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MANAGEMENT ACCOUNTING - Solutions Manual

CHAPTER 19
RELEVANT COSTS FOR DECISION MAKING
I.

Questions
1. Quantitative factors are those which may more easily be reduced in terms
of pesos such as projected costs of materials, labor and overhead.
Qualitative factors are those whose measurement in pesos is difficult and
imprecise; yet a qualitative factor may be easily given more weight than
the measurable cost savings. It can be seen that the accountants role in
making decisions deals with the quantitative factors.
2. Relevant costs are expected future costs that will differ between
alternatives. In view of the definition of relevant costs, historical costs are
always irrelevant because they are not future costs. They may be helpful
in predicting relevant costs but they are always irrelevant costs per se.
3. The differential costs in any given situation is commonly defined as the
change in total cost under each alternative. It is not relevant cost, but it is
the algebraic difference between the relevant costs for the alternatives
under consideration.
4. Analysis:
Future costs:
New Truck
Less: Proceeds from
disposal, net

Replace
P10,200

Rebuild

1,000
P 9,200

Advantage of rebuilding

P8,500
P700

The original cost of the old truck is irrelevant but its disposal value is
relevant. It is recommended that the truck should be rebuilt because it
will involve lesser cash outlay.
5. No. Variable costs are relevant costs only if they differ in total between the
alternatives under consideration.
6. Only those costs that would be avoided as a result of dropping the product
line are relevant in the decision. Costs that will not differ regardless of
whether the product line is retained or discontinued are irrelevant.
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Chapter 19 Relevant Costs for Decision Making

7. Not necessarily. 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 as a result of dropping the line is less than the
fixed costs that would be avoided. Even in that situation the product line
may be retained if its presence promotes the sale of other products.
8. Allocations of common fixed costs can make a product line (or other
segment) appear to be unprofitable, whereas in fact it may be profitable.
9. In cost-plus pricing, prices are set by applying a markup percentage to a
products cost.
10. The price elasticity of demand measures the degree to which a change in
price affects unit sales. The unit sales of a product with inelastic demand
are relatively insensitive to the price charged for the product. In contrast,
the unit sales of a product with elastic demand are sensitive to the price
charged for the product.
11. The profit-maximizing price should depend only on the variable
(marginal) cost per unit and on the price elasticity of demand. Fixed costs
do not enter into the pricing decision at all. Fixed costs are relevant in a
decision of whether to offer a product or service, but are not relevant in
deciding what to charge for the product or service. Because price affects
unit sales, total variable costs are affected by the pricing decision and
therefore are relevant.
12. The markup over variable cost depends on the price elasticity of demand.
A product whose demand is elastic should have a lower markup over cost
than a product whose demand is inelastic. If demand for a product is
inelastic, the price can be increased without cutting as drastically into unit
sales.

II. Exercises
Exercise 1 (Identifying Relevant Costs)
Case 1
Item

Relevant
19-2

Not
Relevant

Case 2
Relevant

Not
Relevant

Relevant Costs for Decision Making Chapter 19


a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.

Sales revenue................................... X
Direct materials............................... X
Direct labor...................................... X
Variable manufacturing
overhead.......................................... X
Book value Model E7000
machine...........................................
Disposal value Model E7000
machine...........................................
Depreciation Model E7000
machine...........................................
Market value Model F5000
machine (cost)................................. X
Fixed manufacturing
overhead..........................................
Variable selling expense.................. X
Fixed selling expense...................... X
General administrative
overhead.......................................... X

X
X

X
X

X
X

X
X

X
X

X
X
X
X

Exercise 2 (Identification of Relevant Costs)


Requirement 1
Fixed cost per mile (P3,500* 10,000 miles)..........................................................
P0.35
Variable operating cost per mile...............................................................................
0.08
Average cost per mile...............................................................................................
P0.43
* Depreciation............................................................................................................
P2,000
Insurance.................................................................................................................
960
Garage rent.............................................................................................................
480
Automobile tax and license.....................................................................................
60
Total........................................................................................................................
P3,500
Requirement 2
The variable operating costs would be relevant in this situation. The
depreciation would not be relevant since it relates to a sunk cost. However,
any decrease in the resale value of the car due to its use would be relevant.
The automobile tax and license costs would be incurred whether Ingrid decides
to drive her own car or rent a car for the trip during summer break and are
therefore irrelevant. It is unlikely that her insurance costs would increase as a
result of the trip, so they are irrelevant as well. The garage rent is relevant
only if she could avoid paying part of it if she drives her own car.
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Chapter 19 Relevant Costs for Decision Making

Requirement 3
When figuring the incremental cost of the more expensive car, the relevant
costs would be the purchase price of the new car (net of the resale value of the
old car) and the increases in the fixed costs of insurance and automobile tax
and license. The original purchase price of the old car is a sunk cost and is
therefore irrelevant. The variable operating costs would be the same and
therefore are irrelevant. (Students are inclined to think that variable costs are
always relevant and fixed costs are always irrelevant in decisions. This
requirement helps to dispel that notion.)
Exercise 3 (Make or Buy a Component)
Requirement 1

Cost of purchasing
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead, traceable1

Per Unit
Differential
Costs
15,000 units
Make
Buy
Make
Buy
P200
P3,000,000
P60
P900,000
80
1,200,000
10
150,000
20

Fixed manufacturing overhead, common


Total costs
Difference in favor of continuing to make
the parts
1

0
P170
P30

300,000
0
0
0
P200 P2,550,000 P3,000,000
P450,000

Only the supervisory salaries can be avoided if the parts are purchased. The
remaining book value of the special equipment is a sunk cost; hence, the P3 per
unit depreciation expense is not relevant to this decision. Based on these data, the
company should reject the offer and should continue to produce the parts internally.

Requirement 2
Make
Buy
Cost of purchasing (part 1)...................................................................................................
P3,000,000
Cost of making (part 1)........................................................................................................
P2,550,000
Opportunity costsegment margin forgone on a
650,000
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Relevant Costs for Decision Making Chapter 19


potential new product line................................................................................................
Total cost...............................................................................................................................
P3,200,000 P3,000,000
Difference in favor of purchasing from the outside
supplier..............................................................................................................................
P200,000
Thus, the company should accept the offer and purchase the parts from the outside
supplier.

Exercise 4 (Evaluating Special Order)


Only the incremental costs and benefits are relevant. In particular, only the
variable manufacturing overhead and the cost of the special tool are relevant
overhead costs in this situation. The other manufacturing overhead costs are
fixed and are not affected by the decision.
Per
Unit
P3,499.50

Total
10 bracelets
P34,995.00

Incremental revenue
Incremental costs:
Variable costs:
Direct materials
1,430.00
14,300.00
Direct labor
860.00
8,600.00
Variable manufacturing overhead
70.00
700.00
Special filigree
60.00
600.00
Total variable cost
P2,420.00
24,200.00
Fixed costs:
Purchase of special tool
4,650.00
Total incremental cost
28.850.00
Incremental net operating income
P 6.145.00
Even though the price for the special order is below the companys regular
price for such an item, the special order would add to the companys net
operating income and should be accepted. This conclusion would not
necessarily follow if the special order affected the regular selling price of
bracelets or if it required the use of a constrained resource.
Exercise 5 (Utilization of a Constrained Resource)
Requirement 1
X
Y
Z
(1) Contribution margin per unit................................................................................................
P18 P36 P20
(2) Direct labor cost per unit.......................................................................................................
P12 P32 P16
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Chapter 19 Relevant Costs for Decision Making


(3) Direct labor rate per hour......................................................................................................
8
8
8
(4) Direct labor-hours required per unit (2) (3).......................................................................
1.5
4.0
2.0
Contribution margin per direct labor-hour (1) (4).............................................................
P12 P9 P10

Requirement 2
The company should concentrate its labor time on producing product X:
X
Contribution margin per direct labor-hour
Direct labor-hours available
Total contribution margin

P12
3,000
P36,000

Y
P9
3,000
P27,000

Z
P10
3,000
P30,000

Although product X has the lowest contribution margin per unit and the
second lowest contribution margin ratio, it has the highest contribution margin
per direct labor-hour. Since labor time seems to be the companys constraint,
this measure should guide management in its production decisions.
Requirement 3
The amount Jaycee Company should be willing to pay in overtime wages for
additional direct labor time depends on how the time would be used. If there
are unfilled orders for all of the products, Jaycee would presumably use the
additional time to make more of product X. Each hour of direct labor time
generates P12 of contribution margin over and above the usual direct labor
cost. Therefore, Jaycee should be willing to pay up to P20 per hour (the P8
usual wage plus the contribution margin per hour of P12) for additional labor
time, but would of course prefer to pay far less. The upper limit of P20 per
direct labor hour signals to managers how valuable additional labor hours are
to the company.
If all the demand for product X has been satisfied, Jaycee Company would
then use any additional direct labor-hours to manufacture product Z. In that
case, the company should be willing to pay up to P18 per hour (the P8 usual
wage plus the P10 contribution margin per hour for product Z) to manufacture
more product Z.
Likewise, if all the demand for both products X and Z has been satisfied,
additional labor hours would be used to make product Y. In that case, the
company should be willing to pay up to P17 per hour to manufacture more
product Y.

19-6

Relevant Costs for Decision Making Chapter 19

Exercise 6 (Sell or Process Further)


Sales value after further processing
Sales value at split-off point
Incremental revenue
Cost of further processing
Incremental profit (loss)

Product A
P80,000
50,000
30,000
35,000
P(5,000)

Product B
P150,000
90,000
60,000
40,000
20,000

Product C
P75,000
60,000
15,000
12,000
3,000

Products B and C should be processed further, but not Product A.


Exercise 7 (Identification of Relevant Costs)
Requirement 1
The relevant costs of a fishing trip would be:
Fuel and upkeep on boat per trip.............................
Junk food consumed during trip*.............................
Snagged fishing lures...............................................
Total........................................................................

P25
8
7
P40

* The junk food consumed during the trip may not be completely relevant.
Even if Shin were not going on the trip, he would still have to eat. The
amount by which the cost of the junk food exceeds the cost of the food he
would otherwise consume would be the relevant amount.

The other costs are sunk at the point at which the decision is made to go on
another fishing trip.
Requirement 2
If he fishes for the same amount of time as he did on his last trip, all of his
costs are likely to be about the same as they were on his last trip. Therefore, it
really doesnt cost him anything to catch the last fish. The costs are really
incurred in order to be able to catch fish and would be the same whether one,
two, three, or a dozen fish were actually caught. Fishing, not catching fish,
costs money. All of the costs are basically fixed with respect to how many fish
are actually caught during any one fishing trip, except possibly the cost of
snagged lures.
Requirement 3
In a decision of whether to give up fishing altogether, nearly all of the costs
19-7

Chapter 19 Relevant Costs for Decision Making

listed by Shins wife are relevant. If he did not fish, he would not need to pay
for boat moorage, new fishing gear, a fishing license, fuel and upkeep, junk
food, or snagged lures. In addition, he would be able to sell his boat, the
proceeds of which would be considered relevant in this decision. The original
cost of the boat, which is a sunk cost, would not be relevant.
These three requirements illustrate the slippery nature of costs. A cost that is
relevant in one situation can be irrelevant in the next. None of the costs are
relevant when we compute the cost of catching a particular fish; some of them
are relevant when we compute the cost of a fishing trip; and nearly all of them
are relevant when we consider the cost of not giving up fishing. What is even
more confusing is that CG is correct; the average cost of a salmon is P167,
even though the cost of actually catching any one fish is essentially zero. It
may not make sense from an economic standpoint to have salmon fishing as a
hobby, but as long as Shin is out in the boat fishing, he might as well catch as
many fish as he can.

Exercise 8 (Dropping or Retaining a Segment)


Requirement 1
No, the housekeeping program should not be discontinued. It is actually
generating a positive program segment margin and is, of course, providing a
valuable service to seniors. Computations to support this conclusion follow:
Contribution margin lost if the housekeeping program
is dropped............................................................................................
P(80,000)
Fixed costs that can be avoided:
Liability insurance...............................................................................
P15,000
Program administrators salary...........................................................
37,000
52,000
Decrease in net operating income for the organization
as a whole...........................................................................................
P(28,000)
Depreciation on the van is a sunk cost and the van has no salvage value since
it would be donated to another organization. The general administrative
overhead is allocated and none of it would be avoided if the program were
dropped; thus it is not relevant to the decision.
The same result can be obtained with the alternative analysis below:
19-8

Relevant Costs for Decision Making Chapter 19

Current
Total
Revenues......................................................................
P900,000
Variable expenses.........................................................
490,000
Contribution margin....................................................
410,000
Fixed expenses:
Depreciation*..........................................................
68,000
Liability insurance...................................................
42,000
Program administrators salaries............................
115,000
General administrative overhead............................
180,000
Total fixed expenses.....................................................
405,000
Net operating income (loss).........................................
P 5,000

Difference:
Total If
Net Operating
HouseIncome
keeping Is
Increase or
Dropped
(Decrease)
P660,000
P(240,000)
330,000
160,000
330,000
(80,000)
68,000
27,000
78,000
180,000
353,000
P(23,000)

0
15,000
37,000
0
52,000
P (28,000)

*Includes pro-rated loss on disposal of the van if it is donated to a charity.

Requirement 2
To give the administrator of the entire organization a clearer picture of the
financial viability of each of the organizations programs, the general
administrative overhead should not be allocated. It is a common cost that
should be deducted from the total program segment margin. Following the
format for a segmented income statement, a better income statement would be:
Total
Revenues........................................................
P900,000
Variable expenses..........................................
490,000
Contribution margin......................................
410,000
Traceable fixed expenses:
Depreciation..............................................
68,000
Liability insurance....................................
42,000
Program administrators
salaries..................................................
115,000
Total traceable fixed expenses.......................
225,000
Program segment margins............................
185,000
General administrative overhead..................
180,000
P5,000
Net operating income (loss)..........................

Exercise 9 (Special Order)


Requirement 1
19-9

Home
Nursing
P260,000
120,000
140,000

Meals on
Wheels
P400,000
210,000
190,000

Housekeeping
P240,000
160,000
80,000

8,000
20,000

40,000
7,000

20,000
15,000

40,000
68,000
P72,000

38,000
85,000
P105,000

37,000
72,000
P8,000

Chapter 19 Relevant Costs for Decision Making

Monthly profits would be increased by P9,000:


Total for
Per Unit 2,000 Units
Incremental revenue.........................................................................
P12.00
P24,000
Incremental costs:
Variable costs:
Direct materials........................................................................
2.50
5,000
Direct labor..............................................................................
3.00
6,000
Variable manufacturing overhead.............................................
0.50
1,000
Variable selling and administrative...........................................
1.50
3,000
Total variable cost........................................................................
P 7.50
15,000
Fixed costs:
None affected by the special order............................................
0
Total incremental cost...................................................................... 15,000
Incremental net operating income.....................................................P9,000
Requirement 2
The relevant cost is P1.50 (the variable selling and administrative costs). All
other variable costs are sunk, since the units have already been produced. The
fixed costs would not be relevant, since they would not be affected by the sale
of leftover units.
Exercise 10 (Make or Buy a Component)
The costs that are relevant in a make-or-buy decision are those costs that can
be avoided as a result of purchasing from the outside. The analysis for this
exercise is:
Per Unit
Differential Costs
Make
Buy
Cost of purchasing....................................................... P23.50
Cost of making:
P4.80
Direct materials.......................................................
Direct labor..............................................................
7.00
Variable manufacturing overhead...........................
3.20
Fixed manufacturing overhead................................
4.00 *
Total cost..................................................................
P19.00
P23.50

20,000 Units
Make
Buy
P470,000
P96,000
140,000
64,000
80,000
P380,000

P470,000

* The remaining P6 of fixed manufacturing overhead cost would not be relevant, since
it will continue regardless of whether the company makes or buys the parts.

19-10

Relevant Costs for Decision Making Chapter 19

The P150,000 rental value of the space being used to produce part R-3
represents an opportunity cost of continuing to produce the part internally.
Thus, the completed analysis would be:
Make
Buy
Total cost, as above..........................................................................................
P380,000 P470,000
Rental value of the space (opportunity cost)...................................................
150,000
Total cost, including opportunity cost.............................................................
P530,000 P470,000
Net advantage in favor of buying....................................................................
P60,000

Profits would increase by P60,000 if the outside suppliers offer is accepted.


Exercise 11 (The Economists Approach to Pricing)
Requirement (1)
Cecile makes more money selling the ice cream cones at the lower price, as
shown below:
P17.90 Price P13.90 Price
Unit sales........................................................
860
1,340
Sales...............................................................P15,394.00
Cost of goods sold @ P4.10............................ 3,526.00
Contribution margin........................................ 11,868.00
Fixed expenses................................................
425.00
Net operating income...................................... P11,443.00
Requirement (2)
The price elasticity of demand is computed as follows:

In(1 + % change in quantity sold)


In(1 + % change in price)
In(1 +

1,340 860
)
860

In(1 +

13.90 17.90
)
17.90

In(1 + 0.55814)
In(1 0.22346)

In(1.55814)
In(0.77654)

0.44349
0.25291

19-11

1.75

P18,626.00
5,494.00
13,132.00
425.00
P12,707.00

Chapter 19 Relevant Costs for Decision Making

Requirement (3)
The profit-maximizing price can be estimated using the following formulas:
Profit-maximizing
markup on variable cost

1
1 + d
1
1 + (1.75)

=
=

Profit-maximizing
price

1 +

1.333

Profit-maximizing
markup on variable cost

Variable cost
per unit

= (1 + 1.3333) x P4.10 = P9.60


This price is much lower than the prices Cecile has been charging in the past.
Rather than immediately dropping the price to P9.60, it would be prudent to
drop the price a bit and see what happens to unit sales and to profits. The
formula assumes that the price elasticity is constant, which may not be the
case.
Exercise 12 (Target Costing)
Sales (50,000 batteries P65 per battery).....................................P3,250,000
Less desired profit (20% P2,500,000)........................................ 500,000
Target cost for 50,000 batteries.....................................................P2,750,000
Target cost per battery

= (P2,750,000 50,000 batteries)


= P55 per battery

19-12

Relevant Costs for Decision Making Chapter 19

Exercise 13 (Pricing a New Product)


The selling price of the new amaretto cappuccino product should at least cover
its variable cost and its opportunity cost. The variable cost of the new product
is P4.60 and its opportunity cost can be computed by multiplying the
opportunity cost of P34 per minute of order filling time by the amount of time
required to fill an order for the new product:

Selling price of
the new product

Variable cost of
the new product

Opportunity cost
per unit of the
x
constrained resource

Amounts of the constrained


resource required by a unit
of the new product

Selling price of
the new product

P4.60 + P34 per minute

Selling price of
the new product

P4.60 + P34 per minute

+ 0.75 minute

45 seconds
60 seconds per minute

Selling price of
P30.10
the new product P4.60 + P25.50 =
Hence, the selling price of the new product should at least cover both its variable
cost of P4.60 and its opportunity cost of P25.50, for a total of P30.10.
III. Problems
Problem 1 (Accept or Reject an Order)
Selling price per unit
Less Variable costs/unit:
Materials
Labor
Factory overhead (25%)
Contribution margin/unit
Multiplied by number of units to be sold
Total contribution margin

19-13

Product A
P1.20

Product B
P1.40

0.50
0.20
0.10
0.80
P0.40
21,000 units
P8,400

0.70
0.24
0.14
1.08
P0.32
30,000 units
P9,600

Chapter 19 Relevant Costs for Decision Making

Product B should be accepted because its total contribution margin is higher


than that of Product A.

Problem 2 (Eliminate or Retain a Product Line)


Requirement 1
No, production and sale of the round trampolines should not be discontinued.
Computations to support this answer follow:
Contribution margin lost if the round trampolines
are discontinued.............................................
Less fixed costs that can be avoided:
Advertising traceable..................................
Line supervisors salaries...............................
Decrease in net operating income for the
company as a whole.......................................

P(80,000)
P41,000
6,000

47,000
P(33,000)

The depreciation of the special equipment represents a sunk cost, and


therefore it is not relevant to the decision. The general factory overhead is
allocated and will presumably continue regardless of whether or not the round
trampolines are discontinued; thus, it is not relevant.
Requirement 2
If management wants a clear picture of the profitability of the segments, the
general factory overhead should not be allocated. It is a common cost and
therefore should be deducted from the total product-line segment margin. A
more useful income statement format would be as follows:
Total
Sales...................................... P1,000,000
Less variable expenses..........
410,000
Contribution margin.............
590,000
Less fixed expenses:
Advertising traceable.....
216,000
Depreciation of special
equipment......................
95,000
19-14

Trampoline
Round
Rectangular
P140,000
P500,000
60,000
200,000
80,000
300,000

Octagonal
P360,000
150,000
210,000

41,000

110,000

65,000

20,000

40,000

35,000

Relevant Costs for Decision Making Chapter 19


Line supervisors
salaries...........................
Total traceable fixed
expenses............................
Product-line segment
margin...............................
Less common fixed
expenses............................
Net operating income
(loss).................................. P

19,000

6,000

7,000

6,000

330,000

67,000

157,000

106,000

260,000

P 13,000

P143,000

P104,000

200,000
60,000

Problem 3 (Product Mix)


Requirement 1
Selling price per unit
Variable cost per unit
Contribution margin / unit
Divided by no. of hours required
for each unit
Contribution per hour
Product ranking:
1. D
2. B

Product Line
B
C
P25
P10
10
5
P15
P 5

A
P30
25
P5
5 hrs.
P1

3. C

10 hrs.
P1.5

4 hrs.
P1.25

D
P8
4
P4
1 hr.
P4

4. A

Based on the above analysis, first priority should be given to Product D. The
company should use 4,000 out of the available 96,000 hrs. to produce 4,000
units of product D. The remaining 92,000 hrs. should be used to produce
9,200 units of Product B. Hence, the best product combination is 4,000 units
of Product D and 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.
The difference in profit between the two alternatives is computed as follows:
Contribution margin of combination (1)
Product D (4,000 x P 4.00)
Product B (9,200 x P15.00)
Total contribution margin of D and B
19-15

P 16,000
138,000
P154,000

Chapter 19 Relevant Costs for Decision Making

Less contribution margin of D only


(96,000 x P4)
Difference, excess over profit in combination (1)
Problem 4 (Accept or Reject a Special Order)

384,000
P230,000

Requirement 1
The company should accept the special order of 4,000 @ P10 each because
this selling price is still higher than the additional variable cost to be incurred.
Whether or not variable marketing expenses will be incurred, the decision is
still to accept the order.
Supporting computations:
(a) Assume no additional variable marketing cost will be incurred.
Selling price per unit
Less variable manufacturing costs:
Direct materials
Direct labor
Variable overhead
Contribution margin/unit
Multiplied by number of units of order
Total increase in profit

P10.00
P5.00
3.00
0.75

8.75
P 1.25
4,000 units
P5,000

(b) Assume additional variable marketing cost will be incurred.


Selling price per unit
Less variable costs (P8.75 + P0.25)
Contribution margin / unit
Multiplied by number of units of order
Total increase in contribution margin

P10.00
9.00
P 1.00
4,000 units
P4,000

Requirement 2
P8.75, the total variable manufacturing cost.
Requirement 3
Direct materials
Direct labor
Variable factory overhead
Total cost of inventory under direct costing

19-16

P5.00
3.00
0.75
P8.75

Relevant Costs for Decision Making Chapter 19

Requirement 4
Present contribution margin
[10,000 units x (P15 - P9)]
Less proposed contribution margin
[(P14 - P9) x 11,000 units]
Decrease in contribution margin

P60,000
55,000
P 5,000

The company should not reduce the selling price from P15 to P14 even if
volume will go up because total contribution margin will decrease.
Problem 5 (CVP Analysis used for Decision Making)
Requirement (a)
Units sold per month
4,000
5,000
6,000

No. of months
6
15
9
30

Probability
20%
50%
30%
100%

Requirement (b)
4,000 units
P160,000

Production
5,000 units
P160,000

6,000 units
P160,000

100,000
-

125,000
-

150,000
-

Total
Contribution margin

P100,000
P 60,000

P125,000
P 35,000

P150,000
P 10,000

Sales (5,000 x P40)


Less variable costs
Production cost @ P25
Purchase cost @ P45

P200,000

P200,000

P200,000

100,000
45,000

125,000
-

150,000
-

Total
Contribution margin

P145,000
P 55,000

P125,000
P 75,000

P150,000
P 50,000

Sales (4,000 x P40)


Less variable costs
Production cost @ P25
Purchase cost @ P45

19-17

Chapter 19 Relevant Costs for Decision Making

Sales (6,000 x P40)


Less variable costs
Production cost @ P25
Purchase cost @ P45
Total
Contribution margin

P240,000

P240,000

P240,000

100,000
90,000
P190,000
P 50,000

125,000
45,000
P170,000
P 70,000

150,000
0
P150,000
P 90,000

Requirement (c)
Sales Order
Contribution Margin
4,000
P35,000
5,000
75,000
6,000
70,000
Average Contribution Margin

Probability
0.20
0.50
0.30

Expected Value
P 7,000
37,500
21,000
P65,500

Problem 6 (Pricing)
Requirement A:

Sales
Less Variable cost
Contribution margin
Less Fixed cost
Net income (loss)

2005
P 100,000
130,000
(P 30,000)
40,000
(P 70,000)

2006
P 400,000
520,000
(P120,000)
40,000
(P160,000)

Operating
Result at Full
Capacity
P 480,000
624,000
(P144,000)
40,000
(P184,000)

The company had been operating at a loss because the product had been
selling with a negative contribution margin. Hence, the more units are sold,
the higher the loss will be.
Requirement B: P60.14
Requirement C: P74.29
Requirement D: P56.58

Problem 7 (Make or Buy)


19-18

Relevant Costs for Decision Making Chapter 19

Cost of Making
Outside purchase
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead*
Total cost

Cost of Buying
P90,000

P15,000
30,000
10,000
15,000
P70,000

P90,000

* 1/3 x P45,000 = P15,000

Therefore, the annual advantage to make the parts is P20,000.


Problem 8 (Close or Retain a Store)
Requirement 1
The simplest approach to the solution is:
Gross margin lost if the store is closed.............................................
Less costs that can be avoided:
Direct advertising..........................................................................
P36,000
Sales salaries.................................................................................
45,000
Delivery salaries............................................................................7,000
Store rent.......................................................................................
65,000
Store management salaries (new employee would not
be hired to fill vacant position at another store)......................
15,000
General office salaries...................................................................8,000
Utilities..........................................................................................
27,200
Insurance on inventories (2/3 P9,000)......................................6,000
Employment taxes*.......................................................................9,000
Decrease in company net operating income if the
Ortigas Store is closed...................................................................

P(228,000)

218,200
P( 9,800)

*Salaries avoided by closing the store:


Sales salaries..........................................................................................................
P45,000
Delivery salaries.................................................................................................... 7,000
Store management salaries....................................................................................15,000
General office salaries............................................................................................ 8,000
Total salaries..........................................................................................................75,000
Employment tax rate.............................................................................................. 12%
P9,000
Employment taxes avoided....................................................................................

Requirement 2
The Ortigas Store should not be closed. If the store is closed, overall company
19-19

Chapter 19 Relevant Costs for Decision Making

net operating income will decrease by P9,800 per quarter.


Requirement 3
The Ortigas Store should be closed if P200,000 of its sales are picked up by
the Makati Store. The net effect of the closure will be an increase in overall
company net operating income by P76,200 per quarter:
Gross margin lost if the Ortigas Store is closed.......................................................................
P(228,000)
Gross margin gained at the Makati Store:
P200,000 43%...................................................................................................................
86,000
Net loss in gross margin............................................................................................................
(142,000)
Costs that can be avoided if the Ortigas Store is closed (part 1)..............................................
218,200
Net advantage of closing the Ortigas Store..............................................................................
P 76,200

Problem 9 (Shutting Down or Continuing to Operate a Plant)


Requirement 1
Product KK-8 yields a contribution margin of P14 per gallon (P35 P21 =
P14). If the plant closes, this contribution margin will be lost on the 22,000
gallons (11,000 gallons per month 2 = 22,000 gallons) that could have been
sold during the two-month period. However, the company will be able to avoid
certain fixed costs as a result of closing down. The analysis is:
Contribution margin lost by closing the plant for two
months (P14 per gallon 22,000 gallons).................................................P(308,000)
Costs avoided by closing the plant for two months:
Fixed manufacturing overhead cost
(P60,000 2 months = P120,000)..........................................................
P120,000
Fixed selling costs
(P310,000 10% 2 months)...............................................................
62,000
182,000
Net disadvantage of closing, before start-up costs.......................................... (126,000)
Add start-up costs............................................................................................ (14,000)
Disadvantage of closing the plant...................................................................P(140,000)

No, the company should not close the plant; it should continue to operate at
the reduced level of 11,000 gallons produced and sold each month. Closing
will result in a P140,000 greater loss over the two-month period than if the
company continues to operate. Additional factors are the potential loss of
goodwill among the customers who need the 11,000 gallons of KK-8 each
month and the adverse effect on employee morale. By closing down, the needs
of customers will not be met (no inventories are on hand), and their business
may be permanently lost to another supplier.

19-20

Relevant Costs for Decision Making Chapter 19

Alternative Solution:

Plant Kept
Open
Plant Closed
Sales (11,000 gallons P35 per gallon 2)............................
P 770,000
P
0
Less variable expenses (11,000
gallons P21 per gallon 2)..............................................
462,000
0
Contribution margin.................................................................
308,000
0
Less fixed costs:
Fixed manufacturing overhead cost
(P230,000 2;
P170,000 2)................................................................
460,000
340,000
Fixed selling cost (P310,000 2; P310,000
90% 2)......................................................................
620,000
558,000
Total fixed cost.........................................................................
1,080,000
898,000
Net operating loss before start-up costs...................................
(772,000)
(898,000)
Start-up costs...........................................................................
(14,000)
Net operating loss....................................................................
P (772,000) P(912,000)

Difference
Net
Operating
Income
Increase
(Decrease)
P(770,000)
462,000
(308,000)

120,000
62,000
182,000
(126,000)
(14,000)
P(140,000)

Requirement 2
Ignoring the additional factors cited in part (1) above, Kristin Company
should be indifferent between closing down or continuing to operate if the level
of sales drops to 12,000 gallons (6,000 gallons per month) over the two-month
period. The computations are:
Cost avoided by closing the plant for two months (see above)...............................
P182,000
Less start-up costs....................................................................................................
14,000
Net avoidable costs..................................................................................................
P168,000

Net avoidable costs


Contribution margin per gallon

=
=

Verification:

P168,000
P14 per gallon
12,000 gallons

Operate at
12,000
Gallons for
Two Months
Sales (12,000 gallons P35 per gallon)...............................................
P 420,000
Less variable expenses (12,000 gallons P21 per gallon)...................
252,000
Contribution margin..............................................................................
168,000
Less fixed expenses:
19-21

Close for
Two
Months
P
0
0
0

Chapter 19 Relevant Costs for Decision Making


Manufacturing overhead (P230,000 and P170,000 2
months).........................................................................................
460,000
Selling (P310,000 and P279,000 2 months).................................
620,000
Total fixed expenses..............................................................................
1,080,000
Start-up costs.........................................................................................
0
Total costs..............................................................................................
1,080,000
Net operating loss..................................................................................
P (912,000)

340,000
558,000
898,000
14,000
912,000
P(912,000)

Problem 10 (The Economists Approach to Pricing)


Requirement (1)
The postal service makes more money selling the souvenir sheets at the lower
price, as shown below:
P500 Price
P600 Price
Unit sales...................................................
50,000
40,000
Sales..........................................................
Cost of goods sold @ P60 per unit............
Contribution margin..................................

P25,000,000
3,000,000
P22,000,000

P24,000,000
2,400,000
P21,600,000

Requirement (2)
The price elasticity of demand, as defined in the text, is computed as follows:

=
=
=
=
=

In(1 + % change in quantity sold)


In(1 + % change in price)
40,000 50,000
In(1 +
)
50,000
600.00 500.00
In(1 +
)
500.00
In(1 0.2000)
In(1 + 0.2000)
In(0.8000)
In(1.2000)
0.2231
0.1823
1.2239
19-22

Relevant Costs for Decision Making Chapter 19

Requirement (3)
The profit-maximizing price can be estimated using the following formulas:
Profit-maximizing
markup on variable cost

=
=

Profit-maximizing
price

1
1 + d
1
=
1 + (1.2239)
1 +

4.4663

Profit-maximizing
markup on variable cost

= (1 + 4.4663) x P60 = P328


This price is much lower than the price the postal service has been charging in
the past. Rather than immediately dropping the price to P328, it would be
prudent for the postal service to drop the price a bit and observe what happens
to unit sales and to profits. The formula assumes that the price elasticity of
demand is constant, which may not be true.
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. If this is true, we can estimate
the demand schedule for souvenir sheets as follows:
Price*
Quantity Sold
P600
40,000
P500
50,000
P417
62,500
P348
78,125
P290
97,656
P242
122,070
P202
152,588
P168
190,735
P140
238,419
P117
298,024
*

The price in each cell in the table is computed by taking 5/6 of the price just
above it in the table. For example, P500 is 5/6 of P600 and P417 is 5/6 of
P500.

The quantity sold in each cell of the table is computed by multiplying the
quantity sold just above it in the table by 50,000/40,000. For example, 62,500
is computed by multiplying 50,000 by the fraction 50,000/40,000.
19-23

Variable cost
per unit

Chapter 19 Relevant Costs for Decision Making

The profit at each price in the above demand schedule can be computed as
follows:
Price
(a)
P600
P500
P417
P348
P290
P242
P202
P168
P140
P117

Quantity
Sold (b)
40,000
50,000
62,500
78,125
97,656
122,070
152,588
190,735
238,419
298,024

Sales
(a) (b)
P24,000,000
P250,00,000
P26,062,500
P27,187,500
P28,320,200
P29,540,900
P30,822,800
P32,043,500
P33,378,700
P34,868,800

19-24

Cost of Sales
P60 (b)
P2,400,000
P3,000,000
P3,750,000
P4,687,500
P5,859,400
P7,324,200
P9,155,300
P11,444,100
P14,305,100
P17,881,400

Contribution
Margin
P21,600,000
P22,000,000
P22,312,500
P22,500,000
P22,460,800
P22,216,700
P21,667,500
P20,599,400
P19,073,600
P16,987,400

Relevant Costs for Decision Making Chapter 19

The contribution margin is plotted below as a function of the selling price:


23,000,000

Contribution Margin

22,000,000

21,000,000

20,000,000

19,000,000

18,000,000

17,000,000
100.00

200.00

300.00

400.00

500.00

600.00

Selling Price
The plot confirms that the profit-maximizing price is about P328.
Requirement (4)
If the postal service wants to maximize the contribution margin and profit
from sales of souvenir sheets, the new price should be:
Profit-maximizing price = 5.4663 P70 = P383
Note that a P100 increase in cost has led to a P55 (P383 P328) increase in
the profit-maximizing price. This is because the profit-maximizing price is
computed by multiplying the variable cost by 5.4663. Since the variable cost
has increased by P100, the profit-maximizing price has increased by P100
5.4663, or P55.
Some people may object to such a large increase in price as unfair and some
19-25

Chapter 19 Relevant Costs for Decision Making

may even suggest that only the P10 increase in cost should be passed on to the
consumer. 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.
Problem 11 (Ranking Alternatives and Managing with a Constraint)
Requirement (1)
This problem can be solved by first computing the profitability index of each
customer and then ranking the customers based on that profitability index:
Incremental
Profit
Customer
(A)
Lalaine................................
P1,400
Emily...................................
1,240
Anna....................................
1,600
Catherine.............................
960
Gee Ann...............................
1,900
Lily......................................
2,880
Lourdes...............................
930
Ma. Cecilia..........................
1,360
Sheila Raya.........................
2,340
Jane.....................................
2,040

Ji Euns Time
Required
(B)
4
4
5
3
5
8
3
4
6
6

Profitability
Index
(A) (B)
P350
P310
P320
P320
P380
P360
P310
P340
P390
P340

Cumulative
Amount of Ji Euns
Profitability
Ji Euns Time
Time
Customer
Index
Required
Required
Sheila Raya......
P390
6
6
Gee Ann...........
P380
5
11
Lily..................
P360
8
19
Lalaine.............
P350
4
23
Jane..................
P340
6
29
Ma. Cecilia......
P340
4
27
Anna................
P320
5
38
Catherine..........
P320
3
41
Emily...............
P310
4
45
Lourdes............
P310
3
48
Given that Ji Eun should not be asked to work more than 33 hours, the four
customers below the line in the above table should be told that their
reservations have to be cancelled.
19-26

Relevant Costs for Decision Making Chapter 19

Requirement (2)
The total profit on wedding cakes for the weekend after canceling the four
reservations would be:
Sheila Raya......
Gee Ann............
Lily...................
Lalaine..............
Jane..................
Ma. Cecilia.......
Total.................

P 2,340
1,900
2,880
1,400
2,040
1,360
P11,920

Notes:
Both Ji Euns time and the cakes would have to be very carefully
scheduled to make sure that all cakes are completed on time. We have
assumed that the 33 hours of Ji Euns time that are available for cake
decorating do not include hours that have been set aside as a buffer to
provide protection from inevitable disruptions in the schedule.
If the cumulative amount of Ji Euns time required did not exactly
consume the total amount of time available, some adjustment might be
required in which reservations are cancelled to ensure that the most
profitable plan is selected.
Requirement (3)
To avoid disappointing customers, reservations should probably not be
accepted for any particular weekend after 33 hours of Ji Euns time have been
committed for that weekends cakes. To ensure that only the most profitable
cake reservations are accepted, a reservation for any cake with a profitability
index of less than P340 should probably not be accepted. This was the cutoff
point for the cakes in the first weekend in June. This cutoff may need to be
adjusted upward or downward over timethe cakes that were reserved for the
first weekend in June may not be representative of the cakes that would be
reserved for other weekends. If too many reservations are turned down and Ji
Euns time is not fully utilized, then the cutoff should be adjusted downward.
If too few reservations are turned down and Ji Euns time is once again
overbooked or profitable cake orders are turned away, then the cutoff should
be adjusted upward.
Requirement (4)
19-27

Chapter 19 Relevant Costs for Decision Making

Ms. Hye Young should consider changing the way prices are set so that they
include a charge for Ji Euns time. On average, the prices may be the same,
but they should be based not only on the size of the cakes, but also on the
amount of cake decorating that the customer desires. The charge for Ji Euns
time should be her hourly rate of pay (including any fringe benefits) plus the
opportunity cost of at least P340 per hour. Because Ji Eun will not be working
more than 33 hours per week, if another cake reservation is accepted, some
other cake reservation will have to be cancelled. Ms. Hye Young would have
to give up at least P34 profit per hour to accept another cake reservation.
Requirement (5)
Making Ji Eun happy involves not asking her to work more than 33 hours per
week decorating cakes. Making customers happy involves not canceling their
reservations, not raising prices, and providing top quality wedding cakes. Ms.
Hye Young can accomplish both of these objectives and increase her profits by
clever management of the constraintJi Euns time. The possibilities include:

Ms. Hye Young should make sure that none of Ji Euns time is wasted on
unnecessary tasks. For example, Ji Eun should not be asked to cream
butter by hand for frostings if a machine could do the job as well with less
labor time.

Ms. Hye Young should make sure that none of Ji Euns time is wasted on
tasks that can be done by other persons. For example, an assistant can be
assigned to prepare frosting and to clean up, relieving Ji Eun of those
tasks. As long as the cost of the assistants time is less than P34 per hour,
the result will be higher profits and more pleased customers.

Ms. Hye Young should consider assigning an apprentice to Ji Eun. The


apprentice could relieve Ji Eun of some of her workload while learning the
skills to eventually expand the companys cake decorating capacity.

Ms. Hye Young might consider subcontracting some of the less demanding
cake decorating to another baker. This would be profitable as long as the
charge is less than P340 per hour.

IV. Multiple Choice Questions


1.
2.
3.
4.
5.

C
C
B
B
A

11.
12.
13.
14.
15.

D
A
D
A
D

21.
22.
23.
24.
25.
19-28

D
A
D
E
B

31.
32.
33.
34.
35.

A
D
C
A
C

Relevant Costs for Decision Making Chapter 19

6.
7.
8.
9.
10.

B
C
B
A
B

16.
17.
18.
19.
20.

C
A
C
B
C

26.
27.
28.
29.
30.

D
D
C
A
A

Supporting computations for nos. 16 - 29:


16. Sales [(100,000 x 90%) x (P5.00 x 120%)]
Less: Variable costs (P300,000 x 90%)
Contribution margin
Less: Fixed costs
Operating income

P540,000
270,000
P270,000
150,000
P120,000

17. Direct materials


Direct labor
Overhead
Selling cost
Minimum selling price per unit

P 4
5
2
3
P14

18. Relevant cost to make (10,000 x P24)


Purchase cost
Less: Savings in manufacturing cost
Avoidable fixed overhead
Net purchase price
Difference in favor of buy alternative

P240,000
P300,000
P45,000
50,000

95,000
P205,000
P 35,000

19. Increase in sales (60,000 x P3)


P180,000
Less: Increase in variable cost (60,000 x P2.50)
150,000
Net increase in income
P 30,000
20.
R
S
T
Sales (10,000 x P20)
P200,000
P200,000
P200,000
Less: Variable costs
R (P12 x 10,000)
120,000
S (P 8 x 10,000)
80,000
T (P 4 x 10,000)
40,000
Contribution margin

P 80,000

P120,000

P160,000

Sales (P16 x 15,000)

R
P240,000

S
P240,000

T
P240,000

21.

19-29

Chapter 19 Relevant Costs for Decision Making

Less: Variable costs


R (P12 x 15,000)
S (P 8 x 15,000)
T (P 4 x 15,000)

180,000
120,000
60,000

Contribution margin
Less: Fixed costs
Operating income

P 60,000
40,000
P 20,000

P120,000
80,000
P 40,000

22. Old operating income:


Contribution margin
Less: Fixed cost

P180,000
120,000
P 60,000
P80,000
40,000
P40,000
20,000
P20,000

New operating income


Difference - decrease
23. Sales
Less: Variable costs
Direct materials
Direct labor
Factory overhead
Marketing expenses
Administrative expenses
Contribution margin
Less: Fixed costs
Factory overhead
Marketing expenses
Administrative expenses
Increase in fixed costs
Profit
24. Sales
Less: Variable costs
Direct materials
Direct labor
Factory overhead
Marketing expenses
Administrative expenses
Contribution margin
Less: Fixed costs
Factory overhead
Marketing expenses
19-30

P1,200,000
P300,000
400,000
80,000
70,000
50,000
P 50,000
30,000
20,000
10,000

900,000
P 300,000

110,000
P 190,000
P1,200,000

P275,000
375,000
80,000
70,000
50,000
P 50,000
30,000

850,000
P 350,000

Relevant Costs for Decision Making Chapter 19

Profit

Administrative expenses
Decrease in fixed costs
(P25,000 4)

20,000
(6,250)

25. Direct materials


(P2 x 5,000)
Direct labor
(P8 x 5,000)
Variable overhead
(P4 x 5,000)
Total variable costs
Add: Avoidable fixed overhead
Total
26. Avoidable fixed overhead
Direct materials
Direct labor
Variable overhead
Total
Multiplied by: Number of units to be produced
Total relevant costs to make the part
27. Purchase cost (P1.25 x 10,000)
Variable costs to make
Savings of making the blade
28. Selling price per unit
Less: Variable costs of goods sold per unit
([P320,000 - P80,000] 20,000 units)
Contribution margin per unit
Multiplied by units to be sold under Special Order
Increase in operating income
29. Budgeted operating income:
Contribution margin (P2,000,000 x 30%)
Less fixed costs
Net operating income
Operating income under the proposal:
Sales
P2,000,000
Less Variable costs
([70% x P2,000,000] x 80%) 1,120,000
Contribution margin
P 880,000
Less fixed costs
520,000
Increase in budgeted operating profit

19-31

93,750
P 256,250
P10,000
40,000
20,000
P70,000
10,000
P80,000
P 4
4
16
18
P42
20,000
P840,000
P12,500
10,000
P 2,500
P17
12
P 5
2,000
P10,000
P600,000
400,000
P200,000

360,000
P160,000