ACCT3500(19) Lecture and Tutorial 5 Relevant Costs PDF

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LaiACCT3500/19 (lecture 5) ADA University, School of Business ACCT3500 Managerial Accounting, Spring 2019 Lecture 5 – Relevant costs and decision making

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It may be useful to go through the lecture notes on cost-volume-profit analysis. In the short-term, fixed costs may not change, and contribution (sales revenue – variable costs) may be relevant rather than profit for decision making.

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Special studies: measuring relevant costs and benefits for non-routine, short- term decisions.  Special studies require only those costs and revenues (cash outflows and cash inflows) that are relevant to the specific alternative courses of action to be considered.  A relevant cost / benefit must satisfy the following three conditions: (a) To be relevant for decision making, costs and benefits must be differential, incremental (additional or avoidable) between the alternatives (to go ahead or not to go ahead with the decision). (b) Only cash items of relevant costs and benefits will be considered, non-cash items such as depreciation will not be considered. In other words, a relevant cost / benefit must result in a cash flow. (c) In addition, relevant costs and benefits must relate to the future as historical costs and revenues are sunk and therefore irrelevant for decision making.  A relevant cost / benefit is a future, incremental cash flow.  The objective of special studies: to select the best alternative course of action which will maximize profit / contribution / net cash flow or minimize cost.

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Examples of special studies:  Making a component within the company or buying from an outside supplier.  Decision making and the influence of limiting factors.  Deleting a segment or discontinuing a product or a channel of distribution.  Special selling price decisions.

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Measuring relevant costs and benefits: ● The relevant costs and benefits for decision making purposes are future cash flows which will differ between the various alternatives being considered. In other words, only differential or incremental cash flows should be considered and cash flows which will be the same for all alternatives are irrelevant for decision making.

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Non-relevant costs: o Past costs / sunk costs o Committed Costs – costs that cannot be changed by a decision o Notional (or imputed) costs – example, a transfer price between two departments within an organisation – there is no cash flow. o Depreciation and provision for bad debts LaiACCT3500/19 (lecture 5) 1

o Fixed Costs in general – e.g. head office costs. However, directly attributable (specific) fixed costs can be relevant (if a fixed cost comes about because of a decision or is not incurred because of a decision, then it is a relevant cost to the decision, e.g. hiring a special equipment if the decision is taken).

● Example of a make or buy decision: Rich Student Company produces a component X which is used to manufacture another product sold by the company. Component X has a budgeted unit manufacturing cost as follows: $ Direct material 14 Direct labour 12 Variable production overhead 8 Fixed production overhead 20 Total cost per unit 54 The company is not currently working at full capacity. The direct workers are hired on a daily basis (without any contractual agreement) and the direct materials will have to be purchased if the component is manufactured internally. The Poor Lecturer Company has offered to supply component X at a price of $50 per unit for the next two quarters. Should Rich Student Company purchase component X from Poor Lecturer Company? Intuitive answer?

● Determining the relevant / differential costs:

Direct material Direct labour Variable production overhead Fixed production overhead Cost of purchase

Make $ 14 12 8 20 54

Buy $ 20 50 70

The relevant costs between the two alternatives are: Make $ Direct material 14 Direct labour 12 Variable production overhead 8 Cost of purchase 34

Buy $ 50 50

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Additional costs of manufacturing ($34) are lower than purchase price ($50) from Poor Lecturer Company, therefore Rich Student Company should not purchase component X from Poor Lecturer Company.

o Note that the cost of manufacturing component X will be recorded in the financial accounts as $54 per unit and using this cost would lead to the incorrect decision being made - $54 versus $50 per unit.

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Cost relevancy depends on the situation: o In the above example, direct labour cost is relevant because the workers were hired on a daily basis, but if they are employed on a contractual basis, then direct labour cost will be the same for both alternatives over the short-term and become irrelevant. o In the above example, direct material cost will be an irrelevant cost if the company has already purchased the materials which are now surplus to requirements, the materials have no alternative use and cannot be sold as scrap. o Short-term irrelevant costs can become relevant over the long term.

● Opportunity cost – the cost of losing a benefit because one alternative is chosen over another. An opportunity cost is a relevant cost.  Lost Contribution as a Relevant Cost - if a decision involves diverting a scarce resource from an activity that already provides the company with a contribution, then the relevant cost of the diversion is the actual cost of the resource PLUS the lost contribution (which is an opportunity cost). Example - Material costing $10 is used in a process to make one unit of product X. The material is in short supply. Each product X provides a contribution of $20 to the company. If we divert material from product X to make product Y, the relevant cost of making Y for decision making purposes is $30 [$10 (the cost of the material) + the lost contribution of $20].

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Make or buy decisions with opportunity costs: ● In the original example, it was assumed that the Rich Student Company was not working at full capacity. If the company is operating at full capacity, and manufacturing one unit of component X will mean a diversion of 2 direct labour hours which are currently used in the making of product Y and yielding a contribution of $9 per direct labour hour, then the opportunity cost of manufacturing component X internally is $18 per unit.

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Hence the relevant costs between the two alternatives are: Make $ Direct material 14 Direct labour 12 Variable production overhead 8 Opportunity cost of using scarce resource18 Cost of purchase 52

Buy $ 50 50

In such a situation, Rich Student Company should buy component X from Poor Lecturer Company.

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Decision making under the constraint of scarce resources: ● Situation – o company cannot produce the required volume to meet sales demand due to certain scarce resources (limiting factors) such as shortage of labour, materials, or equipment. In the short term, it is not possible to overcome these shortages. o if the company produces a range of products, the issue is deciding on the optimum production plan / mix that will maximize profit.

● Optimum production plan rule: (a) calculate the contribution per limiting factor for each product and then rank the products in order of profitability based on this calculation. (b) allocate the scarce resources in accordance with the ranking. ● Example: Perth Company manufactures three products X, Y and Z for which the following information is available for the next production period: X Y Z Selling price per unit $52 $40 $36 Variable cost per unit $28 $20 $24 Machine hours required per unit 12 4 2 Estimated sales demand in units 400 400 400 Required machine hours 4,800 1,600 800 Machine capacity is limited to 4,800 hours for the period, and is insufficient to meet total sales demand. What product mix should be produced that will maximize profit for the period?

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● Solution: Step (a) - calculate the contribution per limiting factor for each product and then rank the products in order of profitability based on this calculation. Note: The “intuitive” response is to rank them according to their unit contribution but this will not produce the optimal solution. Product X Contribution per unit $24 Machine hours required per unit 12 Contribution per machine hour $2 Ranking 3 Ranking based on unit contribution 1

Product Y $20 4 $5 2 2

Product Z $12 2 $6 1 3

Step (b) - allocate the scarce resources in accordance with the ranking. Optimal product mix: Production Machine hours used Balance of available machine hours 400 units of Z 800 4,000 400 units of Y 1,600 2,400 200 units of X 2,400 4,800 Total contribution = ($12 x 400) + ($20 x 400) + ($24 x 200) = $4,800 + $8,000 + $4,800 = $17,600. Note: Total contribution if based on unit contribution ranking = $24 x 400 = $9,600.

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Qualitative factors:  Factors which affect decision-making but can only be expressed in monetary terms only with much difficulty or imprecision.  Qualitative factors should be brought to the attention of management during the decision making process, otherwise a wrong decision may be made.  Manufacturing a component internally may be more costly than buying from an outside supplier. However, the latter alternative could result in the closing down of the company’s facilities for manufacturing the component, leading to redundancies and a decline in employees’ morale which could affect future output. In addition, the company will be dependent on an outside supplier who may not always be reliable in the future, thus resulting in a loss of goodwill and future sales. Decline in employee morale and loss of goodwill are qualitative factors which are not easy to quantify in monetary terms. Additional qualitative factors to consider are loss of control, loss of skills, customer perception of the company.  Management has to attach weighting to these factors, for instance, if the component can be obtained from many suppliers and repeat orders for the company are unlikely, then the company may attach little weighting to the qualitative factor of loss of goodwill.  Alternatively, if the component can be obtained from only one supplier and the company relies heavily on repeat sales to existing customers, then the qualitative factor of loss of goodwill will be of considerable importance. LaiACCT3500/19 (lecture 5) 5

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Non-Financial Information: • Is it useful? Should the management accountant provide it? • Management Accounting will rarely provide enough information by itself to permit an informed decision to be taken. • Example, consider Baku Metro – quality, safety, time.

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Conclusions: o Management accountant concentrates on contribution for short-term decisionmaking. o Financial accountant concentrates on the bottom line – profit. o Relevant costs can be confusing, especially if they include opportunity costs.

● Readings: • Drury C, Management and Cost Accounting, 9th edition, 2015, Cengage Learning, chapter 9. • Proctor R, Managerial Accounting: Decision Making and Performance Management, 4th edition, 2012, Pearson, chapters 6 and 7.

LaiACCT3500/19 (tutorial 5)

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ADA University, School of Business ACCT3500 Managerial Accounting, Spring 2019 Tutorial 5 – Relevant costs and decision making  Issue 1 (make or buy decision): Stacey Company produces a component X which is used to manufacture another product sold by the company. Component X has a budgeted unit manufacturing cost as follows: $ Direct material 21 Direct labour 18 Variable production overhead 12 Fixed production overhead 30 Total cost per unit 81 (a) The company is not currently working at full capacity. The direct workers are hired on a daily basis (without any contractual agreement) and the direct materials will have to be purchased if the component is manufactured internally. The Gypsy Company has offered to supply component X at a price of $75 per unit for the next two quarters. Should Stacey Company purchase component X from Gypsy Company? (b) Should Stacey Company purchase component X from Gypsy Company if the company is operating at full capacity, and manufacturing one unit of component X will mean a diversion of 1 direct labour hour which is currently used in the making of product Y and yielding a contribution of $27 per direct labour hour?  Issue 2 (Production Plans when resources are scarce): The Leather Goods division of the “Buy First Pay Later” Company (an imaginary company, of course), makes briefcases, coats and dirndls. The budgeted selling price and costs associated with each product (based on normal production) are as follows:

Labour (£6 per hour) Leather (£6 per sq. metre) Variable Overheads Fixed Overheads Total Cost Selling Price Profit

Briefcases 6 18 8 14 46 80 34

Coats 12 24 6 2 44 85 41

Dirndls 8 9 6 15 38 60 22

Normally, the monthly demand is for 700 briefcases, 400 coats and 200 dirndls and no stocks of finished goods are held. During the coming months the supply of leather will be limited to 3000 square metres per month. Required Write a short report to the manager of the Leather Goods division calculating the best production plan for the coming months and explaining the reasoning behind the method that you have used to work it out. Comment on your recommendation. Homework assignment: What is the optimal production plan if leather was in plentiful supply but labour will be limited to 1,100 hours per month? Check out your answers with each other. LaiACCT3500/19 (tutorial 5)

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Issue 3: (a) Why is it important to recognize qualitative factors when presenting information for decision making? Provide examples of qualitative factors. (b) What underlying principle should be followed in determining the relevant costs for decision making? (c) Define limiting factors.

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Issue 4: LA Limited manufactures three products X, Y and Z, the selling price and cost details of which are given below: X Y Z $ $ $ Selling price per unit 75 95 95 Direct materials ($5 per kg) 10 5 15 Direct labour ($4 per hour) 16 24 20 Variable overhead 8 12 10 Fixed overhead 24 36 30 In a period when direct materials are restricted in supply, determine the most and the least profitable uses of direct materials. (CIMA Stage 2)

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Issue 5: A company produces a range of products and absorbs production overhead using a rate of 200 % on direct wages. This rate was calculated from the following budgeted figures: $ 64,000 96,000 80,000

Variable overhead production costs Fixed overhead production costs Direct labour costs

The cost of making component X, which forms part of product Y, is stated below: $ Raw materials 4 Direct labour 8 Production overhead 16 28

Component X could be bought from an outside supplier for $20. You are required, assuming that fixed production costs will not change, to: (a) State whether the company should continue making component X or buy it from outside. (b) Comment on the principle you have followed in your cost analysis to arrive at your answer in (a) above. (CIMA Cost Accounting 1)

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Issue 6: The Sleeping Bag division of the “Take It Easy” Company, makes a variety of sleeping bags namely silk-lined, cotton-lined and wool-lined. The budgeted selling price and costs associated with each type of sleeping bag (based on normal production) are as follows:

Labour (£8 per hour) Material Variable Overheads Fixed Overheads Total Cost Selling Price Profit

Silk 10 13 8 14 45 90 45

Cotton 6 12 12 10 40 76 36

Wool 4 6 13 8 31 60 29

Normally, the monthly demand is for 800 silk-lined, 500 cotton-lined and 600 wool-lined sleeping bags. No stocks of finished goods are held. During the next three months the workers will be taking their annual holidays and labour time will be limited to 900 hours per month. Required The Financial Accountant has said that, when labour is scarce, the products with the maximum profit should be emphasized. Therefore, she states that the silk-lined sleeping bags are the best product to make, followed by the cotton-lined bags and finally the wool-lined bags. Write a report to the manager of the Sleeping Bag division setting out the production plan that will maximize profits during the next three months. You should explain the reasoning behind the method that you have used to work out your plan. You should also state whether or not you agree with the Financial Accountant and support your argument with calculations.

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