topic 3 relevant costing and contribution analysis

Topic 3Topic 3

Relevant Costing andContribution Analysis

Learning Objective 1Learning Objective 1

Use the seven-step decisionprocess to make decisions.

Information and theDecision Process

Information and theDecision Process

A decision model is a formal methodfor making a choice, often involvingquantitative and qualitative analysis.

Seven-Step Decision ProcessSeven-Step Decision Process

identify objectives

Search for alt. course of action

Gather data on alternatives

Implement the Decision

Compare actual vs planned outcomes

Step 1.

Step 2.

Step 3.

Step 5.

Step 6.

Make Specific Predictions

Feed

back

Step 7. Respond to divergences from plan

Step 4. Select alt. course of action

Historical CostsOther Information


Differentiate relevant from irrelevant

costs and revenues indecision situations.

The Meaning of RelevanceThe Meaning of Relevance

Relevant costs and relevant revenues areexpected future costs and revenues thatdiffer among alternative courses of action.

Historical costs Sunk costs

Differential income Differential costs


Distinguish between quantitativeand qualitative factors in decisions.

Quantitative and QualitativeRelevant Information

Quantitative and QualitativeRelevant Information

Quantitative factors

Financial Nonfinancial

Qualitative factors

Quantitative and QualitativeQuantitative and QualitativeRelevant InformationRelevant Information

Generally, relevant-cost analysis emphasises quantitative factors that can be expressed financially.But qualitative and quantitative non-financial factors are also important, and managers must at times give more weight to these factors.

Quantitative and QualitativeQuantitative and QualitativeRelevant InformationRelevant Information

Key features of relevant information:•Past (historical) costs may be helpful as basis for making predictions, but, in themselves are always irrelevant when making decisions.•Different alternatives can be compared in examining differences in expected total future revenues and costs.•Not all expected future revenues and costs are relevant. Those that do not differ among alternatives are irrelevant, hence can be eliminated from the analysis (key question is always: what difference will an action make?).•Appropriate weight must be given to qualitative and quantitative non-financial factors.

Example:One-Time-Only Special Order

Example:One-Time-Only Special Order

The Bismark Co. manufacturing plant has aproduction capacity of 44,000 towels each month.

Current monthly production is 30,000 towels.

Costs can be classified as either variable or fixedwith respect to units of output.

Relevance: Choosing output levels

One-Time-OnlySpecial Order Example


Variable costs per

unit

Fixed costs per unit

Direct materials TShs. 6.50 TShs. - 0 - Direct labour 0.50 1.50Manufacturing costs 1.50 3.50Total TShs. 8.50 TShs. 5.00



Total fixed direct manufacturing labour is TShs. 45,000.

Total fixed overhead is TShs. 105,000.

Marketing costs per unit are TShs. 7(TShs. 5 of which is variable).

What is the full cost per towel?



A hotel in San Juan has offered to buy5,000 towels from Bismark Co. atTShs. 11.50 per towel for a total of TShs. 57,500.

No marketing costs will be incurred.

Variable (TShs. 8.50 + TShs. 5.00): TShs. 13.50Fixed: 7.00Total (full cost) TShs. 20.50



TShs. 8.50 × 5,000 = TShs. 42,500 incremental costs

What are the incremental revenues ?

What are the relevant costs of making the towels ?

TShs. 57,500 – TShs. 42,500 = TShs. 15,000


Beware of two potentialproblems in

relevant-cost analysis.

Two Potential Problems inRelevant-Cost Analysis

Two Potential Problems inRelevant-Cost Analysis

Incorrect generalassumptions:

All variable costsare relevant.

All fixed costsare irrelevant.

1 2Misleadingunit-cost data:

Includeirrelevant costs.

Use same unitcosts at differentoutput levels.

Outsourcing versus InsourcingOutsourcing versus Insourcing

Outsourcing ispurchasing goodsand services fromoutside suppliers.

Insourcing isproducing goods

or providing serviceswithin the organisation.

Make-or-Buy Decisions ExampleMake-or-Buy Decisions Example

Bismark Co. also manufactures bath accessories.

Management is considering producing a part itneeds (#2) or buying a part producedby Towson Co. for TShs. 0.55.


Bismark Co. has the following costs for150,000 units of Part #2:

Direct materials TShs. 28,000Direct labour 18,500Mixed overhead 29,000Variable overhead 15,000Fixed overhead 30,000Total TShs. 120,500


Mixed overhead consists of material handlingand setup costs.

Bismark Co. produces the 150,000 units in 100batches of 1,500 units each.

Total material handling and setup costs equal fixedcosts of TShs. 9,000 plus variable costs of TShs. 200per batch.


What is the cost per unit for Part #2?

TShs. 120,500 ÷ 150,000 units = TShs. 0.8033/unit

Should Bismark Co. manufacture the part or buy itfrom Towson Co.?


Bismark Co. anticipates that next year the150,000 units of Part #2 expected to besold will be manufactured in 150 batchesof 1,000 units each.


Variable mixed costs per batch are expected todecrease to TShs. 100.

Bismark Co. plans to continue to produce150,000 next year at the same variablemanufacturing costs per unit as this year.

Fixed costs are expected to remain the same asthis year.


What is the variable manufacturing cost per unit?

TShs. 61,500 ÷ 150,000 = TShs. 0.41 per unit

Direct material TShs. 28,000Direct labour 18,500Variable overhead 15,000Total TShs. 61,500


Expected relevant cost to make Part #2:

Cost to buy: (150,000 × TShs. 0.55) TShs. 82,500

Manufacturing TShs. 61,500Material handling and setups 15,000*Total relevant cost to make TShs. 76,500*150 × TShs. 100 = TShs. 15,000

Bismark Co. will save TShs. 6,000 by making the part.


Now assume that the TShs. 9,000 in fixed clerical salariesto support material handling and setup will not beincurred if Part #2 is purchased from Towson Co.

Should Bismark Co. buy the part or make the part?


Relevant cost to make:

Variable TShs. 76,500Fixed 9,000Total TShs. 85,500

Cost to buy: TShs. 82,500

By buying the part, Bismark would save: TShs. 3,000


Explain the opportunity-costconcept and why it is

used in decision making.

Opportunity Costs,Outsourcing, and Constraints


Assume that if Bismark buys the part from Towson,it can use the facilities previously used tomanufacture Part #2 to produce Part #3 forKrista Company.

The expected additional future operating incomeis TShs. 18,000.

What should Bismark Co. do?



Bismark Co. has three options regarding Krista:

1. Make Part #2 and do not make Part #3.

2. Buy Part #2 and do not make Part #3.

3. Buy the part and use the facilities to produce Part #3.



Expected cost of obtaining 150,000 parts:

Buy Part #2 and do not make Part #3: TShs. 82,500

Buy Part #2 and make Part #3:TShs. 82,500 – TShs. 18,000 = TShs. 64,500

Make Part #2: TShs. 76,500



Opportunity cost is the contribution toIncome that is forgone (rejected) by notusing a limited resource in its next-bestalternative use.



Assume that annual estimated Part #2requirements for next year is 150,000.

Cost per purchase order is TShs. 40.

Cost per unit when each purchase is 1,500 units= TShs. 0.55.

Cost per unit when each purchase is equal to orgreater than 150,000 = TShs. 0.54.



Average investment in inventory is either:

(1,500 × .55) ÷ 2 = TShs. 412.50 or

(150,000 × TShs. 0.54) ÷ 2 = TShs. 40,500

Annual interest rate for investment ingovernment bonds is 6%.

TShs. 412.50 × .06 = TShs. 24.75

TShs. 40,500 × .06 = TShs. 2,430



Option A: Make 100 purchases of 1,500 units:Purchase order costs: (100 × TShs. 40) TShs. 4,000.00

Purchase costs: (150,000 × TShs. 0.55) TShs. 82,500.00

Annual interest income: TShs. 24.75

Relevant costs: TShs. 86,524.75



Option B: Make 1 purchase of 150,000 units:Purchase order costs: (1 × TShs. 40) TShs. 40

Purchase costs: (150,000 × TShs. 0.54) TShs. 81,000

Annual interest income: TShs. 2,430

Relevant costs: TShs. 83,470


Know how to choose whichproducts to produce when there

are capacity constraints.

Product-Mix DecisionsUnder Capacity Constraints


Per unit Product #2 Product #3Sales price TShs. 2.11 TShs. 14.50Variable expenses 0.41 13.90Contribution margin TShs. 1.70 TShs. 0.60Contribution margin ratio 81% 4%

Bismark Co. has 3,000 machine-hours available.



One unit of Prod. #2 requires 7 machine-hours.

One unit of Prod. #3 requires 2 machine-hours.

What is the contribution of each product permachine-hour?

Product #2: TShs. 1.70 ÷ 7 = TShs. 0.24Product #3: TShs. 0.60 ÷ 2 = TShs. 0.30


Discuss what managersmust consider when

adding or discontinuing customers and segments.

Profitability, Activity-Based Costing, and Relevant Costs


Mountain View Furniture supplies furniture to two localretailers – Stevens and Cohen.

The company has a monthly capacity of 3,000machine-hours.

Fixed costs are allocated on the basis of revenues.



Stevens CohenRevenues TShs. 200,000 TShs. 100,000Variable costs 70,000 60,000Fixed costs 100,000 50,000Total operating costs TShs. 170,000 TShs. 110,000Operating income TShs. 30,000 TShs. (10,000)Machine-hours required 2,000 1,000



TotalRevenues TShs.

300,000Variable costs 130,000Fixed costs 150,000Total operating costs TShs. 280,000Operating income TShs. 20,000Machine-hours required 3,000



Should Mountain View Furniture drop the Cohenbusiness, assuming that dropping Cohen woulddecrease its total fixed costs by 10%?

New fixed costs would be:TShs. 150,000 – TShs. 15,000 = TShs. 135,000



Stevens AloneRevenues TShs. 200,000Variable costs 70,000Fixed costs 135,000Total operating costs TShs. 205,000Operating income TShs. (5,000)Machine-hours required 3,000



Cohen’s business is providing a contribution marginof TShs. 40,000.

TShs. 40,000 decrease in contribution margin– TShs. 15,000 decrease in fixed costs= TShs. 25,000 decrease in operating income.



Assume that if Mountain View Furniture drops Cohen’sbusiness it can lease the excess capacity to thePerez Corporation for TShs. 70,000.

Fixed costs would not decrease.

Should Mountain View Furniture lease to Perez?



Steven Perez Total

Revenues 200,000 70,000 270,000

Variable costs 70,000 0 70,000

Fixed costs 135,000 0 135,000

Total operating costs 205,000 0 205,000

Operating income (5,000) 70,000 65,000


Explain why the book valueof equipment is irrelevant in

equipment-replacement decisions.

Equipment-Replacement Decisions Example


Existing ReplacementMachine Machine

Original cost TShs. 80,000 TShs. 105,000Useful life 4 years 4 yearsAccumulated depreciation TShs. 50,000Book value TShs. 30,000Disposal price TShs. 14,000Annual costs TShs. 46,000 TShs. 10,000



Ignoring the time value of money and income taxes,should the company replace the existing machine?

The cost savings over a 4-year period will beTShs. 36,000 × 4 = TShs. 144,000.

Investment = TShs. 105,000 – TShs. 14,000= TShs. 91,000

TShs. 144,000 – TShs. 91,000 = TShs. 53,000advantage of the replacement machine.


Explain how conflicts can arisebetween the decision modelused by a manager and the

performance evaluation modelused to evaluate the manager.

Decisions andPerformance Evaluation


What is the journal entry to sell the existing machine?

Cash 14,000Accumulated Depreciation 50,000Loss on Disposal 16,000Machine 80,000



In the real world would the manager replace themachine?

An important factor in replacement decisions is themanager’s perceptions of whether the decisionmodel is consistent with how the manager’sperformance is judged.



Top management faces a challenge – that is, makingsure that the performance-evaluation model ofsubordinate managers is consistent with thedecision model.

topic 3 relevant costing and contribution analysis

Documents

total of tshs

variable tshs

relevant revenues

manufacturing costs

future costs

marketing costs

unitfixed costs

past historical costs