Download Relevant Costs for Non-Routine Decision Making: A Guide to Cost Analysis in Business and more Exercises Cost Accounting in PDF only on Docsity!
Relevant Costs for Non-Routine
Decision Making
Relevant Costs for Non-Routine Decision
Making
Quantitative and Qualitative Factors
Quantitative factors are those that can be easily measured in monetary terms, such as projected costs of materials, labor, and overhead. Qualitative factors are those that are difficult to measure precisely in monetary terms, yet may be given more weight than the measurable cost savings.
Relevant costs are expected future costs that will differ between alternatives. Historical costs are always irrelevant because they are not future costs, although they may be helpful in predicting relevant costs.
Differential costs are the change in total cost under each alternative, which is not the same as relevant costs.
Rebuilding vs. Replacing a Truck
Analysis: Future costs of replacing the truck: P10, Less: Proceeds from disposal of old truck (net): P1, Net cost of replacing: P9, Cost of rebuilding the truck: P8, Advantage of rebuilding: P
The original cost of the old truck is irrelevant, but its disposal value is relevant. It is recommended to rebuild the truck as it involves a lower cash outlay.
Variable Costs and Relevant Costs
Variable costs are relevant costs only if they differ in total between the alternatives under consideration.
Only those costs that would be avoided as a result of dropping a product line are relevant in the decision. Costs that will not differ regardless of whether the product line is retained or discontinued are irrelevant.
An apparent loss may be the result of allocated common costs or of sunk costs that cannot be avoided if the product line is dropped. A
product line should be discontinued only if the contribution margin that will be lost is less than the fixed costs that would be avoided.
Allocations of common fixed costs can make a product line appear unprofitable, whereas it may be profitable.
Pricing Decisions
In cost-plus pricing, prices are set by applying a markup percentage to a product's cost.
The price elasticity of demand measures the degree to which a change in price affects unit sales. Products with inelastic demand are relatively insensitive to price changes, while products with elastic demand are sensitive to price changes.
The profit-maximizing price should depend only on the variable (marginal) cost per unit and on the price elasticity of demand. Fixed costs are not relevant in the pricing decision.
The markup over variable cost depends on the price elasticity of demand. A product with elastic demand should have a lower markup over cost than a product with inelastic demand.
Exercises
Identifying Relevant Costs: Case 1: Relevant costs include sales revenue, direct materials, direct labor, variable manufacturing overhead, disposal value of the old machine, and variable selling expense.
Case 2: Relevant costs include sales revenue, direct materials, direct labor, variable manufacturing overhead, market value of the new machine, and variable selling expense.
Identification of Relevant Costs:
The variable operating costs would be relevant, as well as any decrease in the resale value of the car due to its use.
The automobile tax, license costs, and insurance costs are likely irrelevant.
Make or Buy a Component:
The relevant costs are the variable manufacturing costs and the supervisory salaries, which can be avoided if the parts are purchased.
The remaining book value of the special equipment is a sunk cost and is not relevant.
Evaluating a Special Order:
Pricing a New Product
Target Cost per Battery
The target cost per battery is P55, calculated as P2,750,000 divided by 50,000 batteries.
Profit-Maximizing Markup on Variable Cost
The profit-maximizing markup on variable cost is calculated as: d = In(1 + % change in quantity sold) / In(1 + % change in price) = (1,340 - 860) / 860 / In(1 + (13.90 - 17.90) / 17.90) = 0.44349 / -0.25291 = -1.75 Profit-maximizing markup on variable cost = -1 / (1 + d) = -1 / (1 + (-1.75)) = 1.
Profit-Maximizing Price
The profit-maximizing price is calculated as: Profit-maximizing price = (1 + Profit-maximizing markup on variable cost) × Variable cost per unit = (1 + 1.333) × P4.10 = P9.
Selling Price of the New Amaretto Cappuccino Product
The selling price of the new amaretto cappuccino product should at least cover its variable cost of P4.60 and its opportunity cost of P25.50, for a total of P30.10.
Accept or Reject an Order
Product B should be accepted because its total contribution margin of P9,600 is higher than that of Product A, which is P8,400.
Eliminate or Retain a Product Line
The production and sale of the round trampolines should not be discontinued, as the depreciation of the special equipment represents a sunk cost and the general factory overhead is allocated and will continue regardless. If management wants a clear picture of the profitability of the segments, the general factory overhead should not be allocated, as it is a common cost and should be deducted from the total product-line segment margin.
Product Mix
Requirement 1
The company should use 4,000 out of the available 96,000 hours to produce 4,000 units of product D, and the remaining 92,000 hours should be used to produce 9,200 units of Product B.
Requirement 2
If there were no market limitations on any of the products, the company should use all the available 96,000 hours in producing 96,000 units of product D only, as this would result in a difference in profit of P230, compared to the combination of D and B.
Accept or Reject a Special Order
Requirement 1
The company should accept the special order of 4,000 units at P each, as this selling price is still higher than the additional variable cost to be incurred.
Requirement 2
The total variable manufacturing cost is P8.75.
Requirement 3
The total cost of inventory under direct costing is P8.75, consisting of P5.00 for direct materials, P3.00 for direct labor, and P0.75 for variable factory overhead.
Requirement 4
The company should not reduce the selling price from P15 to P14 even if volume will go up, as the total contribution margin will decrease by P5,000.
CVP Analysis used for Decision Making
Requirement (a)
The probability distribution of the number of units sold per month is provided.
The Economists' Approach to Pricing
Requirement (3)
The profit-maximizing price is estimated to be P328, which is much lower than the price the postal service has been charging in the past. It would be prudent to drop the price gradually and observe the impact on unit sales and profits. The critical assumption in the calculation of the profit-maximizing price is that the percentage increase (decrease) in quantity sold is always the same for a given percentage decrease (increase) in price. The profit-maximizing price to maximize contribution margin and profit is P383, which is a P55 increase from the previous estimate of P due to a P100 increase in variable cost.
The Enduring Popularity of Full-Cost Pricing
The enduring popularity of full-cost pricing may be explained to some degree by the notion that prices should be "fair" rather than calculated to maximize profits. This idea suggests that prices should cover all costs, including a reasonable profit margin, rather than being set solely to achieve the highest possible profit.
Pricing Based on "Fairness" Rather than Profit
Maximization
The text suggests that the popularity of full-cost pricing is driven by the belief that prices should be "fair" rather than focused solely on profit maximization. This implies that there is a perception that prices should cover all costs, including a reasonable profit, rather than being set at the highest possible level.
Managing Constraints and Maximizing Profits
The text provides an example of a bakery business that is managing the constraint of a cake decorator's time to maximize profits. The key points include:
Ranking customers based on a "profitability index" to determine which orders to accept or cancel Considering changing the pricing structure to include a charge for the cake decorator's time, with a minimum hourly rate plus an opportunity cost Ensuring the cake decorator's time is used efficiently by avoiding unnecessary tasks and leveraging assistants or apprentices Potentially subcontracting some cake decorating to other bakers if the cost is less than the opportunity cost
These strategies demonstrate how the business is trying to balance customer satisfaction, employee workload, and profitability by carefully managing the constraint of the cake decorator's time.
Adjusting the Profitability Index Cutoff
The text suggests that the bakery should adjust the profitability index cutoff over time to ensure that only the most profitable cake reservations are accepted. If too many reservations are turned down and the cake decorator's time is not fully utilized, the cutoff should be adjusted downward. If too few reservations are turned down and the time is overbooked, the cutoff should be adjusted upward.
Pricing Based on Cake Decorating Time
The text recommends that the bakery should consider changing the pricing structure to include a charge for the cake decorator's time. This charge should be based on the hourly rate of pay (including benefits) plus the opportunity cost of at least P340 per hour, as the decorator's time is a limited resource.
Efficient Use of the Cake Decorator's Time
The text suggests several ways the bakery can ensure the cake decorator's time is used efficiently:
Avoiding unnecessary tasks that could be done by machines or assistants Assigning an assistant to prepare frosting and clean up, freeing the decorator for more skilled work Considering an apprentice to learn decorating skills and expand the company's capacity Subcontracting some less demanding decorating to other bakers, as long as the cost is less than the opportunity cost
These strategies aim to maximize the use of the decorator's time and increase profitability.
