Relevant Costing Problem for SELL AS IS OR Process Further decision PDF

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ACT 1107_STRATCO_RELEVANT COSTING_05 (SELL AS IS OR PROCESS FURTHER)

SELL AS IS OR PROCESS FURTHER Much like with the dilemma of accepting or rejecting a special order, the question whether to sell a product as is (aka at split-off point) or process it further is focused on the incremental (aka additional profit). If you sell a product as is, you would no longer incur costs. On the other hand, processing a product further would entail additional cost but also an opportunity to increase sales price. If the additional (or incremental) revenue due to the increase in sales price is greater than the additional (or incremental) cost, it would be advisable to process further to maximize profit. Illustration 1 Aling Nena Corporation produces three main products. Its production and costs data are given below: Product Unit sales price before processing further Unit sales price after processing further Cost of separate further processing Units produced and sold Total joint costs

WALANG

GANUN

MARS

250

530

190

300

550

220

120,000

65,000

190,000

2,000

4,000

7,500

1,400,000

Which of the products should be processed further? Solutions/Discussions:

Incremental sales Incremental costs Increase (decrease) in profit 1 2,000 units x ₱50*

WALANG 100,0001 (120,000)

GANUN 80,0002 (65,000)

MARS 225,0003 (190,000)

(20,000)

15,000

35,000

2

4,000 units x ₱20*

3

7,500 units x ₱30* *Selling price (after less before) With the computation, it is apparent that:  Products GANUN and MARS should be processed further. Their incremental revenue > incremental cost  Product WALANG should be sold now at split-off point. Its incremental revenue < incremental cost. Notice also the following:  Incremental sales equals increase in unit sales price times the number of units sold. The unit sales price normally increases after further processing.  Incremental costs are those incurred in the act of processing further the product.  The total joint cost is irrelevant in this decision because it does not change regardless of selling the products at split-off point or processing further. Illustration 2 Practice Corporation produces three products at segregation point, Four, Tee, and Chood. These products could be processed further then later sold at higher sales value. The total joint cost in manufacturing these three products was P3 million. The data below were made available by the accounting and production personnel: Product Production and sales in units Unit sales price at split-off point Unit sales price after further processing Unit variable cost of subsequent processing

Four

Tee

Chood

10,000

40,000

50,000

80

100

200

90

120

230

8

18

27

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ACT 1107_STRATCO_RELEVANT COSTING_05 (SELL AS IS OR PROCESS FURTHER)

If product Four is processed further, a machine should be rented at a cost of ₱12,000. To process further product Tee an outside contractor will be engaged for an amount of ₱90,000 because the company has no available space and manpower for its subsequent processing. Product Chood could be subsequently processed by using idle machine and manpower time within the company. The total setup cost of subsequently processing product Chood is ₱120,000. Which product should be processed further to maximize profit? Solutions/Discussions: Again, to answer this, determine first the incremental revenue from the increase in selling price and determine the incremental cost of processing the products further.

Incremental sales1 Incremental costs: Variable cost2 Fixed cost3 Increase (decrease) in profit

FOUR 100,000 (80,000) (12,000) 8,000

TEE 800,000

CHOOD 1,500,000

(720,000) (1,350,000) (90,000) (120,000) (10,000)

30,000

1

Increase in selling price x units sold Incremental unit variable cost x units sold 3 Given

Another question: To maximize profit, what is the minimum sales price for product Four that should be set after it is processed further? This is a situation where you can work back the answer. Minimum sales price means the selling price that would cover the initial selling price and the incremental costs. The original selling price is ₱80. Accordingly the incremental costs per unit are ₱8 (variable cost) and ₱1.20 (fixed cost of ₱12,000 distributed over the total units of 10,000). You would want to at least cover these figures in setting up your new selling price so as to avoid incurring losses. FOUR ₱80.00 8.00 1.20

Unit sales price at split-off point Unit variable cost of processing further Incremental fixed cost Minimum sales price after further processing

₱89.20

Now try this on your own: AWTS DO DIRTY Company produces the following products from a joint process costing ₱450,000 per batch of 5,000 units. Other related data are also presented below:

2

Note that the joint cost is a sunk cost as it was already incurred at the split-off point and therefore cannot be avoided in either decision to sell as is or process further. It is irrelevant in this decision analysis. Products Four and Chood should be processed further, while product Tee is advisable to be sold now.

ROD Units sales price at split-off point Unit sales price after further processing Additional cost of subsequent processing Net realizable value from a by-product of the joint production process Net realizable value from a by-product after further processing

RIG

GOH

200

320

125

230

340

160

340,000

270,000

220,000

28,000

10,000

12,000

50,000

20,000

20,000

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ACT 1107_STRATCO_RELEVANT COSTING_05 (SELL AS IS OR PROCESS FURTHER)

Budgeted units sales Joint production costs

10,000

12,000 3,000,000

18,000

Required: 1. Which product(s) should be processed further? 2. The additional profit from further processing to maximize profit? 3. The relevant costs of further processing to maximize profit. 4. If the company wants a profit of ₱450,000 from further processing, how much should be the maximum additional cost of further processing to be incurred by the company? 5. The sunk cost in the decision to sell the product(s) at split-off point or process further. Note: The net realizable value from the by-product is income that may arise and therefore considered as deduction from the incremental cost to be incurred from processing further.

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