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LEARNING UNIT 2: RELEVANT COSTING

2.1 Introduction
Learning unit 2, “Relevant costing”, delves deeper into the topic of decision making by
addressing advanced scenarios regarding short-term decision making. Pivotal to
recommending an appropriate decision in a given scenario is an understanding of the
concepts of relevant costing, such as sunk costs, incremental costs and opportunity
costs. You will learn to consider the decisions based on differential cash flows: only
the costs and revenues that differ between the alternatives are relevant and are taken
into consideration. Qualitative factors could also have an effect on whether a decision
would be appropriate under a specific set of circumstances.

2.2 Learning outcomes

After you have studied learning unit 2, you should be able to:
 distinguish whether a specific decision has a short-term or long-term timeframe
 perform appropriate calculations to support preliminary recommendations in
relevant costing scenarios, including, but not limited to, the following advanced
scenarios:
o special pricing (special orders)
o product mix when capacity constraints exist
o outsourcing vs insourcing (making or buying)
o discontinuation of products, product lines or divisions (“closing-down
decisions”)
 identify, list and discuss qualitative issues relating to each decision, including, but
not limited to, ethical, environmental, social, legislative and governance factors
 evaluate linear programming and able to describe the different uses of this
technique
 solve the allocation of resources problem by applying linear programming (using
either the graphical method or the simultaneous equation method)
 calculate the shadow price and the maximum price for additional supplies of the
limited resources per input unit

Assumed prior knowledge:

You can
 identify the characteristics that make information relevant.
 distinguish between relevant and irrelevant information with regard to a specific
decision.
 calculate relevant incremental cash flows in a given scenario.
 identify qualitative factors that may affect decision making in a specific scenario.
 identify the preconditions for a special price.
 determine an appropriate price of a special order.
 define and identify limiting factors in a given scenario.
 identify the need for calculating contribution per unit of the limiting factor.
 calculate contribution per unit of the limiting factor in a given scenario.
 determine the optimal allocation of available resources and the optimal product
mix.
 recommend optimal decisions in basic scenarios of uncertainty and risk.
 use decision trees to recommend appropriate decisions under conditions of risk
and uncertainty and to determine the sensitivity of profit to and the expected
outcome of decisions and events.

2.3 Topic outline

Some of the sections outlined below, were already covered in your second-year
costing module and, therefore, comprise revision material. The remainder of the
learning unit, however, builds further on what you have learnt in second year. Study
the following sections in chapters 10 and 11 of Principles of management
accounting: A South African perspective (3rd edition). It should take you an
estimated 3 hours and 40 minutes to complete this section.

Principles of management
SAICA accounting (3rd edition)
knowledge Estimated
CHAPTER 10 Theoretical Prescribed time
level
basis exercises
Introduction 2 Section 10.1 None 5 min

Understanding the 2 Section 10.2

concept of relevance
 What is relevance? Section 10.2.1 Example 10.1 15 min

Decisions under 2 Section 10.3 None 60 min

conditions of certainty
 Special order Section 10.3.1 Example
decisions 10.2–10.4
 The make-or-buy Section 10.3.2 Example 10.5
decision
 The closing-down Section 10.3.3 Example 10.6
decision

Applying the concept 2 Section 10.4 15 min

of relevance to basic
cost elements
 Materials Section 10.4.1 Example 10.7
 Labour Section 10.4.2 Example 10.8
 Principles of management
CHAPTER 10 SAICA accounting (3rd edition)
knowledge Estimated
(continued) Theoretical Prescribed time
level
basis exercises
Decisions under 2 Section 10.5 20 min
conditions of
uncertainty
 Probabilities Section 10.5.1 Example 10.9
 Expected values Section 10.5.2
 Decision trees Section 10.5.3 Example 10.10

CRITICAL THINKING QUESTION 2.1:

Before proceeding to the next chapter below, work through the multiple-choice
questions (2.1 Relevant costing (MCQs)). Note that you will not be able to proceed
to the next question until your answer is correct.

Principles of management
SAICA accounting (3rd edition) Estimated
CHAPTER 11 knowledge Theoretical Prescribed time
level
basis exercises
Introduction 2 Section 11.1 None 3 min

The importance of 2 Section 11.2 None 3 min

contribution
Limiting factors 2 Section 11.3 44 min
 A single limiting-factor Section 11.3.1 Example
11.1–11.2
 Two potentially Section 11.3.2 Example
limiting factors 11.3–11.5
Make-or-buy decisions 2 Section 11.4 Example 11.6 10 min
and scarce resources
Linear programming: 2 Section 11.6 15 min
the graphical method
 Introduction Section 11.6.1 None
 Steps in the graphical Section 11.6.2 Example 11.8
method
 Slack Section 11.6.3 None
Shadow prices and 2 Section 11.7 None 10 min
linear programming
 Calculating the Section 11.7.1
shadow price: adding
one unit to the
available limited
resource Section 11.7.2
 Calculating the
shadow price:
alternative method
 Principles of management
CHAPTER 11 SAICA accounting (3rd edition) Estimated
(continued) knowledge Theoretical Prescribed time
level
basis exercises
Concluding on 2 Section 11.9 None 5 min
operational constraints
scenarios
Linear programming in 2 Section 11.10 None 10 min
practice
 Introduction Section 11.10.1
 Practical application Section 11.10.2
of linear programming
 Limitations of linear Section 11.10.3
programming

Take note: Simplex tableaus (section 11.8 in the textbook) fall outside the scope of
this module.

CRITICAL THINKING QUESTION 2.2:

C-cooloo Manufacturing Company produces 4 products. Details of the costs and selling prices
of these products are given in the spreadsheet. The company is currently experiencing
difficulty in recruiting the necessary grades and skills of labour to produce its products and
has asked for your assistance to determine which products it should produce to maximise its
profits. The company currently has 10 000 labour hours available for the next month. Maximum
demand for all four products for next month is estimated to be as follows:

A: 1 000 units
B: 700 units
C: 2 000 units
D: 500 units

REQUIRED:
Using the provided spreadsheet to perform the necessary calculations:

A (i) Advise the directors on which product should be produced to maximise contribution for
the coming month assuming that there are no limits on demand for any product.

(ii) Calculate the contribution that would result from producing that product up to the limit
imposed by the 10 000 labour hours.

B (i) Assuming that the maximum demand for each product is as given above, advise the
directors on which products to produce and draw up the production plan for the next
month.

(ii) Calculate the contribution that would result from this production plan.
 2.4 Value analysis and value engineering
Value analysis (VA) is an organised approach to improving the profitability of product
application. The value analysis process utilises many different techniques in order to
achieve this objective (Rich & Holweg 2000). The value analysis process seeks to
identify product/service features which add little value to the customers.
The VA approach is often applied to existing products or services, whereas the value
engineering (VE) approach mainly applies to new products. Value engineering is
defined as a set of systematic tools and creative methodologies to rectify constraints
of costs, quality and scope. Whether it is a value analysis or value engineering, the
objective of an organisation is ensuring that avoidable costs or processes are
eliminated. This exercise may assist an organisation in improving its capacity and
removing constraints and bottlenecks, leading to increased profitability.

CRITICAL THINKING EXERCISE 2.3 (DISCUSSION):

A. Consider how the value analysis and value engineering processes may be
undertaken to address operational constraints covered in chapter 11. Read to
the article, 2.4 Value analysis and value engineering, under Additional
Resources.

In your study group, review Cases of VA success, covered in the article, and
discuss your understanding of value analysis and identify a listed
manufacturing company that can apply VA in order to improve profitability. You
can visit this link to choose a company. Your answer should also consider the
implementation stages.

B. Read the article on this link to see practical application of value engineering:
https://dailynewsegypt.com/2022/08/29/adopting-value-engineering-would-
circumvent-building-materials-price-hikes/

2.5 Using data and technology in linear programming

You are now familiar with the underlying principles of linear programming. This section
serves to draw your attention to technology at your disposal to perform linear
programming exercises. For example, a widely used spreadsheet software package
such as Excel® gives you access to a ‘Solver’ tool, which can assist you to formulate
and solve a linear programming model.

Excel® also enables you to compare various scenarios through the ‘What-if analysis’
tool, to support the decision-making process regarding the determination of optimal
product mix. Both these tools can be used in conjunction with other software to help
visualise problems in and solutions to scenarios.
While the use of technology can be an efficient way to perform linear programming
exercises, one should also be cognisant of both the advantages and issues associated
with using software in this regard. These include the following:

2.5.1 Advantages associated with using software for optimisation

 Allows for working with more complex scenarios and more data.
 Enables users to execute task quicker and more efficiently.
 A visual display of information may make it easier for users to understand problems
and solutions.
 Software may be helpful in conducting sensitivity analysis, because formulae and
lookup tables may be used to perform underlying calculations. This means that, if
any figure is amended, all relevant figures will be updated and recalculated
automatically.
 The results can be distributed to other decision-makers and users easily and
efficiently, either in printer or electronic format.

2.5.2 Issues associated with using software for optimisation

 Off-the-shelf programmes may not be equipped with the capability to solve all
potential problem scenarios, which may require more advanced software
programmes.
 The cost associated with these software programmes may not match the benefit in
the instance of an organisation where optimal product mix decisions are not made
on a regular basis.
 The principle of “garbage-in-garbage-out” also applies in using technology, in this
context. The quality of output provided by the software will only be as good as the
input. For example, if an error regarding the total of constraints occurs during the
input phase, the output delivered will result in an incorrect solution to the
organisation’s problem.
 A visual display of information in the form of graphs and figures may provide a
simpler, more user-friendly version of the data. However, some of detail and
subtleties of the raw data may be lost in the process, which may negatively impact
decision-makers.

The following resources are recommended for further reading relating to section 2.4
as per CIMA P1 (Kaplan Publishing 2020:480–481):
https://www.excel-easy.com/data-analysis/what-if-analysis.html
https://www.excel-easy.com/data-analysis/solver.html
2.6 Summary
Let us summarise what you learnt in this learning unit. You learnt how to apply relevant
costing principles in advanced decision-making scenarios. In some of these scenarios,
conditions of uncertainty existed. You also learnt how to apply linear programming,
using the graphical and algebraic (simultaneous equation) methods, to optimise the
use of two or more limited resources when contribution per limiting factor calculations
do not provide a unanimous ranking.

2.6 Self-review exercises

2.6.1 Attempt BQ2, BQ3, BQ4, BQ5, BQ9, BQ13 and BQ14 in chapter 10 of
Principles of management accounting: A South African perspective (3rd
edition).

2.6.2 Attempt BQ3 and BQ8 in chapter 11 of Principles of management accounting:

A South African perspective (3rd edition).

2.6.3 Attempt LQ2 in chapter 11 of Principles of management accounting: A South

African perspective (3rd edition).

2.7 Activities
2.7.1 Watch the three short videos on “Decision-making scenarios”:
a. Decision Making Scenario Podcast 1: Asset Replacement
b. Decision Making Scenario Podcast 2: Optimisation
c. Decision Making Scenario Podcast 3: Special Pricing

In your e-tutor group, each member should provide an example of a company in any
industry which may be faced with all of the above 3 advanced decision-making options
(give examples of each scenario).

You must also consider the following decision-making scenarios in your example
above: (d) outsourcing (make or buy) and (e) discontinuation.

2.7.2 Read 2.5 Incremental analysis for decision-making. Refer back to your group
discussions in 2.7.1 to identify any concept you might not have covered in your
discussions.
2.7.3 In your study group, attempt LQ3, LQ4 and LQ5 in chapter 10 of Principles of
management accounting: A South African perspective (3rd edition).
(Please refer to Additional Resources for a detailed explanation on how to
approach LQ5.)

LQ3 & LQ4: Discuss your answers in your e-tutor group and provide feedback
on challenges experienced. You must also discuss the amount of time taken to
complete the task in comparison to allocated time.

LQ5: In addition to the quantitative factors provided in your workings in part (a),
discuss in your e-tutor groups qualitative factors to be considered before
deciding on whether to discontinue the printing and distribution departments.