Chapter 24

Notes to teachers
1 2

Cost Accounting for Decision-making

This chapter deals with the application of costing concepts and techniques to more complicated business decisions. Teachers are advised to explain the concepts of sunk costs, opportunity costs, incremental costs, relevant costs, irrelevant costs, avoidable costs and unavoidable costs with the use of various examples. This is more useful than merely reciting the definitions. Costs may be avoidable in one situation and not the other. There is no hard and fast rule. Examples are to be used to illustrate different types of business decisions: accept or reject a special order; hire, make or buy products/equipment; sell or process products further; retain or replace equipment, eliminate unprofitable business segments. It is recommended that the topics of sell or process products further, and retain or replace equipment be taught at the end of the chapter as these two types of decisions are the most difficult. When analysing the various proposals for decision-making, the key is to compare the profit or loss before and after the proposal is adopted. The proposal that gives the highest profit or lowest loss is to be chosen.

Q1

The restaurant should accept the order as it can earn a net profit of $48,000 on the order.
Sales revenue (1,000 $550) Variable costs Opportunity cost Delivery charge Net profit $ 550,000 (235,000) (265,000) (2,000) 48,000

Q2 Avoidable costs are the costs which can be reduced or avoided when a certain action is taken. Unavoidable
costs are the costs which have to be incurred regardless of what action is taken.

Q3

Management should make the ice cream itself as the costs are $10,000 lower under this alternative.
Direct materials Direct labour Variable manufacturing overheads Fixed manufacturing overheads Purchase costs Total manufacturing costs Make $ 100,000 150,000 80,000 120,000 450,000 Buy $ 90,000 350,000 440,000

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A1

Incremental costs are the additional costs incurred when a certain action is taken. Avoidable costs are the costs which can be reduced or avoided when a certain action is taken. Incremental costs and avoidable costs are opposite in nature. In this case, we need to consider the change in sales revenue. If the sales volume drops by 8% with no change in the selling price, sales revenue will reduce by $48,000. The incremental analysis would be as follows:
Direct materials Direct labour Variable manufacturing overheads Fixed manufacturing overheads Hire charge Reduction in sales revenue ($600,000 8%) Total manufacturing costs Make $ 100,000 150,000 80,000 120,000 450,000 Hire $ 80,000 75,000 60,000 100,000 100,000 48,000 463,000

A2

A3 A4

Total costs under the hire alternative are higher than under the make alternative. In this situation, the company should not hire the machinery. The management should still replace the old machine as the new machine has a lower equivalent annual cost. EAC of the old machine = $320,070 EAC of the new machine = {$230,000 + $238,095 + $226,757 + $215,959 + $205,676 + [($250,000 $30,000) (1 + 5%)5]} 4.329 = $1,288,863 4.329 = $297,728 The company should eliminate the ice cream segment as the net profit after eliminating this segment will be higher than keeping this segment ($18,900,000 vs. $18,800,000).
Sales revenue Variable costs Contribution margin Fixed costs (Workings) Net profit Local Continental lunch box lunch Box Total $ $ $ 60,000,000 12,000,000 72,000,000 (24,000,000) (8,400,000) (32,400,000) 36,000,000 3,600,000 39,600,000 (18,583,333) (2,116,667) (20,700,000) 17,416,667 1,483,333 18,900,000

Workings: Allocation of fixed costs: Local lunch box business segment = [$18,000,000 + ($700,000 $60,000,000 )]
$72,000,000

= $18,583,333
$72,000,000

Continental lunch box business segment = [$2,000,000 + ($700,000 $12,000,000 )] = $2,116,667

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Alternatively, we can compare the net loss suffered with and without the ice cream segment. The company will arrive at the same decision.
Sales revenue Variable costs Contribution margin Fixed costs Net loss Segment retained $ 4,000,000 (3,600,000) 400,000 (1,200,000) (800,000) Segment eliminated $ (700,000) (700,000)

A5

The company should eliminate the ice cream segment as the net profit after eliminating this segment will be higher than keeping this segment ($19,000,000 vs. $18,800,000).
Sales revenue (W1) Variable costs Contribution margin Fixed costs (W2) Net profit Local Continental lunch box lunch Box Total $ $ $ 60,300,000 12,000,000 72,300,000 (24,000,000) (8,400,000) (32,400,000) 36,300,000 3,600,000 39,900,000 (18,767,220) (2,132,780) (20,900,000) 17,532,780 1,467,220 19,000,000

Workings: (W1) (W2) Local lunch box sales revenue = $60,000,000 + $300,000 = $60,300,000 Allocation of fixed costs: Local lunch box business segment = [$18,000,000 + ($800,000 $60,300,000 ) + $100,000]
$72,300,000

= $18,767,220
$72,300,000

Continental lunch box business segment = [$2,000,000 + ($800,000 $12,000,000 )] = $2,132,780

Alternatively, we can compare the net loss suffered with and without the ice cream segment. The company will arrive at the same decision.
Sales revenue Variable costs Contribution margin Fixed costs Net loss Segment retained $ 4,000,000 (3,600,000) 400,000 (1,200,000) (800,000) Segment eliminated $ 300,000 300,000 (900,000) (600,000)

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ASSESSMENT

Application Problems
24.1
(a) (b) (c) (d) (e) Avoidable Unavoidable Avoidable Unavoidable 30% is avoidable, 70% is unavoidable.

24.2
(a) & (b) Sales (2,000 $200) Direct materials (2,000 $25) Direct labour (2,000 $40) Variable manufacturing overheads (2,000 $15) Net profit
Order accepted $ 400,000 (50,000) (80,000) (30,000) 240,000 Order rejected $ 0 0 0 0 0

As net profit will increase by $240,000, this special order should be accepted.

24.3X
Costs to be incurred when the order is accepted:
Variable cost of goods sold (1,000 $175) Variable operating expenses (1,000 $60) Delivery charge Total costs $ 175,000 60,000 2,000 237,000

The minimum price that the restaurant should charge is $237,000.

24.4
(a)

Contribution margin per unit:

Sales ($1,600,000 40,000) Less Variable cost of goods sold ($800,000 40,000) Variable operating expenses ($40,000 40,000) Contribution margin $ 40 (20) (1) 19

Break-even point in units = ($320,000 + $60,000) $19 = 20,000 Break-even point in sales dollars = 20,000 $40 = $800,000

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(b)

(c)

Margin of safety in units = $800,000 $40 = 20,000 Margin of safety in sales dollars = $1,600,000 $800,000 = $800,000 Expected increase in profit by accepting the order:
Sales (6,000 $25) Less Variable cost of goods sold (6,000 $20) Variable operating expenses [6,000 ($1 $0.6)] Profit $ 150,000 (120,000) (2,400) 27,600

(d)

Expected increase in profit by accepting the order:

Sales (2,500 $29) Less Variable cost of goods sold (2,500 $20) Variable operating expenses (2,500 $1) Profit $ 72,500 (50,000) (2,500) 20,000

The order stated in part (c) should be accepted, as this will result in a higher increase in profit.

24.5X
(a) (b) Outsourcing is the practice of buying products from outside suppliers rather than producing them within the company. Comparison of costs:
Food costs Labour (W1) Variable overheads (W2) Food sales (W3) Shinagawa's charges (W4) Total costs Food service Keeping the operations outsourced hospital caf $ $ 890,000 8,500 85,000 17,500 35,000 (115,000) (100,000) 894,250 805,250 910,000

(c)

Workings: (W1) Labour = $85,000 10% = $8,500 (W2) Variable overheads = $35,000 50% = $17,500 (W3) Food sales = $100,000 115% = $115,000 (W4) Shinagawas charges = 250 70% $14 365 = $894,250 The hospital should outsource its food service operations as outsourcing would result in lower total costs. The fixed hospital overheads are irrelevant costs and should be ignored. Factors to consider include the food quality, the caterers reliability and labour issues.

24.6
(a) (b) Avoidable costs = $420,000 + $100,000 + $300,000 + ($200,000 10%) = $840,000 Purchase cost = 1,000 $850 = $850,000. Profit will be reduced by $10,000 ($850,000 $840,000) if the component is purchased from an outside supplier.

(c) Maximum price that Kangaroo is willing to pay = Avoidable costs per unit = $840,000 1,000 = $840 per unit 63

24.7X
(a)
Variable operating costs (10 years) Current disposal value of the existing truck Purchase cost of the new truck Total operating costs Existing truck $ 1,650,000 1,650,000 New truck $ 1,000,000 (225,000) 900,000 1,675,000

(b)

Difference in total operating costs = $1,675,000 $1,650,000 = $25,000 The new truck has higher total operating costs over the 10-year period. The management should keep the existing truck as it has lower total costs over the 10-year period.

24.8
(a) Sales Variable costs Contribution margin Fixed costs Avoidable Fixed costs Unavoidable Net profit/(loss) Product X Product Y $ $ 7,000,000 9,000,000 (4,200,000) (4,800,000) 2,800,000 4,200,000 (1,000,000) (1,800,000) (600,000) (1,000,000) 1,200,000 1,400,000 Product Z Total $ $ 16,000,000 (9,000,000) 7,000,000 (2,800,000) (540,000) (2,140,000) (540,000) 2,060,000

If Product Z is eliminated, the unavoidable fixed costs of $540,000 will remain. Net profit will become $2,060,000, which is lower than the original net profit of $2,460,000. Therefore, Product Z should be kept. Effect on overall net profit:
Sales/Rental revenue Variable costs Contribution margin Fixed costs Avoidable Fixed costs Unavoidable Net profit Product X Product Y $ $ 7,000,000 9,000,000 (4,200,000) (4,800,000) 2,800,000 4,200,000 (1,000,000) (1,800,000) (600,000) (1,000,000) 1,200,000 1,400,000 Product Z Total $ $ 1,500,000 17,500,000 (9,000,000) 1,500,000 8,500,000 (2,800,000) (540,000) (2,140,000) 960,000 3,560,000

(b)

The overall net profit will become $3,560,000, which is higher than the original net profit of $2,460,000. In this case, Product Z should be eliminated.

24.9X
The profits generated by Forever Furniture Ltd when an unfinished table is not processed further and when it is processed further are shown in the following table:
Selling price Direct materials Direct labour Variable manufacturing overheads Fixed manufacturing overheads Profit Unfinished table $ 100 (30) (20) (12) (8) 30 Finished table $ 120 (34) (28) (16.8 ) (8) 33.2

As a finished table can generate a higher profit, Forever Furniture Ltd should process the unfinished table further. 64

24.10X
(a)
Year 0 1 2 3 4 5 6 7 8 9 10 Retain the existing truck Present value $ $ 165,000 149,985 165,000 136,290 165,000 123,915 165,000 112,695 165,000 102,465 625,350 Replace with a new truck $ 675,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 Present value $ 675,000 90,900 82,600 75,100 68,300 62,100 56,400 51,300 46,700 42,400 38,600 1,289,400

(b)

EAC of the existing truck = $625,350 3.791 = $164,956 EAC of the new truck = $1,289,400 6.145 = $209,829 Difference in total operating costs = $209,829 $164,956 = $44,873 The old truck has lower total operating costs. The equivalent annual cost of the new truck is higher than that of the old truck. The existing truck should be retained.

24.11
(a)
Make Costs of 1,000 units: $ Purchase cost Direct materials 50,000 Direct manufacturing labour 25,000 Variable manufacturing overheads 20,000 Fixed manufacturing overheads 35,000 Warranty costs 130,000 Bought from South Ocean Motors $ 125,000 24,500 149,500 Bought from East Harbour Motors $ 90,000 10,500 27,230 127,730

(b)

Note:  The warranty costs are $10 per air-conditioner, i.e. $10,000 per day (1,000 1% $1,000) for three years. The present value of an annuity of $10,000 for three years using an interest rate of 5% is $27,230 ($10,000 2.723). Yoyogi Ltd should buy the motors from East Harbour Motors as this will result in the lowest costs. Yoyogi Ltd should consider qualitative factors when deciding whether to make or buy the motors. They include: Quality Which of the three companies makes better motors? Delivery performance Can the suppliers deliver the motors on time? Is Yoyogi Ltd capable of making enough motors to meet its production requirements? Commitment Are the suppliers committed to supplying motors to Yogogi Ltd on a long-term basis at reasonable prices? Compatibility Are the motors purchased from outside suppliers compatible with the other components used in the air-conditioners? (Any two or other reasonable answers) 65

(c)

This practice is called outsourcing. Yoyogi Ltd may still want to make the motors itself even though it can buy them from outside suppliers at very attractive prices. This is because there are factors other than price to consider. They include quality, fear of losing trade secrets, effect on staff morale and customers satisfaction. (Any two or other reasonable answers)

24.12X
(a) Profit after eliminating the traditional DVD player product line:
Sales Less Variable manufacturing costs (W1) Variable selling expenses (3,700 $200) Contribution margin Less Fixed manufacturing costs (W2) Fixed selling expenses (W3) Net profit $ 7,400,000 (4,070,000) (740,000) 2,590,000 (1,040,000) (720,000) 830,000

If the traditional DVD player product line is eliminated, net profit will be reduced by $420,000 ($1,250,000 $830,000). Workings: (W1) Variable manufacturing costs of Blu-ray DVD players:
Cost of goods sold Less Fixed manufacturing costs (3,700 $200) Variable manufacturing costs $ 4,810,000 (740,000) 4,070,000

(W2) (W3)

(10,000 $30) + (3,700 $200) = $1,040,000 Fixed selling expenses:

Total selling expenses before eliminating the traditional DVD player product line Less Variable selling expenses: Traditional DVD players (10,000 $40) Blu-ray DVD players (3,700 $200) Fixed selling expenses before eliminating the traditional DVD player product line $ 1,940,000 (400,000) (740,000) 800,000

(b)

Fixed selling expenses after eliminating the traditional DVD player product line = $800,000 90% = $720,000
$ 10,400,000 (5,720,000) (1,040,000) 3,640,000 (1,040,000) (800,000) 1,800,000

Profit after eliminating the traditional DVD player product line:

Sales (W4) Less Variable manufacturing costs (W5) Variable selling expenses (W6) Contribution margin Less Fixed manufacturing costs Fixed selling expenses (W7) Net profit

If the traditional DVD player product line is eliminated, net profit will be increased by $550,000 ($1,800,000 $1,250,000).

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Workings: (W4) $7,400,000 3,700 5,200 = $10,400,000 (W5) $4,070,000 3,700 5,200 = $5,720,000 (W6) $740,000 3,700 5,200 = $1,040,000 (W7) Fixed selling expenses:
Total selling expenses Less Variable selling expenses: Traditional DVD players (10,000 $40) Blu-ray DVD players (3,700 $200) Fixed selling expenses $ 1,940,000 (400,000) (740,000) 800,000

24.13X
(a)

(b) (c)

Costs per unit for the special order = Variable costs ($100 + $125 + $60) + Additional direct materials cost ($30) = $315 Stable Cabinet Ltd should accept this special order as the price offered of $350 per unit is higher than the costs of $315 per unit. The company can earn a profit of $35 per unit on this special order. Some of the costs are not counted as these costs are not relevant in the decision-making process. For example, the fixed manufacturing overheads remain unchanged regardless of what decision is made. The pricing strategy used by Stable Cabinet Ltd is called cost-plus pricing. Under this pricing strategy, the price is determined by adding a fixed mark-up to the cost of a product. This pricing strategy is very easy to use and can ensure that a certain amount of profit is earned. Stable Cabinet Ltd should consider the impact on existing customers when they find out that a customer was able to buy products at a discount price. Also, it should consider the reaction of its competitors. If they match the discounted price and reduce their prices, how would this affect Stable Cabinet Ltds profits? Currently, the incremental costs are $315 per Trendy cabinet. If the company expands its production capacity to fill this special order, incremental costs will become higher due to the costs of adding capacity. On the other hand, if the company uses its existing production capacity to fill this special order, it will have to consider the opportunity costs of giving up some sales of its regular products.

(d)

(e)

Past Exam Questions

24.14
(a) Incremental cost to make the part:
Direct materials Direct labour Variable manufacturing overhead Fixed manufacturing o/h eliminated (15,000 $2) Incremental cost to make $ 34,500 68,300 49,200 30,000 182,000

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(b)

Relevant cost to buy Part Q-1: ($13 15,000) $10,000 = $185,000 Brown should not accept the offer to buy the Part Q-1 from Violet, because it would be $3,000 cheaper for Brown to make the part itself. $185,000 $182,000 = $3,000

24.15X
(a) (i) Make or buy decision:
Relevant costs per unit: Direct materials Direct labour Variable production overheads Avoidable fixed costs ($20,000 2,000) Opportunity cost of letting out ($30,000 2,000) Unit cost of purchase $ 30 60 20 10 15 135 120

Lily Industrial Limited should buy the component from the outside supplier as the unit cost of purchase is lower than the relevant costs of production.

(ii) The qualitative factors to be considered include: The reliability of the outside supplier as an on-time supplier. Late deliveries could affect the companys production schedule and delivery dates for the final product. The quality of the components bought from outside supplier should be equal to, or better than, the quality of components made internally. Otherwise, the quality of the final products might be compromised. Redundancies may result if the components are out-sourced. This could affect employee morale and cause labour problems. Minimum quoted price:
Direct materials X (600 $5) Direct labour (1,000 $80) Variable production overheads (1,000 $2) Fixed production overheads Opportunity cost for Zoda {[($500 $350) 3] 1,000} $ 3,000 80,000 2,000 50,000 135,000

(b)

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