Relevant Costing

Overview

Definitions
Attributes of Cost Information for
Decision Making
Approaches to Decision Making
Decision Problems
Class Examples
General Guidelines on Relevant Costing

Definitions

Relevant costs

Costs that differ between decision options

Relevant revenues

Revenues that differ between decision

options

Definitions

Opportunity Cost

Benefit foregone when choosing one option

precludes receiving benefits from another
option

Sunk Costs

Costs incurred or committed in the past

that would not change due to decision

Attributes of Cost Information

for Decision Making

Accuracy
Timeliness
Cost and Value of Cost Information

Approaches to Decision Making

Total Approach

Incremental Approach

Decision Problems

Product Mix Decision

Special Order / Pricing Decision
Outsourcing / Make-or-Buy Decision
Machine Replacement Decision

Class Example
Product Mix

(P11-22)

Taylor Furniture produces and sells specialty mattresses.

Production is a machine-intensive process. Taylors
variable costs are direct materials costs, variable
machining costs, and sales commissions. Marion Taylor,
the owner is planning production for the upcoming year
and collects the following data:
Estimated
demand
(units)
Nealy
Tersa
Pelta

Selling
price
1,800 $3,000
4,500 $2,100
39,000
$800

Direct
materials
$ per unit

Variable
MCH $
per unit

$750

$600

$500

$500

$100

$200

Salespeople are paid a 5% commission on each Nealy and

Tersa sold, and a 10% commission on each Pelta sold. All
other marketing and administrative costs are fixed and,
along with the fixed manufacturing costs, total $8,750,000.
annual capacity is 50,000 machine-hours, which is limited
by the availability of machines. Variable machining costs
are $200 per hour. Taylor Furniture holds negligible
inventories to minimize risk.
Determine the optimal product mix for Nealy, Tersa and
Pelta.

For product mix decision with one production

constraint, the decision criterion is:

Contribution margin per unit of constrained

resource

Selling price
Direct materials
Variable machining
Commission
Contribution margin (CM)
Machine time (MCH)
CM per MCH
Expected sales (units)
MCH requirement
Production Plan (units)

Nealy
$3,000

Tersa
$2,100

Pelta
$800

(750)

(500)

(100)

(600)
(150)

(500)
(105)

(200)
(80)

$1,500

$995

$420

3.0

2.5

1.0

$500
1,800
5,400
1,800

$398
4,500
5,600
2,240

$420
39,000
39,000
39,000

Class Example
Special Order

(P11-24)

Swat Corporation produces tennis racquets for kids that it

sells for $16 each. At capacity, the company can produce
50,000 racquets per year. The costs of producing and
selling 50,000 racquets are as follows:
Cost per unit
Direct materials

Total costs

$6

$300,000

Direct manufacturing labour

100,000

Variable manufacturing overhead

50,000

Fixed manufacturing overhead

100,000

Variable selling expenses

50,000

Fixed selling expenses

50,000

$13

$650,000

Total costs

Suppose Swat is currently producing and selling 40,000

racquets. Lanny Corporation wants to place a one-time
special order for 10,000 racquets at $11 each. Swat will
incur no variable selling costs for this special order.
Should Swat accept this special order?
Incremental revenue ($11 x 10,000)
Incremental costs ($9 x 10,000)
Net contribution

$110,000
90,000
$ 20,000

Class Example
Special Order Decisions
Selling price
=
$10 per unit
Variable manufacturing costs
=
$ 3 per unit
Variable selling & admin. costs
=
$ 2 per unit
Total fixed manufacturing costs =
$20,000
Total fixed selling & admin. costs =
$10,000
Relevant range: 0 unit to 12,000 units
Fixed manufacturing costs increase $2,000 for every 5,000
units above the 12,000 units range

Class Example
Special Order Decision
Suppose the company is currently producing and selling
10,000 units.
Should the company accept a special order of 3,000 units @
$6.00 per unit?
Incremental revenue ($6 x 3,000)
Incremental costs
Variable costs [($3+$2) x 3,000]
Fixed manufacturing costs
Net contribution

$18,000
$15,000
2,000
$17,000
$ 1,000

Class Example
Special Order Decision
Suppose the company is currently producing and selling
10,000 units.
What is the breakeven price for a special order of 5,000
units?
Relevant costs
Variable costs ($5 x 5,000)
Fixed manufacturing costs
Relevant costs
Breakeven price ($27,000/5,000)

$25,000
2,000
$27,000
$5.40

Class Example
Special Order Decision
Suppose the company is currently producing and selling
10,000 units.
If the current idle capacity can be leased for a fee of $800,
should a special order for 2,000 units @$6 per unit be
accepted?
Incremental revenue ($6 x 2,000)
Incremental costs [($3+$2) x 2,000]
Net contribution
Opportunity costs

$12,000
10,000
$ 2,000
$
800

Class Example
Sourcing Decision

(P11-25)

Mitchell Ltd. manufactures electronic components used in

producing appliances. Data relating to the unit cost of
manufacturing one of its components are provided below:
Direct materials
$8.00
Direct manufacturing labour
$3.00
Variable manufacturing overhead $4.00
Fixed manufacturing overhead
$2.50
The unit fixed manufacturing overhead cost is based on a
denominator volume of 100,000 units. Since the
component is used internally, there are no associated
selling costs.

Phillips Corporation has offered to supply the component at a

price of $16.25 per unit. Mitchell believes that if it
purchases the component, it will save $62,000 a year in
fixed manufacturing salaries. It has been assured that the
quality of the purchased component is consistent with its
own product.
Mitchell is planning to produce 100,000 units of the
component for the upcoming year.

Should Mitchell continue to manufacture the component or

should it purchase from Phillips Corporation? What
nonfinancial factors should be considered by Mitchell.
Cost savings:
Variable manufacturing costs ($15 x 100,000) $1,500,000
Fixed manufacturing salaries
62,000
Total cost savings
$1,562,000
Total purchase costs ($16.25 x 100,000)
$1,625,000

Class Example
Sourcing Decision (Make or Buy)
Product X (Current production at full capacity, 10,000 units):
Selling price
=
$30.00 per unit
Variable manufacturing costs
Direct materials
=
$ 6.00 per unit
Direct labour
=
$ 4.00 per unit
Variable manufacturing OH
=
$ 3.00 per unit
Variable selling & admin. costs
=
$ 1.50 per unit
Total fixed manufacturing costs =
$40,000
Total fixed selling & admin. costs =
$10,000

Class Example
Sourcing Decision (Make or Buy)
Offer from an external supplier at a cost of $16.00 per unit.
With the external offer,
fixed selling & admin. costs slashed by 20%;
variable selling & admin. costs slashed by 30%; and
fixed manufacturing costs will continue at 40% of present
level despite idle.
Required:
Should the suppliers proposal be accepted?

Cost savings
Variable manufacturing costs ($13 x 10,000)
Fixed manufacturing costs ($40,000 x 60%)
Variable selling & admin. costs
($1.50 x 30% x 10,000)
Fixed selling & admin. costs ($10,000 x 20%)
Total cost savings
Total purchase costs ($16 x 10,000)

$130,000
24,000
4,500
2,000
$160,500
$160,000

Class Example
Equipment Costs

(P11-19)

Sparkles Ltd. has just today paid for and installed a special
machine for polishing cars at one of its several outlets. It
is the first day of the companys fiscal year. The machine
cost $25,000. Its annual operating costs total $18,200,
exclusive of amortization. The machine will have a fouryear useful life and a zero terminal disposal price.
After the machine has been used for a day, a machine sales
person offers a different machine that promises to do the
same job at a yearly operating cost of $10,250, exclusive
of amortization. The new machine will cost $28,700 cash,
installed. The old machine is unique and can be sold
outright for only $12,000, minus $2,400 removal cost.

The new machine, like the old one, will have a four-year
useful life and zero estimated disposal price.
Sales, all in cash, will be $170,000 annually, and other cash
costs will be $123,000 annually, regardless of this
decision.
For simplicity, ignore income taxes, interest, and present
value considerations.

Should Sparkles replace the old machine?

Keep Old
Cost of new machine
Disposal price of old machine
Disposal price of new machine

Operating costs
Net cash flow

Buy New
-$28,700
0
9,600
0
-$72,800
-$41,000
-$72,800
-$60,100

To avoid a loss, we should keep the old machine. What is

the role of book value in decisions about replacement of
machines?
Sales proceeds of old machine
Book value of old machine
Loss on disposal of old machine

$9,600
25,000
$15,400

Class Example
Machine Replacement Decision
Old machine
$300,000
6 years
$100,000

Acquisition cost
Remaining life
Disposal value now
Salvage value at end
of 6 years
$ 4,000
Annual operating costs
(excluding rework costs) $140,000

New machine
$360,000
6 years
n/a
$

8,000

$ 80,000

Class Example
Machine Replacement Decision
Old machine was purchased 3 months ago.
New machine reduces defective rate from 5% to 2%.
All defective units are reworked at a cost of $2 per unit.
The company produces an average of 100,000 units
annually.
Required:
Should the old machine be replaced by the new machine?

Keep Old
Cost of new machine
Disposal price of old machine

Disposal price of new machine

Operating costs
Rework costs
Net cash flow

Buy New
-$360,000
100,000

4,000
-840,000
-60,000
-$896,000

8,000
-480,000
-24,000
-$756,000

General Guidelines on
Relevant Costing

Variable (Incremental) costs are

relevant.
Incremental and avoidable fixed costs
are relevant.
Opportunity cost is relevant.
Sunk cost is irrelevant.