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 COSTa) 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 buyXY Ltd manufactures auto parts. The following costs are incurred for processing 1 lakh units of a component:

Direct material Cost Rs. 5 LakhsDirect labour Cost Rs. 8 LakhsVariable factory OverheadsRs. 6 LakhsFixed Factory Overheads Rs. 5 lakhs

Continue….

….ContinueThe 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.

SolutionI Relevant cost to make

Direct material Cost Rs. 5 LakhsDirect labour Cost Rs. 8 LakhsVariable factory Overheads Rs. 6 LakhsTotal Rs 19 Lacs

Solution

Relevant cost to buy

Purchase price 22 lacsLess:-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?

SolutionWhen released capacity is rented out:-Relevant cost to make Rs 19 Lacs

Purchase priceRs.22 lacsLess:-Reduction in fixed cost 2 LacsLess:-Rental Income 1.5 lacsII Relevant cost to buy 18.50 Lacs

Advisable to Buy the component

Make or BuyAuto parts Ltd. has an annual production of 90000 units for a motor component. The component cost structure is as below:Material 270 per unitLabour( 25% fixed) 180 per unitExpenses:

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 270Labour (75% of 180) 135Variable expenses 90Total variable cost when Component is produced 495Suppliers price 540It 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 cont..b) 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

Solutionb)Selling price of per unit of new product 485Less Variable cost- Material 200

Labour 135Expenses 90 425Contribution per unit 60

Loss if present component is purchased 45If 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 unitDirect Labour Rs. 7 per unitFactory Expenses:Fixed Rs. 12 per unitVariableRs 4 per unitOffice and selling expensesFixed Rs 6 per unitVariableRs.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?

SolutionSales 60

Less:- Variable CostDM 10Dl 7exp 7 2436

Less Fixed Cost 18Profit 18

Profitability Statement(Export )Export Sales(6000 units @ Rs.30)

180000Less:-Variable cost @ Rs. 24

144000 36000Less:-Additional cost of exports

10000 Profit 26000Conclusion:-Accept the order

Export OrderA 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 8280Direct Wages 11160Variable and other mfg exp 3960Total 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:

Material40Labour Skilled (fixed) 20Unskilled(Variable) 20Variable overheads 20Fixed Overhead 40Total Cost 140 per unit

Cont..a) Advise the management whether

to accept the foreign order or not.b) What will be your advice if the

same order had come from a local merchant?

Profitability Statement  80% 20% 100%

Particulars

80000 units (for domestic sales)

20000 units (for foreign Order)

Total 100000 units

  Total  (Rs.) Per Unit(Rs.) Total (Rs) Per Unit(Rs.) Total (Rs)Sales 14400000 180 2000000 100 16400000Less:-Variable Cost          Material 3200000 40 800000 40 4000000Labour (unskilled) 1600000 20 400000 20 2000000Overhead 1600000 20 400000 20 2000000Total 6400000 80 1600000 80 8000000Contribution 8000000 100 400000 20 8400000Less:-Fixed Cost        Labour (skilled) 1600000 20     1600000Overhead 3200000 40     3200000Total 4800000 60   4800000 Profit 3200000 40 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 C

Production (units) 3000 2000 5000Selling price per unit 40 60 61Less:-Variable cost 27 38 43

Contribution 13 22 18Less:-Fixed Cost 5 8 9

Profit 8 14 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

C-7500 unitscontribution on B=3000 X 22=66000Contribution on C-7500 x

18=135000Total Contribution=201000

If B is discontinued A & C will increase by 50%Sales of A would be 4500 units and

C-7500 unitsContribution on A=4500 X

13=58500Contribution on C=7500 x

18=135000Total Contribution=193500

If C is discontinued A & B will increase by 50%Sales of A would be 4500 units and

B-3000 unitscontribution on A=4500 X 13=58500contribution on B=3000 X 22=66000Total Contribution=124500

Home workA company currently operating at 80 % capacity has the following particulars:

Sales 3200000Direct Material 1000000Direct Labour 400000Variable Overhead 200000Fixed 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.. The alternatives available to the

management are:1. Reject the order and continue with the

domestic sales only(as at present),or2. 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, andb)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.