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GE ELEC 6 – BUSINESS LOGICRELEVANT COSTING, DIFFERENTIAL COST ANALYSIS, SHORT-TERM NON- ROUTINE DECISIONSDecision making means choosing between at least two alternative courses of action. Before making the final choice, each alternative is evaluated considering both qualitative and quantitative fact...

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TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY GE ELEC 6 – BUSINESS LOGIC

RELEVANT COSTING, DIFFERENTIAL COST ANALYSIS, SHORT-TERM NONROUTINE DECISIONS

MAKE OR BUY – Choosing between producing an item or buying it from outside suppliers.

Decision making means choosing between at least two alternative courses of action. Before making the final choice, each alternative is evaluated considering both qualitative and quantitative factors.

Decision Guide: Choose the option that involves the lowest relevant costs. Considering also, opportunity costs.

In conducting a quantitative analysis of the different alternatives, it is advisable to identify relevant factors, particularly relevant costs. Relevant Costs – Are future costs that are expected to be different under each alternative course of action. Based on this definition, we can say that relevant costs have two features – differential and futureoriented. Differential Costs – May be increments (increases) or decrements (decreases) in total costs that change from one alternative to another. Future Costs – Refers to planned costs, budgeted costs, projected costs, or estimated costs yet to be incurred in upcoming activities. Other types of costs used in decision making: Avoidable Costs – Costs that will be saved or those that will not be incurred if a certain decision is made. Opportunity Costs – The income or benefit sacrificed or forgone when an alternative is chosen. SOME OF THE SHORT-TERM ROUTINE DECISIONS 1. 2. 3. 4. 5. 6. 7. 8. 9.

NON-

Make or buy Accept or reject a special order Continue or discontinue a business segment Sell as-is or process further Continue operations or temporary shutdown Optimization of scarce resources Maximize or minimize bid price Replace or retain an old asset Determining the indifference point

Sample Problem. Imarflex Company manufactures 5,000 timers a month that it uses in producing oven-toasters. Production costs for each timer unit are as follows: Materials Labor Variable overhead Fixed overhead (based on 5,000) Total

P

P

25 20 15 18 78

The company is considering to purchase the timers from a well-known timing control manufacturer for P65 per unit. If the timers are purchased, the factory space currently used to produce the timers can be used as a warehouse, thus reducing warehouse rental by P5,000 a month. Should Imarflex Company continue to make the timers or just buy them from the outside supplier? Cost to Make Materials (5,000 x P25) Labor (5,000 x P20) Variable OH (5,000 x P15) Warehouse Rental Total

125,000 100,000 75,000 5,000 305,000

Cost to Buy Purchase Price (5,000 x P65)

325,000

Savings if timers are made, 20,000. The company should continue making the timers needed. ACCEPT OR REJECT A SPECIAL ORDER – Pertains to orders outside the regular sales of the business which usually involves large volumes with discounted or lower sales price. Decision Guide: Accept when there is incremental profit – when incremental revenue exceeds incremental cost. Considering also, alternative uses of capacity, if there is any.

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TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY GE ELEC 6 – BUSINESS LOGIC

Incremental profit should be compared with the best benefit that may be derived from alternative use of capacity to get the net advantage or disadvantage from accepting the special order. Sample Problem. Dasmarinas Company produces organic fertilizer which is retailed through farm supply companies. Presently, the company uses 85% of its maximum capacity of 2,000 tons a year. Under its present capacity, the company has the following costs structure of producing a ton of fertilizer: DM DL Var. OH Fx OH Total

P

P

1,600 2,400 2,100 1,000 7,100

The average sales price of the fertilizer is P10,000 per ton. The firm has been approached by a Malaysian company about supplying 250 tons of fertilizer next year at a price of P6,800 per ton, FOB Dasmarinas Company's plant. No production modifications would be necessary to fulfill the order from the Malaysian Company. Required: 1. If no other factors are expected to affect the decision, should Dasmarinas Company accept the special order? Incremental Revenue per ton Incremental Cost per ton DM DL Var. OH Total

P P

P

6,800 1,600 2,400 2,100 6,100

By accepting the special order, the company would generate an incremental profit of P700 per ton or a total of P175,000 for the 250 tons. Therefore, the company should accept the special order. 2. Assuming that the idle capacity can be (a) used to produce another type of fertilizer which would contribute a P160,000 contribution margin or (b) can be rented out for P200,000 a. The company should still accept the special order since the incremental profit (P175,000) from accepting the special order is greater than the contribution margin (P160,000) to be generated if Dasmarinas produced the other type of fertilizer.

b. The company should decline the special order and rent out the idle capacity to outsiders. Since the company can benefit more from the latter, generating P200,000 compared to the incremental profit of P175,000 generated by the special order. 3. What if the Malaysian company instead, ordered 400 tons of fertilizer next year. Should Dasmarinas Company accept the special order? Incremental Profit Opportunity Cost Effect in Overall Profit

P175,000 ( 390,000) ( 215,000)

The company should not accept the special order. Since the company’s excess capacity is only 300 tons, by accepting the special order, it needs to sacrifice 100 tons coming from its regular sales which contributes a P390,000 contribution margin. As a result, this would decrease the overall profitability of the company by P215,000. CONTINUE OR DISCONTINUE A SEGMENT – An organizational segment is referred as any business unit such as a division, product line, or geographical operation. The continuance of which is anchored on its ability to be profitable. Decision Guide: If the segment margin is positive – contribution margin is greater that avoidable fixed costs, continue the business unit assuming no alternative use of released facilities. If there is an alternative use, compare segment margin from the net benefit of the alternative. If segment margin is still greater, then continue. Sample Problem. TuloyBa Company sells three products, A, B and C. Following are the sales and cost data for the three products. Units SP/unit Costs/unit Variable Fixed Total unit cost Profit (loss)/unit

A B C 5,000 6,000 3,000 15 12 20 12 5 17 (2)

5 5 10 2

10 5 15 5

Total fixed cost is allocated among the products based on the units produced and sold. The company does not keep inventories. Production is done based on sales orders received from customers.

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TARLAC STATE UNIVERSITY – COLLEGE OF BUSINESS AND ACCOUNTANCY GE ELEC 6 – BUSINESS LOGIC

Required: 1. Which product, if any, should be eliminated? None. Since the segment margin of Products A, B, and C are still positive. Discontinuing the Production of Product A will only decrease further the overall profitability of the firm by P15,000 (5,000 x P3), equal to Product A’s segment margin. 2. Assuming that if production of product A is discontinued, some customers originally buying A will shift to Product B. It is estimated that B's sales will go up by 1,000. Fixed cost per unit of the remaining products will increase to P7 while the facilities used to produce A can be rented out for P10,000. Should production and sale of Product A be discontinued? Alternative 1. Continue Product A Units SP/unit Costs/unit Variable Fixed Total unit cost Profit (loss)/unit

A B C 5,000 6,000 3,000 15 12 20 12 5 17 (2)

5 5 10 2

10 5 15 5

Total Company Profit A (5,000 x P2) B (6,000 x P2) C (3,000 x P5)

P (10,000) 12,000 15,000 17,000

Alternative 2. Discontinue Product A A Units SP/unit Costs/unit Variable Fixed Total unit cost Profit (loss)/unit

B C 7,000 3,000 12 20 5 7 12 0

10 7 17 3

Total Company Profit B (7,000 x P0) C (3,000 x P3) Rental Income

P

0 9,000 10,000 19,000

The company should discontinue the production of Product A as this would result to an increased overall company profit from P17,000 to P19,000.

SELL AS-IS OR PROCESS FURTHER – If the product is processed further, the unit sales price is expected to increase. However, there is also costs for subsequent processing. Decision Guide: If the incremental revenue is greater than the incremental costs of further processing, it is advisable to process further. TAKE NOTE: The same decision guide applies for decisions regarding sell now or later and scrap or rework a defective unit. Sample Problem. Inseparable Company produces Product Trio in a joint manufacturing process. The joint cost allocated to Product Trio amounts to P10 per unit. At the split-off point, the product can be sold for P15 per unit. The company is considering to incur additional processing cost of P4 for Trio, after which the product can be sold for P22. Should Product Trio be processed further or just sold at the split off point? Incremental Revenue (P22 – P15)

P7

Incremental Cost

P4

The company should process Product Trio further since incremental revenue is greater than the incremental cost of further processing thus, further processing will result to an incremental profit of P3 per unit of each product. CONTINUE OPERATIONS OR TEMPORARY SHUTDOWN – Arises when some internal or external factors adversely affect the operations of the business on a temporary basis which may warrant temporary closure of the business to avoid greater amounts of loss. Decision Guide: If loss from continuing operations is less than the shutdown costs, it is advisable to continue operating. Or simply, if continuing operations will result to sales greater than the shutdown point, it is better to continue operations. Shutdown Point – The level of operations where the loss from continuing is equal to the loss from discontinuing. May be expressed in terms of units or pesos. Shutdown point in units =

FC − SDC UCM

Shutdown point in pesos =

FC − SDC CM ratio

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