5102013_195546_F002_Relevant Cost

7/27/2019 5102013_195546_F002_Relevant Cost

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relevant costing and

decision making

7/27/2019 5102013_195546_F002_Relevant Cost


Mr. Pravat is the Cluster Head in HDFC in Bhubaneswar.

Following the declaration of one week vacation for puja,

he is faced with and important decision : Should he drive to

Chennai for puja vacation, or should he fly?

If he drives, he will leave on Saturday, stay in a hotel in

Rajamuhundry Saturday night, and arrive in Chennai late

Sunday evening. This option will allow him to enjoy five fulldays in Chennai (Mon to Fri). However, he would have to

leave the Following Saturday, and spend another Saturday

night in a Hotel in Rajamuhundry in order to arrive back in

Bhubaneswar Late Sunday evening.

If he flies, he will leave on Saturday afternoon and arrive in

Chennai in the evening. This option will allow him to relax

in Chennai for full seven days before flying back to

Bhubaneswar the following Sunday.

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Relevant factors affecting his decisions :

• Average cost per night to stay in a hotel is Rs.2,000.

• Cost to have someone watch Tommy (Pravat’s dog) is

Rs.150 per day.

• Eating out costs approximately Rs.400 per day.

• In August, Pravat paid Rs.9,200 for annual car insurancepremium.

• Pravat’s Santro is showing 16 kms mileage.

• Distance between Bhubaneswar and Chennai is 1237 kms.

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Relevant information

in Business Decisions

All business decisions involve choosing among alternative

courses of action. The only information relevant to a decision

is :

that which varies among the possible courses of action being considered.

Costs, revenues and other factors that do not vary among the

possible courses of action are not relevant to the decision.

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RedStar Ketchup Company

RedStar is closed for a labour strike. During the strike,

company is incurring costs of approximately Rs.1,50,000per week for utilities, interest and salaries of non-striking

employees.

A major film production company has offered to rent thefactory for a week at a price of Rs.1,00,000 to shoot several

scenes of a new action movie. If the factory is rented,

RedStar’s management estimates that its cleaning costs will

amount to nearly Rs.20,000.

Would it be profitable to rent the ketchup factory to the

Film company?

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Relevance of Opportunity Costs,

Sunk Costs, and Out-of-Pocket Costs

in making Business Decisions

Opportunity Costs

The benefit that could have been obtained by pursuingan alternative course of action.

Assume labour strike ends just before filming begins. As a

consequence RedStar must forego any profit that the factorycould’ve earned during the week that filming is in process.

Thus, if operating profit could have totaled Rs.2,50,000,

The opportunity cost of renting to the film company is

Rs.2,50,000 foregone.

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Sunk Costs

That has already been incurred and can not be changed

by future decisions.

RedStar’s investment in its ketchup factory is a sunk cost .

This cost will not change regardless of whether RedStar

rents the factory, resumes operations, or lets the buildingstand vacant.

The only cost relevant to a decision are those that vary

among the courses of action being considered. Sunk costs

are not relevant because they can not be changed regardlessof what decision is made.

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Out-of-Pocket Costs

The costs that have not yet been incurred and that may vary

among the possible courses of action.

RedStar’s estimated cleaning expenditure are considered

Out-of-Pocket Costs.

This is normally identified as relevant in most business

Decisions.

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Incremental Analysis in Common Business Decisions

Special Order Decisions

Dhawan Sports Co. Ltd. manufacturers table tennis balls

that it distributes exclusively through professional sports

shops in India. Although the company has capacity toproduce 2 million balls per month, its current sales volume

requires that only 8,00,00 units be produced. At this level

of output, monthly manufacturing costs average approximately

Rs.48,00,000 as follows:

Variable Costs @ Rs.2 per ball…………Rs.16,00,000

Fixed Costs………………………………. 32,00,000

Total Mfg. Costs 48,00,000

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Dhawan Sports

Dhawan Sports receives a special order from ORBIT, a

company that sells sports products in Srilanka, for

5,00,000 ‘special level’ tennis balls per month. The balls will

be imprinted with the ORBIT name and logo and would not

in any way be identified with Dhawan Sports.

To avoid direct competition with regular customers of Dhawan Sports, ORBIT has agreed not to sell these balls

outside of Srilanka. However, it is willing to pay Dhawan

Sports only Rs.25,00,000 per month for the special order.

However, the regular sales price per ball charged by

Dhawan Sports is Rs.12.50.

Would it be profitable for Dhawan Sports to accept this

order?

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Production Constraint Decisions

Bangla Art Gallery creates three products viz.

a. Water Color Paintings

b. Oil Paintings

c. Custom Frames

Total output is however limited to what can be produced in

6000 hours of direct labour.

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Bangla Art Gallery

Water Col Oil CustomPainting Painting Painting

Selling Price per unit (Rs) 9000 16000 3500

Variable Cost per unit (Rs) 3000 6000 1500

Direct Labour Hours

required per unit 2 hrs 4 hrs 1 hr

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Make or Buy Decisions

The management of Ultrasonic is considering whether to

buy a component (required for its main product) Rs.50 per unit that costs the company Rs.60 per unit to produce.

The monthly cost data of producing 10,000 units (normal

required volume) of that component are given in the next

slide:

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Ultrasonic

Monthly Production : 10,000 units

Amount (Rs)

Direct Material 80,000

Direct Labour 1,25,000

Variable Overhead 1,00,000

3,05,000

Fixed Overhead per month 2,95,000

Total Mfg Costs per month 6,00,000

Avg Unit Mfg Cost (Rs.) 60

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Sale, Scrap, or Rebuild Decisions

Renovo Ltd. has its inventory 500 computers that cost

Rs.32,50,000 to produce. Unfortunately their processorsnow are considered technologically obsolete.

What to do with these computers?

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Renovo Ltd. The management is considering the following options to

deal with these machines :

a. Sell the computers ‘as is’ to Television Shopping

Network (TSN) for Rs.25,00,000.

b. Sell them for Rs.23,50,000 to the schools of the

nearby districts for use in their computer lab.

c. Scrap the existing processor in each machine

and replace it with a faster, state-of-the-art chip ata total cost of Rs.19,00,000. If this option is

selected, the rebuilt computers could be sold for

Rs.Rs.45,00,000.

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Joint Product Decisions

CharCore mixes together wood chips and pine oil. After

joint manufacturing costs of Rs.20,000 the mixtureseparates into two saleable products

a. Granulated Charcoal (sales value Rs.50,000)

b. Methyl Alcohol (sales value Rs.90,000)

How should the Rs.20,000 in joint costs be allocated

between these products?

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Charcore Ltd. The company may sell its charcoal and alcohol after the

split-off point without further processing or it may continueprocessing either of these products.

Charcore can use the granulated charcoal to manufacture

air filters and the methyl alcohol to make cleaning solvent.

The sales value of air filters and cleaning solvents

produced after further processing of given quantity of

charcoal and methyl alcohol (as produced in the first case)

are as follows:

Air filters (sales value Rs.1,50,000)

Cleaning solvent (sales value Rs.1,40,000)

5102013_195546_F002_Relevant Cost

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