Lesson 2 dm budget costing

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Relevant cost and short termdecision making

In this chapter, we will be looking in details tovarious possible short term decision making.We will look into each of the followings:

1. Acceptance or rejection of a contract2. Minimum price quotation3. Limiting factor – Single constraint & Multi

constraint4. Make or buy decision5. Shut-down decisions6. Further processing decisions



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Example: A company has been making a machine to order for acustomer, but the customer has since gone intoliquidation, and there is no prospect that any money willbe obtained from the winding up of the company. Costsincurred to date in manufacturing the machine areRM50,000 and progress payments of RM15,000 hadbeen received from the customer prior to the liquidation.The sales department has found another company willingto buy the machine for RM34,000 once it has been

completed.To complete the work, the following costs would beincurred:



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1. Materials: these have been bought at a cost of RM6,000.They have no other use, and if the materials is not finished,they would be sold for scrap for RM2,000.

2. Further labour costs would be RM8,000. Labour is in shortsupply, and if the machine is not finished, the work forcewould be switched to another job, which would earnRM30,000 in revenue, and incur direct costs of RM12,000and absorbed (fixed) overhead of RM8,000.

3. Consultancy fees RM4,000. If the work is not completed, theconsultant’s contract would be cancelled at a cost ofRM1,500.

4. General overheads of RM8,000 would be added to the cost of

the additional work

Required: Should the customer’s offer be accepted?



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Solution RM Note

Materials 1

Labour costs 2

Consultancy fees 3

General overheads 4

Total

Note

1) The relevant cost for material is related theopportunity costs which is the scrap income to beforgone.



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Note:

2) The relevant cost of labor is the total of further labour cost andthe opportunity cost of forgoing the contribution to be earnedfrom the other job.

3)4)



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Minimum price quotation

The minimum price for a once off job is its total relevantcosts: this is the price at which the company would makeno incremental loss from undertaking the work, but would

just achieve an incremental cost breakeven point

Example:

You have received a request from EXE to provide aquotation for the manufacture of a specialized piece ofequipment. This would be a one-off order, in excess ofnormal budgeted production. The following cost estimatehas already been prepared:



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Note RMDirect materials:Steel 10m²@ RM5 per m² 1 50Brass fittings 2 20Direct labour

Skilled 25 hours @ RM8 per hour 3 200Semi-skilled 10 hours @ RM5 per hour 4 50Overhead 35 hours @ RM10 per hour 5 350Estimating time 6 100

770

Administration overhead @ 20% of production cost 1547 924

Profit @ 25% of production cost 8 231Selling price 1155



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Notes1. The steel is regularly used and has a current stock value

of RM5 per square meter. There are currently 100 squaremeters in stock. The steel is readily available at a price ofRM5.50 per square meter.

2. The brass fittings would have to be brought specificallyfor this job: a supplier has quoted the price of RM20 forthe fittings required.

3. The skilled labour is currently employed by your companyand paid at a rate of RM8 per hour. If this job wereundertaken it would be necessary either to work 25 hours’overtime which would be paid at time plus one half, OR inorder to carry out the work in normal time, reduceproduction of another product that earns a contribution ofRM13 per hour.



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Notes4. The semi –skilled labour currently has sufficient paid idle

time to be able to complete this work.5. The overhead absorption rate includes power costs

which are directly related to machine usage. If this job

were undertaken, it is estimated that the machine timerequired would be ten hours. The machines incur powercosts of RM0.75 per hour. There are no other overheadcosts that can be specifically identified with this job.

6. The cost of the estimating time is that attributed to thefour hours taken by the engineers to analyse thedrawings and determine the cost estimate given above.

7. It is the company policy to add 20% to the productioncost as an allowance for administration costs associatedwith the jobs accepted.



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Notes

8. This is the standard profit added by your companyas part of its pricing policy.

Required:Prepare on a relevant cost basis, the lowest costestimate that could be used as the basis for aquotation.



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Solution RMDirect materials:SteelBrass fittings

Direct labourSkilledSemi-skilledOverhead

Estimating time Administration overhead @ 20% of production costProfit @ 25% of production costSelling price



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Limiting Factor Analysis

Limiting factor or key factor is ‘Anything whichlimits the activity of an entity. An entity seeks tooptimize the benefit it obtains from the limiting

factor’. It is assumed that in limiting factor analysis,

management would optimize its profit byproducing the product mix that gives the highestpossible profit and profit is maximized when

contribution is maximized. Hence, products thatgive the highest possible contribution per unit oflimiting factor would be given production priority.



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Make or buy decision

An option is to be made whether to buy externally orproduced internally

If an organization has the freedom of choice to make

internally or purchase externally under the followingconditions:

1. No scarce resources – relevant costs will be thedifferential cost between the two options

2. Insufficient internal resources – comparison betweenthe purchase price of the said product with thevariable cost of making plus the opportunity cost ofusing the scarce resource is to be made.



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Example (no scarce resources):

Pixie Pharmaceuticals is a research-basedcompany which manufactures a wide variety of

drugs for use in hospitals. The purchasingmanager has recently been approached by anew manufaturer based in a newly industrialisedcountry who have offered to produce three of the

drugs at their factory. The following unit costand unit price information has been provided.



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Drug Fairyoxide Spriteolite Goblinex

Production (units) 20,000 40,000 80,000

$ $ $

Direct material cost 0.80 1.00 0.40

Direct labour cost 1.60 1.80 0.80Direct expense cost 0.40 0.60 0.20

Fixed cost 0.80 1.00 0.40

Selling price each 4.00 5.00 2.00

Imported price 2.75 4.20 2.00

Required:

(a) Recommend to the management whether any drugs should bepurchased on the basis of cost only.



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Solution

Drug Fairyoxide Spriteolite Goblinex

Unit variable costs:

Direct material 0.80 1.00 0.40

Direct labour 1.60 1.80 0.80Direct expenses 0.40 0.60 0.20

Total cost of making 2.80 3.40 1.40

Imported price 2.75 4.20 2.00

Saving/(Loss) from 0.05 (0.80) (0.60)Buying

Decision



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Shut down decision/ Discontinuing a product

Shut down decision involves the following decisions:

Whether to shut down a factory, a department or aproduct line either due to it making a loss or tooexpensive to run

If the decision is to shut down, whether the closure ispermanent or temporary

If the decision is to shut down a product line, should anew product line be set up to replace ceased productline.



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Approach

Method 1: Comparing the contribution/profit beforeand after the closure

Method 2: Considering the relevant cost (for eg the

contribution forgone from the ceased operation withthe savings obtained from closure)

Note: Students will most likely be required to use

the marginal costing approach to prepare thecontribution earned from a particular segment ofbusiness to determine whether that segment ofbusiness should cease operation or to continue.



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Example: Ayeco with a head office in Ayetown, has threemanufacturing units. One in Beetown, the second inCeetown and the third in Deetown. The companymanufactures and sells an air-conditioner under the brand-

name of Ayecool at a price of RM200. It is unable to utilizefully its manufacturing capacity. The management of thecompany has to decide whether or not to renew the leaseof the property at Beetown, which expires next year. Thecompany has been offered an extension to the lease at anadditional cost of RM50,000 per annum. This situation

concerning the lease has been known for some time, so theaccountant has collected relevant information to aid thedecision. It is estimated that the cost of closing downBeetown would be offset by the surplus obtained by thesale of plant, machinery and inventories.



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Beetown Ceetown Deetown Total

RM'000 RM'000 RM'000 RM'000

Costs

Direct Materials 200 800 400 1,400

Direct Wages 200 900 350 1,450

Production overhead: Variable 50 300 150 500

Fixed 200 600 300 1,100Subtotal 650 2,600 1,200 4,450

Selling overhead:Variable 25 200 100 325

Fixed 75 250 150 475

Administration overhead 100 450 200 750

Subtotal 850 3,500 1,650 6,000

Head office costs 50 200 100 350

Total 900 3,700 1,750 6,350Profit 100 300 250 650

Sales 1,000 4,000 2,000 7,000



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If Ayeco does not renew the lease of the Beetown property ithas two alternatives:a) Accept an offer from Zeeco, a competitor, to take over the

manufacture and sales in the Beetown area and pay to Ayeco a commission of RM3 for each unit sold.

b) Transfer the output at present made in Beetown to eitherCeetown or Deetown. Each of these units has sufficientplant capacity to undertake the Beetown output butadditional costs in supervision, salaries, storage andmaintenance would be incurred. These additional costsare estimated as amounting yearly to RM250,000 at

Ceetown and to RM200,000 at Deetown.If the Beetown sales are transferred to either Ceetown orDeetown, it is estimated that additional transport costswould be incurred in delivering to customers in the r

egion of Beetown, and that these would amount to RM15per unit and RM20 per unit respectively.



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Required:

Present a statement to the board of directors of Ayecoto show the estimated annual profit which would arisefrom the following alternative course of action.

a) Continuing production at all three sitesb) Closing down production at Beetown and

accepting the offer from Zeeco

c) Transferring Beetown sales to Ceetown

d) Transferring Beetown sales to Deetown



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SolutionBeetown Ceetown Deetown Total

Quantity sold 5000 20000 10000 35000

Sales 1000 4000 2000 7000

Less:-Variable Cost

Direct Materials 200 800 400 1400Direct Wages 200 900 350 1450

V. Production Overhead 50 300 150 500

V. Selling Overhead 25 475 200 2200 100 1000 325

Contribution 525 1800 1000 3325

Less:- Directly Attributable Fixed

CostFixed Production Overhead 200 600 300 1100

Fixed Selling Overhead 75 250 150 475

Administration Overhead 100 375 450 1300 200 650 750

Attributable Profit 150 500 350 1000

Less:- Head Office Cost 50 200 100 350

Profit 100 300 250 650



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Solution



Relevant cost and short term decisionmaking

Solution

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Further processing decision Further processing decision involve the selection of

the joint products whether to sell it after further

processing it or immediately after split-off point. In such a case, the joint cost incurred before the

split off point would not be considered as this costwould have to be incurred regardless of whetherthe product is sold at split off point or after furtherprocessing.



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Example:

Rustam Ali Sdn Bhd produces two products from a singleprocess. During one period in which the process costs areexpected to be RM150,000, the following outputs areexpected:

Output Unit selling(litres) Price (RM)

Product X 5,000 15.00

Product Y 15,000 10.00

Each product can be further processed using skilled labour,costing RM10 per hour, to create superior products; Super Xand Super Y.

R l d h



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Further modifications will result in the following increases inlabour hours and amended selling prices:

Skilled Labour Unit SP (RM)

Product Super X 75hrs per lit 25 per lit

Product Super Y 40hrs per lit 13 per lit

Required:

Advise Rustam Ali Sdn Bhd whether Product X and Product Y

should be further processed before it is being sold.

R l t t d h t t



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Solution

R l t t d h t t



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Qualitative factors

Before any decisions is made, the management wouldneed to consider other factors which may not bequantifiable but represents an important aspects in

coming up with the conclusion. Below are someexamples which may affect a particular decision:

R l t t d h t t



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FactorsAvailability of resources such ascash, materials, labours etc

Inflation

DetailsAn opportunity might exists for acompany, but such an opportunitycan only be taken when there is noconstraints on taking up theopportunity

The effects on inflation on the prices of various items may need to be considered especially fixed pricecontract that may require years tocomplete should be taken into

account as the contracts profitabilitymay be affected if there is costoverrun

R l t t d h t t



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Employees

Customers

The company must consider theeffects of a particular decision on

the employees in terms of

motivation, morale, possible

resistance etc

Decisions involving undertaking a

once off job, product abandonment,

shutting down, make or buy will

inevitably affects the customers

loyalty.

R l t t d h t t



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Competitors

Suppliers

Every decision made by a companywill indirectly result in competitorsreacting to safeguard its own

profitability and survival. Forexample, before a company decidesto reduce its products’ selling price,the management will need to

consider its effectiveness as theremay be a possibility that a price warmay arise.

Certain decisions may affect thesuppliers such as the possible shut

down of a particular product line ormay result in the loss of goodwill ofthe company due to the negative

perception it has on the companyreducing its scale of operations.

Lesson 2 dm budget costing

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