59 Chapter 24 Cost Accounting for Decision-making Notes to teachers 1 This chapter deals with the application of costing concepts and techniques to more complicated business decisions. 2 Teachers are advised to explain the concepts of sunk costs, opportunity costs, incremental costs, relevant costs, irrelevant costs, avoidable costs and unavoidable costs with the use of various examples. This is more useful than merely reciting the definitions. Costs may be avoidable in one situation and not the other. There is no hard and fast rule. 3 Examples are to be used to illustrate different types of business decisions: accept or reject a special order; hire, make or buy products/equipment; sell or process products further; retain or replace equipment, eliminate unprofitable business segments. It is recommended that the topics of sell or process products further, and retain or replace equipment be taught at the end of the chapter as these two types of decisions are the most difficult. 4 When analysing the various proposals for decision-making, the key is to compare the profit or loss before and after the proposal is adopted. The proposal that gives the highest profit or lowest loss is to be chosen. Q1 The restaurant should accept the order as it can earn a net profit of $48,000 on the order. $ Sales revenue (1,000 × $550) 550,000 Variable costs (235,000) Opportunity cost (265,000) Delivery charge (2,000) Net profit 48,000 Q2 Avoidable costs are the costs which can be reduced or avoided when a certain action is taken. Unavoidable costs are the costs which have to be incurred regardless of what action is taken. Q3 Management should make the ice cream itself as the costs are $10,000 lower under this alternative. Make Buy $ $ Direct materials 100,000 — Direct labour 150,000 — Variable manufacturing overheads 80,000 — Fixed manufacturing overheads 120,000 90,000 Purchase costs — 350,000 Total manufacturing costs 450,000 440,000 Notes to teachers
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Chapter 24 Cost Accounting for Decision-making
Notestoteachers
1 This chapter deals with the application of costing concepts and techniques to more complicated business decisions.
2 Teachers are advised to explain the concepts of sunk costs, opportunity costs, incremental costs, relevant costs, irrelevant costs, avoidable costs and unavoidable costs with the use of various examples. This is more useful than merely reciting the definitions. Costs may be avoidable in one situation and not the other. There is no hard and fast rule.
3 Examples are to be used to illustrate different types of business decisions: accept or reject a special order; hire, make or buy products/equipment; sell or process products further; retain or replace equipment, eliminate unprofitable business segments. It is recommended that the topics of sell or process products further, and retain or replace equipment be taught at the end of the chapter as these two types of decisions are the most difficult.
4 When analysing the various proposals for decision-making, the key is to compare the profit or loss before and after the proposal is adopted. The proposal that gives the highest profit or lowest loss is to be chosen.
Q1 The restaurant should accept the order as it can earn a net profit of $48,000 on the order.
Q2 Avoidable costs are the costs which can be reduced or avoided when a certain action is taken. Unavoidable costs are the costs which have to be incurred regardless of what action is taken.
Q3 Management should make the ice cream itself as the costs are $10,000 lower under this alternative.
A1 Incremental costs are the additional costs incurred when a certain action is taken. Avoidable costs are the costs which can be reduced or avoided when a certain action is taken. Incremental costs and avoidable costs are opposite in nature.
A2 In this case, we need to consider the change in sales revenue. If the sales volume drops by 8% with no change in the selling price, sales revenue will reduce by $48,000. The incremental analysis would be as follows: Make Hire $ $Directmaterials 100,000 80,000Directlabour 150,000 75,000Variablemanufacturingoverheads 80,000 60,000Fixedmanufacturingoverheads 120,000 100,000Hirecharge — 100,000Reductioninsalesrevenue($600,000×8%) — 48,000Totalmanufacturingcosts 450,000 463,000
Total costs under the ‘hire’ alternative are higher than under the ‘make’ alternative. In this situation, the company should not hire the machinery.
A3 The management should still replace the old machine as the new machine has a lower equivalent annual cost.
EAC of the old machine = $320,070
EAC of the new machine = {$230,000 + $238,095 + $226,757 + $215,959 + $205,676
+ [($250,000 − $30,000) ÷ (1 + 5%)5]} ÷ 4.329
= $1,288,863 ÷ 4.329
= $297,728
A4 The company should eliminate the ice cream segment as the net profit after eliminating this segment will be higher than keeping this segment ($18,900,000 vs. $18,800,000).
A5 The company should eliminate the ice cream segment as the net profit after eliminating this segment will be higher than keeping this segment ($19,000,000 vs. $18,800,000).
24.2(a) & (b) Order Order accepted rejected $ $Sales(2,000×$200) 400,000 0Directmaterials(2,000×$25) (50,000) 0Directlabour(2,000×$40) (80,000) 0Variablemanufacturingoverheads(2,000×$15) (30,000) 0Netprofit 240,000 0
As net profit will increase by $240,000, this special order should be accepted.
24.3XCosts to be incurred when the order is accepted: $Variablecostofgoodssold(1,000×$175) 175,000Variableoperatingexpenses(1,000×$60) 60,000Deliverycharge 2,000Totalcosts 237,000
The minimum price that the restaurant should charge is $237,000.
The hospital should outsource its food service operations as outsourcing would result in lower total costs. The fixed hospital overheads are irrelevant costs and should be ignored.
(c) Factors to consider include the food quality, the caterer’s reliability and labour issues.
If Product Z is eliminated, the unavoidable fixed costs of $540,000 will remain. Net profit will become $2,060,000, which is lower than the original net profit of $2,460,000. Therefore, Product Z should be kept.
(b) Effect on overall net profit: Product X Product Y Product Z Total $ $ $ $Sales/Rentalrevenue 7,000,000 9,000,000 1,500,000 17,500,000Variablecosts (4,200,000) (4,800,000) — (9,000,000)Contributionmargin 2,800,000 4,200,000 1,500,000 8,500,000Fixedcosts—Avoidable (1,000,000) (1,800,000) — (2,800,000)Fixedcosts—Unavoidable (600,000) (1,000,000) (540,000) (2,140,000)Netprofit 1,200,000 1,400,000 960,000 3,560,000
The overall net profit will become $3,560,000, which is higher than the original net profit of $2,460,000. In this case, Product Z should be eliminated.
24.9XThe profits generated by Forever Furniture Ltd when an unfinished table is not processed further and when it is processed further are shown in the following table: Unfinished Finished table table $ $Sellingprice 100 120Directmaterials (30) (34)Directlabour (20) (28)Variablemanufacturingoverheads (12) (16.8)Fixedmanufacturingoverheads (8) (8)Profit 30 33.2
As a finished table can generate a higher profit, Forever Furniture Ltd should process the unfinished table further.
EAC of the existing truck = $625,350 ÷ 3.791 = $164,956
EAC of the new truck = $1,289,400 ÷ 6.145 = $209,829
Difference in total operating costs = $209,829 − $164,956 = $44,873
The old truck has lower total operating costs.
(b) The equivalent annual cost of the new truck is higher than that of the old truck. The existing truck should be retained.
24.11
(a) Bought from Bought from South Ocean East Harbour Make Motors MotorsCostsof1,000units: $ $ $Purchasecost — 125,000 90,000Directmaterials 50,000 — —Directmanufacturinglabour 25,000 — —Variablemanufacturingoverheads 20,000 — —Fixedmanufacturingoverheads 35,000 24,500 10,500Warrantycosts — — 27,230 130,000 149,500 127,730
Note: The warranty costs are $10 per air-conditioner, i.e. $10,000 per day (1,000 × 1% × $1,000) for three years. The present value of an annuity of $10,000 for three years using an interest rate of 5% is $27,230 ($10,000 × 2.723).
Yoyogi Ltd should buy the motors from East Harbour Motors as this will result in the lowest costs.
(b) Yoyogi Ltd should consider qualitative factors when deciding whether to make or buy the motors. They include:
• Quality — Which of the three companies makes better motors?
• Delivery performance — Can the suppliers deliver the motors on time? Is Yoyogi Ltd capable of making enough motors to meet its production requirements?
• Commitment — Are the suppliers committed to supplying motors to Yogogi Ltd on a long-term basis at reasonable prices?
• Compatibility — Are the motors purchased from outside suppliers compatible with the other components used in the air-conditioners?
(Any two or other reasonable answers)
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(c) This practice is called outsourcing. Yoyogi Ltd may still want to make the motors itself even though it can buy them from outside suppliers at very attractive prices. This is because there are factors other than price to consider. They include quality, fear of losing trade secrets, effect on staff morale and customers’ satisfaction.
(Any two or other reasonable answers)
24.12X(a) Profit after eliminating the traditional DVD player product line:
Fixed selling expenses after eliminating the traditional DVD player product line = $800,000 × 90% = $720,000
(b) Profit after eliminating the traditional DVD player product line: $Sales(W4) 10,400,000Less Variablemanufacturingcosts(W5) (5,720,000) Variablesellingexpenses(W6) (1,040,000)Contributionmargin 3,640,000Less Fixedmanufacturingcosts (1,040,000) Fixedsellingexpenses(W7) (800,000)Netprofit 1,800,000
If the traditional DVD player product line is eliminated, net profit will be increased by $550,000 ($1,800,000 − $1,250,000).
Stable Cabinet Ltd should accept this special order as the price offered of $350 per unit is higher than the costs of $315 per unit. The company can earn a profit of $35 per unit on this special order.
(b) Some of the costs are not counted as these costs are not relevant in the decision-making process. For example, the fixed manufacturing overheads remain unchanged regardless of what decision is made.
(c) The pricing strategy used by Stable Cabinet Ltd is called cost-plus pricing. Under this pricing strategy, the price is determined by adding a fixed mark-up to the cost of a product. This pricing strategy is very easy to use and can ensure that a certain amount of profit is earned.
(d) Stable Cabinet Ltd should consider the impact on existing customers when they find out that a customer was able to buy products at a discount price. Also, it should consider the reaction of its competitors. If they match the discounted price and reduce their prices, how would this affect Stable Cabinet Ltd’s profits?
(e) Currently, the incremental costs are $315 per Trendy cabinet. If the company expands its production capacity to fill this special order, incremental costs will become higher due to the costs of adding capacity. On the other hand, if the company uses its existing production capacity to fill this special order, it will have to consider the opportunity costs of giving up some sales of its regular products.
Lily Industrial Limited should buy the component from the outside supplier as the unit cost of purchase is lower than the relevant costs of production.
(ii) The qualitative factors to be considered include:
• The reliability of the outside supplier as an on-time supplier. Late deliveries could affect the company’s production schedule and delivery dates for the final product.
• The quality of the components bought from outside supplier should be equal to, or better than, the quality of components made internally. Otherwise, the quality of the final products might be compromised.
• Redundancies may result if the components are out-sourced. This could affect employee morale and cause labour problems.