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# RELEVANT COSTS FOR DECISIONS MAKING

SUMMARY

Cost information is necessary for making certain decisions. A relevant cost is one
which is pertinent to the decision under consideration. Those costs which would remain
unaffected whether a decision is made or not are irrelevant costs. Thus variable costs are
relevant costs as they always change with a change in a decision. All fixed costs may not
change due to a decision; they are irrelevant costs. Relevant costs include the concepts of
differential cost and marginal cost. Differential cost is the difference of costs of two or more
alternatives. In cost accounting, marginal cost is treated equivalent to variable cost since, in
the short run, fixed costs are assumed to remain constant. Contribution is the difference
between sales and variable cost.
Relevant cost approach, particularly the marginal cost analysis, helps in making a
number of short-term decisions. It helps in determining prices of product under special
situations like one time export order, and in deciding whether a product should be dropped,
or whether the firm should make a component or buy it from outside, or whether the firm
should sell an intermediate product or process it further, or whether a plant should be shut-
downetic. Generally, if an alternative yield positive or higher contribution, it would be

ILLUSTRATIVE PROBLEMS

PROBLEM 1
The S.K. Company manufactures and sells three products A,B, and C. The data for them are
given below:
Product

A B C

## Quantity 10,000 25,000 35,000

Selling Price Rs 18 Rs 10 Rs 30
Variable Cost 16 6 22
Fixed Cost Rs 2,10,000

Fixed costs are allocated on the basis of number of units produced. The plant is operated on
full capacity. Each unit requires same manufacturing time.
Product A is unprofitable. The firm proposes to drop it. The loss per unit of Product A is
calculated as follows by the accountant:

## Selling price per unit Rs 18

Variable cost per unit Rs 16
Fixed cost per unit 3 19
(Rs 2,10,000 : 70,000)
Loss per unit (Rs 1)
(1) Should Product A be dropped?
(2) Should Product A be dropped if more units of Product B could be sold?
(3) What should be the selling price of Product A to make it as profitable as Product B?
(4) Assume that sale of Product B cannot be increased when Product A is dropped.
However, a new Product D, can be added. Product Ds selling price and variable cost
per unit are estimated at Rs 16 and Rs 15.50 respectively. The sales manager prefers
to add Product D since in his opinion, although the contribution from Product D is
less than that from Product A, more units of Product D can be produced and sold
that will reduce fixed cost per unit. He thinks that 24,000 units of Product D can be
sold if Product A is dropped. You are required to comment on the sales managers
opinion. What should be Product Ds selling price if it should be as profitable as

SOLUTION
1. Product A should not be dropped since it generates positive contribution:
Rs 18 Rs 16 = Rs 2 per unit. The profit would decrease by Rs 20,000 (i.e., 10,000
units x Rs 2) if Product A is dropped.
2. If more units or Product B could be sold, Product A should be dropped since Product
B yields a higher contribution per unit: Rs 10 Rs 6 = Rs 4 per unit. Net increase in
profits will be 10,000 x Rs 4 Rs 10,000 x Rs 2 = Rs 20,000.
3. The selling price of Product A will have to be increased to Rs 20 to give contribution
per unit equal to that of Product B (viz. Rs 4).
4. The sales managers reasoning is invalid. Total fixed costs will not change if Product
D is added. Fixed cost per unit is not relevant in making the decision. The
contribution from Product D will be : (Rs 16 Rs 15.50) x 24,000 units = Rs 12,000,
while contribution from Product A is Rs 20,000. Thus profit will decrease by Rs 8,000
if Product D is added and Product A is dropped.

PROBLEM 2
The Raisilly Manufacturing Company manufactures a component which is finally assembled
to its main product. The component is produced in two manufacturing steps. The normal
annual production of the part is 50,000 units.
The following are the standard costs of performing the manufacturing steps:

## Manufacturing step 1 : Rs 82,800

Direct materials 1,10,400
Direct labour 55,200
Total cost Rs 2,96,240

Manufacturing step 2 :
Direct labour Rs 73,600
Total cost Rs 1,62,560

## Total cost of both steps Rs 4,58,800

The other overhead, comprising both fixed and variable overhead, is allocated as: Rs 36,000
+ 10% of direct labour cost.
The company will not require manufacturing step 1 if components are bought from outside.
The outsider will supply 50,000 units a year at Rs 4.35 per unit. The company will have to
pay freight of Rs 10,000 per year on purchases. If the components are purchased, this will
release space occupied for performing manufacturing step 1. The opportunity cost of the
space is Rs 20,000 per year.
Suggest whether the component should be manufactured inside or bought from outside.

SOLUTION
Fixed general overhead of Rs 36,000 are irrelevant in the present decision-making.
Differential costs of purchasing parts and perfoming manufacturing step 1 should be
compared:
Differential costs of manufacturing step 1:
Direct materials Rs 82,800
Direct labour 1,10,400
Variable general overhead (10% of Rs 1,10,400) 11,040
Rs 2,59,440

## Differential costs of purchasing parts:

50,000 x Rs 4.35 Rs 2,17,500
Freight 10,000
Less: Opportunity loss (if components are manufactured) 20,000
Rs 2,07,500

## The company should buy components from outside.

PROBLEM 3
The board of directors of Eskay Company, manufacturing three Products A,B and C wants
The following information is available:

Product
A B C

## Direct material per unit Rs 10 Rs 30 Rs 20

Variable overhead per unit 3 2 5

## Department Rate per hour Hour required per unit

1 Rs 0.5 28 hrs. 16 hrs. 30 hrs.
2 1.0 5 hrs. 6 hrs. 10 hrs.
3 0.5 16 hrs. 8 hrs. 30 hrs.
Data from current budget
Production 000 units p.a. 10 5 6
Selling price per unit Rs 50 Rs 68 Rs 90
Sales forecasts for the next
year, 000 units 12 7 9
The type of labour required by department 2 is in short supply and it is not possible to
increase the manpower of this department beyond its present level.
(1) Prepare a statement to advise the directors of the most profitable product mix. The
statement should show: (a) the profit expected on the current budgeted production
and (b) the profit which could be expected if the most profitable mixture was
produced.
(2) Direct the directors attention to any problems which are likely to arise if the mix in
(1) (b) above were to be produced. (I.C.W.A., adapted)

SOLUTION
1. (a) Profit on current production
Product
A B C Total
Units 1,000 5,000 6,000 21,000
Sales Rs 5,00,000 Rs 3,40,000 Rs 5,40,000 Rs 13,80,000
Variable costs:
Direct materials Rs 1,00,000 Rs 1,50,000 Rs 1,20,000 Rs 3,70,000
Direct wages:
Dept. 1 1,40,000 40,000 90,000 2,70,000
2 50,000 30,000 60,000 1,40,000
3 80,000 20,000 90,000 1,90,000
Total variable costs Rs 4,00,000 2,50,000 3,90,000 10,40,000
Contribution Rs 1,00,000 Rs 90,000 Rs 1,50,000 Rs 3,40,000
Net profit Rs 1,40,000
Contribution ratio
to limiting factor
(i.e. wages of Dept. 2) 200% 300% 250%

## (b) Profit from most profitable mix

Product
A B C Total
Units 1,600 7,000 9,000 17,000
Sales Rs 80,000 Rs 4,76,000 Rs 8,10,000 Rs 13,66,000
Variable costs:
Direct materials Rs 16,000 Rs 2,10,000 Rs 1,80,000 Rs 4,06,000
Direct wages:
Dept. 1 22,400 56,000 1,35,000 2,13,400
2 8,000 42,000 90,000 1,40,000
3 12,800 28,000 1,35,000 1,75,000
Total variable costs Rs 64,000 3,50,000 5,85,000 9,99,000
Contribution Rs 16,000 Rs 1,26,000 Rs 2,25,000 Rs 3,67,000
Net profit Rs 1,67,000
2. The directors should ensure that reduction in the sales of Production A does not
damage the customers goodwill. The status of Product A vis-a-vis Products C and B
should be examined. If Product A is complementary to Products C and B, the fall in
As sales will tend to reduce sales of C and B.
Thus, in terms of limiting factor, B is the most profitable product, followed by
products C and A. Production hours, therefore, should be first concentrated to
Product B and C and the balance may be devoted to Product A. As per the current
production budgets, the total hours available at Dept. 2 are : A : 10,000 x 5 + B :
5,000 x 6 + C : 6,000 x 10 = 1,40,000 hours.
If the Company produces maximum units (expected to be sold of B and C), the
production hours will be allocated as follows:

## Product Units Dept. B hours per product unit Total hours

A 7,000 6 42,000
B 9,000 10 90,000
C 1,600 5 8,000
1,40,000
(balancing)
How does ABC product costing correct the situation?
An activity-based cost system is one that traces costs first to activities and then to products.
Traditional product costing also involves two stages, but in the first stage costs are traced to
departments, not to activities. In both traditional and activity-based costing, the second
stage consists of tracing costs to the product. The principal difference between the two
methods is the number of cost drivers used. Activity-based costing uses a much larger
number of cost drivers than the one or two volume-based cost drivers typical in a
conventional system. In fact, the approach separates overhead costs into overhead cost
pools, where each cost pool is associated with a different cost driver. Then a predetermined
overhead rate is computed for each cost pool and each cost driver. Consequently, this
method has enhanced accuracy.

## Setup (1) 0.40 0.60 Production runs

Quality control (2) 0.40 0.60 Inspection hours
Power (3) 0.17 0.83 Kilowatt hours
Maintenance (4) 0.17 0.83 Machine hours

Exhibit 1
PRODUCT DIVERSITY: PROPORTION OF CONSUMPTION
( 1 ) 20/50 (Nitro-X) and 30/50 (Nitro-Y)
( 2 ) 800/2,000 (Nitro-X) and 1,200/2,000 (Nitro-Y)
( 3 ) 5,000/30,000 (Nitro-X) and 25,000/30,000 (Nitro-Y)
( 4 ) 10,000/60,000 (Nitro-X) and 50,000/60,000 (Nitro-Y)

First-Stage Procedure
In the first stage of activity-based costing, overhead costs are divided into
homogeneous cost pools. A homogeneous cost pool is a collection of overhead costs for
which cost variations can be explained by a single cost driver. Overhead activities are
Once a cost pool is defined, the cost per unit of the cost driver is computed for that
pool. This is referred to as the pool rate. Computation of the pool rate completes the first
stage. Thus, the first stage produces two outcomes: (1) a set of homogeneous cost pools
and (2) a pool rate.
For example, in Exhibit 1, quality control costs and setup costs can be combined into
one homogeneous cost pool and maintenance and power costs into a second. For the first
cost pool, the number of production runs or inspection hours could be the cost driver. Since
the two cost drivers are perfectly correlated, they will assign the same amount of overhead
to both products. For the second pool, machine hours or kilowatt-hpurs could be selected as
the cost driver.
Assume for the purpose of illustration that the number of production runs and
machine hours are the cost driver chosen. Using data from Exhibit 2, the first-stage
outcomes are illustrated in Exhibit 3.

## Units produced per year 10,000 50,000 60,000

Production runs 20 30 50
Inspection hours 800 1,200 2,000
Kilowatt hours 5,000 25,000 30,000
Prime costs (direct materials and direct labor) \$50,000 \$250,000 \$300,000

1 2

## Direct labor hours:

Nitro-X 4,000 16,000 20,000
Nitro-Y 76,000 24,000 100,000
Total 80,000 40,000 120,000
Machine hours:
Nitro-X 4,000 6,000 10,000
Nitro-Y 16,000 34,000 50,000
Total 20,000 40,000 60,000
Setup costs \$48,000 \$48,000 \$96,000
Quality control 37,000 37,000 74,000
Power 14,000 70,000 84,000
Maintenance 13,000 65,000 78,000
Total \$112,000 \$220,000 \$332,000

## Exhibit 2 PRODUCT-COSTING DATA

Second-Stage Procedure
In the second stage, the costs of each overhead pool are traced to products. This is done
using the pool rate computed in the first stage and the measure of the amount of resources
consumed by each product. This measure is simply the quantity of the cost driver used by
each product. In our example, that would be the number of production runs and machine
hours used by each product. Thus, the overhead assigned from each cost pool to each
product is computed as:

## Applied overhead = pool rate x cost driver units used

To illustrate, consider the assignment of cots from the first overhead pool to Nitro-X.

Pool 1
Setup costs \$ 96,000
Quality control costs 74,000
Total costs \$170,000
Production runs 50
Pool rate (cost per run) \$170,000/50 \$ 3,400
Pool 2
Power cost \$ 84,000
Maintenance 78,000
Total costs \$162,000
Machine hours 60,000
Pool rate (cost per machine hour)
\$162,000/60,000 \$ 2.70

## Exhibit 3 ACTIVITY-BASED COSTING: FIRST STAGE PROCEDURE

From Exhibit 3, the rate for this pool is \$3,400 per production run. From Exhibit 2, Nitro-X
uses 20 production runs. Thus, the overhead assigned from the first cost pool is \$68,000
(\$3,400 x 20 runs). Similar assignments would be made for the other cost pool and for the
other product (for both cost pools).
The total overhead cost per unit of product is obtained by first tracing the overhead costs
from the pools to the individual products. This total is then divided by the number of units
per-unit prime cost yields the manufacturing cost per unit. In Exhibit 4, the manufacturing is
computed using activity-based costing.

## Comparison of Product Costs

In Exhibit 5, the unit cost from activity-based costing is compared with the unit costs
produced by conventional costing using either a plantwide or departmental rate. This
comparison clearly illustrates the effects of using only volume-based cost drivers to assign
consumption and is, therefore, the most accurate of the three costs shown in the exhibit.
Activity-based product costing reveals that the conventional method undercosts the Nitro-X
significantly by at least 37.7% = (\$14.50 10.53)/\$10.53 and overcosts the Nitro-Y by at
least 8.1% = (\$10.53 - \$9.74) / \$9.74

NOTE
Using only volume-based cost drivers can lead to one product subsidizing another. This
subsidy could create the appearance that one group of products is highly profitable and
could adversely impact the pricing and competitiveness of another group of products. In a
highly competitive environment, accurate cost information is critical to sound planning and
decision making.
Nitro-X

Pool 1 : \$3,400 x 20 \$68,000
Pool 2 : \$2.70 x 10,000 27,000
Prime costs 50,000
Total manufacturing costs \$145,000
Units produced 10,000
Unit cost \$ 14.50

Nitro-Y

Pool 1 : \$3,400 x 30 \$102,000
Pool 2 : \$2.70 x 50,000 135,000
Prime costs 250,000
Total manufacturing costs \$487,000
Units produced 50,000
Unit cost \$ 9.74

## Nitro-X Nitro-Y Source

Conventional
Plantwide rate 10.53 10.53 Exhibit 6
Department rates 8.86 10.87 Exhibit 7
Activity-based cost \$14.50 \$9.74 Exhibit 1

Nitro-X

## Prime costs \$ 50,000

Overhead costs \$5.53 x 10,000 55,300
\$105,300
Unit cost \$105,300/10,000 units \$ 10.53

Nitro-Y

## Prime costs \$250,000

Overhead costs \$5.53 x 50,000 276,500
\$526,500
Unit cost \$526,500/50,000 units \$ 10.53

Nitro-X

## Prime costs \$50,000

Department 1 : \$1.40 x 4,000 = \$5,600
Department 2 : \$5.50 x 6,000 = 33,000
38,600
\$88,600
Unit cost \$88,600/10,000 units \$ 8.86

Nitro-Y

## Prime costs \$250,000

Department 1 : \$1.40 x 76,000 = \$106,400
Department 2 : \$5.50 x 34,000 = 187,000
293,400
\$543,400
Unit cost \$543,400/50,000 units \$ 10.87

## Which cost drivers should be used?

At least two major factors should be considered in selecting cost drivers: (1) the cost of
measurement and (2) the degree of correlation between the cost driver and the actual
THE COST OF MEASUREMENT
In an activity-based cost system, a large number of cost drivers can be selected and used.
However, it is preferable to select cost drivers that use information that is readily available.
Information that is not available in the existing system must be produced, which will
increase the cost of the firms information system. A homogeneous cost pool could offer a
number of possible cost drivers. For this situation, any cost driver that can be used with
existing information should be chosen. This choice minimizes the costs of measurement.
In our example, for instance, quality control costs and setup costs were placed in the same
cost pool, giving the choice of using either inspection hours or number of production runs as
the cost driver. If the quantities of both cost drivers used by the two products are already
being produced by the companys information system, then which is chosen is unimportant.
Assume, however, that inspection hours by product are not tracked but data for production
runs are available. In this case, production runs should be chosen as the cost driver, avoiding
the need to produce any additional information.

## INDIRECT MEASURES AND THE DEGREE OF CORRELATION

The exsisting information structure can be exploited in another way to minimize the costs of
obtaining cost driver quantities. It is sometimes possible to replace a cost driver that directly
measures the consumption of an activity with a cost driver that indirectly measures that
consumption. For example, inspection hours could be replaced by the actual number of
inspections associated with each product; this number is more likely to be known. This
replacement only works, of course, if hours used per inspection are reasonably stable for
each product. Linear regressions can be utilized to determine the degree of correlation.
A list of potential cost drivers is given in Exhibit 8. Cost drivers that indirectly measure the
consumption of an activity usually measure the number of transactions associated with that
activity. It is possible to replace a cost driver that directly measures consumption with one
that only indirectly measures it without loss of accuracy, provided that the quantities of
activity consumed per transaction are stable for each product. In such a case, the indirect
cost driver has a high correlation and can be used.
BIAYA RELEVAN UNTUK KEPUTUSAN PEMBUATAN

RINGKASAN

informasi biaya yang diperlukan untuk membuat keputusan tertentu. Sebuah biaya
yang relevan adalah salah satu yang berhubungan dengan keputusan yang
dipertimbangkan. Biaya-biaya yang akan tetap tidak terpengaruh apakah keputusan
dibuat atau tidak adalah biaya yang tidak relevan. Dengan demikian biaya variabel
adalah biaya relevan karena mereka selalu berubah dengan perubahan keputusan.
Semua biaya tetap tidak berubah karena keputusan; mereka biaya tidak relevan.
biaya relevan meliputi konsep biaya diferensial dan biaya marjinal. biaya diferensial
adalah perbedaan biaya dari dua atau lebih alternatif. Dalam akuntansi biaya, biaya
marjinal diperlakukan setara dengan biaya variabel karena, dalam jangka pendek,
biaya tetap diasumsikan tetap konstan. Kontribusi adalah perbedaan antara
penjualan dan biaya variabel.
pendekatan biaya yang relevan, khususnya analisis biaya marjinal, membantu dalam
membuat sejumlah keputusan jangka pendek. Ini membantu dalam menentukan
harga produk di bawah situasi khusus seperti rangka ekspor satu waktu, dan dalam
memutuskan apakah suatu produk harus turun, atau apakah perusahaan harus
membuat komponen atau membelinya dari luar, atau apakah perusahaan harus
menjual produk menengah atau memprosesnya lebih lanjut, atau apakah tanaman
harus ditutup-downetic. Umumnya, jika yield alternatif positif atau kontribusi yang
lebih tinggi, itu akan diadopsi oleh perusahaan.

MASALAH ILUSTRASI

MASALAH 1
The S.K. Perusahaan memproduksi dan menjual tiga produk -A, B, dan C. Data untuk
mereka diberikan di bawah ini:

biaya tetap dialokasikan atas dasar jumlah unit yang diproduksi. Tanaman ini
dioperasikan pada kapasitas penuh. Setiap unit membutuhkan waktu manufaktur
yang sama.
Produk A adalah tidak menguntungkan. Perusahaan mengusulkan untuk
menjatuhkannya. Hilangnya per unit Produk A dihitung sebagai berikut oleh akuntan:
(1) Haruskah Produk A akan turun?
(2) Haruskah Produk A akan turun jika lebih unit Produk B bisa dijual?
(3) Apa yang harus menjadi harga jual produk A untuk menjadikannya sebagai
menguntungkan sebagai Produk B?
(4) Asumsikan bahwa penjualan Produk B tidak dapat ditingkatkan saat Produk A
dijatuhkan. Namun, Produk D baru, dapat ditambahkan. harga jual produk D's dan
biaya variabel per unit diperkirakan Rs 16 dan Rs 15.50 masing-masing. Manajer
penjualan lebih memilih untuk menambahkan produk D karena dalam pendapatnya,
meskipun kontribusi dari Produk D kurang dari itu dari Produk A, lebih unit Produk D
dapat diproduksi dan dijual yang akan mengurangi biaya tetap per unit. Ia berpikir
bahwa 24.000 unit Produk D dapat dijual jika Produk A dijatuhkan. Anda diminta
untuk mengomentari pendapat manajer penjualan. Apa yang harus menjadi harga
jual produk D's jika harus keuntungan seperti Produk A? (Diadaptasi)

LARUTAN
1. Produk A tidak boleh dijatuhkan karena menghasilkan kontribusi positif:
Rs 18 - Rs 16 = Rs 2 per unit. keuntungan akan menurun Rs 20.000 (yaitu, 10.000 unit
x Rs 2) jika Produk A dijatuhkan.
2. Jika lebih unit atau Produk B bisa dijual, Produk A harus menurun sejak Produk B
menghasilkan kontribusi yang lebih tinggi per unit: Rs 10 - Rs 6 = Rs 4 per unit.
Kenaikan bersih keuntungan akan 10.000 x Rs 4 - Rs 10.000 x Rs 2 = Rs 20.000.
3. Harga jual produk A harus ditingkatkan untuk Rs 20 untuk memberikan kontribusi
per unit sama dengan Produk B (viz. Rs 4).
4. Alasannya penjualan manajer tidak valid. Total biaya tetap tidak akan berubah jika
Produk D ditambahkan. biaya tetap per unit tidak relevan dalam membuat
keputusan. Kontribusi dari produk D akan: (Rs 16 - Rs 15,50) x 24.000 unit = Rs
12.000, sedangkan kontribusi dari Produk A adalah Rs 20.000. Dengan demikian laba
akan menurun Rs 8.000 jika Produk D ditambahkan dan Produk A dijatuhkan