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TUTORIAL – COST MANAGEMENT AND STRATEGIC DECISION MAKING

QUESTIONS

1-3 Cost management information is a broad concept. It is the information the manager
needs to effectively manage the firm or not-for-profit organization -- both financial
information about costs and revenues and relevant non-financial information about
productivity, quality, and other key success factors for the firm. Typically, cost
management is the responsibility of the Chief Financial Officer (CFO) who often
delegates much of this responsibility to the Controller.

1-6 The four functions of management are:


1. Strategic Management -- information is needed by management to make sound strategic
decisions regarding choice of products, manufacturing methods, marketing techniques and
channels, and other long term issues.
2. Planning and Decision Making -- information is needed to support recurring decisions
regarding replacement of equipment, managing cash flow, budgeting raw materials
purchases, scheduling production, and pricing.
3. Management and Operational Control -- information is needed to provide a fair and
effective basis for identifying inefficient operations, and to reward and support the most
effective managers.
4. Preparation of Financial Statements -- information is needed to provide accurate
accounting for inventory and other assets, in compliance with reporting requirements, for
the preparation of financial reports and for use in the three other management functions.

11-1 Relevant costs are costs to be incurred at some future time and differ for each option
available to the decision maker.
Relevant costs in replacing equipment would include the cost of purchasing and installing
the new equipment, the operating costs of the new equipment, and the disposal costs of
the old equipment, the cost of repair of the old equipment, and so on. The purchase price
of the old equipment would not be relevant to the decision.

11-6 The limitations of relevant cost analysis include:


1. Excessive focus on short-term decisions
2. Tendency to focus on quantitative factors only, and to not include the important
strategic factors
3. Managers’ tendency to include irrelevant costs, such as sunk costs, in the decision
making
4. Tendency to focus on a single product or department in isolation of others, and then to
perhaps not find the strategically correct analysis

BRIEF EXERCISES

11-11 $35 – ($33 - $5) = $7


11-12 The contribution on the order is $3,000 – 10 x $100 = $2,000, or $200 per sofa; Adams
should accept the order.

If Adams is at full capacity, then the opportunity cost for lost sales is $500 - $100 = $400
per sofa; the opportunity cost is higher than the contribution on the special order, $200;
so now the special order should not be accepted

11-14 Relevant Costs:

Repair:
Variable Costs:
Labor = $0.50 x 10,000 = $5,000
Fixed Costs:
Repair Cost = $1,000
Total Costs: = $5,000 + $1,000 = $6,000

Replace:
Variable Costs:
Labor = $0.25 x 10,000 = $2,500
Fixed Costs:
New Machine = $5,000
Total Costs: = $2,500 + $5,000 = $7,500

Relevant Cost Difference: = $7,500 - $6,000


= $1,500 more to replace than repair

Decision: Williams should repair the existing machine

11-15 Contribution Margin = $100,000


Overhead that can be eliminated = $90,000
Change in Income if Division is eliminated = ($10,000)

Jamison should keep the division.

EXERCISES

11-21 Special Order

1. The costs fall from $11 to $10 because of the fixed overhead costs which are the same at each
level of production, so that the unit fixed costs decrease as production level increases.

2. The relevant costs are:


Materials $2 ($80,000/40,000)
Labor 3 ($120,000/40,000)
Variable Overhead 3 ($300,000-$240,000)/20,000
Total $8

The relevant costs are $8 per unit, so the bid price should be any price above $8. The sales
manager’s price will produce a contribution of 20,000 ($9-$8) = $20,000

11-30 Relevant Cost Exercises

a. Make or Buy:

The relevant cost for producing the product is as follows:

Cost Per Unit


Direct Materials $28
Direct Labor 18
Variable Overhead 16
Total $62

($62/unit × 2,000 units) = $124,000

The total cost to purchase the units is $120,000 (i.e., $60 per unit).

Savings by outsourcing = $124,000 − $120,000 = $4,000

b. Disposal of Assets
Re-machine Scrap
Future Revenues $30,000 $2,500
Deduct future costs 25,000
Difference $5,000 $2,500

The difference is in favor of re-machining. The $50,000 inventory cost is irrelevant.

c. Replacement of an Asset
Replace Rebuild
New boat $92,000 -
Deduct current disposal price $ 9,000
Rebuild of existing boat $75,000
Margin $83,000 $75,000

The difference is in favor of rebuilding. The $90,000 original purchase cost is irrelevant
as it is a “sunk cost.”
11-35 Make or Buy

1. Since the contribution for manufactured fans ($24) is higher than for purchased fans ($12),
the answer for part 1 should be to manufacture as many as possible, or 15,000, and to purchase
the remaining 5,000 from Harris Products.

Price and Price and


Relevant Costs Relevant Costs
Original Data to Manufacture to Purchase
Selling price per unit $72.00 $72.00 $72.00
Costs per unit 46.00
Electric motor $6.00 6.00
Other parts 8.00 8.00
Direct labor ($15.00/hr.) 15.00 15.00
Manufacturing overhead 15.00 (1) 5.00
Selling and adm. Cost 20.00 (2) 14.00 14.00
Total variable cost per unit $48.00 $ 60.00

Contribution per unit $24.00 $12.00

(1) Of the total per unit manufacturing overhead of $15 per unit, $10 is fixed ($100,000/10,000 units)
and the remainder $5 is variable
(2) Of the total per unit selling and administrative cost, $6 is given as fixed,
and the remainder $14 is variable.

The total contribution is 15,000 x $24 + 5,000 x $12 = $420,000

2.The total contribution for the marine pumps = $21x25,000 = $525,000

Price and
Relevant Costs
for Pumps
Selling price per unit $ 60.00
Costs per unit
Electric motor 5.50
Other parts 7.00
Direct labor ($15.00/hr.) 7.50
Manufacturing overhead 5.00 (1)
Selling and adm. Cost 14.00 (2)
Total variable cost per unit $ 39.00

Contribution per unit $ 21.00

(1) Of the total per unit manufacturing overhead of $9 per unit, $4 is fixed ($100,000/25,000 units)
and the remainder $5 is variable
(2) Of the total per unit selling and administrative cost, $6 is given as fixed,
and the remainder $14 is variable.

The contribution from the pumps ($525,000) is greater than for fans ($420,000); subject to
strategic consideration the pumps are more profitable.