Costing for decision making

The P3 syllabus requires candidates to be able to:

G3(c) Evaluate the following strategic options using marginal and relevant costing techniques:

i) Make or buy decisions
ii) Accepting or declining special contracts
iii) Closure or continuation decisions
iv) Effective use of scarce resources

It is not sufficient to know the techniques. As a level 3 capability, this requires 'synthesis and evaluation', requiring candidates to select appropriate data, show technical capability and evaluate both the technique and the findings as required by the question asked.

Marginal costing assigns only variable costs to the product or service being produced. It is sometimes referred to as a variable or direct costing system. The marginal cost represents the additional cost of one extra unit of output.

Relevant costing assigns future costs and revenues to the decision being made. It includes only those cash flows which will be affected by the decision.

There is commonly an overlap between the two methods, as variable costs will commonly be future costs affected by the decision, and hence also be considered relevant.

The remainder of this article will focus on the use of relevant costing for short-term or one-off decisions.

Relevant costs must be future (incremental) cash flows affected by the decision and therefore ignore the following:

  • Sunk costs – those which have already been incurred before the decision is made, for example if a company has already purchased material then the cost of the material at that time is irrelevant. Instead, the current replacement value (if material is still regularly used) or the scrap value (if material is no longer used) would be considered the relevant cost to the decision.
  • Unavoidable (committed)  costs – those costs which will be incurred/cannot be avoided regardless of the decision. The difference between these and sunk costs is the time at which the costs are incurred. These are future costs, whereas sunk costs are in the past.
  • Apportioned costs – those costs which have been split between units of production or service based on some arbitrary allocation method, for example fixed machine service costs apportioned based on the number of machine hours used.


However, relevant costs do include opportunity costs; the costs of the benefit foregone when the decision being made means that an alternative opportunity must be rejected. For example, if a company owns an asset which can be leased out to other companies, but is used on a short-term internal contract instead, then the relevant cost would include the external rental income foregone.

Let us consider the use of relevant costing in the following scenarios:

Make or Buy Decisions

A company may choose to make its own products or component parts (insource), or may choose to buy them in from an external supplier (outsource). There are a number of factors which will influence this decision, both qualitative as well as quantitative. However, there needs to be some basis on which to compare the financial impact of the alternative choices. The basic rule, if considering this from a purely financial perspective, is to choose the cheaper of the two options. For example, the decision would be to outsource if:

Cost of outsource option < relevant costs (of insource option) + opportunity costs

The following shows a simple example of a make or buy decision using relevant costing.

A manufacturer of music and sound systems, Audio Tech, has decided to use a new speaker technology in its systems. The technology was developed overseas and its patent does not apply in  the country in which Audio Tech operates. Audio Tech believes it is capable of producing this technology itself, but it is considering whether it should do this or outsource to the company (STT) holding the overseas patent. STT has offered to supply the speakers using this technology, for a cost of $8 per speaker. Each speaker would also incur a shipping fee of $2 and would have a lead time of five working days from order to arrival. Estimated demand is 12,000 speakers per month.

Audio Tech could manufacture these speakers internally, and have estimated the following unit costs:

 $ 
Labour (note 1)                  1 
Materials (note 2)7 
Variable overheads1 
Fixed Overheads (note 3)2 
 11 

Notes:

  1. There is currently spare capacity of 1,000 hrs of labour per month. Labour is paid at $10 per hour, increasing to $12 an hour for any overtime incurred. Overtime is limited to 4,000 hrs per month.
  2. Materials will need to be bought in new for this speaker.
  3. Fixed overheads are absorbed at the rate of $20.00 per labour hour


Required
Using relevant costing as the basis of the decision, should Audio Tech produce the speakers in-house or outsource to STT?

Solution

Outsourcing option
The costs of outsourcing are $8 (buy in) + $2 (shipping) = $10 per speaker

Insourcing option
It is necessary to determine which costs are relevant. This is not always a clear cut decision. Taking each of the notes in turn:

Note 1. There is spare capacity which suggests that labour is being paid to be idle. Spare capacity of 1,000 hrs would allow for production of 10,000 speakers, given that the labour cost per speaker is $1, which is one tenth of the hourly rate (1,000/0.1 = 10,000). Existing capacity of labour would not normally be considered a relevant cost, given that the salaries are likely to be committed costs.

However, the demand is estimated to be 12,000 speakers, which would require 200 (2,000 * 0.1) hours of overtime at $12 an hour. This would cost $2,400 ($12 * 200) which would be considered relevant, as it would be a future cash flow, incurred directly as a result of this decision. If this cost were to be split evenly between the total production, it would equate to a labour cost of $0.20 per speaker ($2,400/12,000).

Note 2. This is clearly a relevant cost as the materials will be bought in for the new speaker.

Note 3. Fixed overheads are not considered relevant, given that they are costs which will not be changed by the decision being made.

Therefore, the relevant costs of producing in house are $0.20 (labour) + $7 (material) + $1 (variable overheads) = $8.20 per speaker

$10 (cost of outsourcing) > $8.20 (relevant costs of insourcing)

Therefore, Audio Tech should choose to produce in-house from a financial perspective.

It is easy to see decision from a purely financial perspective, but decisions of this type also require some consideration of qualitative measures. For example, the decision above would require the use of 200 hours of overtime per month. It is unclear whether this is sustainable, or whether there would be capacity to employ more staff in the long term. The effect on staff morale and productivity is also unclear. Similar consideration would need to be given to any make or buy decision – for example, a buy in decision may lead to redundancies and a reduction of morale in remaining staff.

Consideration needs to be given to the quality of the alternative sources. With outsourcing, the company cannot always control the quality or delivery schedule of the external supplier. In this scenario, however, it could be the quality of the in-house option that is uncertain. It is mentioned that 'Audio Tech believes it is capable...', but if it failed to produce a speaker of sufficient quality, this may damage its reputation, and subsequent sales. From an alternative perspective, however, in-house production may allow Audio Tech to acquire this knowledge, and with it a competitive advantage in its home country.

It is also important to consider that in the long-term, the labour capacity would be addressed and therefore it may be worthwhile including the full cost of labour in this calculation. In the example described above, this would not change the decision being made.

Accepting or declining special contracts

A special contract is a one-off, usually short-term contract, which will make use of specified company resources. Using relevant costing, the costs and revenues of accepting a special contract would be calculated using the same principles as the make or buy decision previously mentioned. However, instead of comparing to an alternative approach, the entire contract would be evaluated to determine whether the contract price would be greater than the relevant costs in addition to the opportunity cost of choosing to use the resources for an alternative action. The basic rule for accepting a special contract is, therefore, that the contract is worthwhile if:

Contract price ≥ relevant costs + opportunity costs

The following shows a simple example of a special contract decision:

A food production company, Dragon Foods, has been approached by a local charity, Coakers, with a request to produce a special order of soup, which it wishes to distribute in its homeless shelters for 3 months over the winter period. Dragon Foods currently produce this type of soup and has a capacity of 3,500 soups per month. Current production is 2,500 soups a month. Coakers has said it would like 1,000 portions per month and can pay up to $1,750 for the entire contract. Dragon Foods had considered using the spare capacity for an alternative contract that would earn a total contribution  of $200 over the 3 month period.

Total costs, of $1.20 per portion of soup, are currently as follows:

 Cost per portion
$
 
Manufacturing costs
  Direct materials*
  Direct labour
  Variable overhead

0.30
0.20
0.20
 
Total cost to manufacture0.70 
Fixed overhead0.35 
Sales commission0.15 
Total cost1.20 

* at current replacement cost


Given that Dragon Foods currently has the spare capacity, it can be assumed that the labour is available and the salary costs are committed costs, therefore these costs can be ignored. The fixed overhead will not change as a result of the contract and can also be ignored. As Coakers approached the company, there should be no sales commission required and this can also be ignored. Therefore, the total relevant cost is $0.50 per portion of soup.

Relevant costs = $0.50 * 3,000 portions (1,000 * 3 months) = $1,500

Opportunity costs = $200

 $1,750 (Contract price) > $1,700 (relevant costs + opportunity cost) therefore the contract can be accepted from a financial perspective

As with make or buy decisions, there are qualitative factors to take into account with special contracts. For example, a special contract may provide some experience not previously gained within the company, or could potentially lead to further future orders. However, if the latter is the case, the company must be careful to ensure they cover fixed costs in the long-term. All contracts could not be priced using relevant costing techniques as the company would fail to break-even.

In the scenario above, another qualitative consideration may be the positive reputation gained from assisting a local charity in this way. This could lead to further sales as a result. Therefore companies should also consider any specific potential benefits or otherwise, of each contract individually.

Closure or continuation decisions

Companies usually account separately for different businesses or production lines, in order to determine the profitability of each. This can lead to the consideration of closure of one or more areas of the business. When considering this, a company should determine whether the closure of that part of the business will lead to the entire company being more or less well off than they would be if they retained it. The basic rule for a closure or continuation decision is, therefore, that the area of the business should be closed if:

Contribution < relevant fixed costs + opportunity costs

To identify whether a fixed cost is relevant, we need to determine whether the cost would be avoidable if the product or department were to be dropped. If it is, then the fixed cost is relevant, if not, then we ignore it as an irrelevant cost.

The following shows a simple example of a closure or continuation decision:

ShortBowl, a sportswear and trophy retail outlet has several product lines and is carrying out profitability analysis on each line. The following are the monthly costs and revenues associated with the product lines:

 Sportswear
$
Equipment
$
Trophies
$
Revenue15,0007,5005,000
Variable costs8,5001,500500
Contribution6,5006,0004,500
Fixed costs10,0003,0002,500
Profit(3,500)3,0002,000

As a result of the above analysis the company is considering dropping the sportswear product line. It has further analysed the fixed costs for the sportswear line as follows:

Company fixed costs absorbed on the basis of labour hours$2,000 
Rental of storage warehouse used for sportswear only

$6,000

 
Depreciation on ironing and printing equipment used for sportswear$2,000 
 $10,000 

Clearly, the first is unavoidable as it relates to company fixed costs, which would still exist if the company continued to operate in any way. The depreciation would also not be relevant as it is a notional cost, not an actual cash flow. Therefore these should not be taken into consideration. However, the storage warehouse could presumably be discarded should this area of the business close. Therefore this would be considered a relevant fixed cost.

Contribution = $6,500 (given)
Relevant fixed costs = $6,000 (from above)
No opportunity costs are mentioned.

$6,500 (contribution) > $6,000 (relevant fixed costs) and so the product line should be continued from a financial perspective

As with the other decision types discussed in this article, there are qualitative factors to be considered. The decision to discontinue a product line or business unit could have a negative effect on the company as a whole, as it may be seen as a signal that the company is in difficulty. If the products are complimentary, as they are in the above example, then the discontinuation of one product line may lead to fewer customers for the remaining products, if they prefer to use a one-stop shop.

Discontinuation may also have a negative effect on the employees, and possibly the local area if it leads to mass redundancies within the organisation.  For example, when Tata Steel was considering closing its UK business, it was suggested that up to 40,000 jobs could be at risk (over half of which were indirect) and the UK Government may have to cover a £4,6bn bill. Tata Steel has now scrapped these discontinuation plans, but still finds itself at odds with unions and employees, over the continued confusion of the future of the business. It also needs to find large savings to make the division viable, an alternative option available to a discontinuation decision.

Summary

As with all management accounting techniques, there isn’t necessarily a 'one rule fits all' approach to the decisions discussed in this article. Some companies may prefer to consider fixed costs in all their decisions and therefore choose not to use methods of relevant costing at all. Even within the method itself, there might be slightly different approaches taken. For example, some companies may prefer to include the full costs of direct labour, even if the spare capacity exists, thus treating it as an entirely variable cost, rather than one which is fixed in the short-term. Academics do not necessarily agree on this with Drury (2012) suggesting that if direct labour is to remain unchanged for the period under consideration then direct labour costs 'are irrelevant for this decision'. However, Eldenburg and Wolcott (2011) include direct labour when performing quantitative analysis for all of the above decisions. It is important, therefore, to always state reasons regarding the inclusion or exclusion of costs within your analysis.
 

Bibliography
Drury, C (2012), Management and Cost Accounting (8th edition), Cengage Learning
Eldenburg, LG and Wolcott, SK (2011), Cost Management (2nd edition), John Wiley & Sons

Written by a member of the P3 examining team