LESSON 5

Relevant data for decision making and product pricing

Introduction

The quality of decisions made by managers at anyone stage depends on the quality of
information that is before them. Management accounting unlike financial accounting which is
based on historical accounting is concerned about making decisions. Managers have to assess the
effects of every decision that they make.

Relevant information

Management accountants need relevant information to make appropriate decision. Information is

relevant if it will be an aid to decision making. Relevant information may come in the form of
relevant revenues. Relevant revenue is income streams expected from particular options at hand.
Information is irrelevant if it will not help a manager to make decision. An example of irrelevant
information is could be revenue arising from activities that are not currently under consideration.
Relevant information may come in the form of costs. Costs are relevant if they will help a
decision maker to arrive at a satisfactory decision. For example costs that will be incurred in
future under each decision option at hand could constitute relevant information. If for instance
making a certain decision will not affect certain costs, those costs are irrelevant and we do not
consider them as we make a decision.

Sunk costs

In the same breath, there is what are known as a sunk costs. These are costs we have already
incurred and they are historical. Our overall cost position will not change whether or not we
make a decision regarding the issue at hand.
For example assume that you want to build a house. You hired someone to draw a house plan for
you which you took to the local authority for approval. However, the local authority has refused
to approve the house plan on the basis that it is flawed. You had paid $1000 to get the plan
drawn . You suddenly come across an experienced draftsman who offers to do a good job for $1
200. Assume that he is the only one who can do a good job which will not create problems with
the local authority. If you give up and decide not to contract him, the house remains unbuilt
because you have no plan. As you decide on whether or not to engage the new draftsman, the
amount you have already paid to the fake drafts man is irrelevant. Even if you had paid $5 000 to
the first draftsman, it is irrelevant because this one wants usd1 200 for his services; you accept or
you give up. The $ 1 000 you lost in the first transaction is referred to as a sunk cost. It should
not come into the decision making process on whether we should engage the new drafts man or
not.

For proper decision making, fixed costs should not be considered as these will be incurred
whether a certain course of action is taken or not. Marginal costing is used to make decisions in
the following circumstances.

a. Whether or not to accept an order at below market price.

b. To determine the optimum production level
c. To decide which product to produce where a production resource is in short supply.
d. Whether or not to drop a product
e. Whether to continue making a product or we should buy it in.
f. Determining break even points and profits at various levels of output.
g. Relevant cost and opportunity costs

1.Relevant costs for decision making

The costs which should be used for decision making are often referred to as "relevant costs".
CIMA defines relevant costs as 'costs appropriate to aiding the making of specific management
decisions'.

To affect a decision a cost must be:

a) Future: Past costs are irrelevant, as we cannot affect them by current decisions and they are
common to all alternatives that we may choose.

b) Incremental: ' Meaning, expenditure which will be incurred or avoided as a result of making a
decision. Any costs which would be incurred whether or not the decision is made are not said to
be incremental to the decision.
c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not relevant.
Similarly, the book value of existing equipment is irrelevant, but the disposal value is relevant.

Other terms:

d) Common costs: Costs which will be identical for all alternatives are irrelevant, e.g. rent or
rates on a factory would be incurred whatever products are produced.

e) Sunk costs: Another name for past costs, which are always irrelevant, e.g. dedicated fixed
assets, development costs already incurred.

f) Committed costs: A future cash outflow that will be incurred anyway, whatever decision is
taken now, e.g. contracts already entered into which cannot be altered.

Example 1

Zimglass Industries Ltd. has been approached by a customer who would like a special job to be
done for him, and is willing to pay $60,000 for it. The job would require the following materials.

Material Total units Units already Book value of units Realisable value Replacement cost
required in stock in stock $/unit $/unit $/unit

A 1000 0 - - 16.00

B 1000 600 12.00 12.50 15.00

C 1000 700 13.00 12.50 14.00

D 200 200 14.00 16.00 19.00

a) Material B is used regularly by Zimglass Industries Ltd, and if units of B are required for this
job, they would need to be replaced to meet other production demands.
b) Materials C and D are in stock due to previous over-buying, and they have restricted use. No
other use could be found for material C, but the units of material D could be used in another job
as a substitute for 300 units of material E, which currently costs $15 per unit (of which the
company has no units in stock at the moment).
Calculate the relevant costs of material for deciding whether or not to accept the contract. You
must carefully and clearly explain the reasons for your treatment of each material.
The assumptions in relevant costing
Some of the assumptions made in relevant costing are as follows:
a) Cost behaviour patterns are known, e.g. if a department closes down, the attributable fixed
cost savings would be known.
b) The amount of fixed costs, unit variable costs, sales price and sales demand are known with
certainty.
c) The objective of decision making in the short run is to maximise 'satisfaction', which is often
known as 'short-term profit'.
d) The information on which a decision is based is complete and reliable

Opportunity cost

Relevant costs may also be expressed as opportunity costs. An opportunity cost is the benefit
foregone by choosing one opportunity instead of the next best alternative.

Example 2

A company is considering publishing a limited edition book bound in a special leather. It has in
stock the leather bought some years ago for $1,000. To buy an equivalent quantity now would
cost $2,000. The company has no plans to use the leather for other purposes, although it has
considered the possibilities:

a) of using it to cover desk furnishings, in replacement for other material which could cost $900
b) of selling it if a buyer could be found (the proceeds are unlikely to exceed $800).

In calculating the likely profit from the proposed book before deciding to go ahead with the
project, the leather would not be costed at $1,000. The cost was incurred in the past for some
reason which is no longer relevant. The leather exists and could be used on the book without
incurring any specific cost in doing so. In using the leather on the book, however, the company
will lose the opportunities of either disposing of it for $800 or of using it to save an outlay of
$900 on desk furnishings.

The better of these alternatives, from the point of view of benefiting from the leather, is the
latter. "Lost opportunity" cost of $900 will therefore be included in the cost of the book for
decision making purposes.

The relevant costs for decision purposes will be the sum of:

i) 'avoidable outlay costs', i.e. those costs which will be incurred only if the book project is
approved, and will be avoided if it is not

ii) the opportunity cost of the leather (not represented by any outlay cost in connection to the
project).

This total is a true representation of 'economic cost'.

Accepting a lowly priced order

Accepting an order below market price’s sometimes management is faced with a decision on
whether or not to accept an order at a price below the normal market price. This usually happens
when there we idle capacity. The managerial decision to make is whether or not the order at
below market prices should be accepted.

Example 3

DD Ltd has an annual production budget of 40 000 units. Overheads are absorbed into
production at an overhead absorption rate of $5/unit. The marginal cost of production is $20. The
normal selling price per unit is $34. An order has been small customers for 5 000 units at a price
of $28/unit.

Assuming that all other conditions are met, should the order be accepted?

Solution

Proposed selling price per unit $28

Less marginal costs of production $20
Contribution $8

Total contribution: $8 x 5 000 = $40 000

Accepting the order will increase overall profits by $40 000

The guiding principle which should guide management in their decision making is:

a) Contribution
Is the price that is being offered enough to cover the variable cost of production and possibly
generate some excess cash flows which may increase our profit?

b) Nature of costs
Are the costs pertaining to this product really constant? Are there no chances that there may be
movements in fixed costs?

c) Impact on other customers

Will the customer not go onto the market and upset prices because they have been able to source
the product cheaper? Will the customer not go and boast among other competitors that they
always have a special price and hence no one can beat their price. This may see loyal customers
revolting against the company and preferring competitors who may have cheaper brands as a
way of matching the new lower price.

d) Crowding out effect

After accepting an order at a much lower price, if a new order is received slightly higher price,
are we also able to take advantage of that. Are we not going to let a good opportunity pass by
whilst we are chasing a cheaper less profitable order? To avoid this happening we should only
accept a lowly priced order at a special price provided the period within which it has to be
manufactured is short. Where the production period is prolonged, there may be a change in
variable costs and we should check if a customer will accept a price adjustment.

e) Poor quality products

If production employees get to know that the offered price is below market price, they may be so
unhappy that they may want to match price to the quality by producing lower standard goods.
 f) Payment terms

For a cash strapped company where the customer is offering cash upfront or on delivery it is a
good inducement. Where this is not the case and the customer takes his time to pay there is a risk
that we may end up using materials acquired for cash for a poorly priced product and when we
get an order, we may not be able to source raw materials due to cash flow challenges.

Whether or not to drop a loss making product

Sometimes management is faced with a loss making product and the temptation is to want to
drop the loss making product. To enable managers to make an informed decision, the following
factors should be taken into account.

Is the product making a contribution?

Where a product is able to cover its marginal cost and still be able to contribute a small amount
towards the fixed overheads, it is not advisable to drop the product because overall profits will be
lower.

Example 4

DD Ltd Company manufactures three products whose details are as follows:

Product A B C
Selling price/unit 40 38 29
Cost/ unit
Labour 18 16 15
Material 12 12 12
Fixed costs 4 34 5 33 5 32
Profit 6 5 (3)
Average Production 5 000 8 000 10 000

Management are considering dropping product C because it is making losses.

Required
Advise management whether or not to drop the product.

Contribution per product:

A B C
Selling price/unit 40 38 29
Less marginal costs
Labour 18 16 15
Material 12 30 12 28 12 27
Contribution 10 10 2
Annual Product 5 000 8 000 10 000
Total contribution 50 000 80 000 20 000

Current overall profit:

Product A ($6 X 5 000) 30 000
Product B ($5 X 8 000) 40 000
Product C ($3 X 10 000) (30 000)
Overall profit 40 000
 Profit structure without Product C

Total contribution:
A ($10 000 x 5 000) 50 000
B ($10 000 x 6 000) 80 000
130 000
Less fixed cost
A ($4 X 50 000) 20 000
B ($5 X 80 000) 40 000
C ($5 X 10 000) 50 000 110 000
Profit 20 000

Thus if we stop producing Product C. our overall profits will fall by $20 000, which is the benefit
we were having of producing the product even though it was loss making. of the $5 of the fixed
costs for product C , the product was able to contribute $@ per unit towards fixed costs or $20
000 in total. By stopping production, unless the fixed costs can be reduced also, there will be a
reduction in profits of $20 000.

Before we decide to drop the product, we should take into account the following:

Redundancy pay

There are people who are involved in the production of C, if we discontinue production, are we
able to avoid labour costs at no extra costs. Chances are that there is a cost involved with regard
to redundancy pay and this should be taken into account. Besides the only cost that is purely
avoidable may be material cost. People involved n the manufacture of product C may actually be
the same people required in a way for one or more of the other products.
Complementary products

Sometimes the products are complementary. When products are complementary, if we

discontinue production of one product it may actually affect the gross revenues of other products.
We have noticed that in a college business suppose an A Level student wants to study three
subjects Economics, Accounting and Business Management. If the college offers only two
subjects Economics and Accounting but does not offer Business Management, students may not
enroll at the college at all even though the college is reputed for for good results. The standard
thing to do at A level is to study at least three subjects at A Level at the same place. Since the
subject are complementary ,leaving one of them out may result in the other subjects not having
any takers as well..

Will skilled lab our be available in future?

When you have to drop a product, there is a risk that in future when production resumes, skilled
labour will have been hired elsewhere .

Staff moral

Each time some people are sent home, a feeling of,’’(them vs. us,’’ develops in the organization
and productivity falls and sometimes sabotage may set in. Remaining employees develop an anti
organization attitude. They are not sure who is next to go and an air of anxiety sets in. Some may
even resort to having some part time job or business on the sidelines in preparation for being laid
off.

Deterioration of machinery

Although a product may be dropped, the machinery may still be kept. The machinery may still
deteriorate without usage due to changes in technology. Shutdown problems
Shutdown problems involve the following types of decisions:
a) Whether or not to close down a factory, department, product line or other activity, either
because it is making losses or because it is too expensive to run.
b) If the decision is to shut down, whether the closure should be permanent or temporary.
Shutdown decisions often involve long term considerations, and capital expenditures and
revenues.
c) A shutdown should result in savings in annual operating costs for a number of years in the
future.
d) Closure results in release of some fixed assets for sale. Some assets might have a small scrap
value, but others, e.g. property, might have a substantial sale value.
e) Employees affected by the closure must be made redundant or relocated, perhaps even offered
early retirement. There will be lump sums payments involved which must be taken into
consideration. For example, suppose closure of a regional office results in annual savings of
$100,000, fixed assets sold off for $2 million, but redundancy payments would be $3 million.
The shutdown decision would involve an assessment of the net capital cost of closure ($1
million) against the annual benefits ($100,000 per annum).
It is possible for shutdown problems to be simplified into short run decisions, by making one of
the following assumptions
a) Fixed asset sales and redundancy costs would be negligible.
b) Income from fixed asset sales would match redundancy costs and so these items would be
self-cancelling.
In these circumstances the financial aspects of shutdown decisions would be based on short run
relevant costs.

Example 5 or deleting products

Brass Ltd. manufactures three products, Swans, Ducks and Chicks. The present net annual
income from each item is as follows:
Swans Ducks Chicks Total
$ $ $ $
Sales 50,000 40,000 60,000 150,000
Variable costs 30,000 25,000 35,000 90,000
Contribution 20,000 15,000 25,000 60,000
Fixed costs 17,000 18,000 20,000 55,000
Profit/(loss) 3,000 (3,000) 5,000 5,000
Brass Ltd. is concerned about its poor profit performance, and is considering whether or not to
cease selling Ducks. It is felt that selling prices cannot be increased or lowered without adversely
affecting net income. $5,000 of the fixed costs of Ducks are direct fixed costs which would be
saved if production ceased. All other fixed costs will remain the same.
a) Advise Brass Ltd. whether or not to cease production of Ducks.
b) Suppose, however, it were possible to use the resources realised by stopping production of
Ducks, and switch to produce a new item, Eagles, which would sell for $50,000 and incur
variable costs of $30,000 and extra fixed costs of $6,000. What will the new decision be?

What product to produce when there is a limiting factor/ resource.

In some cases, management is faced with a decision of what product to make where there is a
limiting factor. A limiting factor may come in the form of raw materials, labour hours or
machine hours due to power outages. The raw materials may be in short supply and a need to
ration it in the best possible manner arises.

Whatever the input that is a constraint, the basic procedure is that:

a) We calculate the contribution per unit of every product

b) We find the contribution per limiting factor using the formula;

Contribution per unit

Quantity of limiting factor/limit

c) Rank products in order of contribution per limiting factor starting off with a product that
has the highest contribution per limiting factor.
d) Provide the production plan in quantities and the resources to be used.
e) Some questions may then ask for a marginal cost statement. This is simply a proposed P
& L account based on the proposed production schedule.
Example 6

Lagrad Ltd manufactures four types of cameras which all use ‘’yugara,’’ a component made only
in one factory. Each ‘’yugara’’ costs $50 to purchase. Due to a prolonged strike of workers in the
‘’yugara’’ factory, Lagrad Ltd will only be able to purchase 20 000 yugaras ths year this year.

The following information relates to each type of camera manufactured by Lagrad Ltd.

Digital cameras Cine cameras Closed circuit Medical camera

TV cameras

Maximum demand (units) 10 000 4 000 3 000 500

Costs per camera $ $ $ $

Yugaras 50 100 200 350
Other direct material 40 90 98 300
Direct labour 20 30 30 55
Fixed costs 60 80 40 70
Profit per camera 50 70 52 490
Selling price per camera 220 370 420 1 265

Required

a) Calculate the numbers of each type of camera to be produced and sold that would
maximize the profit of Lagrad Ltd.
b) Prepare a marginal cost statement showing the profit for the year.
Whether to make or buy- in a product

Sometimes management is faced with a decision of whether to make or buy a product. This
happens when competitors are able to access an input at a cheaper cost than we can actually
make it at.

As a rule we can only buy in a product if the marginal costs of making a product are higher than
the buy- in price. If the product is making a contribution towards fixed costs, a drop of that
product would reduce the overall profit of the activity.

Other factors to consider before jumping into a conclusion will include:

Reliability of supply source

If we stop producing our own product, will the supplier be able to meet increased demand arising
from the company’s demand. Will the product always be available or it may be available or it
will be available for a short while.

Bargaining power of suppliers

By stopping production we could be creating a monopoly in the supply of the input. Will the
supplier not unilaterally increase prices and hence affect our final product which will destroy our
possible competitive strategy of cost leadership. This is a real possibility.

Product Quality
Are we able to guarantee the quality of the product to be bought in. Do we have the capacity to
test the buy in product without increasing the buying in price beyond our ceiling.

Redundancy costs

There are people who are involved in the production of the product whose production is to be
stopped. If we discontinue production, are we able to avoid labour costs at no extra costs.
Chances are that there is a cost involved with regard to redundancy pay and this should be taken
into account. Besides the only cost that is purely avoidable may be material cost. People
involved n the manufacture of the product may actually be the same people required in a way for
one or more of the other products. If we discontinue production of the product, are we able to
avoid labour costs at no extra costs. Chances are that there is a cost involved with regard to
redundancy pay and this should be taken into account. Besides the only cost that is purely
avoidable may be material cost. People involved in the manufacture of the product may actually
be the same people required in a way for one or more of the other products.

Staff moral

Each time some people are sent home, a feeling of,’’(them vs. us,’’ develops in the organization
and productivity falls and sometimes sabotage may set in. Remaining employees develop an anti
organization attitude. They are not sure who is next to go and an air of anxiety sets in. Some may
even resort to having some part time job or business on the sidelines in preparation for being laid
off.

Deterioration of machinery

+
Although a product may be dropped, the machinery may still be kept. The machinery may still
deteriorate without usage due to changes in technology.
Complementary products

Sometimes the products are complementary. When products are complementary, if we

discontinue production of one product it may actually affect the gross revenues of other products.
We have noticed that in a college business suppose an A Level student wants to study three
subjects Economics, Accounting and Business Management. If the college offers only two
subjects Economics and Accounting but does not offer Business Management, students may not
enroll at the college at all even though the college is reputed for good results. The standard thing
to do at A level is to study at least three subjects at A Level at the same place. Since the subject
are complementary, leaving one of them out may result in the other subjects not having any
takers as well..

Will skilled labour be available in future?

When you have to drop a product, there is a risk that in future when production resumes, skilled
labour will have been hired elsewhere .

The birth of competitors

Quite often, the people who are retrenched if skilled will usually go and set up shop and they
become the next manufacturers and hence the next competitors.

Make or buy decisions

EXAMPLE 7
A company is often faced with the decision as to whether it should manufacture a component or
buy it outside.
Suppose for example, that Masanzu Ltd. make four components, W, X, Y and Z, with expected
costs for the coming year as follows:

W X Y Z

Production (units) 1,000 2,000 4,000 3,000

Unit marginal costs $ $ $ $

Direct materials 4 5 2 4

Direct labour 8 9 4 6

Variable production overheads 2 3 1 2

14 17 7 12

Direct fixed costs/annum and committed fixed costs are as follows:

Incurred as a direct consequence of making W 1,000

Incurred as a direct consequence of making X 5,000

Incurred as a direct consequence of making Y 6,000

Incurred as a direct consequence of making Z 8,000

Other committed fixed costs 30,000

 50,000

A subcontractor has offered to supply units W, X, Y and Z for $12, $21, $10 and $14
respectively.
Decide whether Masanzu Ltd. should make or buy the components.
Solution and discussion
a) The relevant costs are the differential costs between making and buying. They consist of
differences in unit variable costs plus differences in directly attributable fixed costs.
Subcontracting will result in some savings on fixed cost.

W X Y Z

$ $ $ $

Unit variable cost of making 14 17 7 12

Unit variable cost of buying 12 21 10 14

(2) -4 2 2

Annual requirements in units 1,000 2,000 4,000 3,000

Extra variable cost of buying per annum (2,000) 8,000 12,000 6,000

Fixed cost saved by buying 1,000 5,000 6,000 8,000

Extra total cost of buying (3,000) 3,000 6,000 (2,000)

b) The company would save $3,000/annum by sub-contracting component W, and $2,000/annum

by sub-contracting component Z.
c) In this example, relevant costs are the variable costs of in-house manufacture, the variable
costs of sub-contracted units, and the saving in fixed costs.
d) Other important considerations are as follows:
i) If components W and Z are sub-contracted, the company will have spare capacity. How should
that spare capacity be profitably used? Are there hidden benefits to be obtained from sub-
contracting? Will there be resentment from the workforce?
ii) Would the sub-contractor be reliable with delivery times, and is the quality the same as those
manufactured internally?
iii) Does the company wish to be flexible and maintain better control over operations by making
everything itself?
iv) Are the estimates of fixed costs savings reliable? In the case of product W, buying is clearly
cheaper than making in-house. However, for product Z, the decision to buy rather than make
would only be financially attractive if the fixed cost savings of $8,000 could be delivered by
management. In practice, this may not materialise.

Example 8
The Pip, a component used by Goya Manufacturing Ltd., is incorporated into a number of its
completed products. The Pip is purchased from a supplier at $2.50 per component and some
20,000 are used annually in production.
The price of $2.50 is considered to be competitive, and the supplier has maintained good quality
service over the last five years. The production engineering department at Goya Manufacturing
Ltd. has submitted a proposal to manufacture the Pip in-house. The variable cost per unit
produced is estimated at $1.20 and additional annual fixed costs that would be incurred if the Pip
were manufactured are estimated at $20,800.
a) Determine whether Goya Manufacturing Ltd. should continue to purchase the Pip or
manufacture it in-house.
b) Indicate the level of production required that would make Goya Manufacturing Ltd. decide in
favour of manufacturing the Pip itself.

Example 9

DD Ltd manufacturers vehicle most of the components are internally made. Of late, , due to the
incidence of imports from China, it would appear imported shocks are cheaper than own made
shocks. The cost of making a set of shocks is as follows:

Direct material $20

Direct labour $15
Variable cost/unit $10
Fixed cost/u $12
$57

A set of shocks can be bought in at $50 each set. Normal production is 30 000 units per year.
Ignore redundancy costs and any other closure related costs.
Should the shocks be bought in or should they be purchased?

Marginal production costs

$
Direct material 20
Direct labour 15
Variable costs 10
Total marginal costs 45

Since the buying price is $50, it means we will pay more to get the product and hence it is not
advisable that we buy in the product.

If we buy in the product, it means that our profits will reduce down by:

Extra cost ($50 = $45) 30 000 150 000

Fixed costs (30 000 X 12) 360 000
510 000
Less saving of (57-50)30 000 210 000
Net decrease in profits 300 000

Changes in fixed costs

So far we have given an impression that whichever way the fixed costs would remain fixed. In
some cases these do change and we should always include the increased cost in our costings.

Opportunity costs
This is the best alternative forgone as a result of our decision. For example, if we decide to
accept an order for a particular product, we may use space from which we having earning rentals.
The cost revenues would be part of the cost of the new product.

Example

DD Ltd is into the business of Motor Vehicle assembly .Up until now, they have been buying in
shock absorbers. Unfortunately the price of the shock absorbers keeps going up unpredictably
and the quality has been deteriorating. The cost of manufacturing a set of shocks is as follows:

Direct material $20

Direct labour $15
Variable cost/unit $10
Fixed cost/unit $15

The fixed costs above are fixed costs that will specifically be associated with the manufacturing
option. If the company stopped manufacturing, they will also cease to accumulate. The space for
which the production is to take place is currently been rented out for $2500 per year
The cost of buying in a set of shocks is $70.

What should the company do? Assume the budgeted output is 10 000 set.

Solution

Marginal cost per unit

Direct material $20
Direct labour $15
Variable cost $10
Total marginal cost/u $45
Current buying in cost(1 000 x $70) $70 000
Less lost benefit from the rental ($2500 -$1200) $ 2 500
$67 500

Net manufacturing cost (1 000 x 45) 45 000

Fixed cost (1 000 x 15 000) 15 000
Add loss of rentals 2 500
62 500

So, on the basis of the above analysis, it makes sense to manufacture the product.

Exercises

The management account of Foneco Ltd presents the following information on daily demand and
price:

Smart($) Value ($)

Sales price 1 000 800
Costs
Materials 500 480
Process
A 100 100
B 80 60
C 40 30
D 20 30
Total unit cost 740 700
Unit profit 260 100
 Sales volume (units) 50 80

The process costs include labour and relevant overhead, with 60% of the total cost considered
variable. Value requires three minutes and Smart six minutes per unit in process C which has
limited capacity.

Required

Determine the production priority. 25 marks