Relevant Cost and Decision Making – An example

Creative Designing plc a printing company is seeking to increase its business by winning work from new customers. It has received an order from a multinational national company for printing New Year Greeting Cards.

The technical team of Creative Designing has given a detailed report on the resource requirement for the order. The total cost has been calculated as $1,000 and its details are summarized below:

Production period –

It is expected that the total time required to print and dispatch the cards will be one week.

Material X –

10,000 sheets of special printing paper will be required. This is a paper that is in regular use by the company and it has 3,400 sheets in inventory. These originally cost $1·40 per sheet but the current market price is $1·50 per sheet. The resale price of the sheets held in inventory is $1·20 per sheet.

Material Y –

This is a special ink that Creative Designing will need to purchase at a cost of $8 per litre. 200 litres will be required for this order but the supplier has a minimum order size of 250 litres. Creative Designing does not foresee any other use for this ink, but will hold the surplus in inventory. Creative Designing’s inventory policy is to review slow moving items regularly. The cost of any inventory item that has not been used for more than 6 months is accounted for as an expense of the period in which that review occurs.

Direct labor –

Sufficient people are already employed to print the cards, but some of the printing will require overtime working due to the availability of a particular machine that is used on other work. The employees are normally paid $8 per hour, the order will require 150 hours of work and 50 of these hours will be in excess of the employees’ normal working week. A rate of $10 per hour is paid for these overtime hours. Employees are paid using an hourly rate with a guaranteed minimum wage for their normal working week.

Supervision –

An existing supervisor will take responsibility for the cards in addition to his existing duties. He is not currently fully employed and receives a salary of $500 per week.

Machinery –

Two different types of machine will be required:

Machine A will print the cards. This is expected to take 20 hours of machine time. The running cost of machine A is $5 per hour. There is currently 30 hours of unused time on machine A per week that is being sold to other printers for $12 per hour.

Machine B will be used to cut the cards. This machine is being used to full capacity in the normal working week and this is why there is a need to work overtime. The cards will require 25 machine hours and these have a running cost of $4 per hour.

Transportation

There will be a delivery cost of $400 to transport the cards to the customer.

Fixed overhead costs

The absorption rate that it uses is $20 per direct labor hour.

Profit mark-up

Creative Designing applies a 30% mark-up to its costs to determine its selling prices.

Creative Designing has appointed you as the management accountant of the company, in order to assist the management in preparing its quotation, prepare a schedule showing the relevant costs for the production of the catalogues. State clearly your reason for including or excluding each value that has been provided in the above scenario.

SOLUTION:

relevant costs

Particulars Total Cost Relevant Cost Remarks
Material X
(3400 sheets @ $1.50 per sheet) $5,100 $5,100 Replacement cost (since the material is in regular use)
(6600 sheets @ $1.50 per sheet) $9,900 $9,900 Replacement cost (fresh purchase from the market)
Material Y
(200 Lts @ $ 8 per ltr) $1,600 $1,600 Replacement cost (fresh purchases)
(50 Lts @ $ 8 per ltr) $400 $400 Purchases made for this order and have no other use have to borne by this order
Direct Labor
Normal Hrs (100Hrs @ $ 8 per hour) $800 $0 Labor is paid/week wages irrespective of this order
Overtime Hrs (50Hrs @ $ 10 per hour) $500 $500 Incurred specifically for this order
Supervisor’s Salary $500 $0 Supervisor is paid/week salary irrespective of this order
Machine A
Running cost (20Hrs @ $ 5 per hour) $100 $100 Incurred specifically for this order
Opportunity cost (20Hrs @ $ 7per hour)
($ 12 – $ 5)
$140 $140 Opportunity cost (contribution foregone by not selling the idle hours)
Machine B
Running cost (25 Hrs @ $ 4 per hour) $100 $100 Incurred specifically for this order
Transportation $400 $400 Incurred specifically for this order
Fixed overhead costs (150Hrs @ $ 20 per hour) $3,000 $0 Sunk costs hence not relevant
Total Cost $22,540 $18,240
Profit Markup $5,472 Profit mark-up depends on the competitors’ pricing and could go down to zero in aggresive competition
Selling Price $23,712

Therefore the quotation for catalogues should be $ 23,712.

Comments

  1. Few cents from Me:
    1. Why did u not accounted for the additional Material required ie., (10000-3400 in stock) that should also be accounted for Selling Price working
    2. As per the above example, Direct Labour is already engaged and working on products having contribution. So, for the normal hours they have to be shifted for this work, we need to account for the contribution lost also as part of relevant cost working

    3. Whats the conversion factor for cards to catalouge?

    Let me know, if I missed reading something here

    Anyways, nice work man,

    Thanks
    SRK

    • Hi SRK,

      Appreciate your meticulous reading.

      Here are my views against the points mentioned by you:

      1) You are absolutely right. One needs to include the cost of 6,600 sheets of Material X that need to be purchased from the market. It was an oversight error. We would correct the calculation in the post accordingly.

      2)In the example, there is no mention whether Labour is currently working at their full capacity or if there is some spare capacity. Also, no mention of any contribution lost by not taking up other orders.

      My assumption here is that the spare capacity would be used for the new order therefore I didn’t consider any opportunity cost.

      However…generally for such decisions, the point you mentioned is very relevant.

      3) There is no mention of size of the order (# of cards) here. Also, the total material required to execute the order is available. Therefore, Paper to Card conversion is not relevant.

      Let me know your thoughts. Once again thanks for all the inputs.

      Regards

  2. Hi AVK,

    Thanks for considering my views,

    Rg. Pt3, what I meant is that you have concluded that “Therefore the quotation for catalogues should be $ 23,712.” but no where in the question mentioned about the catalogue size or the order size. Only thing that was given is no. of cards that are needed for executing the order. Hence, concluding the cost of the catalouge is bit confusing. Can you reframe the wording.

    2. As per the question “Creative Designing plc a printing company is seeking to increase its business by winning work from new customers” we can understand that the company is desperately wanting to increase its business by winning contracts from new customers. Given this, how correct we are projecting profit into the pricing. Since, as per decision making principles, for new quotations or winning new businesses pricing will always be aggressive and mostly will be on Minimal or breakeven concepts. Profit Markup of 30% is not a relevant cost for decision making.

    3. Another point we need to confirm is ‘The total cost has been calculated as $1,000 and its details are summarized below”, what is the break of $1000 (that not mentioned in Question) and from our conclusion are we saying the cost is $23,172 against $1000? How are we concluding this, can you elaborate it and establish a comparison. Because, generally role of management accounting is how good are we in defending a decision

    4. Thanks for agreeing to the Labour cost, because the cost of normal labour hours are not relevant for the decision making.

    No doubt, its a good effort to establish the principle. But, when we are trying to project the role of a management accountant in decision making, we have to highlight few more things on why the price we projected is correct and how different the price initially assumed varies from the one we calculated

    Regards,
    SRK

    • Hi SRK,

      Here are my views:

      1) I agree with you. We would change the terminology..perhaps call it order instead of catalogue

      2) I don’t think it is a decision making prinicple to exclude profit element for new orders. However, I agree with your point that the pricing needs to be competitive when taking up new orders or when entering new markets.

      In other words profit need to be minimal (could go down to zero) depending on the existence of competition. However its not mandatory to maintain zero profits on all new orders.

      3) In the given case, there is no detail of how the technical team has arrived at $1,000 as cost.

      We are concluding that $23,712 should be the price for the order including a 30% markup (and not cost). This has been arrived at using the ‘relevant cost’ concept with specific details for each cost element mentioned in the remarks column of the table.

      In your opinion, general role of management accountant is “how good we are defending a decision..”.

      I would prefer to refrain from commenting on this statement.

      4) My pleasure. Exchanging views always gives us an opportunity to learn more. I’m absolutely fine doing that.

      Thanks for all your views / opinions. I really appreciate that.

      Best Regards

  3. Thanks,

    For patiently reviewing my comments and sharing your thoughts.

    For the Pt 2, Yes Sir agreed, No business is done for charity :-),
    But my point is as this question is about relevant cost for decision making and since the question did capture that Management is thinking of increasing new business, we can avoid the profit, which is profit buffered very huge ie., 30%, and these days of economy it is a windfall 😉

    Regards,
    SRK

    • Hi SRK,

      Agree with you. I think it makes sense adding a note in the calculation on this.

      Once again thanks for all your inputs.

      Best Regards

  4. Hi Kiran,
    awesome conversation at the end which made the elaboration fruitful . thanks you guys.

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