Lesson 2 Relevant Costing PDF

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Warning: TT: undefined function: 32 Warning: TT: undefined function: 32SAN PEDRO COLLEGE12 C. Guzman Street, 8000 Davao City, PhilippinesMaster of Arts in Hospital Administration Third Trimester, SY 2019-ACCOUNTING & FINANCIAL MANAGEMENTLESSON 2 – RELEVANT COSTINGTHE DECISION-MAKING PROCESS ...

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SAN PEDRO COLLEGE 12 C. Guzman Street, 8000 Davao City, Philippines

Master of Arts in Hospital Administration Third Trimester, SY 2019-2020

ACCOUNTING & FINANCIAL MANAGEMENT LESSON 2 – RELEVANT COSTING THE DECISION-MAKING PROCESS

1. 2. 3. 4.

Definition of the DECISION PROBLEM. Identification of the DECISION CRITERIA. Selection of possible ALTERNATIVE COURSES OF ACTION . Collection of the RELEVANT DATA and assessment of its quantitative and qualitative factors involved in each alternative. 5. Formulation of a DECISION by selecting the best alternative.

Limitations of the Decision-Making Process: a. Insufficiency or excessiveness of information. b. Misidentification of the decision problem. c. Overconfidence in the decision outcome. IDENTIFY RELEVANT COSTS & BENEFITS

Costs that differ between alternatives are relevant in a decision. All other irrelevant costs and benefits should be ignored. In addition, managers need different costs for different purposes. 1. RELEVANT COST and IRRELEVANT COST – The former refers to future differential costs, while the latter refers to the cost that neither varies in amount from one alternative to another nor involves incurrence in the future. 2. DIFFERENTIAL COST and MARGINAL COST – The former refers to the difference in cost between two alternatives, while the latter refers to the increase in total cost arising from the production or sale of additional unit of a product. 3. DIRECT COST and INDIRECT COST – The former refers to the cost which can be directly attributable to a product, service, or department while the latter refers to the cost which is allocated to other product, service or department.

4. AVOIDABLE COST and UNAVOIDABLE COST – The former refers to the cost that can be eliminated by choosing one alternative over another, while the latter refers to the cost that would be incurred regardless of chosen decision. 5. OUT-OF-POCKET COST and SUNK COST – The former refers to the cost which are to be incurred in the future, while the latter refers to the cost which are already incurred in the past decisions and cannot be avoided regardless of what a manager decides to do. 6. OPPORTUNITY COST and IMPUTED COST – The former refers to the potential income or benefit foregone by choosing another alternative, while the latter refers to the value assigned to an item but which has not been the result of any transaction. APPROPACHES IN ANALYZING ALTERNATIVE IN NON-ROUTINE DECISION MAKING

1. TOTAL APPROACH – considers all costs, whether relevant or not. 2. INCREMENTAL APPROACH – considers only relevant costs. Both approaches yield the same results. The best approach to use depends on information availability. If the required information is available for both alternatives, use the total approach for a better and clearer information. Using both approaches are also better for comparison and validation of answers and solutions if enough time is available. TYPES OF SHORT-TERM DECISION

1. MAKE or BUY –

Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead (savings foregone) Opportunity cost (profit foregone) Purchase price Total relevant costs

Cost to Make xx xx xx

Cost to Buy

xx xx __ xx

xx xx

Decision Criteria: If Cost to Make ˃ Cost to Buy, then choose Buy. If Cost to Make ˂ Cost to Buy, the choose Make. Note:

Selling & administrative expenses, whether variable or fixed, are assumed irrelevant except they vary across alternatives.

Illustration: Sylistic Guitar Center produces a premium multifunctional acoustic guitar that is far superior to other guitars on the market. It currently sells 200 units of acoustic guitar for P4,400 per unit. The company is considering acquiring the acoustic guitars from JR Guitar Company, a manufacturer of custommade guitars. The costs incurred in the production of acoustic guitars are as follows: Per unit Total Materials (wood) P1,000 P200,000 Salary of luthier (guitar maker) 1,500 300,000 Variable overhead (strings, glue, sealer) 500 100,000 Fixed overhead 600 120,000 P3,600 P720,000 JR Guitar Company is offering to sell the guitars to Stylistic Guitar for P3,400 per unit. Required: 1. Based on the above assumptions, which decision is better for the management and by how much is the savings? Answer – Solution –

Make, savings of P80,000.

Direct materials (P1,000 x 200) Direct labor (P1,500 x 200) Variable manufacturing overhead (P500 x 200) Purchase price (P3,400 x 200)

Make P200,000 300,000 100,000 ________ P600,000

Net savings/ advantage of producing guitars

Buy

P680,000 P680,000 P80,000

2. Assume that Stylistic Guitar could save up to P90,000 of fixed overhead from its current leasing of a woodworking equipment if it chooses to buy guitars from JR Guitar, which decision is better for the management and by how much is the savings? Answer – Solution –

Buy, savings of P10,000.

Direct materials (P1,000 x 200) Direct labor (P1,500 x 200) Variable manufacturing overhead (P500 x 200)

Make P200,000 300,000 100,000

Buy

Make

Buy

Fixed manufacturing overhead savings – opportunity foregone 90,000 Purchase price (P3,400 x 200) ________ P690,000

P680,000 P680,000

Net savings/ advantage of buying guitars

P10,000

3. Assume that instead of saving up P90,000 fixed overhead from leasing a woodworking equipment, Stylistic Guitar could rent out for P 100,000 the building space that it used to manufacture guitars, which decision is better for the management and by how much is the savings? Answer – Solution –

Buy, savings of P20,000.

Direct materials (P1,000 x 200) Direct labor (P1,500 x 200) Variable manufacturing overhead (P500 x 200) Purchase price (P3,400 x 200) Rental of unused building space - opportunity cost

Make P200,000 300,000

Buy

100,000 P680,000 100,000 P700,000

Net savings/ advantage of buying guitars

________ P680,000 P20,000

4. Before making the final decision, Stylistic Guitar’s management will have to assess the qualitative factors of either making or buying the guitars. Identify some of these factors. Answer – a. b. c. d.

Quality of guitars Future technological advancements of the guitars Commitment of guitar suppliers Potential income of leasing out or using the unused building space

ADDING or DROPPING PRODUCTS/ SEGMENTS –

Incremental loss on revenues if dropped Less: Incremental savings on costs if dropped: Variable costs Avoidable fixed costs Opportunity cost (profit foregone) Incremental decrease in profit if dropped

(xx) xx xx xx (xx)

Decision Criteria: If Avoidable Fixed Costs is ˃ Contribution Margin, then choose Drop the product or segment. If Avoidable Fixed Costs is ˂ Contribution Margin, then choose Continue the product or segment. Note: In case of adding products/ segments, contribution margin must be greater than avoidable fixed costs. Illustration: Ace International has three major product lines – homewares and decors, stationery and craft, and health and beauty. The latest income statements of the product lines are given below: Product Line _ Homewares Stationery Health & Total & Decors & Craft Beauty Sales P2,500,000 P1,250,000 P750,000 P500,000 Variable expenses 1,050,000 500,000 250,000 300,000 Contribution margin P1,450,000 P 750,000 P500,000 P200,000 Fixed expenses: Salaries & wages P 500,000 P 295,000 P125,000 P 80,000 Marketing 150,000 10,000 75,000 65,000 Utilities 20,000 5,000 5,000 10,000 Depreciation 50,000 10,000 20,000 20,000 Rentals 200,000 100,000 60,000 40,000 Insurance 30,000 20,000 5,000 5,000 General admin 300,000 150,000 90,000 60,000 Total fixed expenses P1,250,000 P 590,000 P380,000 P280,000 Net profit (loss) P 200,000 P 160,000 P120,000 (P80,000)

The management analyzed the fixed costs being charged to the three product lines as follows: a. Salaries and wages – represent the labor paid to employees working directly on the products. All of the employees working in the health and beauty would be discharged if the product line is dropped. b. Marketing – represents the advertisements and promotions that are specific to the product line and are avoidable if the line is dropped. c. Utilities – represent the light, water and communication costs for the entire company. They are allocated to the product line based on space occupied and are not avoidable if the product line is dropped. d. Depreciation – represents the depreciation on furniture and fixtures used to display the various product lines which do not have resale value even if the health and beauty is dropped. e. Rentals – represent the noncancelable, long-term lease on the entire building of the company which is allocated based on the area size. f. Insurance – represents insurance premiums carried on inventories of each three product lines. If a product line is dropped, the related inventories will be liquidated and the premiums will decrease accordingly. g. General administrative – represents the costs of accounting, purchasing and general management, which are allocated to the product lines. Such costs will not change if the product line is dropped. Required: 1. With the above information, should production and sale of health and beauty be dropped? Answer – No, dropping the product line will incur additional loss of P50,000. Solution – Incremental loss on revenues Less: Incremental savings on costs: Variable costs Avoidable fixed costs (80,000 + 65,000 + 5,000) Incremental decrease in profit

(500,000) 300,000 150,000 ( 50,000)

Based on the computation, the company would suffer additional loss of P50,000 if it decides to drop the health and beauty product (h &b) line.

The extra loss of P50,000 can also be analyzed as follows: Effect Keep Drop on H&B H&B Profit Sales P500,000 (P500,000) Variable expenses (300,000) 300,000 Contribution margin P200,000 (P200,000) Avoidable fixed expenses: Salaries & wages P 80,000 P 80,000 Marketing 65,000 65,000 Insurance 5,000 5,000 Total (P150,000) P150,000 Segment margin P 50,000 (P50,000) Allocated fixed expenses: Utilities P 10,000 P 10,000 Depreciation 20,000 20,000 Rentals 40,000 40,000 General admin 60,000 60,000 ___-____ Total P130,000 (P130,000) _ Net profit (loss) (P80,000) (P130,000) (P50,000) 2. Indicate some of the qualitative factors that the company must consider before dropping the product line. Answer – a. Introduction of a new profitable product line b. Attractiveness of the product line to customers Illustration: The Flint Fan Company is considering the addition of a new model fan, the F27, to its current product lines. The expected cost and revenue data for the F-27 fan are as follows: Annual sales 4,000 units Unit selling price P58 Unit variable costs: Production P34 Selling P4 Avoidable fixed costs per year: Production P20,000 Selling P30,000 If the F-27 model is added as a new product line, it is expected that the contribution margin of other product lines at Flint will drop by P7,000 per year.

Required: 1. If the F-27 product line is added next year, how much is the change in operating income? Answer – Net increase of P23,000. Solution – Incremental sales (58 x 4,000) Less: Incremental costs: Variable costs (38 x 4,000) Avoidable fixed costs (20,000 + 30,000) Incremental increase in profit Decrease in contribution margin of other product lines (opportunity cost) Net increase in operating income

P232,000 (152,000) ( 50,000) 30,000 ( 7,000) P 23,000

2. What is the lowest unit selling price that could be charged for the F-27 model and still make it economically desirable for Flint to add the new product line? Answer – P52.25 Solution – Incremental costs: Variable costs Avoidable fixed costs ( 50,000/ 4,000) Decrease in contribution margin of other product lines (7,000/ 4,000) Lowest unit selling price

P38.00 12.50 1.75 P52.25

SELL “AS IS” or PROCESS FURTHER –

Sales value after further processing Less: Sales value at the split-off point Incremental revenue from further processing Less: Incremental processing costs incurred after the split-off point Incremental increase in profit if processed further

xx (xx) xx (xx) xx

Decision Criteria: If Incremental Revenue ˃ Incremental Cost of Processing, then choose Process Further. If Incremental Revenue ˂ Incremental Cost of Processing, then choose Sell at Split-off Point Note:

Joint or common costs are treated as irrelevant costs.

Illustration: Renaissance Wool Company buys raw wall from local sheepherders, separates the wool into three grades – coarse, fine and superfine, and then dyes the wool using traditional methods that rely on pigments from local materials. A diagram of the production process is shown below:

Required: 1. What is the overall profit if all intermediate products are processed into final products? Answer – P20,000 Solution – Combined final sales value (170,000 + 250,000 +100,000) Less: Cost of producing the end products Joint costs (300,000 + 50,000) Additional processing costs (60,000 + 70,000 + 20,000) Overall profit

P520,000 350,000 150,000 P 20,000

2. What is the profit from further processing each of the intermediate products? Answer – Coarse Wool (loss of P20,000), Fine Wool (profit of P20,000), and Superfine Wool (profit of P10,000) Solution –

3. If your recommendation is followed, what should be the overall profit of the company? Answer – P40,000 Solution – Combined final sales value (130,000 + 250,000 +100,000) Less: Cost of producing the end products Joint costs (300,000 + 50,000) Additional processing costs (70,000 + 20,000) Overall profit

P480,000 350,000 90,000 P 40,000

TEMPORARY SHUTDOWN or CONTINUE –

Incremental loss on revenues if shutdown Less: Incremental savings on costs if shutdown: Variable costs Avoidable fixed costs Incremental decrease in profit if shutdown

(xx) xx xx (xx)

Decision Criteria: If Avoidable Fixed Costs is ˂ Contribution Margin, then choose Continue the business operation. If Avoidable Fixed Costs is ˃ Contribution Margin, then choose Temporary Shutdown of the business operation. The shutdown point (indifference point) is that estimated sales, in pesos or units, that must be generated in order to equal the loss to be incurred if business operations were discontinued. It can be formulated as:

Sales at Shutdown Point(p) = Fixed Costs – Shutdown Costs* Contribution Margin Ratio Sales at Shutdown Point(u) = Fixed Costs – Shutdown Costs* Unit Contribution Margin

*

Shutdown costs refer to the costs, such as security and maintenance and other unavoidable costs, that the company will continue to incur even when there is no operation.

Illustration: Phoelab Company plans to discontinue a department that has a contribution margin of P24,000 or P4.00 per unit. Its sales are P60,000 and fixed costs are P48,000. Of the fixed cost, P21,000 cannot be eliminated. Required: 1. Should the company temporarily shutdown or continue its operation? Answer – Continue its business operation.

Solution – Incremental loss on contribution margin if shutdown Less: Avoidable fixed costs (48,000 – 21,000) Incremental increase in profit if shutdown

(P24,000) 27,000 P 3,000

2. How many units is currently sold? Answer – 6,000 units Solution – Sales = P24,000/ P4.00 per unit 3. How much is the shutdown costs? Answer – P21,000 4. What is the shutdown point? Answer – P67,500 or 6,750 units Solution – Sales at Shutdown Point(p) = P48,000 – 21,000 = P67,500 40%* * sales 60,000 10 less: variable cost 36,000 6 contribution margin 24,000 4

100% 60% 40%

Sales at Shutdown Point(u) = P48,000 – 21,000 = 6,750 P4 5. What are the possible qualitative factors to consider before shutting down temporarily? Answer – a. b. c. d.

Shortage in materials and other supplies Labor unrest Effect on company’s image Loss of customer’s confidence

ACCEPT OR REJECT SPECIAL SALES ORDER –

Incremental revenues from special order Less: Incremental costs from special order: Direct materials Direct labor Variable manufacturing overhead Variable selling and administrative Additional variable costs* Opportunity cost (profit foregone) Incremental profit from special order

*

xx xx xx xx xx xx xx

(xx) xx

design cost, overtime cost, subcontracting cost, etc.

Decision Criteria: If Special Order Price is ˃ Avoidable Costs plus Opportunity Costs, the choose Accept the special order. If Special Order Price is ˂ Avoidable Costs plus Opportunity Costs, the choose Reject the special order. A special order is a one-time order that is not considered part of the company’s normal business operations. If the company has excess production capacity, the minimum selling price is equal to the relevant variable costs if the special order is rejected. If, however, the company is operating at full production capacity (no excess capacity for the special order), the minimum selling price is equal to the sum of the relevant variable costs and opportunity costs (contribution margin to be lost from regular customers). Illustration: Atom Company is a manufacturer of electronic switches. One of their products, “Sensory Switch,” is used as a component of most electrical appliances. Sensory Switch has the following financial data per unit: Selling price P180 Variable costs: Materials P24 Labor 18 Factory overhead 15 Shipping and handling 3 60

Fixed costs:

Factory overhead

P36

Selling and administrative 14 50 Total P110 During the month, Atom has received a special, one-time order for 1,500 units of Sensory Switch. Required: 1. Assuming that the company has excess capacity that is enough to produce this special order without affecting sales to regular customers, and the company wants to improve its profitability, the price that is acceptable for this special, one-time order in excess of what amount? Answer –

P60.00 per unit

Solution – Incremental revenues from special order Less: Incremental costs from special order: Variable manufacturing costs (24 + 18 + 15 + 3) Incremental profit from special order

xx

60 xx

2. Assume that Atom is operating at full capacity and that it does not want to incur a loss from this order, the minimum acceptable price is what amount? Answer –

P180.00 per unit

Solution – Incremental revenues from special order Less: Incremental costs from special order: Variable manufacturing costs (24 + 18 + 15 + 3) 60 Opportunity cost on lost sales (180 – 60) 120 Incremental profit from special order

xx

180 xx

3. Assume that the excess capacity available for the special order is only 1,000 units, so that if the order were accepted, Atom would have to reduce sales to regular customers. What is the minimum price for this special order? Answer –

Solution –

P100.00 per unit

Incremental revenues from special order Less: Incremental costs from special order: Variable manufacturing costs (24 + 18 + 15 + 3) 60 Opportunity cost on lost sales (180 – 60 = 120 x 500/1,500) 40 Incremental profit from special order

xx

100 xx

4. What are the qualitative factors that Atom Company should consider before making a decision on whether to accept or reject a special sales order? Answer – a. Excess or idle production capacity b. Production capability of existing machinery, labor and facilities c. Impact on customers relations such as delivery delays and special-order pricing