Measuring relevant cost and revenues for decision

making (Chapter 9)
Lecture 1
Name: Ms Reinette van Gaalen
Office: C Ring 751
rvangaalen@uj.ac.za
Unit 5 – 7
OUTCOMES

• Distinguish between relevant and irrelevant costs and revenues.

• Explain the importance of qualitative factors.
• Distinguish between the relevant and irrelevant costs and revenues
for the decision-making problems described.
• Describe the key concepts that should be applied for presenting
information for product mix decisions when capacity constraints
apply.
• Describe the opportunity cost concept.
• Explain the misconception relating to relevant costs and revenues.

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Relevant costs and revenues

Relevant costs are future costs that differs between alternatives.

Not routine decisions

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Identifying Relevant Costs

• The relevant financial inputs for decision-making are future cash flows
that will differ between the various alternatives being considered.

• Therefore only relevant (incremental/differential) cash flows should

be considered.

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 Identifying Relevant Costs

• Costs that can be eliminated (in whole or in part) by choosing one

alternative over another are avoidable costs. Avoidable costs are
relevant costs.

. Unavoidable costs are never relevant and include:

 Sunk costs.

 Future costs that do not differ between the alternatives.

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Relevant Costs-Other considerations

• Decisions should not be based only on items that can be expressed in

quantitative terms
• Qualitative factors must also be considered.

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Relevant Costs

Relevant costs and revenues are required for special studies such as :

1. Decisions on replacement of equipment.

2. Outsourcing (Make or buy) decisions.

3. Discontinuation decisions.

4. Special selling price decisions.

5. Product mix decisions when capacity constraints exist

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Relevant cost
1. Decisions on replacement of equipment.

Example
Book value of existing machine (remaining life of 3 years) £90 000
Cost of new machine
(expected life of 3 years and zero scrap value) £70 000

Operating costs (£3 per unit old machine)

(£2 per unit new machine)
Output of both machines is 20 000 units per annum

Disposal value of old machine now £40 000

Disposal value of new and old machines
(3 years time) Zero
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Decisions on replacement of equipment

• Should the old machine be replaced?

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Decisions on replacement of equipment

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Decisions on replacement of equipment

Recommended approach
Savings on variable operating costs (3 years) 60 000
Sale proceeds of existing machine 40 000
100 000
Less purchase cost of replacement machine 70 000
Savings on purchasing replacement machine 30 000

• Note that qualitative factors should be taken into account.

Read section in your

textbook

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Outsourcing (make or buy decisions)

• Involves obtaining goods or services from outside suppliers instead of

from within the organization.

• A decision concerning whether an item should be produced internally

or purchased from an outside supplier is called a “make or buy”
decision.
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Outsourcing (make or buy decisions)

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Outsourcing (make or buy decisions)

A supplier has offered to supply 10 000 components per annum at a price of £30
per unit for a minimum of three years. If the components are outsourced the
direct labour will be made redundant. Direct materials and variable overheads are
avoidable and fixed manufacturing overhead would be reduced by £10 000 per
annum but non-manufacturing costs would remain unchanged. The capacity has
no alternative uses.

• Should we accept the supplier’s offer?

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Outsourcing (make or buy decisions)

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Outsourcing (make or buy decisions)

Make or Buy?

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Outsourcing (make or buy decisions)

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Outsourcing (make or buy decisions)

Where the released internal capacity arising from outsourcing can be used to generate rental income
or a profit contribution the lost income or profit contribution represents an opportunity cost
associated with making the components.

Assume that the released capacity from outsourcing enables a profit contribution of £90 000 to be
generated. The relevant costs of making will now be:

Relevant costs (described above) £240 000

Opportunity cost (Lost profit contribution) 90 000
______
Total relevant costs of making 330 000
Outsourcing is now the cheaper alternative.

Refer to example 9.5 (Page 208)- Yes, That’s your Homework 19

Discontinuation decisions (Adding / Dropping Segments)

One of the most important decisions managers make is whether to add

or drop a business segment such as a product or a store.

Let’s see how relevant costs should be used in this decision

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Discontinuation decisions (Adding / Dropping Segments)

Assume the periodic profitability analysis of sales territories reports the following:

Southern Northern Central Total

£000 £000 £000 £000
Sales 900 1 000 900 2 800
Variable costs (466) (528) (598) (1 592)
Fixed costs (266) (318) (358) (942)
Profit/(Loss) 168 154 (56) 266

Assume that special study indicates that £250 000 of Central fixed costs and all
variable costs are avoidable and £108 000 fixed costs are unavoidable if the
territory is discontinued.

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Discontinuation decisions (Adding / Dropping Segments)

Should Central be discontinued?

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Discontinuation decisions Southern Northern Central Total

(Adding / Dropping Segments) Sales 900 1 000 900 2 800

Variable costs (466) (528) (598) (1 592)
Fixed costs (266) (318) (358) (942)
Profit/(Loss) 168 154 (56) 266

Assume that special study indicates that £250 000 of Central fixed
costs and all variable costs are avoidable and £108 000 fixed
costs are unavoidable if the territory is discontinued.

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Discontinuation decisions (Adding / Dropping Segments)

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Special pricing decisions

Special pricing decisions are typically one-time only orders and/or

orders below the prevailing market price.

Extra capacity of 15 000

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Special pricing decisions

• The excess capacity is temporary and a company has offered to buy 3 000 each
month for the next three months at a price of £20 per unit. Extra selling costs for
the order would be £1 per unit.
• Estimated costs and revenues (for 35 000 units):

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Special pricing decisions

Should the special order be accepted?

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Special pricing decisions Recommended
Approach
Column 3

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Special pricing decisions

Only variable costs, the extra selling costs and sales revenues differ between
alternatives and are relevant costs/revenues.

• Since relevant revenues exceed relevant costs the order is acceptable subject to
the following assumptions:

1. Normal selling price of £40 will not be affected.

2. No better opportunities will be available during the period.
3. The resources have no alternative uses.
4. The fixed costs are unavoidable for the period under consideration.

• Note that the identification of relevant costs depends on the circumstances.

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Special pricing decisions

Example 2 (A longer-term order)

• Assume now spare capacity in the foreseeable future (Capacity = 50 000 units
and demand = 35 000 units) and that an opportunity for a contract of 15 000 units
per month at £25 emerges involving £1 per unit special selling costs.

• No other opportunities exist so if the contract is not accepted direct labour will be
reduced by 30%, manufacturing non-variable costs by £70 000 per month and
marketing by £20 000. Unutilised facilities can be rented out at £25 000 per
month.

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Special pricing decisions Recommended
Approach
Column 3

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Product mix decisions with capacity constraints

• Firms often face the problem of deciding how to best utilize a constrained resource.
• Usually, fixed costs are not affected by this particular decision, so management
can focus on maximising total contribution margin.
• The objective is to concentrate on those products/services that yield the largest
contribution per limiting factor.
• Limiting or scarce factors are factors that restrict output.

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Product mix decisions with capacity constraints

Example

Components X Y Z
Contribution per unit £12 £10 £6
Machine hours per unit 6 2 1
Estimated sales demand (units) 2 000 2 000 2 000

Capacity for the period is restricted to 12 000 machine hours.

Required: Calculate the production mix that will maximize contribution

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Product mix decisions with capacity constraints

Step 1: Determine if restricted/scarce capacity is a limiting factor

Step 2: Calculate contribution per unit
Step 3: Calculate contribution per unit of a limiting factor(s) (CULF)
Step 4: Allocate rankings for every limiting factor
Step 5: Consistent rankings-Profits are maximized by allocating scarce
capacity according to ranking per unit of a limiting factor

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Product mix decisions with capacity constraints

Step 1
Components X Y Z
Machine hours per unit 6 2 1
Estimated sales demand (units) 2 000 2 000 2 000
Required machine hours 12 000 4 000 2 000

• Required machine hours to satisfy demand : (12 000 + 4 000 + 2 000) =18 000
machine hours
• Capacity for the period is restricted to 12 000 machine hours.
• Therefore machine hours is a limiting factor

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Product mix decisions with capacity constraints

Step 2,3 and 4

Components X Y Z

Contribution per unit £12 £10 £6 (Step 2)

Machine hours per unit 6 2 1

Contribution per machine hour £2 £5 £6 (Step 3)

Ranking per machine hr 3 2 1 (Step 4)

Conclusion: Thus produce in the following order: Z , Y and then X

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Product mix decisions with capacity constraints

Step 5

Conclusion: Thus produce in the following order: Z , Y and then X

Machine hours Balance of machine

Production used hours available
2 000 units of Z (1 hour/unit) 2 000 10 000
2 000 units of Y (2 hours/unit) 4 000 6 000
1 000 units of X (6 hours /unit) 6 000 –

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Product mix decisions with capacity constraints

The production programme will result in the following:

• 2 000 units of Z at £6 per unit contribution 12 000

• 2 000 units of Y at £10 per unit contribution 20 000
• 1 000 units of X at £12 per unit contribution 12 000
Total contribution 44 000

Note that qualitative factors should

be taken into account.

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 Class Example 1

SUPERSLOW is a company that manufactures two products namely Beta and Alpha. The selling
price and manufacturing details for the two products are as follows:

Beta Alpha
R R
Unit selling price 90 100
Variable manufacturing costs:
Direct labour (R7 per hour) (28) (14)
Material A (R5 per kg) (10) (45)
Material B (R10 per litre) (10) (20)
Fixed overheads absorbed (12) (6)
Profit per unit 30 15

Variable non-manufacturing costs for Beta and Alpha are estimated at R20 and R10 per unit,
respectively.

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Class Example 1
At a recent meeting of the production department, to discuss the production plans for 2013,
the following resource availability was identified:
Direct labour 3 500 hours
Material A 6 000 kg
Material B 1 600 litres

During the meeting, the production manager (Mr Knowitall) made a comment that his
department has sufficient resources to achieve its target production plan of 400 units of Beta
and 700 units of Alpha in 2013.

REQUIRED:

1 Advise Mr Knowitall as to whether his department has sufficient resources to achieve

its target production plan of 400 units of Beta and 700 units of Alpha.

2 Assuming that the target production plan will not be achieved with the current
resources, calculate the optimum product mix and calculate the contribution generated
by the optimum product mix. (

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Class Example 1-Suggested Solution

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Product mix decisions with capacity constraints

Components X Y

Ranking per labour hr 1 2 (Step 4)

Ranking per machine hr 2 1 (Step 4)

What happens if you have more than one constraint and the
rankings are inconsistent?
Solution:
Attend Lecture 2 of Measuring relevant cost and
revenues for decision making (Linear Programming)
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Homework question

Uploaded on Ulink

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Lecture 2

Linear Programming

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