FOCUS
This session covers the following content from the ACCA Study Guide.
B. Decision-Making Techniques
1. Relevant cost analysis
a) Explain the concept of relevant costing.
b) Identify and calculate relevant costs for a specific decision situation from
given data.
c) Explain and apply the concept of opportunity costs.
5. Make-or-buy and other short-term decisions
a) Explain the issues surrounding make v buy and outsourcing decisions.
b) Calculate and compare "make" costs with "buy-in" costs.
c) Compare in-house costs and outsource costs of completing tasks and
consider other issues surrounding this decision.
d) Apply relevant costing principles in situations involving shut down, one-off
contracts and the further processing of joint products.
Session 3 Guidance
Note that this is an important session; read all the material in this session. Relevant costing and
decision-making are highly examinable.
Work through all the Illustrations.
Appreciate that for decision-making, only relevant costs and revenues should be considered. A cost
or revenue is relevant if it is affected by the decision.
RELEVANT COSTS
Meaning
Non-relevant costs
OPPORTUNITY COST
Importance
Definition
Session 3 Guidance
Be able to identify the relevant costs relating to one-off contracts (s.3 and Examples 14).
Know how to deal with shut down decisions (s.4) and further processing decisions (s.5).
1 Relevant Costs
1.1 Meaning
Relevant costs are those costs that are appropriate to aiding the
making of specific management decisions.
The banqueting department of the Grey Gables Hotel organises special events. Next month a
wedding reception will be held in the hotel. An assistant accountant has prepared a schedule
detailing the cost of the wedding as follows:
Note $ Solution
Yes/No
Food and drinks 1,500
Waiters' wages 1 200
Supervisor's salary 2 100
Flowers 500
Administration 3 300
Cleaning of function room 4 200
Room rental 5 200
Central management costs 6 300
Total costs 3,300
Notes
1. The waiters are not regular employees and work only when required for functions. They are
paid $20 per day and 10 waiters would be required for the wedding.
2. The supervisor is a full-time employee of the hotel and is paid a fixed salary. The charge
here is a portion of his basic salary for the time he will spend supervising the event.
3. Administration costs relate to the time spent by the banqueting department organising the
event. All staff members in this department are full-time employees and are paid a fixed
salary.
4. An external cleaning company is used to clean the function rooms before and after an event.
It charges $200 per event.
5. The wedding reception will be held in one of Grey Gable's banqueting rooms. A notional
rental charge for the room has been added. The hotel building is actually rented from a
property company for a fixed annual rental.
6. When costing an event, the accounting department adds 10% to the cost of each event to
cover central hotel management costs.
Required:
Indicate whether or not each of the costs in the accountant's schedule is
incremental.
2 Opportunity Cost
2.1 Importance
Key Point
All opportunity costs are "relevant".
However, only some relevant costs are opportunity costs.*
2.2 Definition
3 One-Off Contracts
One decision-making scenario is to decide how much to tender
for a one-off contract. To make the decision, it is necessary to
consider all the relevant costs of the contract to ensure that the
revenue from the contract covers them.*
*All of the points
3.1 Minimum Price discussed in sections
1 and 2 are relevant
The minimum price that may be quoted on a contract is equal to for decisions related
the relevant cost. At this price no profit or loss would be made to one-off contracts.
on the contract. There are several reasons why a business might Section 3 also provides
wish to know the minimum price of a contract: guidance in relation to
materials, labour and
It is useful for price negotiations to know the lowest price that non-current assets
can be charged for a contract; if a price is agreed to that is which may be required
below the relevant cost the business would make a real loss. for such contracts.
A business may be prepared to undertake a contract at
relevant cost in the hope that this may bring additional
business in the future.
If a business has under-utilised resources during low season,
it may be willing to take on additional contracts at this time
(provided that no loss is made) as this may build up goodwill
with potential customers.
3.2 Materials
Where materials are required for a one-off contract, the following
guidance, as summarised in Figure 1, can be used to determine
the relevant cost: Historical costs or
If the materials required have not already been acquired then book values are never
relevant costs of
clearly it will be necessary to buy them for the contract. The
materials.
current market price is the relevant cost.
If the materials have already been acquired it is necessary to
consider whether they are used regularly in the business:
If used regularly, any materials consumed by the one-off
contract will need to be replaced, so the replacement
cost (which is also current market price) would be the
relevant cost.
If not used regularly (e.g. they were acquired some time
ago and there is no current use for them), the relevant cost
is their opportunity cost. This is often their scrap value
(i.e. disposal proceeds if the materials can be sold if not
used in the contract). Read exam questions
carefully as they may
contain unessential or
irrelevant information,
such as "the auditors
have demanded that
the value of materials
be written down to
their net realisable
value", which is
unnecessary for
successfully answering
the question.
In warehouse?
NO YES
YES
Use replacement cost Used regularly in
the business?
NO
Opportunity cost
(e.g. scrap value)
Bob is a carpenter who makes kitchen furniture. Recently, a customer has asked him to make a
special dining room table. This will require the following materials:
1. 10m2 of oak wood. Bob already has 20m2 of oak in his storeroom that he bought last month
for $2.50 per m2. The current price of oak is now $2.75 per m2. Bob frequently uses oak in
his work.
2. Two tins of a particular varnish. Bob does not use this type of varnish regularly, so would
have to buy it in. Each tin costs $20.
3. Four hinges, so that the ends of the table can be folded. Bob has four hinges in his
storeroom that he acquired some years ago but never used. Bob remembers that the hinges
cost $3.00 each. The price of such hinges in a shop today would be $3.50 each. Bob said,
"I'm pleased that I can finally use these. They've been in the storeroom for years and if I
don't use them on this table, they will stay in the storeroom for many more years. Nobody
would want to buy second hand hinges, would they?"
Required:
Explain what the relevant cost is for each of the three items above.
Solution
1.
2.
3.
3.3 Labour
One-off contracts usually require some labour. The relevant cost
of labour can be determined from the following situations:
If the organisation has spare (idle) labour time which can be
used on the contract, then the relevant cost is zero. This
might arise, for example, where workers are being paid a fixed
weekly wage and are currently underemployed.
If additional labour time is required and can be obtained
without taking workers away from other activities, then the
direct cost of the labour is relevant. This may be paid at a
higher rate if overtime is involved.
If there is a limit on the amount of labour available a contract
may require workers to be taken away from other profitable
activities. In this case, the relevant cost of labour is the direct
cost plus the lost contribution from the other activities.
(Learn this as a rule but see Example 2 in Session 6 for
further explanation.)
Omega Consulting specialises in helping clients implement new accounting software packages.
The company has just received a request from a new client to implement a new accounting
system, urgently, next week. You have been requested to calculate the relevant cost of the
labour that would be required on the project.
1. A project manager would be needed. One project manager, Bill Bates, is available next week.
Bill earns a fixed salary equivalent to $1,500 a week.
2. A business consultant would be required to work 30 hours on the contract. All consultants
are busy next week. One consultant, Colin Carrington, is scheduled to deliver a training
course to a client. This course will generate contribution of $10,000. If the course is
cancelled Colin could work on the new client. Alternatively, the training course could be
postponed to the following week, when Colin is available. The client would be charged
$5,000 less if the course were delayed a week. Colin is on a fixed weekly salary of $1,000.
3. A technical consultant would be required for 10 hours to install the software and convert the
data from the old system. All technical consultants are busy next week, but David Dawson,
an experienced technical consultant, said he would be prepared to work overtime. He will
work on the new project on Monday and Tuesday, and catch up with the 10 hours missed
on his existing project the following weekend. David is paid a standard hourly rate of $50
and double time (i.e. $100 an hour) for weekend work. Alternatively, a freelance technical
consultant is available. Freelance consultants charge $75 an hour.
4. An analyst would be required for 10 hours to document the new client's system. All analysts
are busy next week, but a small project on which Edward Eaves was due to work can be
cancelled, which would enable Edward to work on the documentation for the new client. If
the other contract is cancelled, contribution of $1,000 would be lost. Edward is paid an
hourly rate of $50.
Required:
Explain what the relevant cost is for each of the four items above.
Solution
1.
2.
3.
4.
Illustration 2 Fall in
Realisable Value
Bob, a builder, owns a crane. He believes that he could sell it today
for $150,000 in the used-crane market.
He is tendering for a contract to renovate the town hall, which is
expected to take a year to complete. If he wins this contract he will
need to keep the crane. Once the town hall contract is complete he
would sell the crane. He estimates that he would be able to sell it
for $120,000 in one year's time.
If he does not win the town hall contract, he will sell the crane
straight away for $150,000.
For the town hall contract, the relevant cost of the crane is $30,000.
This is the fall in the realisable value of the crane if it is used on this
contract.
The lower of
Stella is about to tender for a contract which requires the use of two raw materials, steel and
tungsten. Five hundred tons of steel and 1,000 tons of tungsten will be required to complete
the contract. In addition, 2,000 hours of labour will be needed. Of this, 1,200 hours are in
the assembly process and the remainder in the finishing process. Stella will quote a price that
allows a 50% mark-up on relevant cost.
The following additional information is available for the resources required:
Steel cannot be used by Stella for any other purpose, but tungsten is used in all the
company's manufacturing processes.
All labour is paid at $4 per hour, but to complete the contract in time, labour for the finishing
process will have to be transferred from other work which generates contribution at a rate of $3
per hour (after labour costs). There is currently surplus capacity for assembly labour amounting
to 1,000 hours for the duration of the contract. Owing to other urgent work, any additional
assembly labour will have to be hired on a temporary basis at the rate of $5 per hour.
Required:
Determine the price Stella will quote on the contract.
Solution
Working $
Steel:
Held
Purchased
Tungsten:
Finishing labour:
Cost
Lost contribution
Assembly labour:
Relevant cost
Mark-up
Quote
Rolling Inc is composed of four divisions; North, South, East and West. The directors are
concerned about the performance of East and West divisions, which have consistently shown
losses for the last three years.
The divisional income statements for the last year show the following:
North South East West
$ $ $ $
Sales 5,000 10,000 7,500 6,000
Variable costs 2,500 4,000 4,000 3,000
Contribution 2,500 6,000 3,500 3,000
Fixed costs 1,500 3,500 4,000 3,200
Profits/(losses) 1,000 2,500 (500) (200)
Further analysis of the fixed costs reveals the following. It can be assumed that directly
attributable fixed costs would be saved if the division were closed down. Allocated overheads
would not:
$ $ $ $
Directly attributable 500 1,500 2,500 2,000
Allocated (20% of revenue) 1,000 2,000 1,500 1,200
Total fixed costs 1,500 3,500 4,000 3,200
Required:
Calculate the financial impact on Rolling Inc of closing divisions East and West. Based
on your calculations, advise the management whether the divisions should be closed.
Solution
East West
$ $
Lost contribution
Conclusion:
6 Make or Buy
6.1 Outsourcing
Outsourcing is the practice of buying goods or services externally,
rather than making or providing them internally. In recent years
there has been a trend towards outsourcing of non-core services
in particular. Examples of services which are often outsourced
include:
office cleaning
canteen and catering services
payroll services
IT services
security services
Outsourcing is not limited to the provision of services; certain
parts of manufacturing also may be outsourced. It is quite
common for manufacturing companies to outsource some, or
the entire, component used in their products. This trend has
been strengthened by the reduced costs of international trade;
many components may be made in lower-cost economies and
the assembly of the final products may take place closer to the
markets in which the products are sold. The decision companies
may have to make, therefore, is whether to make components or
to buy them in.
Big Phones makes smart phones. The company sells 1 million phones
each year. Each phone includes a standard rechargeable battery.
Currently, the batteries are manufactured in-house, but the company has
recently received an offer from Super Batteries to supply all the batteries
required for a price of $2 each.
The management accountant has prepared a schedule showing the total
costs of producing 1 million batteries last year as follows:
$000
Materials 1,400
Direct labour 320
Machine running costs 240
Depreciation 250
Other overheads 400
Total 2,610
Depreciation
Other overheads
Total 2,610
Advice:
Session 3 Quiz
Estimated time: 15 minutes
3. Summarise the principles relating to calculating the relevant cost of materials. (3.2)
Q8 Ennerdale 20 minutes
EXAMPLE SOLUTIONS
Solution 1Incremental Costs
Relevant? Explanation
Food and drinks Yes These costs are incurred specifically for the
wedding party. If there were no wedding
party, these costs would not be incurred.
Waiters' wages Yes Waiters are only paid when they work, so are
being paid specially for the wedding.
Supervisor's salary No The supervisor is on a fixed salary, which does
not change as a result of the wedding party.
Flowers Yes They are being purchased specifically for the
wedding.
Administration No This cost relates to the salaries of the staff in
the banqueting department. These are fixed
and not increased by the wedding.
Cleaning of Yes The cleaning company is paid a fee per event.
function room If the wedding did not take place, there would
be no fee.
Room rental No The rent of the hotel building is fixed
regardless of whether the rooms are occupied
or vacant.
Central No 10% has just been added to the cost of the
management costs wedding to cover central overhead costs.
These would probably have been incurred
regardless of the wedding.*
Conclusion
Closing each division would lead to a reduction in profits of $1,000 per
year. They should not be closed. The two departments make a positive
contribution to the company's overall profits and only show a loss
because of allocation of central fixed costs.
$000
Materials 1,400
Direct labour 320
Machine running costs 240
Depreciation (only attributable to batteries) 175*
Other overheads (excludes general 100*
overheads apportioned)
Total 2,235