000
Depreciation of special
equipment...................... 95,000 20,000 40,000 35,000
Line supervisors’
salaries........................... 19,000 6,000 7,000 6,000
Total traceable fixed
expenses............................ 330,000 67,000 157,000 106,000
Product-line segment
margin............................... 260,000 P 13,000 P143,000 P104,000
Less common fixed
expenses............................ 200,000
Net operating income
(loss).................................. P 60,000

Problem 3 (Product Mix)

Requirement 1
Product Line
A B C D
Selling price per unit P30 P25 P10 P8
Variable cost per unit 25 10 5 4
Contribution margin / unit P5 P15 P 5 P4
Divided by no. of hours required
for each unit 5 hrs. 10 hrs. 4 hrs. 1 hr.
Contribution per hour P1 P1.5 P1.25 P4

Product ranking:
1. D 2. B 3. C 4. A

Based on the above analysis, first priority should be given to Product D. The
company should use 4,000 out of the available 96,000 hrs. to produce 4,000
units of product D. The remaining 92,000 hrs. should be used to produce
9,200 units of Product B. Hence, the best product combination is 4,000 units
of Product D and 9,200 units of Product B.

Requirement 2

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If there were no market limitations on any of the products, the company

should use all the available 96,000 hours in producing 96,000 units of product
D only.

The difference in profit between the two alternatives is computed as follows:

Contribution margin of combination (1)

Product D (4,000 x P 4.00) P 16,000
Product B (9,200 x P15.00) 138,000
Total contribution margin of D and B P154,000
Less contribution margin of D only
(96,000 x P4) 384,000
Difference, excess over profit in combination (1) P230,000
Problem 4 (Accept or Reject a Special Order)

Requirement 1
The company should accept the special order of 4,000 @ P10 each because
this selling price is still higher than the additional variable cost to be incurred.
Whether or not variable marketing expenses will be incurred, the decision is
still to accept the order.

Supporting computations:
(a) Assume no additional variable marketing cost will be incurred.
Selling price per unit P10.00
Less variable manufacturing costs:
Direct materials P5.00
Direct labor 3.00
Variable overhead 0.75 8.75
Contribution margin/unit P 1.25
Multiplied by number of units of order 4,000 units
Total increase in profit P5,000
(b) Assume additional variable marketing cost will be incurred.
Selling price per unit P10.00
Less variable costs (P8.75 + P0.25) 9.00
Contribution margin / unit P 1.00
Multiplied by number of units of order 4,000 units
Total increase in contribution margin P4,000

Requirement 2
P8.75, the total variable manufacturing cost.

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Requirement 3
Direct materials P5.00
Direct labor 3.00
Variable factory overhead 0.75
Total cost of inventory under direct costing P8.75

Requirement 4

Present contribution margin

[10,000 units x (P15 - P9)] P60,000
Less proposed contribution margin
[(P14 - P9) x 11,000 units] 55,000
Decrease in contribution margin P 5,000
The company should not reduce the selling price from P15 to P14 even if
volume will go up because total contribution margin will decrease.

Problem 5 (CVP Analysis used for Decision Making)

Requirement (a)

Units sold per month No. of months Probability

4,000 6 20%
5,000 15 50%
6,000 9 30%
30 100%

Requirement (b)
Production
4,000 units 5,000 units 6,000 units
Sales (4,000 x P40) P160,000 P160,000 P160,000
Less variable costs
Production cost @ P25 100,000 125,000 150,000
Purchase cost @ P45 - - -

Total P100,000 P125,000 P150,000

Contribution margin P 60,000 P 35,000 P 10,000

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Sales (5,000 x P40) P200,000 P200,000 P200,000

Less variable costs
Production cost @ P25 100,000 125,000 150,000
Purchase cost @ P45 45,000 - -

Total P145,000 P125,000 P150,000

Contribution margin P 55,000 P 75,000 P 50,000

Sales (6,000 x P40) P240,000 P240,000 P240,000

Less variable costs
Production cost @ P25 100,000 125,000 150,000
Purchase cost @ P45 90,000 45,000 0
Total P190,000 P170,000 P150,000
Contribution margin P 50,000 P 70,000 P 90,000

Requirement (c)

Sales Order Contribution Margin Probability Expected Value

4,000 P35,000 0.20 P 7,000
5,000 75,000 0.50 37,500
6,000 70,000 0.30 21,000
Average Contribution Margin P65,500

Problem 6 (Pricing)

Requirement A:
Operating
Result at Full
2005 2006 Capacity
Sales P 100,000 P 400,000 P 480,000
Less Variable cost 130,000 520,000 624,000
Contribution margin (P 30,000) (P120,000) (P144,000)
Less Fixed cost 40,000 40,000 40,000
Net income (loss) (P 70,000) (P160,000) (P184,000)

The company had been operating at a loss because the product had been
selling with a negative contribution margin. Hence, the more units are sold,
the higher the loss will be.

Requirement B: P60.14
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Requirement C: P74.29

Requirement D: P56.58

Problem 7 (Make or Buy)

Cost of Making Cost of Buying

Outside purchase P90,000
Direct materials P15,000
Direct labor 30,000
Variable manufacturing overhead 10,000
Fixed manufacturing overhead* 15,000
Total cost P70,000 P90,000

* 1/3 x P45,000 = P15,000

Therefore, the annual advantage to make the parts is P20,000.

Problem 8 (Close or Retain a Store)

Requirement 1

The simplest approach to the solution is:

Gross margin lost if the store is closed............................................. P(228,000)

Less costs that can be avoided:
Direct advertising.......................................................................... P36,000
Sales salaries................................................................................. 45,000
Delivery salaries............................................................................7,000
Store rent.......................................................................................
65,000
Store management salaries (new employee would not
be hired to fill vacant position at another store)...................... 15,000
General office salaries...................................................................8,000
Utilities..........................................................................................
27,200
Insurance on inventories (2/3 × P9,000)......................................6,000
Employment taxes*.......................................................................9,000 218,200
Decrease in company net operating income if the
Ortigas Store is closed................................................................... P( 9,800)

*Salaries avoided by closing the store:

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Sales salaries..........................................................................................................
P45,000
Delivery salaries.................................................................................................... 7,000
Store management salaries....................................................................................15,000
General office salaries........................................................................................... 8,000
Total salaries..........................................................................................................75,000
Employment tax rate..............................................................................................× 12%
Employment taxes avoided.................................................................................... P 9,000

Requirement 2

The Ortigas Store should not be closed. If the store is closed, overall company
net operating income will decrease by P9,800 per quarter.

Requirement 3

The Ortigas Store should be closed if P200,000 of its sales are picked up by
the Makati Store. The net effect of the closure will be an increase in overall
company net operating income by P76,200 per quarter:
Gross margin lost if the Ortigas Store is closed.......................................................................
P(228,000)
Gross margin gained at the Makati Store:
P200,000 × 43%...................................................................................................................
86,000
Net loss in gross margin...........................................................................................................
(142,000)
Costs that can be avoided if the Ortigas Store is closed (part 1).............................................. 218,200
Net advantage of closing the Ortigas Store..............................................................................
P 76,200

Problem 9 (Shutting Down or Continuing to Operate a Plant)

Requirement 1

Product KK-8 yields a contribution margin of P14 per gallon (P35 – P21 =
P14). If the plant closes, this contribution margin will be lost on the 22,000
gallons (11,000 gallons per month × 2 = 22,000 gallons) that could have been
sold during the two-month period. However, the company will be able to avoid
certain fixed costs as a result of closing down. The analysis is:
Contribution margin lost by closing the plant for two
months (P14 per gallon × 22,000 gallons).................................................P(308,000)
Costs avoided by closing the plant for two months:
Fixed manufacturing overhead cost
(P60,000 × 2 months = P120,000)..........................................................
P120,000
Fixed selling costs
(P310,000 × 10% × 2 months)...............................................................
62,000 182,000
Net disadvantage of closing, before start-up costs.......................................... (126,000)
Add start-up costs............................................................................................ (14,000)

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 Relevant Costs for Decision Making Chapter 19

Disadvantage of closing the plant...................................................................P(140,000)

No, the company should not close the plant; it should continue to operate at
the reduced level of 11,000 gallons produced and sold each month. Closing
will result in a P140,000 greater loss over the two-month period than if the
company continues to operate. Additional factors are the potential loss of
goodwill among the customers who need the 11,000 gallons of KK-8 each
month and the adverse effect on employee morale. By closing down, the needs
of customers will not be met (no inventories are on hand), and their business
may be permanently lost to another supplier.

Alternative Solution:
Difference—
Net
Operating
Income
Plant Kept Increase
Open Plant Closed (Decrease)
Sales (11,000 gallons × P35 per gallon × 2)............................ P 770,000 P 0 P(770,000)
Less variable expenses (11,000
gallons × P21 per gallon × 2).............................................. 462,000 0 462,000
Contribution margin.................................................................
308,000 0 (308,000)
Less fixed costs:
Fixed manufacturing overhead cost
(P230,000 × 2;
P170,000 × 2)................................................................
460,000 340,000 120,000
Fixed selling cost (P310,000 × 2; P310,000
× 90% × 2)......................................................................
620,000 558,000 62,000
Total fixed cost.........................................................................
1,080,000 898,000 182,000
Net operating loss before start-up costs................................... (772,000) (898,000) (126,000)
Start-up costs........................................................................... (14,000) (14,000)
Net operating loss....................................................................
P (772,000) P(912,000) P(140,000)

Requirement 2

Ignoring the additional factors cited in part (1) above, Kristin Company
should be indifferent between closing down or continuing to operate if the level
of sales drops to 12,000 gallons (6,000 gallons per month) over the two-month
period. The computations are:

Cost avoided by closing the plant for two months (see above)............................... P182,000
Less start-up costs....................................................................................................
14,000
Net avoidable costs..................................................................................................
P168,000

Net avoidable costs P168,000

=
Contribution margin per gallon P14 per gallon
19-21 = 12,000 gallons
Chapter 19 Relevant Costs for Decision Making

Verification: Operate at
12,000 Close for
Gallons for Two
Two Months Months
Sales (12,000 gallons × P35 per gallon)............................................... P 420,000 P   0
Less variable expenses (12,000 gallons × P21 per gallon)................... 252,000 0
Contribution margin.............................................................................. 168,000 0
Less fixed expenses:
Manufacturing overhead (P230,000 and P170,000 × 2
months).........................................................................................
460,000 340,000
Selling (P310,000 and P279,000 × 2 months)................................. 620,000 558,000
Total fixed expenses..............................................................................1,080,000 898,000
Start-up costs......................................................................................... 0 14,000
Total costs..............................................................................................
1,080,000 912,000
Net operating loss..................................................................................
P (912,000) P(912,000)

Problem 10 (The Economists’ Approach to Pricing)

Requirement (1)

The postal service makes more money selling the

souvenir sheets at the lower price, as shown below:
P500 Price P600 Price
Unit sales................................................... 50,000 40,000

Sales.......................................................... P25,000,000 P24,000,000

Cost of goods sold @ P60 per unit............ 3,000,000 2,400,000
Contribution margin.................................. P22,000,000 P21,600,000

Requirement (2)

The price elasticity of demand, as defined in the text, is computed as follows:

d =
In(1 + % change in quantity sold)
In(1 + % change in price)
40,000 – 50,000
In(1 + )
50,000
= 600.00 – 500.00
In(1 + 500.00 )
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 Relevant Costs for Decision Making Chapter 19

In(1 – 0.2000)
=
In(1 + 0.2000)
In(0.8000)
=
In(1.2000)

= –0.2231
0.1823
= –1.2239

Requirement (3)

The profit-maximizing price can be estimated using the following formulas:

Profit-maximizing –1
=
markup on variable cost 1 + d
–1
= = 4.4663
1 + (–1.2239)

Profit-maximizing Profit-maximizing Variable cost

= 1 + x
price markup on variable cost per unit

= (1 + 4.4663) x P60 = P328

This price is much lower than the price the postal service has been charging in
the past. Rather than immediately dropping the price to P328, it would be
prudent for the postal service to drop the price a bit and observe what happens
to unit sales and to profits. The formula assumes that the price elasticity of
demand is constant, which may not be true.

The critical assumption in the calculation of the profit-maximizing price is

that the percentage increase (decrease) in quantity sold is al ways the
same for a given percentage decrease (increase) in
price. If this is true, we can estimate the demand
schedule for souvenir sheets as follows:
Price* Quantity Sold§
P600 40,000
P500 50,000
P417 62,500
P348 78,125

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Chapter 19 Relevant Costs for Decision Making

P290 97,656
P242 122,070
P202 152,588
P168 190,735
P140 238,419
P117 298,024
*
The price in each cell in the table is computed by taking 5/6 of the price just
above it in the table. For example, P500 is 5/6 of P600 and P417 is 5/6 of
P500.
§
The quantity sold in each cell of the table is computed by multiplying the
quantity sold just above it in the table by 50,000/40,000. For example, 62,500
is computed by multiplying 50,000 by the fraction 50,000/40,000.

The profit at each price in the above demand schedule can be computed as
follows:
Price Quantity Sales Cost of Sales Contribution
(a) Sold (b) (a) × (b) P60 × (b) Margin
P600 40,000 P24,000,000 P2,400,000 P21,600,000
P500 50,000 P250,00,000 P3,000,000 P22,000,000
P417 62,500 P26,062,500 P3,750,000 P22,312,500
P348 78,125 P27,187,500 P4,687,500 P22,500,000
P290 97,656 P28,320,200 P5,859,400 P22,460,800
P242 122,070 P29,540,900 P7,324,200 P22,216,700
P202 152,588 P30,822,800 P9,155,300 P21,667,500
P168 190,735 P32,043,500 P11,444,100 P20,599,400
P140 238,419 P33,378,700 P14,305,100 P19,073,600
P117 298,024 P34,868,800 P17,881,400 P16,987,400

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 Relevant Costs for Decision Making Chapter 19

The contribution margin is plotted below as a function of the selling price:

23,000,000

22,000,000
Contribution Margin

21,000,000

20,000,000

19,000,000

18,000,000

17,000,000
100.00 200.00 300.00 400.00 500.00 600.00

Selling Price

The plot confirms that the profit-maximizing price is about P328.

Requirement (4)

If the postal service wants to maximize the contribution margin and profit
from sales of souvenir sheets, the new price should be:
Profit-maximizing price = 5.4663 × P70 = P383
Note that a P100 increase in cost has led to a P55 (P383 – P328) increase in
the profit-maximizing price. This is because the profit-maximizing price is
computed by multiplying the variable cost by 5.4663. Since the variable cost
has increased by P100, the profit-maximizing price has increased by P100 ×
5.4663, or P55.
Some people may object to such a large increase in price as “unfair” and some

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Chapter 19 Relevant Costs for Decision Making

may even suggest that only the P10 increase in cost should be passed on to the
consumer. The enduring popularity of full-cost pricing may be explained to
some degree by the notion that prices should be “fair” rather than calculated to
maximize profits.

Problem 11 (Ranking Alternatives and Managing with a Constraint)

Requirement (1)

This problem can be solved by first computing the profitability index of each
customer and then ranking the customers based on that profitability index:
Incremental Ji Eun’s Time Profitability
Profit Required Index
Customer (A) (B) (A) ÷ (B)
Lalaine................................
P1,400 4 P350
Emily...................................
1,240 4 P310
Anna....................................
1,600 5 P320
Catherine............................. 960 3 P320
Gee Ann..............................
1,900 5 P380
Lily......................................
2,880 8 P360
Lourdes............................... 930 3 P310
Ma. Cecilia..........................
1,360 4 P340
Sheila Raya.........................2,340 6 P390
Jane.....................................
2,040 6 P340

Cumulative
Amount of Ji Eun’s
Profitability Ji Eun’s Time Time
Customer Index Required Required
Sheila Raya...... P390 6 6
Gee Ann........... P380 5 11
Lily.................. P360 8 19
Lalaine............. P350 4 23
Jane.................. P340 6 29
Ma. Cecilia...... P340 4 27
Anna................ P320 5 38
Catherine.......... P320 3 41
Emily............... P310 4 45
Lourdes............ P310 3 48
Given that Ji Eun should not be asked to work more than 33 hours, the four
customers below the line in the above table should be told that their
reservations have to be cancelled.

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 Relevant Costs for Decision Making Chapter 19

Requirement (2)

The total profit on wedding cakes for the weekend after canceling the four
reservations would be:

Sheila Raya...... P 2,340

Gee Ann............ 1,900
Lily................... 2,880
Lalaine.............. 1,400
Jane.................. 2,040
Ma. Cecilia....... 1,360
Total................. P11,920

Notes:
● Both Ji Eun’s time and the cakes would have to be very carefully
scheduled to make sure that all cakes are completed on time. We have
assumed that the 33 hours of Ji Eun’s time that are available for cake
decorating do not include hours that have been set aside as a buffer to
provide protection from inevitable disruptions in the schedule.
● If the cumulative amount of Ji Eun’s time required did not exactly
consume the total amount of time available, some adjustment might be
required in which reservations are cancelled to ensure that the most
profitable plan is selected.

Requirement (3)

To avoid disappointing customers, reservations should probably not be

accepted for any particular weekend after 33 hours of Ji Eun’s time have been
committed for that weekend’s cakes. To ensure that only the most profitable
cake reservations are accepted, a reservation for any cake with a profitability
index of less than P340 should probably not be accepted. This was the cutoff
point for the cakes in the first weekend in June. This cutoff may need to be
adjusted upward or downward over time—the cakes that were reserved for the
first weekend in June may not be representative of the cakes that would be
reserved for other weekends. If too many reservations are turned down and Ji
Eun’s time is not fully utilized, then the cutoff should be adjusted downward.
If too few reservations are turned down and Ji Eun’s time is once again
overbooked or profitable cake orders are turned away, then the cutoff should
be adjusted upward.

Requirement (4)
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Chapter 19 Relevant Costs for Decision Making

Ms. Hye Young should consider changing the way prices are set so that they
include a charge for Ji Eun’s time. On average, the prices may be the same,
but they should be based not only on the size of the cakes, but also on the
amount of cake decorating that the customer desires. The charge for Ji Eun’s
time should be her hourly rate of pay (including any fringe benefits) plus the
opportunity cost of at least P340 per hour. Because Ji Eun will not be working
more than 33 hours per week, if another cake reservation is accepted, some
other cake reservation will have to be cancelled. Ms. Hye Young would have
to give up at least P34 profit per hour to accept another cake reservation.

Requirement (5)

Making Ji Eun happy involves not asking her to work more than 33 hours per
week decorating cakes. Making customers happy involves not canceling their
reservations, not raising prices, and providing top quality wedding cakes. Ms.
Hye Young can accomplish both of these objectives and increase her profits by
clever management of the constraint—Ji Eun’s time. The possibilities include:
 Ms. Hye Young should make sure that none of Ji Eun’s time is wasted on
unnecessary tasks. For example, Ji Eun should not be asked to cream
butter by hand for frostings if a machine could do the job as well with less
labor time.
 Ms. Hye Young should make sure that none of Ji Eun’s time is wasted on
tasks that can be done by other persons. For example, an assistant can be
assigned to prepare frosting and to clean up, relieving Ji Eun of those
tasks. As long as the cost of the assistant’s time is less than P34 per hour,
the result will be higher profits and more pleased customers.
 Ms. Hye Young should consider assigning an apprentice to Ji Eun. The
apprentice could relieve Ji Eun of some of her workload while learning the
skills to eventually expand the company’s cake decorating capacity.
 Ms. Hye Young might consider subcontracting some of the less demanding
cake decorating to another baker. This would be profitable as long as the
charge is less than P340 per hour.
IV. Multiple Choice Questions
1. C 11. D 21. D 31. A
2. C 12. A 22. A 32. D
3. B 13. D 23. D 33. C
4. B 14. A 24. E 34. A
5. A 15. D 25. B 35. C

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6. B 16. C 26. D
7. C 17. A 27. D
8. B 18. C 28. C
9. A 19. B 29. A
10. B 20. C 30. A

Supporting computations for nos. 16 - 29:

16. Sales [(100,000 x 90%) x (P5.00 x 120%)] P540,000
Less: Variable costs (P300,000 x 90%) 270,000
Contribution margin P270,000
Less: Fixed costs 150,000
Operating income P120,000

17. Direct materials P 4

Direct labor 5
Overhead 2
Selling cost 3
Minimum selling price per unit P14

18. Relevant cost to make (10,000 x P24) P240,000

Purchase cost P300,000
Less: Savings in manufacturing cost P45,000
Avoidable fixed overhead 50,000 95,000
Net purchase price P205,000
Difference in favor of “buy” alternative P 35,000

19. Increase in sales (60,000 x P3) P180,000

Less: Increase in variable cost (60,000 x P2.50) 150,000
Net increase in income P 30,000
20. R S T
Sales (10,000 x P20) P200,000 P200,000 P200,000
Less: Variable costs
R (P12 x 10,000) 120,000
S (P 8 x 10,000) 80,000
T (P 4 x 10,000) 40,000

Contribution margin P 80,000 P120,000 P160,000

21. R S T
Sales (P16 x 15,000) P240,000 P240,000 P240,000

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Less: Variable costs

R (P12 x 15,000) 180,000
S (P 8 x 15,000) 120,000
T (P 4 x 15,000) 60,000

Contribution margin P 60,000 P120,000 P180,000

Less: Fixed costs 40,000 80,000 120,000
Operating income P 20,000 P 40,000 P 60,000

22. Old operating income:

Contribution margin P80,000
Less: Fixed cost 40,000
P40,000
New operating income 20,000
Difference - decrease P20,000

23. Sales P1,200,000

Less: Variable costs
Direct materials P300,000
Direct labor 400,000
Factory overhead 80,000
Marketing expenses 70,000
Administrative expenses 50,000 900,000
Contribution margin P 300,000
Less: Fixed costs
Factory overhead P 50,000
Marketing expenses 30,000
Administrative expenses 20,000
Increase in fixed costs 10,000 110,000
Profit P 190,000

24. Sales P1,200,000

Less: Variable costs
Direct materials P275,000
Direct labor 375,000
Factory overhead 80,000
Marketing expenses 70,000
Administrative expenses 50,000 850,000
Contribution margin P 350,000
Less: Fixed costs
Factory overhead P 50,000
Marketing expenses 30,000

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 Relevant Costs for Decision Making Chapter 19

Administrative expenses 20,000

Decrease in fixed costs
(P25,000  4) (6,250) 93,750
Profit P 256,250

25. Direct materials (P2 x 5,000) P10,000

Direct labor (P8 x 5,000) 40,000
Variable overhead (P4 x 5,000) 20,000
Total variable costs P70,000
Add: Avoidable fixed overhead 10,000
Total P80,000
26. Avoidable fixed overhead P 4
Direct materials 4
Direct labor 16
Variable overhead 18
Total P42
Multiplied by: Number of units to be produced 20,000
Total relevant costs to make the part P840,000

27. Purchase cost (P1.25 x 10,000) P12,500

Variable costs to make 10,000
Savings of making the blade P 2,500
28. Selling price per unit P17
Less: Variable costs of goods sold per unit
([P320,000 - P80,000]  20,000 units) 12
Contribution margin per unit P 5
Multiplied by units to be sold under Special Order 2,000
Increase in operating income P10,000
29. Budgeted operating income:
Contribution margin (P2,000,000 x 30%) P600,000
Less fixed costs 400,000
Net operating income P200,000
Operating income under the proposal:
Sales P2,000,000
Less Variable costs
([70% x P2,000,000] x 80%) 1,120,000
Contribution margin P 880,000
Less fixed costs 520,000 360,000
Increase in budgeted operating profit P160,000

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