Relevant Costing

Relevant costs for decision making

The costs which should be used for decision making are often referred to as "relevant costs". CIMA defines relevant costs as 'costs appropriate to aiding the making of specific management decisions'.

To affect a decision a cost must be:

a) Future: Past costs are irrelevant, as we cannot affect them by current decisions and they are common to all alternatives that we may choose. b) Incremental: ' Meaning, expenditure which will be incurred or avoided as a result of making a decision. Any costs which would be incurred whether or not the decision is made are not said to be incremental to the decision. c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not relevant. Similarly, the book value of existing equipment is irrelevant, but the disposal value is relevant.

IRRELEVANT COST
a) Common costs: Costs which will be identical for all alternatives are irrelevant, e.g. rent or rates on a factory would be incurred whatever products are produced. b) Sunk costs: Another name for past costs, which are always irrelevant, e.g. dedicated fixed assets, development costs already incurred. c) Committed costs: A future cash outflow that will be incurred anyway, whatever decision is taken now, e.g. contracts already entered into which cannot be altered.

Opportunity cost

An opportunity cost is the benefit foregone by choosing one opportunity instead of the next best alternative.

Make or buy
XY Ltd manufactures auto parts. The following costs are incurred for processing 1 lakh units of a component:

Direct material Cost Direct labour Cost Variable factory Overheads Fixed Factory Overheads

Rs. Rs. Rs. Rs.

5 8 6 5

Lakhs Lakhs Lakhs lakhs

Continue.

.Continue
The purchase price of the component is Rs. 22 lakhs. The fixed overhead would continue to be incurred even when the component is bought from outside although there would be reduction to the extent of Rs. 200000. Required:Should the part be made or bought.

Solution
I Relevant cost to make Rs. 5 Lakhs Rs. 8 Lakhs Rs. 6 Lakhs

Direct material Cost Direct labour Cost Variable factory Overheads Total

Rs 19 Lacs

Solution Relevant cost to buy Purchase price 22 lacs Less:-Reduction in fixed cost 2 Lacs

20 Lacs Advisable to make the component

.Continue
In case the released capacity can be rented out to another company for Rs. 1,50000,what would be your decision?

Solution
When released capacity is rented out:Relevant cost to make Rs 19 Lacs Purchase price Less:-Reduction in fixed cost Less:-Rental Income II Relevant cost to buy Rs.22 lacs 2 Lacs 1.5 lacs 18.50 Lacs

Advisable to Buy the component

Make or Buy
Auto parts Ltd. has an annual production of 90000 units for a motor component. The component cost structure is as below: Material 270 per unit Labour( 25% fixed) 180 per unit Expenses: Variable 90 per unit Fixed 135 per unit Total 675 per unit
a) The purchase manager has an offer from a supplier who is willing to supply the component at Rs.540.Should the component be purchased and production stopped?

Solution
Material Labour (75% of 180) Variable expenses Total variable cost when Component is produced Suppliers price 270 135 90
495 540

It is advisable to make the product as excess of price over variable cost is 540-495=Rs. 45 for 90000 units extra cost will be Rs. 4050000

Make or Buy
b)

cont..

Assume the resources now used for this components manufacture are to be used to produce another new product for which the selling price is Rs. 485. In this case the material price will be Rs. 200 per unit.90000 units of this product can be produced at the same cost basis as above for labour and expenses. Discuss whether it would be advisable to divert the resources a maufacture that new product, on the footing that the component presently being produced would, instead of being produced, be purchased from the market

Solution
b)
Selling price of per unit of new product 485 Less Variable costMaterial 200 Labour 135 Expenses 90 425 Contribution per unit 60 Loss if present component is purchased 45 If a Company diverts the resources for the production of a new product net benefit Rs. 15 per unit. On 90000 units it will save Rs 1350000

Export Order
Smart Exports Ltd. is producing and selling 20000 units of its products in the home market at a price of Rs. 60 per unit. The per unit cost is as follows: Direct Materials Rs. 10 per unit Direct Labour Rs. 7 per unit Factory Expenses: Fixed Rs. 12 per unit Variable Rs 4 per unit Office and selling expenses Fixed Rs 6 per unit Variable Rs.3 per unit

cont..

An Importer from Australia placed an order for 6000 units at a price of Rs. 30 per unit.Execution of Australian order will result in an additional total cost of Rs. 10000 over and above the variable cost. Should the Australian order be accepted?

Solution
Sales Less:- Variable Cost DM Dl exp Less Fixed Cost Profit 60 10 7 7

24 36 18 18

Profitability Statement(Export )
Export Sales(6000 units @ Rs.30) 180000 Less:-Variable cost @ Rs. 24 144000 36000 Less:-Additional cost of exports 10000 Profit 26000

Conclusion:-Accept the order

Export Order
A Manufacturer has planned his level of operation at 50% of his plant capacity of 30000 units. His expenses are estimated as follows, if 50% of the plant capacity is utilised: Direct material 8280 Direct Wages 11160 Variable and other mfg exp 3960 Total fixed expenses irrespective of capacity utilisation is Rs. 6000 continue..

continue..
The expected selling price in the domestic market is Rs. 2 per unit. Recently the manufacturer has received a trade enquiry from an overseas organization interested in purchasing 6000 units at a price of Rs.1.45 per unit. As a professional management accountant, what would be your suggestion regarding acceptance or rejection of the offer? Support your suggestion with suitable quantitative information.

Mysore University 2009.

A Company producing 80000 units of product B at 80%capacity receives an order from foreign dealer for 20000 units at Rs. 100 per unit, although the local sales price is RS. 180 per unit. The present cost sheet is given below: Material 40 Labour Skilled (fixed) 20 Unskilled(Variable) 20 Variable overheads 20 Fixed Overhead 40 Total Cost 140 per unit

Cont..
a)

b)

Advise the management whether to accept the foreign order or not. What will be your advice if the same order had come from a local merchant?

Profitability Statement
Particulars Sales Less:-Variable Cost Material Labour (unskilled) Overhead Total 3200000 1600000 1600000 6400000 40 20 20 80 800000 400000 400000 1600000 40 20 20 80 4000000 2000000 2000000 8000000 80% 80000 units (for domestic sales) 20% 20000 units (for foreign Order) 100% Total 100000 units

Total (Rs.) Per Unit(Rs.)

14400000 180

Total (Rs)
2000000

Per Unit(Rs.)
100

Total (Rs)
16400000

Contribution
Less:-Fixed Cost Labour (skilled) Overhead Total Profit

8000000
1600000 3200000 4800000 3200000

100
20 40 60 40

400000

20

8400000
1600000 3200000 4800000

400000

20

3600000

Closure/Discontinuance of a product line

Pee Lay Ltd is engaged in 3 lines of production.The Following information is provided as under: A B Production (units) 3000 2000 Selling price per unit 40 60 Less:-Variable cost 27 38 Contribution 13 22 Less:-Fixed Cost 5 8 Profit 8 14 C 5000 61 43 18 9 9

Cont..
The management wants to discontinue one line and gives you the assurances that production in two other lines shall rise by 50%. Which line should be discontinued and support your answer by necessary statements.

If A is discontinued B & C will increase by 50%

Sales of B would be 3000 units and C7500 units contribution on B=3000 X 22=66000 Contribution on C-7500 x 18=135000 Total Contribution=201000

If B is discontinued A & C will increase by 50%

Sales of A would be 4500 units and C7500 units Contribution on A=4500 X 13=58500 Contribution on C=7500 x 18=135000 Total Contribution=193500

If C is discontinued A & B will increase by 50%

Sales of A would be 4500 units and B3000 units contribution on A=4500 X 13=58500 contribution on B=3000 X 22=66000 Total Contribution=124500

Home work
A company currently operating at 80 % capacity has the following particulars: Sales 3200000 Direct Material 1000000 Direct Labour 400000 Variable Overhead 200000 Fixed Overhead 1300000

Cont..
An export order has been received that would utilise half the capacity of the factory. The order cannot be split i.e it has either to be taken in full and executed at 10 % below the normal domestic prices or rejected totally.

Cont..

1.

2.

The alternatives available to the management are: Reject the order and continue with the domestic sales only(as at present),or Accept the order,split capacity between overseas and domestic sales and turn away excess domestic demand, or

Cont..
3.Increase capacity to accept the export order and maintain the present domestic sales by: a) buying an equipment that will increase capacity by 10%. This will result in an increase of Rs. 1,00,000 in fixed costs, and b)work overtime to meet balance of required capacity. In that Case, labour will be paid at one and a half times the normal wage rate. Prepare a comparitive statement of profitability and suggest the best alternative.