Module 5:

Relevant costing.

As a future CPA, you need to prepare reports that will aid management in operational decision making such as accept or not accept a special
order and make or buy a supply material.  Applying relevant costing in these situations will give CPAs a reasonable recommendation to the
management.

But before we start, let us read the ILOs.

Intended Learning Outcomes (ILOs):

At the end of the topic, the students are expected to be able to:                                   

1. Articulate relevant costing, relevant costs, and relevant benefits;

2. Apply relevant costing in a drop or not to drop a segment scenario;
3. Apply relevant costing in a make or buy scenario;
4. Apply relevant costing in an accept or not to accept special order scenario;
5. Apply relevant costing in determining the most profitable use of constraint resources.

5. 1 Relevant costing
The image below shows us two directions: left or right Which way will you go?

Same thing with the Management. They make important decisions that can make or break the company's operation. Which way should they
go? Will they proceed or not proceed with the project.

In doing so, CPA's should aid the management to come up with a viable decision, thereby, using Relevant
costing.                                              
Key terms:

Relevant costs are costs that differ between alternatives.                                    

The relevant benefit is a benefit that differs between alternatives.                                         

Avoidable costs are costs that can be eliminated in whole or in part in choosing between two alternatives.  Hence, avoidable costs are relevant
costs.                                       

Under Relevant costing, we focus only on Relevant costs (also called Avoidable costs or Incremental costs) and Relevant benefits (Differential
benefits) under the existing alternative course of actions.                                   

Remember, the relevant cost in one situation may not be relevant in another context. In depends on the situation.                                           

The following are Irrelevant costs:                                      

1. Sunk costs are costs incurred from the past and cannot affect the current courses of action.
2. Future costs that do not differ in alternatives.
3. Unavoidable costs                  

Opportunity cost is the benefit that is foregone as a result of pursuing some course of action. Hence, it is a relevant cost.

However, opportunity costs are not actual cash outlays and are not recorded in the financial statements.

5.1.1 Annual savings or loss

Below is an image of machinery which is vital in every manufacturing operation:

To illustrate Relevant costing, let us consider the situation of Mineya Company:                                         

Mineya Company is considering a new labor-saving machine with a rent cost of P115,000.

It will reduce the direct labor per unit from ₱35.00  to ₱23.00

The current Segmented Income statement of Mineya Company are as follows:    

Will the company rent the new machine?                                        

We analyze using Relevant costing. Remember, there are two alternatives:                       

Alternative 1:  To rent a new machine                                 

 Alternative 2:  Not to rent a new machine (or the status quo)                                

We have to consider the relevant cost and relevant benefits.                                           

Analysis: If Mineya will rent a new machine, it will incur rental costs and at the same time reduce labor costs. Hence, incurring rent costs and
reducing labor costs is the relevant cost and benefits respectively.                                              

We compute:    
Decision: Since the net annual savings is P125,000, Mineya Company should rent the new machine.
The P12 per unit is computed by deducting the new labor cost of P23 from the P35 old labor cost.

All other items in the Segmented income statement will remain the same, thus, irrelevant.

5.1.2 Incremental net operating income

As an alternative solution, we prepare the Mineya's Income statement if the entity rents the new machine:

We compare the net operating income of Mineya under the two alternatives:

Hence, Mineya should rent the new machine because incremental net operating income exists.

Notice that regardless of which procedure you use (either the incremental approach or net annual savings), you will still arrive at the same
answer.

Which is better? It depends on which way is close to your way of thinking.

5.2 Drop or not to drop a segment

The above image is one of Samsung's array of product lines namely, Kitchen appliances.
Product lines are also known as segments in the business and accounting world.

Imagine, Samsung found out that it's kitchen appliances product line is lagging the net operating income of the entire company, will Samsung's
management drop that product line or not. The answer lies in the relevant costing to be prepared by the CPA. And that CPA could be you.

As a CPA, you assess the relevant costs and relevant benefits that will affect the decision to drop or not to drop a
segment.                                               

Rule: Decide base on the effect on Net Operating Income  

Additional notes:                                                                    

1. The fixed general administrative expense and fixed factory general factory overhead will still be incurred even if the segment is
dropped. These expenses/costs will only be re-allocated to other segments.
2. The equipment used to manufacture the segment line does not have a resale value and alternative use.

Based on the above income statement, should Samsung drop the product line?    

5.2.1 Net disadvantage

We start with the relevant costing analysis, if Samsung will drop the product line, then:

1. The contribution margin of the segment will be lost.

2. Fixed costs will still be incurred, except avoidable costs such as the salary of line manager, advertising - direct and rent of factory
space.
3. Equipment used to manufacture the segment is considered a sunk cost.        
5.2.2 Incremental NOI (Drop or not a segment)

What have you observed?

Allocated common fixed costs are still to be incurred by the company.

Unavoidable costs allocated to the segment make it appear that the segment is less profitable.

But over-all it is not.

Again, regardless of the solution you use, you will still arrive at the same answer.

5.3 Make or buy

The image below shows a product's parts:

When a company is involved in more than one activity in the entire value chain, it is vertically integrated.                                                             

A decision to carry out one of the activities in the value chain internally, rather than to buy externally from a supplier is called make or
buy.                                                       

For illustration, let us solve the problem below:                                                       

Mahogany Company manufactures parts that are used in one of its products.         

The unit cost of this part is as follows:                                                       

Additional notes:                                                        
1. The special equipment used to manufacture the product parts has no resale value.
2. The total amount of general factory overhead, which is allocated based on DL-hours, would be unaffected by this
decision.                                       
3. The P35 unit product cost is based on 15,000 parts produced each year.
4. An outside supplier has offered to provide the 15,000 parts at a cost per part of ₱40

Requirement: Should Mahogany make or buy the product's parts?                                                

Let us analyze using the relevant costing:                                                     

1. If the entity will buy the parts, then, variable product costs will be eliminated.
2. However, there are fixed factory overhead or common costs that will continue to incur.
3. The special equipment with no resale value is considered a sunk cost.
4. The outside supplier's offer price will be also considered relevant.

Solution:

As a CPA, we need to examine all important data.

At first, glance, buying from outside suppliers is a viable decision since it is P5.00 per unit lower than making the parts. However, we need to
consider all relevant costs and benefits to come up with a sound recommendation to the management.

Note that the minimum offer Mahogany should accept from outsider's offer price is P30, which equals the relevant cost or the discretionary cost
the management will not incur if it chooses to buy from an outside supplier.

Why? Because, all remaining costs are fixed, meaning, it will still be incurred by the company regardless if it will make or buy the parts.

5.3.1 Alternative solution (Make or buy)

Alternative solution:

On the alternative solution, we added to the outside supplier's offer price, the common costs that will still be incurred if the entity decided to
purchase outside.                                                  

Regardless of the solution, you arrive at the same answer.      

5.4 Accept or not accept a special order

Imagine you are manufacturing the product above, suddenly, a businessman wants to have a one-time bulk order of this product at a special
rate.

The special rate is lower than your actual price.

The question is, will you accept the one tie special order or not? In doing so, as a CPA, you need to analyze this situation based on relevant
costing.

A special order is a one-time order that is not considered part of the company’s normal ongoing business.                                                           

As long as the special order is within the normal capacity, then, we can use the existing data.                                                    

When analyzing a special order, only the incremental costs and benefits are relevant.               

Since the existing fixed manufacturing overhead costs would not be affected by the order, they are not
relevant.                                                         

Let us have an illustrative problem:                                                  

Aruba Company makes a product with a selling price per unit of ₱30.00.                 

Argentina, distributor offers to purchase 2,500 units at ₱20.00      

This is a one-time order that would not affect the company’s regular business.                

The annual capacity is 10,000 units but currently producing and selling at 6,000 units.

Related data:                                                 

Required: Will Ariba company accept the special offer?                                                          

Let us analyze the situation using relevant costing.                                                  

1. The offer of 2,500 units is within the normal capacity of 10,000 units and Aruba is only operating at 6,000 units.
2. Since the special order is within normal capacity, it would mean that regardless if Aruba accepts or not, it will still incur the fixed
costs.
3. However, it will have to incur additional variable costs for the 2,500 units special order. This is the relevant
cost.                                                 
4. The relevant benefit is the additional revenue it will be generated from the special order.                                     

Since a net benefit of P30,000 will be realized, then, we should accept the special order.

5.5 Most profitable use of constraint resource

Under this situation, the entity has 1 machine with limited time capacity but will have to manufacture 2 products.                                            
The constraint resource is the machine.                                           

How will the entity allocate the time of a machine to these two products?                                                

The biggest consideration is which combination will yield the highest profit for the company.                                         

Let us determine by solving the illustrative problem:                                              

Mariah Company is producing 2 products namely Daydream and Music box using Machine A1.

Related data are:    

Other information:

1. Machine A1 is the constrained resource and is being used at 100% of its capacity.
2. There is excess capacity on all other machines.                              
3. Machine A1 has a capacity of 2,400 minutes per week.

Required: Should Mariah focus its efforts on Product 1 or Product 2?                                

Let solve on a step by step process:

Hence, the allocation of Machine A1 time to the two products based on priority will yield a P64,200 total contribution margin.
5.6 The value of obtaining more of the constrained resource

Under this scenario, the supply is constrained.                                             

You have 2 products that came from 1 supply material.                                          

The question is, which product will be allocated to the constrained supply?                                               

To understand the scenario, let us solve the illustrative problem step by step:      

Hence, Athena should allocate the constraint supply first to Chairs and the balance is allocated to tables.

5.7 Summary

1. Under Relevant costing, we focus only on Relevant costs (also called Avoidable costs or Incremental costs) and Relevant benefits
(Differential benefits) under an existing alternative course of action.                                    
2. Relevant costs are costs that differ between alternatives.
3. The relevant benefit is a benefit that differs between alternatives.
4. Avoidable costs are costs that can be eliminated in whole or in part in choosing between two alternatives. Hence, avoidable costs are
relevant costs.
5. Irrelevant cost is sunk costs, future costs that do not differ in alternatives and unavoidable costs.
6. Relevant costing can be used for different scenarios namely, drop or not to drop the segment, make or buy materials, accept or not
accept special order, and most profitable use of constraint resource.