Chapter 4
Relevant costs and revenues
for decision making
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Learning objectives
After studying this chapter, you should be able to:
• Understand the importance of cost behaviour in short-term decision
making.
• Differentiate between relevant and irrelevant information.
• Recognise non-financial indicators that could impact on the short-term
decisions.
• Distinguish and quantify relevant costs and revenues in various short-term
decisions.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Fundamental differences between long-term
and short-term decision making
Long-term decisions
Short-term decisions
These decisions span over more than a year.
These decisions span over less than a year.
They are strategic in nature and are aligned to the They are operational in nature and are aligned to the
company’s corporate objectives and goals, i.e. profit short-term goals of the company, i.e. profit maximimaximisation resulting from the optimum use of sation resulting from the optimum use of resources in
resources in the long term.
the short term. These types of decisions are often
reactionary, i.e. they are initiated as a response to
problems that have arisen in the business environment.
These decisions Involve a large capital investment.
These decisions involve a small amount of money in
comparison to the long-term decisions.
Incorrect long-term decisions can have a major impact Due to the time frame and monetary value, it is
on the company’s financial position. It is therefore relatively easier to change a short-term decision, i.e.
essential that managers take their time and conduct all withdraw from activities if there are changes in the
the relevant feasibility studies before undertaking
long-term decisions.
business environment. With short-term decisions,
managers need to respond quickly since delaying a
decision can have financial implications for the company.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Relevant costs
Relevant costs and revenues have an impact on the decision at hand. These include:
•
•
•
Discretionary fixed costs are considered relevant, since these costs can be
managed. Managers can choose not to incur these costs again with immediate
effect. Examples include advertising, research and development.
Future costs and revenues are considered relevant because they are cash flows
that arise out of the decision taken. They must be future cash flows, i.e. they must
not have been incurred as yet. If they have already been incurred, then they are
considered past costs (sunk costs) which are irrelevant to the decision at hand.
They must involve the physical flow of cash and not merely be an accounting
adjustment, for example non-cash costs such as depreciation and notional costs,
etc. These non-cash costs are considered irrelevant to the decision at hand.
Differential or Incremental costs and revenues entail the following: For the
manager, decision making involves choosing between alternatives. A differential
cost is the difference in the costs between the alternatives being considered and
differential revenue is the difference in revenue between the alternatives being
considered.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Illustrative example 4.1
A company is considering changing their marketing method from direct
marketing to internet marketing. Internet marketing has become increasingly
popular since it allows the business to reach their target audiences online,
thereby decreasing their advertising costs. Information relating to the two
marketing methods is provided in the table:
Present direct
marketing
Revenues
Less: Cost of goods sold
Commission
Advertising
Warehouse depreciation
Other expenses
Total
Net income
(R)
R1 500 000
750 000
75 000
75 000
50 000
60 000
1 010 000
490 000
Proposed Internet
marketing
(R)
R2 500 000
1 250 000
0
38 000
50 000
60 000
1 398 000
1 102 000
Should the company change their marketing method?
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Solution
Present direct
marketing
(R)
Proposed
Internet
marketing
Differential costs
& revenues
(R)
(R)
Revenues
Cost of goods sold
Advertising
Commissions
Warehouse depreciation
Other expenses
Total
Net income
1 500 000
750 000
2 500 000
1 250 000
1 000 000
500 000
75 000
75 000
50 000
60 000
1010 000
490 000
0
38 000
50 000
60 000
1 398 000
1 102 000
(75 000)
(37 000)
0
0
388 000
612 000
The company should change to internet marketing since this would result in a
positive differential net income of R612 000.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Relevant costs
Opportunity cost is the possible revenue that is lost as a result of
choosing one course of action above the other. With an opportunity
cost, there has to be at least two competing courses of action and the
manager will be required to choose one. Choosing one course of
action results in having to give up the other course of action and all the
possible revenue attached to it.
For example:
Peter is a farmer whose land is big enough to hold only one crop, so he
has to decide whether he would like to grow cabbages or potatoes. At
the end of the season the cabbages can be sold for R4 000 and the
potatoes can be sold for R4 500. If he chooses to grow cabbages, the
R500 is the lost revenue resulting from not choosing to grow potatoes.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Illustrative example 4.2
ABC Ltd has sufficient capacity to manufacture 500 units per month of
product Casa. The normal demand for the product is 400 units per month.
The normal selling price is R40 per unit. Fixed costs are R5 000 per month
and recovered at a rate of R12.50 per unit, based on normal demand.
Variable manufacturing cost is R20 per unit. An opportunity to sell 150
units of the product at a price of R30 per unit presented itself. The order
must be delivered in full next month. This order will not affect normal
demand for the product.
Required:
Quantify the opportunity cost.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Solution
The company has surplus capacity to manufacture 100 units (500 –
400 units). Should the order be accepted, 50 units of the normal
demand will not be available for sale. The company would therefore
forfeit the contribution on the 50 units and not the 150 units. The
opportunity cost relevant to the acceptance of the order will be the
forfeited contribution of R1 000 [950 x (R40 – R20)].
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Relevant costs
Relevant direct material costs:
• There are six special circumstances relating to how the direct material
cost should be treated in the decision-making context:
• Material that is used regularly will have to be
replenished/replaced. The replenishment/replacement cost would
be the relevant material cost. This entails a cash outflow to
purchase or replenish the material that has been used up.
• Extra material that is in stock from a previous contract or job. This
material will not be used on other jobs or contracts and will be
sold. If the organisation decides to use the material instead of
selling it, the cash foregone from the sale of the material is the net
realisable value.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Relevant costs
(cont.)
• Old material that is in stock for a long time, has no value and can be
scrapped. It will cost the organisation nothing if it uses this material on
a current job or contract. The original cost of the material is a past cost
and is therefore irrelevant to the decision at hand.
• Material that is in demand for use on different jobs or contracts. By
using this material on one job or contract would mean that the
organisation will forego profits that could have been generated from
using the material on another job or contract. The relevant cost in this
case would be the contribution lost on the other jobs or contracts.
• Special material for a job or contract. If the organisation has to
purchase material for a specific job or contract, the outflow of cash is
considered relevant to the decision at hand.
• Toxic material. This material could be very expensive to dispose of. If
the organisation uses it instead, the cash saved would be relevant to
the decision at hand.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Decision-making model for isolating
the relevant direct material costs
Is material available in the storeroom?
No
Since material is not available in the
storeroom, it would have to be
purchased.
The relevant cost is
therefore the cost of acquiring material
at the current market prices.
Yes
Is the material in the storeroom used
regularly?
No
Yes
Does the material in the storeroom have an
alternative use?
No
Since the material does not have an
alternate use, the relevant cost would be
either the disposal value or sales value of
the material.
Yes
Since
the
material
in
the
storeroom is used regularly, it
would need to be replaced. The
relevant cost is therefore the
replacement cost of the material
at the current market prices.
Since the material has an alternate use,
the relevant cost would be the cash
foregone from the sale of the material i.e.
the opportunity cost associated with the
alternate use.]
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Illustrative example 4.3
Stocks Ltd produces a variety of products. It has recently received an urgent
order for one of its products, which requires three types of raw material: W1,
W2 and W3. The company has sufficient capacity in terms of labour and
machine hours to meet the order requirements.
Raw material W1 – This raw material is used on a regular basis by the
company to produce its products. Currently there is 27 300kg in stock, which
was purchased previously at a price of R3.25 per kg. The new order requires 1
950kg. The company would need to replenish stock and the current
replenishment price is R3.45. However, if the order is accepted, the reorder
point would have to be accelerated by two weeks and at this point in time the
replenishment price is estimated to be R3.52 per kg.
Raw material W2 – This raw material is not currently used on any other
product. 1 300kgs are in stock, which was purchased previously at a price of
R1.11 per kg. This raw material can be replaced at a current price of R1.24 and
the new order requires 1 040kg. The company has an option of either selling
the stock or using it on the new order. Trade enquiries showed that the raw
material in stock could be sold at a price of R0.72 per kg.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Raw material W3 – 2 600kg of this raw material is in stock. It was purchased
two years ago at a price of R13 per kg for a product that has subsequently
been discontinued by the company. In its present state, it can be scrapped for
R3.90 per kg or used on the new order. It can also be modified at a cost of
R2.60 per kg for use on one of the company’s existing products, which has a
replacement cost of R11.70 per kg.
Required:
Determine the relevant costs for the order for each type of raw material per kg
and in total.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Solution
Raw material W1 → the relevant cost is R 3.52 per kg
The original historical purchase price of R 3.25 is sunk and is therefore irrelevant.
The relevant cost is the replenishment/replacement price at the time of purchase.
R3.52 x 1 950kgs = R6 864
Raw material W2 → the relevant cost is R 0.72 per kg
The original historical purchase price of R 1.11 is sunk and is therefore irrelevant.
There is sufficient raw material in stock to meet the requirements of the new order
and consequently the company would not incur a replenishment/replacement
cost. If they use the raw material that is in stock, it would cost them nothing.
However, by using the raw material, they are incurring an opportunity cost, i.e. the
cash foregone from the sale of the raw material.
1 040kg x R 0.72 = R748.80
Raw material W3 → the relevant cost is R 9.10 per kg
If the company does not take on the order, the other courses of action would be:
Sell the raw material as scrap and generate income of
2 600kg x R3.90 = R10 140
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
OR
Modify the raw material and use it to manufacture an existing product.
Replacement value – Modification costs = Savings x Number of kilograms
R11.70 – R2.60 = R 9.10 x 2 600kg
=R23 660
Of the two options, the modification option yields the greatest saving for the
company. Should the company decide to take on the order, they would be
foregoing the R23 660 savings made from the modification option. The
R23 660 is therefore the relevant cost.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Relevant costs
(cont.)
Relevant direct labour cost is the cash paid for labour used; it is inclusive of overtime.
How the direct labour cost is treated within the decision making context, will be
dependent upon the following conditions:
• Idle time / surplus capacity: Surplus capacity exists when the labour hours
currently being used are less than the available labour hours. When surplus
capacity is available, the relevant labour cost would be the incremental cost of
using the surplus labour hours.
• Overtime and additional staff requirement: When no surplus capacity exists, the
additional labour requirements may be met either by the current workers working
overtime or by hiring new workers. The relevant labour cost in this case would be
the total cost of the extra labour hours utilised.
• Displacement of current production: When no suplus capacity exists and
additional workers cannot be obtained, the current workers would have to be
removed from the current production in order to complete the new project. The
relevant labour cost in this case would be the variable cost of the labour being
used on the new project, plus the lost contribution caused by the discontinuation
of the current production. This lost contribution represents the opportunity cost of
displacing current production by using current labour on the new project.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Decision-making model for isolating
the relevant direct labour costs
Is there surplus capacity available?
Yes
No
Since there is surplus capacity available,
the existing workforce can meet the
production requirements. The relevant
labour cost would be the variable cost of
the labour that would be used.
No
Yes
Is it possible to employ more workers?
Yes
No
No
Since it is possible to employ more workers, the
production requirement can either be met by
employing more workers or by existing workers
working overtime. The relevant labour cost
would therefore be the total cost of employing
new workers or the total cost of the overtime
worked.
Since it is not possible to employ
more workers, existing workers
would have to be removed from
current production. The relevant
labour cost would be the variable
cost of the labour that would be
used plus the lost contribution
from displaced production.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Illustrative example 4.4
A company which manufactures a single product has received a once-off order that
requires 130 skilled labour hours. Information relating to the company’s only product is
as follows:
Selling price R78 per unit and variable costs R50 per unit. The variable costs include
direct labour of R17.50 per unit. Skilled workers take an hour to produce one unit and
are paid R17.50 per hour.
Below are three independent scenarios relating to the treatment of direct labour for the
once off order.
Scenario 1: Surplus capacity is available to meet the requirements of the once-off order.
Scenario 2: Surplus capacity does not exist and the current workers would have to be
paid overtime at a rate of time and a half in order to complete the once-off order.
Alternatively, the company could employ new workers at a rate of R22.50 per hour.
Scenario 3: Currently the company is working at maximum capacity. If the company
wants to take on the once-off order, the skilled workers would have to be removed from
the production of the company’s only product.
Required:
Calculate the relevant labour cost per hour and in total for the once-off order based on
each of the scenarios.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Solution
Scenario 1  The relevant labour cost per unit is R 17.50 and R 2 275 in total.
= R17.50 per hour x 130 hours
= R 2 275
Scenario 2  The relevant cost per unit is R22.50 and in total R 2925.
The overtime cost associated with utilising the current workers must be compared
to the cost of hiring new workers.
Overtime cost of current workers
= (R17.50 x 1.5) x 130 hours
= R26.25 x 130
= R3 412.50
Relevant cost per unit is R26.25 and R3 412.50 in total.
Cost of hiring new workers
= R22.50 x 130 hours
= R2 925
Based on the calculations above, it is cheaper to hire new workers to complete the
once-off order.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Scenario 3  The relevant cost per unit is R45.50 and R 5 915 in total.
The existing product earns a contribution of R28 (R78 - R50). The relevant
cost would be the contribution foregone plus the direct labour cost of the
once off order.
= R28 + R 17.50
= R45.50 per unit ÷ 1 hour
= R45.50 per labour hour
The special order requires 130 hours therefore the total relevant labour costs
would be:
= 130 hours x R45.50
= R5 915
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Relevant costs
(cont.)
Relevant overhead costs are those overhead costs that change as a result of
the decision taken. The relevance of an overhead cost is dependent upon the
circumstance, i.e. an overhead cost may be relevant in a particular situation
and irrelevant in another.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Decision-making model for isolating
the relevant overhead costs
Is the change in the overhead costs
caused directly by the decision taken?
Yes
No
Since the change in the overhead costs are
caused directly by the decision taken, the
relevant overhead costs would be the total
increase or total decrease in the overhead
costs resulting from the decision taken.
No
Yes
Since the change in the overhead costs are not
caused directly by the decision taken, they are
irrelevant to the decision at hand. Consequently
they must be excluded from the decision making
process.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Illustrative example 4.5
A company produces the subcomponents for its main product within a
separate manufacturing facility. This facility is rented out at a cost of R25 000
per month under a lease agreement which covers a one-year period. It is
currently the start of the second quarter of the year and the company is
considering buying these components from an external supplier instead of
manufacturing them in-house. The following scenarios are applicable to the
lease agreement:
Scenario 1: An early exit option from the lease agreement is not possible.
Scenario 2: An early exit option from the lease agreement is not possible, but
the facility can be used for alternate purposes.
Scenario 3: An early exit option from the lease agreement is possible
provided that a months’ notice period is given.
Required:
For each of the scenarios provided above, indicate whether the rental cost is
relevant or irrelevant to the make or buy option which the company is
currently considering.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Solution
Scenario 1  irrelevant cost
The current rental cost is committed and cannot be changed. It is therefore irrelevant to
the make or buy decision.
Scenario 2  irrelevant cost
The current rental cost is committed and cannot be changed, irrespective of whether the
facility can be used for an alternate purpose or not. It is therefore irrelevant to the make
or buy decision.
Scenario 3  R200 000 saving is relevant and R100 000 rental incurred is irrelevant
It is currently the 1st of April, the start of the second quarter. One months’ notice would
end on 1st of May. The rental cost would therefore be saved from May through to
December.
R25 000 x 8 months’ savings = R200 000. This saving would be relevant to the make or
buy decision.
The rental incurred from January to April is a past cost/sunk cost and would be
considered irrelevant to the make or buy decision.
R25 000 x 4 months’ rental incurred = R100 000
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Irrelevant costs
• Irrelevant costs are costs that do not affect the decision at
hand and can consequently be excluded from the decisionmaking process. These include:
• Sunk costs are past costs and no decision made now or in the
future can change these costs. They have already been incurred
and are consequently irrelevant to the decision at hand. A
common misconception is that fixed costs are always regarded as
sunk costs. A fixed cost that has to be incurred in order to provide
infrastructure that is directly related to the situation under
consideration, certainly represents a relevant cost.
Example:
A few years ago a company purchased a machine valued at R100 000. This
machine was used to produce one of the products in their product line.
Customer preferences have changed and consequently there is no longer a
market for the product. The product has now been discontinued. The
R100 000 is considered a sunk cost, since it represents the original cost of
the machine which cannot be recovered. It is irrelevant and therefore can be
ignored in the decision-making process.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
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Irrelevant costs
(cont.)
• Common costs are costs that are present under both options
and consequently whether we leave them out or put them in,
will not affect the decision at hand. Fixed costs that remain
the same, i.e. do not increase or decrease, are considered
irrelevant.
Example:
Jeffrey has to decide to either drive his car to work or to use public
transport. The car license is R500 for the year and is common to both
options. Whether he uses his vehicle to get to work or not, he still has
to purchase a license for it. The R500 is therefore considered irrelevant
to the decision at hand.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Irrelevant costs
(cont.)
• Committed costs are costs that will be incurred in the future,
but have originated from a decision made in the past and
therefore cannot be changed by any decision made now or in
the future. Committed costs are irrelevant in the short term, but
may become relevant in the long term.
Example:
An organisation has seen the benefits of a just-in-time inventory system
and has decided to implement it. Consequently they have entered into a
six-month contract with a raw material supplier. The contract stipulates
that the supplier must supply 100 000 units of raw material at a cost of
R2 per unit and delivery needs to be made on request. The contract is for
a six-month period. The cost of R200 000 (100 000 x R2) cannot be
avoided until the six-month period is over and is therefore considered
irrelevant to the decisions at hand.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Irrelevant costs
(cont.)
• Depreciation – The historical cost is an irrelevant cost, since it does
not involve the physical flow of cash and is merely an accounting
adjustment which spreads the cost price of the asset over its useful
life.
• Notional costs/speculative cost such as notional rent and notional
interest, as mentioned above, are irrelevant costs. The main purpose
of these costs is to make internal decision making more accurate,
since it allows managers to benchmark competitors’ product costs.
Example
If an organisation purchased their premises instead of renting them, each
responsibility centre is charged rent based on market value notional rent.
This helps managers make the optimum use of the space. If there is surplus
space available, it can be sold or rented out. Notional rent only becomes
relevant if the organisation had the option to rent out their premises. The
lost rental is considered an opportunity cost of choosing to use the
premises for manufacturing purposes.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Irrelevant costs
(cont.)
• Arbitrary allocated costs are organisational overheads which
are allocated to products or divisions on an arbitrary basis, for
example marketing and administration costs. These costs are
recovered from individual products or divisions on a selected
basis such as floor space occupied, turnover generated, etc.
They are always irrelevant as they will be reallocated to the
remaining products or divisions should any one of them be
discontinued or shut down.
• The use of relevant costs and revenues for decision making
is known as relevant costing. Relevant costing and the
contribution approach are valuable tools for short-term
decision making. A decision made in one area of an
organisation may have a positive or negative impact on
another part of the organisation. This is known as the
‘ripple effect’.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Qualitative factors
•
Identify non-financial indicators that impact on short-term decisions
The financial indicators are the relevant monetary benefit derived from the
decision taken. The non-financial indicators are the non-quantifiable issues such
as the impact of the decision on the long-term profitability of the organisation,
employee morale, quality of the product produced, customer long-term
satisfaction, legal aspects, ethical aspects, social responsibilities, etc.Non-financial
factors include both internal and external factors that impact on the decision at
hand.
Internal non-financial factors include the following:
• The availability of cash
• Employees and trade unions
• Timing
• Feasibility
• Flexibility and internal control
• Unquantified opportunity costs.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Qualitative factors
(cont.)
External non-financial factors include the following:
•
Inflation
•
Customers
•
Competitors
•
Suppliers
•
Political pressure
•
Legal and ethical contstraints
Before arriving at a final decision, the impact of both the financial and nonfinancial indicators needs to be examined. Sometimes the non-financial indicators
outweigh the economic benefit of the decision. Good decision making therefore
requires the use of a range of tools, i.e. financial as well as non-financial indicators
together with the sound judgement of the manager, based on his or her
experience.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Types of short-term decisions:
utilisation of a single constrained resource
(key factor/limiting factor)
• A constraint is something that prevents the organisation
from meeting their sales demand and consequently has
an impact on the profitability of the organisation.
Examples include limited machine hours, limited labour
hours, limited raw materials, limited floor space, etc.
• Managers are faced with the decision on how best to
utilise the constrained resource in order to order to
maximise profits.
• When faced with more than one constrained resource,
the situation is more complicated and the linear
programming technique must be applied.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Illustrative example 4.6
A timer is a specialised clock that is used to indicate or control the time
for a specific event. We use timers on a daily basis – the watch on our
arm, the clock on our bedroom wall and the stoves in our kitchens are a
few examples of timers that we encounter in our daily lives. Time It Ltd is
a company that produces timers. They were established in the early
1990s and are based in Springfield Park Durban. Their product range
consists of two types of timers, i.e. the analogue microwave timer and
the electronic geyser timer. The geyser timers have become increasingly
popular and their demand has doubled in the last month. Geysers
increase electricity consumption drastically and with the increase in the
cost of electricity, most residences want to install geyser timers in an
attempt to reduce their electricity cost. The information relating to these
two products for the last month is provided on the slide that follows.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Microwave
Geyser timer
timer
Selling price per unit
R100
R500
Less: Variable cost per unit
R40
R300
Contribution per unit
R60
R200
0.75 hours
3.25 hours
4 000 units
8 500 units
Time required to produce 1 unit on the
assembly machine
Maximum sales demand
The operating time for the assembly machine is limited to 30 000 hours. This
machine is a bottleneck since it restricts production.
Required:
Based on the constraint above, calculate the product mix that will maximise
profits and calculate the value of the profit generated.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
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Steps involved in determining the optimum utilisation of a single
constrained resource (key factor/limiting factor):
Step 1
Calculate the contribution per unit of each product based on the
constrained resource.
Step 2
Rank the products in order of which product has the highest contribution
per unit of the constrained resource.
Step 3
Based on the ranking in Step 2 above, calculate how the constrained
resource will be utilised, i.e. the product mix that will maximise profits.
Also indicate which product or products will not be fully supplied.
Step 4
Calculate the total profit generated in terms of the sales mix that was
determined in Step 3 above.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Solution
Step 1
The contribution per unit of the constrained resource is R80 for the
microwave timer and R61.54 for the geyser timer. This indicates that for
every machine hour spent on manufacturing the microwave timer, R80
is generated in contribution and for every machine hour spent on
manufacturing the geyser timer, R 61.54 is generated in contribution.
Contribution per unit of the constrained resource:
Microwave
Geyser timer
timer
Contribution
÷ Constrained resource (machine
60
200
÷ 0.75
÷ 3.75
R80
R61.54
hours of assembly machine)
Contribution per unit per machine
hour
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Step 2
Ranking: The microwave timer generates the greater contribution per
machine hour and is therefore ranked as number 1 and the geyser timer
would be ranked as number 2.
Since the microwave timer makes the best use of the available machine
hours, the company should first spend the available machine hours producing
the microwave timer according to demand. The machine hours that are then
left, will be used to manufacture the remaining product, i.e. the geyser timer.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Step 3
Consequently, the production mix would be as follows:
Total machine hours available
Less: Hours used for microwave timer (4000 x 0.75)
Hours available for production of geyser timer
Hours used for production of geyser timer (8 307* x 3.25)
Machine hours left
30 000
3000
27 000
26 997.75*
2.25
Time It Ltd should therefore produce 4 000 microwave timers and 8 307
geyser timers. This will use up the 30 000 machine hours available. The
geyser timer will therefore not be fully supplied in terms of the demand.
193 geyser timers will not be supplied.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Step 4
Calculation of total profit generated:
Microwave
Geyser timer
Total
timer
Units sold
x Contribution per unit
Total contribution
4 000
8 307
60
200
R240 000
R1 661 400
R1 901
400
The company is losing R38 600 (193 x R200) contribution by not fully supplying
the geyser timer.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
The machine that is limiting output is known as the ‘bottleneck’. The main
aim is for the bottleneck machine to run as long as possible, since time lost
on a bottleneck machine can never be recovered and consequently profit is
lost. Managers can increase the capacity of the bottleneck machine in various
ways:
• Run the machine longer at optimum running speed by letting machine
operators work overtime or implement an extra shift.
• Train workers to ensure that workers can be moved around from nonbottleneck processes to assist with the bottleneck process, thereby
ensuring that the bottleneck machine is never idle.
• Subcontract part of the processing that would be done at the bottleneck
(see ‘Make versus buy decision’ below).
• Invest in more machinery.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
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• Focus on total quality management and business process re-engineering
by:
 ensuring that there is always sufficient stock on hand to keep the
machine going
 reducing or minimising setup time
 reducing defective units
 monitoring the machine cycles to know when it is due for
maintenance to reduce reworking or poor quality products
Most bottlenecks can be controlled and improved without extra capital
being required. Various manufacturing information systems software is
available on the market to assist managers in controlling bottlenecks. The
maximum contribution per unit of constrained resource can only be used
when a single constraint exists. Where multiple constraints exist
concurrently, a quantitative technique called ‘linear programming’ can be
used to determine the optimum production mix. Linear programming is
covered in Chapter 5.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Make or buy decision
(outsourcing decision)
• This decision looks at the option of either making a component in-house
or buying it from an external supplier. It is in essence a vertical integration
decision. The value chain is the processes that raw materials go through in
order to be transformed into finished products. Vertical integration in the
value chain is where an organisation is involved in numerous processes
within the value chain of its products. Some organisations control all of
the processes within the value chain of their products while others
integrate on a smaller scale.
• There are various advantages of vertical integration.
• Integrated organisations are less dependent on suppliers, so they can
ensure that production runs smoothly, i.e. not affected by supplier strike
action. They can also ensure that their products are of a good quality.
• There are two types of make-versus-buy decisions:
• Where the organisation is not working at full capacity, manufacturing the
component in-house would not displace existing production.
• Where the organisation is working at full capacity, manufacturing the
component in-house would displace existing production.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
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Illustrative example 4.7
(where the manufacture of the component does not displace existing production)
Style Components Ltd produces exclusive ladies’ dresses. They have built up a
good reputation within the trade and are well known for the quality of their
clothing. One of the components for a dress is a 30cm nylon clothes zipper.
Currently the company is not working at full capacity and is therefore able to
manufacture the zippers in-house. The components that make up the nylon
clothes zipper are as follows: a chain (metal teeth pressed into the woven cotton
fabric, the tape), a slider, a bottom stop and a top stop.
The zippers are then cut into the required size by a specialised machine. The
nylon zippers they produce are non-corrosive and have a durable service life.
The specialised machine that is used to make the zipper has no salvage value
and cannot be used to manufacture other products. During the manufacturing
process, an expert supervisor checks the quality of the zippers. The expert
supervisor has been hired specifically to check only the processing of the
zippers. The following are the in-house costs related to the manufacturing of the
nylon clothes zipper:
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Per unit
(R)
Direct material
Direct labour
Variable overheads
Supervisor’s salary
Depreciation on special machinery
Allocated fixed overheads
0.65
2.00
0.35
0.50
0.50
1.00
5.00
Rand total
15 000 zippers
per month
9 750
30 000
5 250
7 500
7 500
15 000
75 000
An outside supplier has offered to supply Style Components Ltd with 15 000
zippers per month, for the next 12 months, at a unit cost of R3. If the company
buys the zippers from the outside supplier, the production capacity used at
present will be idle.
Required
Based on the above information, should Style Components Ltd manufacture the
zipper in-house or buy it from the external supplier? Briefly explain any nonfinancial factors that should be considered before a final decision is made.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Steps involved in the make-versus-buy decision:
Step 1
Compare the differential cost to manufacture with the cost to purchase.
Remember the differential costs would be the costs that can be avoided.
Step 2
The decision taken is based on the option that has the lowest costs
associated with it.
Step 3
Consider the non-financial factors that could have an impact on the
decision.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Solution
Step 1
Per unit
Direct material
Direct labour
Variable overheads
Supervisor’s salary
Depreciation on special
machinery
Allocated fixed overheads
Outside purchase price
Total cost
Make
Buy
0.65
2.00
0.35
0.50
-
R3.50
-
Relevant costs
Differential costs
Differential costs 180 000
(15 000 x 12 )
Make
Buy
(Make less Buy)
117 000
117 000
360 000
360 000
63 000
63 000
90 000
90 000
-
R3
-
R3.00
R 630 000
R540 000
(540 000)
R540 000
R90 000
Which are the differential / avoidable / relevant costs?
• It includes all the variable costs associated with the manufacturing of the zipper, i.e.
direct material, direct labour and variable overheads, since these costs can be
avoided if we purchase the zippers from the outside supplier.
• The supervisor’s salary can be avoided since the person had been hired specifically
for the checking of the zippers.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Which are the unavoidable/irrelevant costs?
• Depreciation on special machinery is a sunk cost and therefore cannot be
avoided.
• Depreciation is not a cash flow and is therefore irrelevant.
• Allocated fixed costs are common costs associated with all products
produced by the company and cannot be avoided.
Step 2
Decision:
It is cheaper to buy the zipper from the outside supplier than manufacturing it
in-house. The company will save R7 500 per month [(3.50 – 3) x 15 000
zippers] or R90 000 for the year. The relevant costs for the above decision are
the differential costs of the two alternatives. The differential costs can be
isolated by excluding the common costs and sunk costs, i.e. all the costs that
cannot be avoided.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
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Step 3
What are the non-financial indicators that should be considered before a
decision is taken?
• Will the supplier maintain the company’s required quality of the component,
since this would impact on the reputation of the company’s main product?
• Will the supplier deliver on time as required to ensure that the production
process continues uninterrupted?
• Will the supplier increase the price of the components after the 12-month
period, i.e. consider the relative permanence of the discount offered?
• What if the supplier is taken over by one of the company’s competitors? This
will definitely restrict the supply of the component.
• Suppliers may breach confidentiality since they have to be informed of any
new improvement or developments regarding the component that is required.
• What would the effect be on employee morale if some employees were to be
retrenched?
• Consider the amount of capital that could become available that can be
utilised for other investment opportunities?
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Illustrative example 4.8
(where the manufacturing of the component displaces existing production)
Assume the same information covered in illustrative example 4.7. The
demand for the main product has increased and Style Ltd does not have
spare capacity to manufacture the zipper in-house. This increase in demand
for the main product would results in an increase in contribution by R70 000
per annum. Should the company manufacture the zipper in-house or buy it
from an external supplier? Importantly, if the manufacturing of the product
or component displaces (replaces) existing production, the lost contribution
(opportunity cost) resulting from the displacement in production must be
added to the marginal cost of production, before comparing it to the buying
in price.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
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Make
Differential cost per unit
x annual requirement
Total annual cost
Add: Opportunity cost / lost
contribution
Total cost
Buy
Difference /
differential
(make less
buy)
3.50
180 000
R630 000
70 000
3.00
180 000
R540 000
-
R90 000
R 70 000
R 700 000
R540 000
R160 000
Decision:
It is still cheaper to buy the zippers from the outside supplier than to produce it
in-house. Remember to consider all the non-financial indicators before a final
decision is taken.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
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Closure or deletion
of a business segment
• A business segment is a division or subdivision of a large organisation,
which generates revenue. This decision looks at the option of deleting a
non-profitable business segment.
• In monetary terms, a business segment would be deleted if it fails to
render an acceptable return on capital in the long term.
• It may also be deleted due to a change in the long-term goals of the
organisation, e.g. rationalisation, to concentrate activities on a specific
sector rather than on a number of different sectors.
• The way in which fixed costs have been allocated can impact on the
profitability of a product line or department.
• Absorption costing is used for normal reporting within an organisation,
resulting in a product line or department appearing to be unprofitable.
• By restructuring the income statement into marginal costing format, it can
be clearly seen if the product line or department is profitable or not.
• Allocated fixed costs may not be avoidable even if the product line or
department is dropped.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
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Illustrative example 4.9
(dropping a product line)
Designers Ltd manufactures office furniture and accessories. They were
established in the 1970s and have been providing their customers with
high quality and functional products. The company’s corporate objective
is to offer their customers a complete office solution. Their product lines
consist of desks, seating and office accessories. The desk line consists of
various types of desks including reception desks, boardroom desks,
executive desks and managerial and operators’ desks. The seating line
consists of various types of chairs such as operators’, managerial and
executive chairs. The office accessories line consists of file holders,
cabinets as well as desk accessories such as memo pad trays, pen
holders and business card holders. The sales and cost information for
the last month, for each of the product lines, is provided in the slide that
follows.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
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Sales
Less: Variable costs
Contribution
Less: Total fixed
expenses
Rent
Salaries
Utilities
Advertising
Depreciation
Insurance
General administrative
costs
Net profit or loss
Total (R)
500 000
210 000
290 000
250 000
Desk (R)
Seating (R) Accessories(R)
250 000
150 000
100 000
100 000
50 000
60 000
150 000
100 000
40 000
118 000
76 000
56 000
40 000
100 000
4 000
30 000
20 000
59 000
1 000
2 000
12 000
25 000
1 000
15 000
8 000
16 000
2 000
13 000
10 000
6 000
60 000
2 000
4 000
30 000
4 000
1 000
18 000
4 000
1 000
12 000
40 000
32 000
24 000
(16 000)
Salaries, insurance and advertising relate specifically to each product line. The
office accessories line appears to be making a loss. Should this product line be
dropped? Briefly explain any non-financial factors that should be considered
before a final decision is taken.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Steps involved in dropping a product or department:
Step 1
Analyse the fixed costs being charged to the product line or department and
identify which of the fixed costs can be avoided if we drop the product line or
department.
Step 2
Compare the total avoidable fixed costs to the contribution generated by the
unprofitable product line or department. If the contribution generated by the
unprofitable product line is greater than the total avoidable fixed costs, do not
drop the product line or if the contribution generated by the unprofitable
product line is less than the total avoidable fixed costs, drop the product line.
Step 3
Consider the non-financial factors that could have an impact on the decision.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Solution
Step 1: Analysis of costs
Total (R) Unavoidable / Avoidable /
irrelevant
relevant costs
costs (R)
(R)
Rent
Salaries
Utilities
Advertising
Depreciation: Equipment
Insurance
General administrative costs
Total fixed costs
8 000
16 000
2 000
13 000
4 000
1 000
12 000
56 000
8 000
16 000
2 000
13 000
4 000
1 000
12 000
26 000
30 000
Avoidable costs are salaries, insurance and advertising. They relate
specifically to the office accessories product line and therefore can
be avoided if the line is dropped. We are assuming also that the
workers on this line would be laid off and not redeployed elsewhere
in the company.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
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Unavoidable costs are rent, utilities, depreciation on equipment and
general administration. These costs relate to the company as a whole. A
portion has been allocated using a suitable apportionment basis to the
office accessories product line, but these costs will still continue whether
or not the office accessories product line is dropped or not.
Step 2: Total avoidable fixed costs versus contribution
Lost contribution if accessories line is dropped
Less: Savings in fixed costs (avoidable fixed costs)
Decrease in overall net profit
(R 40 000)
R 30 000
(R 10 000)
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Differential analysis:
Keep
accessories
line (R)
Drop
accessories
line (R)
Difference /
differential
(R)
Sales
Less: Variable costs
Contribution
100 000
60 000
40 000
-
(100 000)
(60 000)
(40 000)
Less: Total fixed expenses
Rent
Salaries
Utilities
Advertising
Depreciation
Insurance
General administrative costs
Net profit or loss
56 000
8 000
16 000
2 000
13 000
4 000
1 000
12 000
(16 000)
26 000
8 000
2 000
4 000
12 000
(26 000)
30 000
16 000
13 000
1 000
10 000
Decision:
Do not drop the office accessories line as this will result in an overall
decrease of R10 000 in profit.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Step 3: The non-financial factors to consider are as follows:
• Redundancies of work force and consequences, i.e. effect on employee morale
and loss of scarce skills
• Customer perceptions
• Competitor perceptions
• Is it in the best interest of the organisation both in the short term and long term?
Does your decision impact on the long-term reputation of the organisation? Will
retaining the product line or department be the best way of utilising available
resources or can the resources be used to manufacture other more profitable
products? Remember a closure decision has far-reaching consequences and
should only be undertaken as a last option, i.e. the organisation has made various
efforts to improve profitability and has failed.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
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Special-order decision
• Special orders are once-off orders that are not part of the normal
business. These once-off orders are usually below the normal selling
price and generally occur when an organisation has surplus production
capacity. By accepting such orders, the organisation can increase its
contribution and consequently its profits.
• Special orders can also be undertaken if the organisation does not
have surplus capacity. In this case, the minimum price of the special
order should include the additional costs required to expand the
production facility in order to meet the special-order requirements, as
well as the lost contribution from the regular sales, that are displaced
by the special order.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
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Illustrative example 4.10
(special orders)
Gear Seal Ltd manufactures bearings and seals for both the automotive and
industrial sectors. The company operates in two divisions: the rubbers division
and the steel division. Their bearings and seals are used in all makes of motor
vehicles as well as for industrial equipment and machinery, both locally and
internationally. The bearings are manufactured in the steel division, while the
seals are manufactured in the rubber division. The cost to produce a bearing is
R4.44 and the cost to produce a seal is R2. They are currently producing 60 000
seals and 27 000 bearings for the month which represents 75% capacity. The total
costs for the steel division is R120 000 of which 70% is variable. They have
received an order from Nadasen’s Auto Manufacturers to supply 8 000 bearings
for a vintage-model Supra at a price of R8 per bearing.
Required:
a. Based on the above information, should Gear Seal Ltd accept the special
order? Briefly explain any non-financial factors that should be considered
before a final decision is taken.
b. Assuming that the special order increased to 10 000 bearings, should Gear
Seal Ltd accept the special order?
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
(a) Steps involved in a special-order decision:
Step 1
Determine if the organisation has surplus capacity to meet the special-order
requirements.
Step 2
Calculate the incremental revenue and incremental costs.
Step 3
If the incremental revenue exceeds the incremental costs, accept the special
order. If the incremental revenue is lower than the incremental costs, then do not
accept the order.
Step 4
Consider the non-financial factors that could have an impact on the decision.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Solution
(a) Step 1: Determine the organisation’s capacity
Current capacity
Total capacity
Surplus capacity
27 000
36 000*
9 000
75%
100%
25%
*27 000 x 100 / 75 = 36 000
The special order is for 8 000 bearings and the surplus capacity is 9 000
bearings. The organisation therefore has sufficient capacity to meet the
special order requirements.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Step 2: Calculate the incremental revenue and incremental costs.
The incremental costs would be the variable costs.
Total fixed costs = Total cost - Total variable costs
Total cost
- Total variable costs
= Total fixed costs
Variable cost per unit
= R120 000
= R84 000 (70% x 120 000)
= R36 000
= Total variable costs / Total number of units produced
= R84 000 ÷ 27 000
= R 3.11
Step 3: Incremental analysis
Incremental revenue (R8 x 8 000)
Less: Incremental costs (R 3.11 x 8 000)
Increase in profit
64 000
24 880
39 120
The incremental revenue exceeds the incremental cost by R39 120. The
organisation should therefore accept the special order since profits would
increase by R39 120.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Step 4: Non-financial indicators that could impact on the decision are as follows:
• Will the special order increase our fixed costs?
• Is the special order the best possible use of the surplus capacity?
• If the demand for our product increases in the future, will we be able to meet
this demand considering that we have tied up our capacity on the special order?
• What impact would selling our product at a lower price have on our customers’
perceptions, as well as our market share?
• Is additional working capital that may be required, available?
• Would downward pressure be placed on normal selling price?
(b) Step 1: Determine the organisation’s capacity
Current capacity
27 000
75%
Total capacity
36 000*
100%
Surplus capacity
9 000
25%
*27 000 ×100 /75 =36 000
Step 2: Calculate the incremental revenue and incremental costs
The special order is for 10 000 bearings and the surplus capacity is 9 000 bearings. The
organisation therefore has insufficient capacity to meet the special order
requirements. Since the company has excess capacity of 9 000 units only, it is not
enough to fill up the special order of 10 000 units. Hence, a portion of the regular
sales (1 000 units) must be sacrificed to fill up the entire special order.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
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Step 3: Incremental analysis
The incremental costs would be the variable costs of R3.11 per bearing. The lost
contribution margin (opportunity cost) from the regular sales should be considered.
Contribution margin is equal to sales (at R7 per bearing) minus variable costs (R3.11
per bearing). Therefore, the lost contribution margin is equal to R3 890 [(R7 - R3.11) ×
1 000 units].
Incremental revenue
(R8 × 8 000 units)
R64 000
Incremental costs
(R3.11 × 8 000 units)(R24 880)
Lost contribution margin (opportunity cost)
(R3 890)
Increase in profit
R35 230
Step 4: Non-financial indicators that could impact on the decision
Even though regular sales will be sacrificed, Gear Seal should still accept the special
order since profits would increase by R35 230. Gear Seal also needs to ensure that this
is a one-time order, and therefore represents a short-run pricing decision. If future
orders from Nadasen’s Auto Manufacturers at R8 per bearing are received, then Gear
Seal must consider the impact this might have on long-run pricing with other
customers.
Regular customers may hear of this special price and demand the same price,
particularly customers who have been loyal to Gear Seal for many years. Gear Seal
might be forced to lower prices for regular customers, thereby eroding the company’s
profits over time.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
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Minimum pricing decision
•
•
•
This technique is particularly useful where there is intensive competition in the
market and the organisation has to price its product or products competitively,
clearance of old stocks; getting special orders and/or improving market share of
the product
It looks at the lowest possible price that the company could sell its products for.
The lowest price is the total relevant costs of producing the product, plus any
opportunity cost that may arise out of the decision.
Illustrative example 4.11
The minimum price for a one-off decision is the price at which the business would
break even, that is, the total relevant costs for the once-off decision.
The minimum price for a one-off decision is the price at which the business would
break even, that is, the total relevant costs for the once-off decision.
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Minimum pricing decision
(cont.)
Notes
(R)
Direct material
-
-
Sheet metal (40m2 @R20 per m2
1
800
Pop rivets (200 @ R2 each)
2
400
Direct labour:
-
Skilled (100 hourse @ 32 hours)
3
3 200
Semi-skilled (40 hourse @ R20 per hour)
4
800
Overheads
5
200
5 400
Administration overhead @ 10% of production cost
6
540
5940
Profit 20% of total cost
Selling price
7
1188
7128
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
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Minimum pricing decision
(cont.)
Additional information:
1. The sheet metal required for the jigs are used regularly on other work within the
business. This metal has an inventory value of R20 per m². However, due to the current
economic circumstances, the purchase price has recently increased to R24 per m².
2. The pop rivets are currently held in inventory and cost R2 each. The company has no
further use for them. A scrap merchant is willing to purchase them at R1 each.
3. The skilled labourers are paid R32 per hour and are currently working at full capacity.
If the job is undertaken, a maximum of 80 hours of overtime (paid at time and a half)
would need to be worked and any additional hours required would displace current
production of other products which earn a contribution of R40 per hour.
4. The idle semi-skilled labour time available totals 200 hours.
5. Overheads are apportioned to cover the factory fixed cost.
6. The company’s policy is to add 10% to the production cost of each job to cover the
administration cost of orders accepted.
7. The standard pricing policy requires a profit of 20% of total cost to be added to each job.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Minimum pricing decision
(cont.)
Solution
Notes
(R)
-
-
Sheet metal (40m2 @R20 per m2
1
960.00
Pop rivets (200 @ R2 each)
2
200.00
Direct material
Direct labour:
-
Skilled (100 hourse @ 32 hours)
3
5 280.00
Semi-skilled (40 hourse @ R20 per hour)
4
0.00
5
0.00
.Overheads
6 440.00
Administration overhead @ 10% of production cost
6
644.00
7 084.00
Profit 20% of total cost
Selling price
7
1 416.80
8 500.80
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Minimum pricing decision
(cont.)
Notes:
1. The sheet metal is in regular use; and therefore needs to be replaced. The current
purchase price is: Relevant cost = 40 m² × R24 = R960.T
2. Pop rivets = Opportunity cost is lost scrap proceeds (200 × R1 = R200).
3. Skilled labour: It is cheaper to work overtime; however, the job requires 100 hours.
Overtime is limited to 80 hours, the shortfall in hours is 20 hours, which will displace the
regular production
80 hours @ (R32 x 1.5)
R3 840
20 hours @ (R32 + R40)
R1 440
R5 280
1. Semi-skilled labour: Relevant cost is nil as there is spare capacity available.
2. Overheads: Relevant cost is nil, as overheads will be incurred regardless of this job.
3. Administration costs will be incurred regardless of whether or not the job is accepted;
therefore, it is not relevant.
4. Profit mark-up is not relevant as the question asks for a minimum price. A minimum
price is one which covers the total of the relevant costs.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Overview of joint and by-products
Split-off point
Further processing costs
for joint products
Direct material
+ Direct labour +
Applied overheads
Joint product 1
Direct material
+ Direct labour +
Applied overheads
= JOINT COSTS
Common
production
process
Joint product 2
Direct material
+ Direct labour +
Applied overheads
Total cost of the
product
Applied joint costs
+ Further processing costs
Applied joint costs
+ Further processing costs
By-product
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Joint product and further
processing decisions
•
•
Organisations that produce a number of products from a common production
process are faced with the problem of how to allocate the costs of the common
production process equitably to all the products produced.
Important terminology related to joint and by-product costing:
•
•
•
•
•
Joint products are products that arise out of a common manufacturing process. They are
produced in large quantities and make a substantial contribution to the organisation’s
profits. They are the main products that the organisation produces.
By-products are products that arise out of a common manufacturing process. They are
produced in smaller quantities in comparison to the joint products and they contribute a
relatively small amount to the overall profits of the organisation. Unlike the main products,
the organisation did not intend to manufacture the by-products.
Split-off point/separation point is the point in the production process where we can
identify the various joint products as well as by-products.
Joint costs/common costs include all direct material, direct labour, as well as
manufacturing overhead costs that are incurred up to the split-off point.
Further processing cost/subsequent costs – Often the main products/joint products
produced cannot be sold at split-off point. They need to be processed further in different
processes in order to bring them into a saleable condition. The costs incurred in these
separate processes are known as the ‘further processing costs’.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Accounting for joint products
•
•
Total cost of joint product = Allocated joint costs + Related further processing
costs
Joint costs are allocated to joint products using the following methods:
• Physical measurement/physical standard method – This method allocates joint costs
to each joint product based on the quantity of the product produced. Obviously this
method allocates more joint costs to high-volume products than low-volume
products.
• Market value at split-off point method – This method allocates joint costs to each
joint product based on the potential market value of the product at split-off point.
One can only use this method if you know or can estimate what the market value is or
would be at split-off point.
• Net realisable value/estimated market value at split-off point – With this method we
assume that the market value at split-off point is not known with certainty. It can
however be estimated by using the further processing costs as well as the market
value of the final product. The net realisable value can be calculated as
= (Production x Selling price of final product) – Further processing costs
•
The various methods used to allocate joint costs are only estimates and the
manager should be cautioned when using these estimates in a decision-making
context. Note each method will result in a different valuation of inventory and
therefore a different gross profit.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Accounting for by-products
•
•
By-products do not constitute part of the main purpose of an organisation’s
operations therefore the approach regarding by-products should be one that
has a minimal effect on the operating results where by-products are sold. One
needs to establish whether a regular market exists for the by-product or not. If
the by-products are sold on a regular and recurring basis, there is clearly a
market for them, and the organisation is assured of the eventual sale of the
by-product at its net realisable value.
Where a regular market exists, the objective is to reflect the sales of the byproduct in a way that it yields no profit. This is achieved by ensuring that the
by-products that arise from the common/joint process are priced at the net
realisable value which is the net proceeds on sales (after subtracting any
further processing costs and other costs). In this method, the total joint costs
for the period will be reduced by the total NRV of the production of the byproduct. After this, the NET joint costs are allocated to the remaining joint
products according to the methods described in illustrative example 4.12. If
indicated that the organisation can sell as much of a product as it can produce,
then that is an indication that a regular market exists.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Accounting for by-products
If there is no market for the by-products, then they constitute waste and would
generally be thrown away/discarded. Incidental sales may occur from these waste
products and since such transactions will occur sporadically and in isolation, there
should be minimal impact on the profit. However, these transactions still need to be
taken into account.
Various options are available for treatment of the net proceeds of the by-product as a
single line item in the statement of comprehensive income. These options are:
• As additional sales revenue
• As a reduction of the cost of goods sold
• As other income
By-products can either be sold as scrap or be processed further. The decision to process
a by-product further will be based on the following:
• The cost to process the by-product further must be less than the additional
revenue generated by the sale of the by-product.
• The costs incurred up to split-off point are sunk and consequently have no impact
on decisions related to the treatment of the by-product.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Illustrative example 4.12
(allocation of joint costs to joint products)
A company produces two products, Joint product 1 and Joint product 2, using a
common manufacturing process. The joint costs that arise out of the common
process is R 3 750.
Joint product 1 Joint product 2
Litres produced
Litres sold
Selling price per litre at split-off point
250
200
R7.50
750
680
R3.00
Required:
Allocate the joint costs to the joint products and determine the estimated gross
profit or loss using:
1. Physical measurement/physical standard method
2. The market value at split-off point method
3. The net realisable value method
Assume that the joint products are processed further before being sold and that
the selling price of each product at split-off point is not known. The further
processing costs of each product amounts to R2 and R3 for Joint products 1 and 2
respectively. These products can be sold after further processing for R10.50 and R7
respectively.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Solution
1.
Physical measurement / physical standard method
= Joint costs/litres produced
= R3 750/1 000 litres
= R3.75 per litre for both products
Estimated gross profit of each product:
Total
Sales (200 x R7.50 ) ( 680 x R3)
Less: Joint costs (R3.75 x 200; 680)
Estimated gross profit/loss
3 540
3 300
R240
Joint
product 1
1 500
750
R750
Joint
product 2
2 040
2 550
(R510)
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Not all products produced were sold. The estimated value of closing stock of
each joint product is as follows:
Joint product 1
Joint product 2
50 x R3.75
70 x R 3.75
=
=
R187.50
R262.50
Note the high-volume product, Joint product 2, has been allocated a greater
portion of the joint cost, resulting in the product showing a loss. Since both
products arise from a common production process, it is not possible to assess
only the profitability of one product as opposed to the other. The profitability
of the common production process would have to be assessed.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
2. Market value at split-off point method
Allocation of joint costs:
Product
Market
value (R)
Joint product 1
1 875*
Joint product 2
2 250*
4 125
Ratio
Joint cost Allocated Cost per
(R)
joint cost litre (R)
(R)
1 875/
x 3 750 1 704.55
6.82*
4 125
2 250/
x 3 750 2 045.45
2.73*
4 125
3 750.00
Market value
*250 x R 7.50 = R1 875
*750 x R 3 = R2 250
Cost per litre
*R1 704.55 ÷ 250 litres = R6.82
*R2 045.45 ÷ 750 litres = R2.73
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Estimated gross profit of each product:
Total
Sales (200 x R7.5 ) (680 x R3)
Less: Joint costs (R6.82 x 200)(R2.73 x 680)
Estimated gross profit
Joint product Joint product
1
2
3 540
1 500
2 040
3 220 40
1 364
1 856.40
R319 60
R136
R 183.60
Not all products produced were sold. The estimated value of closing stock of each
joint product is as follows:
Joint product 1
50 x R6.82
=
R341.00
Joint product 2
70 x R2.73
=
R191.10
Note this method results in a more equitable allocation of joint costs, with both joint
products now reflecting a profit.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
3.
Net realisable value method
Allocation of joint costs:
Production in litres
Total sales (250 x R10.50)(750 x R7)
Less: Further processing costs
(250 x R2)(750 x R3)
Estimated market value at split-off
point
Allocation of joint cost*
Cost per litre
Total
Joint product 1 Joint product 2
1 000
250
750
R7 875
R2 625
R5 250
R2 750
R500
R2 250
R5 125
R3 750
R2 125
R3 000
R 1 554.88
R 2 195.12
R1 554.88 ÷ 250 R2195.12 ÷ 750
= R6.22
=R2.93
*Joint cost:
Joint product 1: 2 125 ÷ 5 125 × 3 750
Joint product 2: 3 000 ÷ 5 125 × 750
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Estimated gross profit of each product:
Sales (200 x R10.50 ) ( 680 x R7)
Less: Cost of sales
Opening stock
Add: Cost of goods manufactured
Joint costs
Further processing costs
Less: Closing stock*
Estimated gross profit
Total
Joint
Joint product
(R)
product 1 (R)
2 (R)
6 860.00
2 100.00
4 760.00
5 674.14
1 643.90
4 030.24
0
0
0
6 500.00
2 054.88
4 445.12
3 750.00
1 554.88
2 195.12
2 750.00
500.00
2 250.00
825.86
410.98
414.88
1 185.86
456.10
729.76
*Closing stock
Joint product 1
Joint product 2
50 ÷ 250 x 2 054.88
70 ÷ 750 x 4 445.12
Note this method results in a more equitable allocation of joint costs, with both
joint products reflecting a profit.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Sell at split-off or process further
The decision to sell a joint product at split-off point or process it further, is
based on whether the incremental revenue from further processing exceeds
the incremental cost of further processing. Joint costs are irrelevant to this
decision, since they are past costs and therefore cannot be changed.
The decision of whether to further process is mainly subject to:
• An acceptable return on the additional capital required
• Consider the demand for the processed and unprocessed product
• The capacity to accommodate the further processing
• The availability of additional working capital
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Illustrative example 4.13
(sell at split-off point or process further)
Joint product 1 (R)
Joint product 2 (R)
Sales value at split-off point
1 875.00
2 250.00
Sales value after further
processing
Allocated joint costs
2 625.00
5 250.00
1 704.55
2 045.45
Cost of further processing
800.00
2 500.00
Required:
Determine whether Joint products 1 and 2 should be sold at split-off point or be
further processed. The net realisable method must be used to allocate joint
costs and all units produced were sold.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Solution
Sales value after further
processing
Sales value at split-off point
Incremental revenue from
further processing
Less: Cost of further processing
Increase/decrease in profit
from further processing
Joint product 1 (R) Joint product 2 (R)
2 625
5 250
1 875
750
2 250
3 000
800
(50)
2 500
500
Decision:
Joint product 1 must be sold at split-off point since further processing will result
in a decline in profits of R50. Joint product 2 can be processed further since
profits will increase by R500.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Illustrative example 4.14
Refer to illustrative example 4.12
The common production process has also resulted in the emergence of 50 litres
of a by-product. This by-product has to be processed further in order to bring it
into a saleable form. The further processing costs of the by-product is R5 per
litre and it can be sold at R10 per litre. The physical standard method is used to
allocate joint costs to joint products and joint products are sold at split-off
point.
Required:
Prepare a statement of comprehensive income indicating the different ways in
which the revenue from the by-product can be treated.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Solution
The revenue from the by-product is R 250 [(10 – 5) x 50)]
Statement of comprehensive income: treatment of the by-product revenue
Sales (200 x R 7.50) (680 x R3)
Reduction in
Reduction in
Additional
Other
joint costs
cost of sales
revenue
income
REGULAR
NO REGULAR
NO REGULAR
NO REGULAR
MARKET
MARKET
MARKET
MARKET
3 540
3 540
3 790
3 540
(3 540 + 250)
Less: Cost of sales
Opening stock
Add: Joint manufacturing costs
3 050
3 050
3 300
3 300
0
0
0
0
3 500
3 750
3 750
3 750
(450)
(450)
(450)
(3 750 – 250)
Less: Closing stock (50 x R3.75) (70 x R3.75)
(450)
Less: By-product income
(250)
Gross profit
Add: Other income (by-product revenue)
Net profit
490
490
440
240
0
0
0
250
490
490
490
490
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Note:
The joint costs are not allocated to the by-product, however, the by-product is
charged with the further processing cost of R5 per litre. The net profit obtained is
the same irrespective of which method was used to allocate the by-product
revenue.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Strategic implications of short-term decisions
The strategic plan of the organisation must integrate both the short-term goals
and long-term objectives of the organisation, i.e. the short-term goals must
coincide with the long-term objectives. All short-term and long-term decision
making must be aligned to the overall strategic plan of the organisation. It is
therefore imperative that the organisation should review the long-term effects
of every short-term decision taken.
As mentioned earlier in the chapter, despite the fundamental differences
between short-term and long-term decision making, both types of decisions are
concerned with maximising the returns of the organisation. If an organisation
focuses solely on short-term profitability, it may not make the necessary
expenditure required to maintain its competitive advantage in the future. On
the other hand, if an organisation focuses solely on investing in its growth in the
long term, it may face shortfalls in the short term.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Short-term decisions and ethics
The three guiding principles that can assist organisations to make better ethical
decisions are as follows:
1. In the decision-making process, the interests of all the stakeholders should
be taken into account. The fundamental principle is ‘assist and avoid harm
where possible’.
2. Ethical values and principles should always take precedence over unethical
ones. In the decision-making process the organisation should always choose
to follow ethical principles over unethical ones. The choice between ethical
and unethical principles is sometimes a difficult one, as this may result in
the organisation giving up profitable options in order to do no harm.
3. In the decision-making process, it is only appropriate to breach an ethical
principle if the violation of the ethical principle results in the long-term
benefit for all stakeholders.
Summary
By improving short-term profitability, long-term profitability is affected as well.
The short-term decisions covered in this chapter looked at special ‘once-off’
situations aimed at improving the organisation’s profitability by allowing it to
respond to changes in its environment. Both financial and non-financial
indicators need to be considered for the accuracy of the decision at hand.
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229