Measuring Relevant Costs and Revenues PDF

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The course discusses roles of management accounting, different types of management accounting systems, and how they are used....

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Measuring Relevant Costs and Revenues for Decision-making     

Decision making involves choosing between alternatives Decision making requires only relevant costs and revenues to the alternatives Planning a time horizon: not to focus on the short-term but to maximize long-term benefits Future cash flows will differ between various alternatives Relevant costs and revenues are required for special studies such as: 1. 2. 3. 4. 5.

Special selling price decisions Product mix decisions when capacity constraints exist Decision on replacement of equipments Outsourcing (make or buy) decisions Discontinuation decisions

1. SPECIAL PRICING DECISIONS: The Caledonian Company is a manufacturer of clothing that sells its output directly to clothing retailers in the UK. One of its departments manufactures sweaters. The department has a production capacity of 50 000 sweaters per month. Because of the liquidation of one of its major customers, the company has excess capacity. For the next quarter, current monthly production and sales volume is expected to be 35 000 sweaters at a selling price of £40 per sweater. Expected monthly costs and revenues for an activity level of 35 000 sweaters are as follows:

Caledonian is expecting an upsurge in demand and considers that the excess capacity is temporary. Therefore, even though there is sufficient direct labour capacity to produce 50 000 sweaters, Caledonian intends to retain the temporary excess supply of direct labour for the expected upsurge in demand. A leisure company located overseas has offered to buy 15 000 sweaters each month for the next three months at a price of £20 per sweater. The company would pay for the transportation costs and thus no additional marketing and distribution costs will be incurred. No subsequent sales to this customer are anticipated. The company would require its company logo inserting on the sweater and Caledonian has predicted that this will cost £1 per sweater. Should Caledonian accept the offer from the company?

Measuring Relevant Costs and Revenues for Decision-making

2. PRODUCT MIX DECISIONS WHEN CAPACITY CONSTRAINTS EXIST: Such as shortage of skilled labour, materials or space. These scarce resources are known as limiting factors. Example: A farmer in Ruritania has 240 000 square metres of land on which he grows maize, potatoes, barley and wheat. He is planning his production for the next growing season. The following information is provided relating to the anticipated demand and productive capacity for the next season:

It is not possible in the short run to increase the area of land beyond for growing the above crops. You have been asked to advise on the mix of crops that should be produced during the period.

Measuring Relevant Costs and Revenues for Decision-making We can now summarize the allocation of the of land:

The above allocation results in the following total contribution:

 This approach applies only to those situations in which capacity constraits cannot be removed in the short term.

3. REPLACEMENT OF EQUIPMENT: Replacement of equipment approach is a capital investment or long-term decision. One aspect of asset replacement decisions is how to deal with the book value of old equipment Example: Three years ago the Anytime Bank purchased a cheque sorting machine for £120 000. Depreciation using the straight line basis, assuming a life of six years and no salvage value, has been recorded each year in the financial accounts. The present written-down value of the machine is £60 000 and it has a remaining life of three years. Recently a new sorting and imaging machine has been marketed that will cost £50 000 and have an expected life of three years with no scrap value. It is estimated that the new machine will reduce variable operating costs from £50 000 to £30 000 per annum. The current sales value of the old machine is £5000 and will be zero in three years’ time.

Measuring Relevant Costs and Revenues for Decision-making

4. Outsourcing and make or buy decisions: Outsourcing is the process of obtaining goods or services from outside suppliers instead of producing the same goods or providing the same services within the organization. Decisions on whether to produce components or provide services within the organization or to acquire them from outside suppliers, are called outsourcing or ‘make-or-buy’ decisions. Example: A division currently manufactures 10 000 components. The costs are as follows:

Measuring Relevant Costs and Revenues for Decision-making Example: A supplier has offered to supply 10 000 components per annum at a price of £30 per unit for a minimum of three years. If the components are outsourced the direct labour will be made redundant. Direct materials and variable overheads are avoidable and fixed manufacturing overhead would be reduced by £10 000 per annum but non-manufacturing costs would remain unchanged. The capacity has no alternative uses. Assuming there is no alternative use of the released internal capacity arising from outsourcing annual costs will be as follows:

5. DISCONTINUATION DECISIONS: Organizations analyze profit by one or more cost objects such as products, services, customers and locations. Periodic profitability analysis highlights unprofitable/profitable activities that require a detailed appraisal whether or not they should be continued or discontinued Example: Assume the periodic profitability analysis of sales territories reports the following:

Assume that special study indicates that £250 000 of Central fixed costs and all variable costs are avoidable and £108 000 fixed costs are unavoidable if the territory is discontinued. The relevant financial information is as follows:

Measuring Relevant Costs and Revenues for Decision-making

Columns 1 and 2 can be presented or just column 3 which shows that the relevant revenues arising from keeping the territory open are £900 000 and the relevant (incremental) costs are £848 000.Therefore Central provides a contribution of £52 000 towards fixed costs and profits....