CHAPTER 19

RELEVANT COSTS FOR DECISION MAKING

I.

Questions
1. Quantitative factors are those which may more easily be reduced in terms of pesos such
as projected costs of materials, labor and overhead. Qualitative factors are those whose
measurement in pesos is difficult and imprecise; yet a qualitative factor may be easily
given more weight than the measurable cost savings. It can be seen that the accountants
role in making decisions deals with the quantitative factors.
2. Relevant costs are expected future costs that will differ between alternatives. In view of
the definition of relevant costs, historical costs are always irrelevant because they are not
future costs. They may be helpful in predicting relevant costs but they are always
irrelevant costs per se.
3. The differential costs in any given situation is commonly defined as the change in total
cost under each alternative. It is not relevant cost, but it is the algebraic difference
between the relevant costs for the alternatives under consideration.
4. Analysis:

Future costs:
New Truck

Replace

Rebuild

P10,200

Less: Proceeds from

1,000
disposal, net
P 9,200
Advantage of rebuilding

P8,500
P700

The original cost of the old truck is irrelevant but its disposal value is relevant. It is
recommended that the truck should be rebuilt because it will involve lesser cash outlay.

II.

Exercises

Exercise 1 (Identifying Relevant Costs)

a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.

Case 1
Not
Releva Releva
Item
nt
nt
Sales revenue......................... X
Direct materials......................X
Direct labor............................ X
Variable manufacturing
overhead................................. X
Book value Model
E7000 machine.......................
X
Disposal value Model
E7000 machine.......................
X
Depreciation Model
E7000 machine.......................
X
Market value Model
F5000 machine (cost).............X
Fixed manufacturing
overhead.................................
X
Variable selling expense.........X
Fixed selling expense.............X
General administrative
overhead................................. X

Case 2
Not
Releva Releva
nt
nt
X
X
X
X
X
X
X
X
X
X
X
X

Exercise 2 (Identification of Relevant Costs)

Requirement 1

Fixed cost per mile (P3,500* 10,000 miles)...............................................

P0.35
Variable operating cost per mile....................................................................
0.08
Average cost per mile.....................................................................................
P0.43
* Depreciation
Insurance
Garage rent

P2,000
960
480

Automobile tax and license

Total

60
P3,500

Requirement 2
The variable operating costs would be relevant in this situation. The depreciation would not
be relevant since it relates to a sunk cost. However, any decrease in the resale value of the
car due to its use would be relevant. The automobile tax and license costs would be incurred
whether Ingrid decides to drive her own car or rent a car for the trip during summer break
and are therefore irrelevant. It is unlikely that her insurance costs would increase as a result
of the trip, so they are irrelevant as well. The garage rent is relevant only if she could avoid
paying part of it if she drives her own car.
Requirement 3
When figuring the incremental cost of the more expensive car, the relevant costs would be
the purchase price of the new car (net of the resale value of the old car) and the increases in
the fixed costs of insurance and automobile tax and license. The original purchase price of
the old car is a sunk cost and is therefore irrelevant. The variable operating costs would be
the same and therefore are irrelevant. (Students are inclined to think that variable costs are
always relevant and fixed costs are always irrelevant in decisions. This requirement helps to
dispel that notion.)

Exercise 3 (Make or Buy a Component)

Requirement 1

Cost of purchasing
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead,
traceable1

Per Unit
Differential
Costs
15,000 units
Make Buy
Make
Buy
P200
P3,000,000
P60
P900,000
80
1,200,000
10

150,000

20

300,000

Fixed manufacturing overhead,

common
Total costs

0
0
0
0
P170 P200
P2,550,000
P3,000,000

Difference in favor of continuing to

make the parts
P30
P450,000
1
Only the supervisory salaries can be avoided if the parts are
purchased. The remaining book value of the special equipment is a
sunk cost; hence, the P3 per unit depreciation expense is not relevant
to this decision. Based on these data, the company should reject the
offer and should continue to produce the parts internally.
Requirement 2
Make
Cost of purchasing (part 1)
Cost of making (part 1)
Opportunity costsegment margin forgone
on a potential new product line
Total cost

Buy
P3,000,00
0

P2,550,00
0
650,00
0
P3,200,00 P3,000,00
0
0

Difference in favor of purchasing from the

outside supplier

P200,000

Thus, the company should accept the offer and purchase the parts from the outside supplier.
Exercise 4 (Evaluating Special Order)

Only the incremental costs and benefits are relevant. In particular, only the variable
manufacturing overhead and the cost of the special tool are relevant overhead costs in this
situation. The other manufacturing overhead costs are fixed and are not affected by the
decision.
Per
Unit
Incremental revenue
Incremental costs:
Variable costs:
Direct materials
Direct labor
Variable manufacturing overhead

P3,499.50

Total
10
bracelets
P34,995.00

1,430.00
860.00
70.00

14,300.00
8,600.00
700.00

Special filigree
60.00
600.00
Total variable cost
P2,420.00
24,200.00
Fixed costs:
Purchase of special tool
4,650.00
Total incremental cost
28.850.00
Incremental net operating income
P 6.145.00
Even though the price for the special order is below the companys regular price for such an
item, the special order would add to the companys net operating income and should be
accepted. This conclusion would not necessarily follow if the special order affected the
regular selling price of bracelets or if it required the use of a constrained resource.

Exercise 5 (Utilization of a Constrained Resource)

Exercise 6 (Sell or Process Further)

Product A Product B Product C
Sales value after further
processing
Sales value at split-off point
Incremental revenue
Cost of further processing
Incremental profit (loss)

P80,000
50,000
30,000
35,000
P(5,000)

P150,000
90,000
60,000
40,000
20,000

P75,000
60,000
15,000
12,000
3,000

Products B and C should be processed further, but not Product A.

EXERCISE 8(Dropping or Retaining a Segment)

EXERCISE 9(Special Order)

EXERCISE 10(Make or Buy a Component)

Exercise 11 ( The Economists Approach to Pricing)

III. Problems
Problem 1 (Accept or Reject an Order)
Product A
Selling price per unit

Product B

P1.20

P1.40

Materials

0.50

0.70

Labor

0.20

0.24

Factory overhead (25%)

0.10

0.14

0.80

1.08

P0.40

P0.32

Less Variable costs/unit:

Contribution margin/unit
Multiplied by number of units to
be sold
Total contribution margin

21,000 units

30,000 units

P8,400

P9,600

Product B should be accepted because its total contribution margin is higher than that of
Product A.
Problem 2 (Eliminate or Retain a Product Line)
Requirement 1
No, production and sale of the round trampolines should not be discontinued. Computations
to support this answer follow:
Contribution margin lost if the round trampolines
are discontinued.......................................
P(80,000)
Less fixed costs that can be avoided:
Advertising traceable............................ P41,000
Line supervisors salaries.........................
6,000 47,000
Decrease in net operating income for the
company as a whole.................................
P(33,000)
The depreciation of the special equipment represents a sunk cost, and therefore it is not
relevant to the decision. The general factory overhead is allocated and will presumably
continue regardless of whether or not the round trampolines are discontinued; thus, it is not
relevant.

Requirement 2
If management wants a clear picture of the profitability of the segments, the general factory
overhead should not be allocated. It is a common cost and therefore should be deducted from
the total product-line segment margin. A more useful income statement format would be as
follows:
Trampoline
Total

Round

Rectangular Octagona
l

Sales.............................. P1,000,00 P140,000 P500,000

0

P360,000

Less variable
expenses.....................

410,00
0

60,000

200,000

150,000

Contribution margin......

590,00
0

80,000

300,000

210,000

Advertising
216,000
traceable..................

41,000

110,000

65,000

95,000

20,000

40,000

35,000

19,00
0

6,00
0

7,000

6,000

330,00
0

67,00
0

157,00
0

106,000

P P143,000
13,000

P104,000

Less fixed expenses:

Depreciation of
special
equipment................
Line supervisors
salaries.....................
Total traceable fixed
expenses.....................

Product-line segment
margin........................ 260,000
Less common fixed
expenses.....................

200,00
0

Net operating
income (loss)..............P 60,000
Problem 3 (Product Mix)
Requirement 1
Product Line
A

Selling price per unit

P30

P25

P10

P8

Variable cost per unit

25

10

Contribution margin / unit

P5

P15

P 5

P4

Divided by no. of hours

required for each unit

5 hrs.

10 hrs.

4 hrs.

1 hr.

P1

P1.5

P1.25

P4

Contribution per hour

Product ranking:
1.
D

2.

3.

4.

Based on the above analysis, first priority should be given to Product D. The company
should use 4,000 out of the available 96,000 hrs. to produce 4,000 units of product D. The
remaining 92,000 hrs. should be used to produce 9,200 units of Product B. Hence, the best
product combination is 4,000 units of Product D and 9,200 units of Product B.
Requirement 2
If there were no market limitations on any of the products, the company should use all the
available 96,000 hours in producing 96,000 units of product D only.
The difference in profit between the two alternatives is computed as follows:
Contribution margin of combination (1)
Product D (4,000 x P 4.00)
P 16,000
Product B (9,200 x P15.00)
138,000
Total contribution margin of D and B
P154,000
Less contribution margin of D only
(96,000 x P4)
384,000
Difference, excess over profit in combination (1) P230,000
Problem 4 (Accept or Reject a Special Order)

Requirement 1
The company should accept the special order of 4,000 @ P10 each because this selling price
is still higher than the additional variable cost to be incurred. Whether or not variable
marketing expenses will be incurred, the decision is still to accept the order.
Supporting computations:
(a) Assume no additional variable marketing cost will be incurred.
Selling price per unit
P10.00
Less variable manufacturing costs:
Direct materials
P5.00
Direct labor
3.00
Variable overhead
0.75
8.75
Contribution margin/unit
P 1.25
Multiplied by number of units of order
4,000 units
Total increase in profit
P5,000
(b) Assume additional variable marketing cost will be incurred.
Selling price per unit
P10.00
Less variable costs (P8.75 + P0.25)
9.00
Contribution margin / unit
P 1.00
Multiplied by number of units of order
4,000 units
Total increase in contribution margin
P4,000
Requirement 2
P8.75, the total variable manufacturing cost.
Requirement 3
Direct materials
P5.00
Direct labor
Variable factory overhead
0.75
Total cost of inventory under direct costingP8.75

3.00

Requirement 4
Present contribution margin
[10,000 units x (P15 - P9)]
P60,000
Less proposed contribution margin
[(P14 - P9) x 11,000 units]
55,000
Decrease in contribution margin
P 5,000
The company should not reduce the selling price from P15 to P14 even if volume will go up
because total contribution margin will decrease.
Problem 5 (CVP Analysis used for Decision Making)

Requirement (a)
Units sold per month

No. of months

Probability

4,000

20%

5,000

15

50%

6,000

30%

30

100%

Requirement (b)
Production

Sales (4,000 x P40)

4,000
units

5,000 units

6,000
units

P160,000

P160,000

P160,000

100,000

125,000

150,000

Less variable costs

Production cost @ P25
Purchase cost @ P45

Total

P100,000

P125,000

P150,000

Contribution margin

P 60,000

P 35,000

P 10,000

Sales (5,000 x P40)

P200,000

P200,000

P200,000

100,000

125,000

150,000

45,000

Less variable costs

Production cost @ P25
Purchase cost @ P45
Total

P145,000

P125,000

P150,000

Contribution margin

P 55,000

P 75,000

P 50,000

Sales (6,000 x P40)

P240,000

P240,000

P240,000

100,000

125,000

150,000

90,000

45,000

Total

P190,000

P170,000

P150,000

Contribution margin

P 50,000

P 70,000

P 90,000

Less variable costs

Production cost @ P25
Purchase cost @ P45

Requirement (c)
Sales Order

Contribution
Margin

Probability

4,000

P35,000

0.20

P 7,000

5,000

75,000

0.50

37,500

6,000

70,000

0.30

21,000

Average Contribution Margin

Expected Value

P65,500

Problem 6 (Pricing)
Requirement A:

2005
Sales
Less Variable cost
Contribution margin
Less Fixed cost
Net income (loss)

2006

Operating
Result at Full
Capacity

P 100,000

P 400,000

P 480,000

130,000

520,000

624,000

(P 30,000)

(P120,000)

(P144,000)

40,000
(P 70,000)

40,000
(P160,000)

40,000
(P184,000)

The company had been operating at a loss because the product had been selling with a
negative contribution margin. Hence, the more units are sold, the higher the loss will be.

Requirement B: P60.14
Requirement C: P74.29
Requirement D: P56.58
Problem 7 (Make or Buy)
Cost of
Making

Cost of Buying

Outside purchase
Direct materials

P90,000
P15,000

Direct labor

30,000

Variable
overhead

manufacturing

10,000

Fixed
overhead*

manufacturing

15,000

Total cost

P70,000

P90,000

* 1/3 x P45,000 = P15,000

Therefore, the annual advantage to make the parts is P20,000.

Problem 8 ( Close or Retain a Store)

1. The simplest approach to the solution is:
Gross margin lost if the store is closed............................
Less costs that can be avoided:
Direct advertising.........................................................
Sales salaries................................................................
Delivery salaries...........................................................
Store rent......................................................................
Store management salaries (new employee would not
be hired to fill vacant position at another store).......
General office salaries..................................................

$(228,000)
$36,000
45,000
7,000
65,000
15,000
8,000

Utilities.........................................................................
Insurance on inventories (2/3 $9,000)......................
Employment taxes*......................................................
Decrease in company net operating income if the
Downtown Store is closed............................................

27,200
6,000
9,000

218,200
$ (9,800)

*Salaries avoided by closing the store:

Sales salaries.....................................................................................
Delivery salaries...............................................................................
Store management salaries...............................................................
General office salaries......................................................................
Total salaries.....................................................................................
Employment tax rate.........................................................................
Employment taxes avoided...............................................................

$45,000
7,000
15,000
8,000
75,000
12%
$9,000

2. The Downtown Store should not be closed. If the store is closed, overall company net
operating income will decrease by $9,800 per quarter.
3. The Downtown Store should be closed if $200,000 of its sales are picked up by the Uptown
Store. The net effect of the closure will be an increase in overall company net operating
income by $76,200 per quarter:
Gross margin lost if the Downtown Store is closed..........................................
Gross margin gained at the Uptown Store:
$200,000 43%............................................................................................
Net loss in gross margin....................................................................................
Costs that can be avoided if the Downtown Store is closed (part 1)................
Net advantage of closing the Downtown Store................................................
Problem 12-20 (45 minutes)
1. Product MJ-7 has a contribution margin of $14 per gallon ($35 $21 =
$14). If the plant closes, this contribution margin will be lost on the
22,000 gallons (11,000 gallons per month 2 = 22,000 gallons) that
could have been sold during the two-month period. However, the
company will be able to avoid some fixed costs as a result of closing
down. The analysis is:
Contribution margin lost by closing the plant for two months
($14 per gallon 22,000 gallons)............................................
Costs avoided by closing the plant for two months:
Fixed manufacturing overhead cost
($60,000 2 months = $120,000)........................................

$120,000

$(228,000)
86,000
(142,000)
218,200
$ 76,200

Fixed selling costs

($310,000 10% 2 months)..............................................
Net disadvantage of closing, before start-up costs......................
Add start-up costs........................................................................
Disadvantage of closing the plant................................................

62,000

No, the company should not close the plant; it should continue to operate
at the reduced level of 11,000 gallons produced and sold each month.
Closing will result in a $140,000 greater loss over the two-month period
than if the company continues to operate. Additional factors are the
potential loss of goodwill among the customers who need the 11,000
gallons of MJ-7 each month and the adverse effect on employee morale.
By closing down, the needs of customers will not be met (no inventories
are on hand), and their business may be permanently lost to another
supplier.
Problem 12-20 (continued)
Alternative Solution:

Sales (11,000 gallons $35 per gallon 2).....

Less variable expenses (11,000
gallons $21 per gallon 2)........................
Contribution margin..........................................
Less fixed costs:
Fixed manufacturing overhead cost
($230,000 2;
$170,000 2)............................................
Fixed selling cost ($310,000 2; $310,000
90% 2).................................................
Total fixed cost..................................................
Net operating loss before start-up costs............
Start-up costs....................................................
Net operating loss.............................................

Plant Kept
Open
Plant Closed
$ 770,000
$
462,000
308,000

460,000

340,000

620,000
1,080,000
(772,000)

558,000
898,000
(898,000)
(14,000
$(912,000

$ (772,000)

Problem 12-20 (continued)

2. Ignoring the additional factors cited in part (1) above, Hallas Company

should be indifferent between closing down or continuing to operate if the

level of sales drops to 12,000 gallons (6,000 gallons per month) over the
two-month period. The computations are:
Cost avoided by closing the plant for two months (see above)..........
Less start-up costs..............................................................................
Net avoidable costs............................................................................

Net avoidable costs

$168,000
=
Contribution margin per gallon $14 per gallon
=12,000 gallons
Verification:

Sales (12,000 gallons $35 per gallon).............................

Less variable expenses (12,000 gallons $21 per gallon).
Contribution margin............................................................
Less fixed expenses:
Manufacturing overhead ($230,000 and $170,000 2
months)........................................................................
Selling ($310,000 and $279,000 2 months).................
Total fixed expenses............................................................
Start-up costs......................................................................
Total costs...........................................................................
Net operating loss...............................................................
IV.

Operate at
12,000
Gallons for Two
Months
$ 420,000
252,000
168,000

460,000
620,000
1,080,000
0
1,080,000
$ (912,000))

Multiple Choice Questions

1.
2.
3.
4.
5.
6.

C
C
B
B
A
B

11.
12.
13.
14.
15.
16.

D
A
D
A
D
C

21.
22.
23.
24.
25.
26.

D
A
D
E
B
D

7. C

17.

27.

8. B

18.

28.

31.
32.
33.
34.
35.

A
D
C
A
C

9. A

19.

29.

10. B

20.

30.

Supporting computations for nos. 16 - 29:

16. Sales [(100,000 x 90%) x (P5.00 x 120%)]
Less: Variable costs (P300,000 x 90%)
Contribution margin
Less: Fixed costs
Operating income

P540,000
270,000
P270,000
150,000
P120,000

17. Direct materials

Direct labor
Overhead
Selling cost
Minimum selling price per unit

P 4
5
2
3
P14

18. Relevant cost to make (10,000 x P24)

Purchase cost
Less: Savings in manufacturing cost P45,000
Avoidable fixed overhead
50,000
Net purchase price
Difference in favor of buy alternative
19.
Increase in sales (60,000 x P3)
Less: Increase in variable cost (60,000 x P2.50)
Net increase in income
20.
Sales (10,000 x P20)

P240,000
P300,000
95,000
P205,000
P 35,000
P180,000
150,000
P 30,000

P200,000

P200,000

P200,000

Less: Variable costs

R (P12 x 10,000)

120,000

S (P 8 x 10,000)

80,000

T (P 4 x 10,000)

Contribution margin

40,000

P 80,000

P120,000

P160,000

21.
Sales (P16 x 15,000)

P240,000

P240,000

P240,000

Less: Variable costs

R (P12 x 15,000)

180,000

S (P 8 x 15,000)

120,000

T (P 4 x 15,000)

Contribution margin

22.

60,000

P 60,000

P120,000

P180,000

Less: Fixed costs

40,000

80,000

120,000

Operating income

P 20,000

P 40,000

P 60,000

Old operating income:

Contribution margin
Less: Fixed cost

P80,000
40,000
P40,000
20,000
P20,000

New operating income

Difference - decrease
23. Sales
Less: Variable costs
Direct materials
Direct labor
Factory overhead
Marketing expenses
Administrative expenses
Contribution margin
Less: Fixed costs
Factory overhead
Marketing expenses
Administrative expenses
Increase in fixed costs
Profit
190,000
24. Sales
Less: Variable costs
Direct materials

P1,200,000
P300,000
400,000
80,000
70,000
50,000
P 50,000
30,000
20,000
10,000

900,000
P 300,000

110,000
P
P1,200,000

P275,000

Direct labor
Factory overhead
Marketing expenses
Administrative expenses
Contribution margin
Less: Fixed costs
Factory overhead
Marketing expenses
Administrative expenses
Decrease in fixed costs
(P25,000 4)
Profit
256,250

375,000
80,000
70,000
50,000
P 50,000
30,000
20,000
(6,250)

25. Direct materials

(P2 x 5,000)
Direct labor
(P8 x 5,000)
Variable overhead
(P4 x 5,000)
Total variable costs
P70,000
Add: Avoidable fixed overhead
Total
26. Avoidable fixed overhead
Direct materials
Direct labor
Variable overhead
Total
Multiplied by: Number of units to be produced
Total relevant costs to make the part
27. Purchase cost (P1.25 x 10,000)
Variable costs to make
Savings of making the blade

850,000
P 350,000

93,750
P

P10,000
40,000
20,000

10,000
P80,000
P 4
4
16
18
P42
20,000
P840,000
P12,500
10,000
P 2,500

28. Selling price per unit

P17
Less: Variable costs of goods sold per unit
([P320,000 - P80,000] 20,000 units)
12
Contribution margin per unit
P 5
Multiplied by units to be sold under Special Order
2,000
Increase in operating income
P10,000
29. Budgeted operating income:

Contribution margin (P2,000,000 x 30%) P600,000

Less fixed costs
400,000
Net operating income
P200,000
Operating income under the proposal:
Sales
P2,000,000
Less Variable costs
([70% x P2,000,000] x 80%) 1,120,000
Contribution margin
P 880,000
Less fixed costs
520,000 360,000
Increase in budgeted operating profit
P160,000