Lesson 2

Relevant cost and short term

decision making

1.
2.
3.
4.
5.
6.

In this chapter, we will be looking in details to

various possible short term decision making.
We will look into each of the followings:
Acceptance or rejection of a contract
Minimum price quotation
Limiting factor Single constraint & Multi
constraint
Make or buy decision
Shut-down decisions
Further processing decisions

Relevant cost and short term

decision making
Acceptance or rejection of contract:
In general terms, a contract will probably be accepted
if it increases contribution and profit, and rejected if it
reduces profit.
If the organization has spare capacity, a special one
off contract at a price below the normal price of the
product should be accepted if the price offered makes
some contribution to fixed costs and profit.
If the organization does not have sufficient spare
capacity, existing business should only be turned
away if the contribution from the contract is greater
than the contribution from the business which must be
sacrificed.

Relevant cost and short term

decision making
Example:
A company has been making a machine to order for a
customer, but the customer has since gone into
liquidation, and there is no prospect that any money will
be obtained from the winding up of the company. Costs
incurred to date in manufacturing the machine are
RM50,000 and progress payments of RM15,000 had
been received from the customer prior to the liquidation.
The sales department has found another company willing
to buy the machine for RM34,000 once it has been
completed.
To complete the work, the following costs would be
incurred:

Relevant cost and short term

decision making
1.

2.

3.

4.

Materials: these have been bought at a cost of RM6,000.

They have no other use, and if the materials is not finished,
they would be sold for scrap for RM2,000.
Further labour costs would be RM8,000. Labour is in short
supply, and if the machine is not finished, the work force
would be switched to another job, which would earn
RM30,000 in revenue, and incur direct costs of RM12,000
and absorbed (fixed) overhead of RM8,000.
Consultancy fees RM4,000. If the work is not completed, the
consultants contract would be cancelled at a cost of
RM1,500.
General overheads of RM8,000 would be added to the cost of
the additional work

Required: Should the customers offer be accepted?

Relevant cost and short term

decision making
Solution
Materials
Labour costs
Consultancy fees
General overheads

RM

Note
1
2
3
4

Total
Note
1)
The relevant cost for material is related the
opportunity costs which is the scrap income to be
forgone.
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Relevant cost and short term

decision making
Note:
2)
The relevant cost of labor is the total of further labour cost and
the opportunity cost of forgoing the contribution to be earned
from the other job.
3)
4)

Relevant cost and short term

decision making
Minimum price quotation
The minimum price for a once off job is its total relevant
costs: this is the price at which the company would make
no incremental loss from undertaking the work, but would
just achieve an incremental cost breakeven point
Example:

You have received a request from EXE to provide a

quotation for the manufacture of a specialized piece of
equipment. This would be a one-off order, in excess of
normal budgeted production. The following cost estimate
has already been prepared:
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Relevant cost and short term

decision making
Direct materials:
Steel
10m@ RM5 per m
Brass fittings
Direct labour
Skilled
25 hours @ RM8 per hour
Semi-skilled 10 hours @ RM5 per hour
Overhead 35 hours @ RM10 per hour
Estimating time

Note

RM

1
2

50
20

3
4
5
6

200
50
350
100
770
154
924
231
1155

Administration overhead @ 20% of production cost

7
Profit @ 25% of production cost
8
Selling price

Relevant cost and short term

decision making
Notes
1.
The steel is regularly used and has a current stock value
of RM5 per square meter. There are currently 100 square
meters in stock. The steel is readily available at a price of
RM5.50 per square meter.
2.
The brass fittings would have to be brought specifically
for this job: a supplier has quoted the price of RM20 for
the fittings required.
3.
The skilled labour is currently employed by your company
and paid at a rate of RM8 per hour. If this job were
undertaken it would be necessary either to work 25 hours
overtime which would be paid at time plus one half, OR in
order to carry out the work in normal time, reduce
production of another product that earns a contribution of
RM13 per hour.
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Relevant cost and short term

decision making
Notes
4.
The semi skilled labour currently has sufficient paid idle
time to be able to complete this work.
5.
The overhead absorption rate includes power costs
which are directly related to machine usage. If this job
were undertaken, it is estimated that the machine time
required would be ten hours. The machines incur power
costs of RM0.75 per hour. There are no other overhead
costs that can be specifically identified with this job.
6.
The cost of the estimating time is that attributed to the
four hours taken by the engineers to analyse the
drawings and determine the cost estimate given above.
7.
It is the company policy to add 20% to the production
cost as an allowance for administration costs associated
with the jobs accepted.
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Relevant cost and short term

decision making
Notes
8.
This is the standard profit added by your company
as part of its pricing policy.
Required:
Prepare on a relevant cost basis, the lowest cost
estimate that could be used as the basis for a
quotation.

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Relevant cost and short term

decision making
Solution
RM
Direct materials:
Steel
Brass fittings
Direct labour
Skilled
Semi-skilled
Overhead
Estimating time
Administration overhead @ 20% of production cost
Profit @ 25% of production cost
Selling price
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Relevant cost and short term

decision making
Limiting Factor Analysis
Limiting factor or key factor is Anything which
limits the activity of an entity. An entity seeks to
optimize the benefit it obtains from the limiting
factor.
It is assumed that in limiting factor analysis,
management would optimize its profit by
producing the product mix that gives the highest
possible profit and profit is maximized when
contribution is maximized. Hence, products that
give the highest possible contribution per unit of
limiting factor would be given production priority.
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Relevant cost and short term

decision making
Make or buy decision

An option is to be made whether to buy externally or

produced internally

If an organization has the freedom of choice to make

internally or purchase externally under the following
conditions:
1.
No scarce resources relevant costs will be the
differential cost between the two options
2.
Insufficient internal resources comparison between
the purchase price of the said product with the
variable cost of making plus the opportunity cost of
using the scarce resource is to be made.
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Relevant cost and short term

decision making
Example (no scarce resources):
Pixie Pharmaceuticals is a research-based
company which manufactures a wide variety of
drugs for use in hospitals. The purchasing
manager has recently been approached by a
new manufaturer based in a newly industrialised
country who have offered to produce three of the
drugs at their factory. The following unit cost
and unit price information has been provided.

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Relevant cost and short term

decision making
Drug
Production (units)
$
Direct material cost
Direct labour cost
Direct expense cost
Fixed cost
Selling price each
Imported price

Fairyoxide
20,000
$
0.80
1.60
0.40
0.80
4.00
2.75

Spriteolite
40,000
$
1.00
1.80
0.60
1.00
5.00
4.20

Goblinex
80,000
0.40
0.80
0.20
0.40
2.00
2.00

Required:
(a) Recommend to the management whether any drugs should be
purchased on the basis of cost only.
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Relevant cost and short term

decision making
Solution
Drug
Unit variable costs:
Direct material
Direct labour
Direct expenses
Total cost of making
Imported price
Saving/(Loss) from
Buying
Decision

Fairyoxide
0.80
1.60
0.40
2.80
2.75
0.05

Spriteolite
1.00
1.80
0.60
3.40
4.20
(0.80)

Goblinex
0.40
0.80
0.20
1.40
2.00
(0.60)

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Relevant cost and short term

decision making
Shut down decision/ Discontinuing a product
Shut down decision involves the following decisions:
Whether to shut down a factory, a department or a
product line either due to it making a loss or too
expensive to run
If the decision is to shut down, whether the closure is
permanent or temporary
If the decision is to shut down a product line, should a
new product line be set up to replace ceased product
line.

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Relevant cost and short term

decision making
Approach
Method 1: Comparing the contribution/profit before
and after the closure
Method 2: Considering the relevant cost (for eg the
contribution forgone from the ceased operation with
the savings obtained from closure)
Note: Students will most likely be required to use
the marginal costing approach to prepare the
contribution earned from a particular segment of
business to determine whether that segment of
business should cease operation or to continue.
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Relevant cost and short term

decision making
Example:
Ayeco with a head office in Ayetown, has three
manufacturing units. One in Beetown, the second in
Ceetown and the third in Deetown. The company
manufactures and sells an air-conditioner under the brandname of Ayecool at a price of RM200. It is unable to utilize
fully its manufacturing capacity. The management of the
company has to decide whether or not to renew the lease
of the property at Beetown, which expires next year. The
company has been offered an extension to the lease at an
additional cost of RM50,000 per annum. This situation
concerning the lease has been known for some time, so the
accountant has collected relevant information to aid the
decision. It is estimated that the cost of closing down
Beetown would be offset by the surplus obtained by the
sale of plant, machinery and inventories.
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Relevant cost and short term

decision making
Beetown Ceetown Deetown Total
RM'000 RM'000 RM'000 RM'000
Costs
Direct Materials
Direct Wages
Production overhead: Variable
Fixed
Subtotal
Selling overhead:Variable
Fixed
Administration overhead
Subtotal
Head office costs
Total
Profit
Sales

200
200
50
200
650
25
75
100
850
50
900
100
1,000

800
900
300
600
2,600
200
250
450
3,500
200
3,700
300
4,000

400
350
150
300
1,200
100
150
200
1,650
100
1,750
250
2,000

1,400
1,450
500
1,100
4,450
325
475
750
6,000
350
6,350
650
7,000

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Relevant cost and short term

decision making
If Ayeco does not renew the lease of the Beetown property it
has two alternatives:
a) Accept an offer from Zeeco, a competitor, to take over the
manufacture and sales in the Beetown area and pay to
Ayeco a commission of RM3 for each unit sold.
b) Transfer the output at present made in Beetown to either
Ceetown or Deetown. Each of these units has sufficient
plant capacity to undertake the Beetown output but
additional costs in supervision, salaries, storage and
maintenance would be incurred. These additional costs
are estimated as amounting yearly to RM250,000 at
Ceetown and to RM200,000 at Deetown.
If the Beetown sales are transferred to either Ceetown or
Deetown, it is estimated that additional transport costs
would be incurred in delivering to customers in the r
egion of Beetown, and that these would amount to RM15
per unit and RM20 per unit respectively.
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Relevant cost and short term

decision making
Required:
Present a statement to the board of directors of Ayeco
to show the estimated annual profit which would arise
from the following alternative course of action.
a) Continuing production at all three sites
b) Closing down production at Beetown and
accepting the offer from Zeeco
c) Transferring Beetown sales to Ceetown
d) Transferring Beetown sales to Deetown

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Relevant cost and short term

decision making
Solution
Quantity sold
Sales
Less:-Variable Cost
Direct Materials
Direct Wages
V. Production Overhead
V. Selling Overhead
Contribution
Less:- Directly Attributable Fixed
Cost
Fixed Production Overhead
Fixed Selling Overhead
Administration Overhead
Attributable Profit
Less:- Head Office Cost
Profit

Beetown
5000
1000

Ceetown
20000
4000

Deetown
Total
10000 35000
2000
7000

200
200
50
25

800
900
300
200

400
350
150
100

200
75
100

475
525

375
150
50
100

600
250
450

2200
1800

1300
500
200
300

300
150
200

1000
1000

1400
1450
500
325
3325

650
350
100
250

1100
475
750
1000
350
650

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Relevant cost and short term

decision making
Solution

26

Relevant cost and short term decision

making
Solution

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Relevant cost and short term

decision making
Further processing decision

Further processing decision involve the selection of

the joint products whether to sell it after further
processing it or immediately after split-off point.
In such a case, the joint cost incurred before the
split off point would not be considered as this cost
would have to be incurred regardless of whether
the product is sold at split off point or after further
processing.

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Relevant cost and short term

decision making
Example:
Rustam Ali Sdn Bhd produces two products from a single
process. During one period in which the process costs are
expected to be RM150,000, the following outputs are
expected:
Output
Unit selling
(litres)
Price (RM)
Product X
5,000
15.00
Product Y
15,000
10.00

Each product can be further processed using skilled labour,

costing RM10 per hour, to create superior products; Super X
and Super Y.
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Relevant cost and short term

decision making
Further modifications will result in the following increases in
labour hours and amended selling prices:
Skilled Labour Unit SP (RM)
Product Super X
75hrs per lit
25 per lit
Product Super Y
40hrs per lit
13 per lit
Required:
Advise Rustam Ali Sdn Bhd whether Product X and Product Y
should be further processed before it is being sold.

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Relevant cost and short term

decision making
Solution

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Relevant cost and short term

decision making
Qualitative factors
Before any decisions is made, the management would
need to consider other factors which may not be
quantifiable but represents an important aspects in
coming up with the conclusion. Below are some
examples which may affect a particular decision:

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Relevant cost and short term

decision making
Factors

Details

Availability of resources such as

cash, materials, labours etc

An opportunity might exists for a

company, but such an opportunity
can only be taken when there is no
constraints on taking up the
opportunity

Inflation

The effects on inflation on the

prices of various items may need to
be considered especially fixed price
contract that may require years to
complete should be taken into
account as the contracts profitability
may be affected if there is cost
overrun

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Relevant cost and short term

decision making
Employees

The company must consider the

effects of a particular decision on
the employees in terms of
motivation, morale, possible
resistance etc
Decisions involving undertaking a
once off job, product abandonment,
shutting down, make or buy will
inevitably affects the customers

Customers

loyalty.

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Relevant cost and short term

decision making
Competitors

Suppliers

Every decision made by a company

will indirectly result in competitors
reacting to safeguard its own
profitability and survival. For
example, before a company decides
to reduce its products selling price,
the management will need to
consider its effectiveness as there
may be a possibility that a price war
may arise.
Certain decisions may affect the
suppliers such as the possible shut
down of a particular product line or
may result in the loss of goodwill of
the company due to the negative
perception it has on the company
reducing its scale of operations.
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