MANAGEMENT SERVICES

MR. JOHN REY B. RODRIGUEZ, CPA

MODULE 1: RELEVANT INFORMATION FOR DECISION MAKING

The Concept of Relevance

Association with Decision: Information must be associated with the decision or question under consideration in
order for the information to be relevant.
Relevant costing is an approach that focuses managerial attention on a decisions relevant (or pertinent)

facts.

A differential cost is a cost that differs between or among the various decision alternatives. A cost must be
differential to be relevant.

Incremental cost is the additional cost of producing or selling a contemplated quantity of output.
Incremental costs can be either variable or fixed. Most variable costs are relevant while most fixed costs are not
relevant.
Incremental revenue is the additional revenue resulting from a contemplated sale or provision of a service.

The difference between the incremental revenue and incremental costs of a particular alternative is the
positive or negative incremental benefit of that course of action.

Management can compare the incremental benefits of various alternatives to decide on the most profitable
or least costly alternative or set of alternatives.

Some relevant factors, such as prime product costs, are easily identified and quantified, and are integral
parts of the accounting system.

Other factors, such as opportunity costs, may be relevant and quantifiable, but are not part of the
accounting system.
An opportunity cost represents the potential benefit foregone because one course of action is chosen over

another.

Importance to Decision Maker: The need for specific information depends on how important the information is
relative to management objectives.
Bearing on the future.

a.

Information can be based on past or present data, but it can only be relevant if it pertains to a future
decision.

b.

The future may be the short run or the long run; future costs are the only costs that can be avoided; and
the longer into the future a decisions time horizon is, the more costs are controllable, avoidable, and relevant.

c.

Only information that has a bearing on future events is relevant in decision making.
Sunk Costs

A sunk cost is a cost incurred in the past that is not relevant to any future courses of action.

Such a cost is the historical or past cost associated with the acquisition of an asset or a resource.

Sunk costs are not relevant to future decisions.

Relevant Costs for Specific Decisions

Managers routinely make decisions on alternative courses of action that have been identified as feasible
solutions to problems or feasible methods to use in the attainment of objectives.

All incremental revenues, costs, and benefits of all courses of action are measured against a baseline
alternative in determining which course of action is best.

Managers, when evaluating alternative courses of action, should select the alternative that provides the
highest incremental benefit to the company.

The change nothing alternative has a zero incremental benefit since it represents current conditions from
which all other alternatives are measured, and it should be chosen only when it is perceived to be the best available
alternative solution.

The chosen course of action should be one that will make the business better off in the future.

Outsourcing Decisions

Outsourcing refers to having work performed for one company by an off-site nonaffiliated supplier; it allows a
company to buy a product (or service) from an outside supplier rather than making the product or performing the
service in-house.

A make-or-buy (or outsourcing) decision is a decision that compares the cost of internally manufacturing
a component of a final product (or providing a service function) with the cost of purchasing it from outside
suppliers or from another division of the company at a specified internal transfer price.

Although most outsourcing decisions are of a make-or-buy nature, this concept is sometimes easy to
overlook when dealing with the outsourcing of services. For example, deciding to outsource the accounting
function to a service company is essentially a make-or-buy decision; does the company want to manufacture its
own accounting services, or does it want to buy such services from an outside vendor?

Variable production costs are relevant, and fixed production costs may be relevant if they can be avoided
when production is discontinued.

Offshoring sends jobs formerly performed in the home country to foreign countries.
Managers in manufacturing environments are constantly concerned about whether the right quality
components will be available at the right time and at a reasonable price to assure production. Companies often
assure the availability of a component by manufacturing it themselves.
Scarce resources decisions

A scarce resource is a resource that is essential to a production or service activity but is available only in some
limited quantity.

Scarce resources create constraints on producing goods or providing services and can include machine hours,
skilled labor hours, raw materials, and production capacity.

Management may desire and be able to obtain a greater abundance of a scarce resource in the long run, but
management must make the best current use of the scarce resources it has in the short run.

The determination of the best use of a scarce resource requires that specific company objectives be recognized
by management. If an objective is to maximize company profits, a scarce resource is best used to produce and sell
the product having the highest contribution margin per unit of the scarce resource.

Company management must consider qualitative aspects of the problem in addition to the quantitative ones.
Sales mix decisions

Sales mix is the relative combination of quantities of sales of the various products that make up the total sales
of a company.

Some important factors that affect the appropriate sales mix of a company are product selling prices, sales force
compensation, and advertising expenditures; a change in one or all of these factors may cause a companys sales
mix to shift.

Sales Price Changes and Relative Profitability of Products.

Managers must constantly monitor the relative selling prices of company products, both in respect to each
other as well as to competitors prices.
Profit maximization is the objective.
Product contribution margin is selling price minus total variable production costs; it does not consider
variable selling costs; it can motivate a companys sales force when used as a basis for determining sales
commission compensation.
Sales Compensation Changes.
Compensate sales based on products with highest contribution margin, not highest sales price.
Advertising Budget Changes.
A factor that may cause shifts in sales mix involves either adjusting the proportion of the advertising
budgets respective to each product the company sells or increasing the total companys advertising budget.
Special order decisions

A special order decision is a situation that requires management to compute a reasonable sales price for
production or service jobs outside the companys normal realm of operations.

The sales price quoted on a special order job typically should be high enough to cover the jobs variable and
incremental fixed costs and to generate a profit.

Overhead costs tend to grow in response to increases in product variety and complexity; such increases
normally occur in receiving, inspection, order processing, and inventory carrying costs.

Activity-based costing techniques allow managers to more precisely determine these incremental costs and
properly include them in analyzing special orders.

Companies sometimes price a special order job with a low-ball bid that produces no profit by barely covering
costs or that is below cost. Such low-balling is used to penetrate a certain market segment with the companys
products or services.

Private label orders, in which the buyers name appears on the products label, are used during slack periods in
order to use available capacity more effectively. Selling prices on private label special orders are usually set high
enough to cover actual variable costs and partially cover ongoing fixed costs.

Special prices may be justified when orders are unusual, because the products are being tailor-made to
customer specifications, or when goods are produced for a one-time job.
Product Line and Segment Decisions

Operating results of multiproduct environments are frequently presented in a disaggregated format that depicts
results for separate product lines within the organization or division.

Managers, in reviewing such statements, must distinguish relevant from irrelevant information regarding
individual product lines.

The segment margin represents the excess of revenues over direct variable expenses and avoidable fixed
expenses; the amount remaining is available to cover unavoidable direct fixed expenses and common expenses, and
to provide profits.

The segment margin figure is the appropriate one on which to base continuation or elimination decisions since
it measures the segments contribution to the coverage of indirect and unavoidable expenses.
EXERCISES
Agri-Magic Corporation
Agri-Magic Corporation grows corn in rural areas of the South. Agri-Magic's costs per bushel of corn (based on an
average yield of 130 bushels per acre) follow:
Direct material
Direct labor
Variable overhead
Fixed overhead
Variable selling costs
Fixed selling costs

P1.10
0.40
0.30
0.60
0.10
0

Agri-Magic defines direct material costs as seed, fertilizer, water, and other chemicals. The variable overhead costs
represent maintenance and repair costs of machinery. The fixed overhead costs are completely comprised of
depreciation expense on machinery and real estate taxes.
1.
Refer to Agri-Magic Corporation. Assume that the current date is March 15. On this date, AgriMagic must make a decision as to whether it is financially better off to plant a certain farm with corn or leave the
land idle (no income is derived from idle land). Corn prices have been severely depressed in recent years and AgriMagics best guess is that corn prices will be around P2.00 per bushel at the time the crop is ready for harvest.
Should the company plant corn or leave the land idle? Explain.
2.
Refer to Agri-Magic Corporation. Assume for this question only that the company decided to plant
the corn. A local oil refiner has approached the company about converting the crop to grain alcohol (used to make
gasohol) rather than selling the grain to the local grain elevator. If Agri-Magic converts the grain to alcohol, it will
incur additional costs of P0.60 per bushel, and the company will be able to sell the crop to the oil refiner for the
equivalent of P2.50 per bushel. Otherwise, the company can sell the corn crop to the local grain elevator for P1.85
per bushel. If Agri-Magic elects to sell the grain to the refinery, the company will not incur the variable selling
costs. What should the company do? Support your answer with calculations.

3.
Refer to Agri-Magic Corporation. Assume that the current date is March 15. On this date, AgriMagic Corporation must make a decision as to whether it is financially better off to plant a certain farm to corn,
leave the land idle (no income is derived from idle land), or rent the land to another farmer for P50 per acre. Corn
prices have been severely depressed in recent years and Agri-Magic Corporation's best guess is that corn prices will
be around P2.00 per bushel at the time the crop is ready for harvest. What should the company do? Show
calculations.
4.
New Iberia Corporation makes and sells the "Tabasco Maiden, a wall hanging depicting a magical
pepper plant. The Tabasco Maidens are sold at specialty shops for P50 each. The capacity of the plant is 15,000
Maidens per year. Costs to manufacture and sell each wall hanging are as follows:
Direct material
Direct labor
Variable overhead
Fixed overhead
Variable selling expenses

P 5.00
6.00
8.00
10.00
2.50

New Iberia Corporation has been approached by an Texas company about purchasing 2,500 Tabasco Maidens. The
company is currently making and selling 15,000 per year. The Texas company wants to attach its own Lone Star
label, which increases costs by P.50 each. No selling expenses would be incurred on this order. The corporation
believes that it must make an additional P1 on each Tabasco Maiden to accept this offer.
a.
b.

What is the opportunity cost per unit of selling to the Texas company?
What is the minimum selling price that should be set?

5.
Mighty Mikes Accounting Service provides two types of services: audit and tax. All company
personnel can perform either service. In efforts to market its services, Mighty Mike relies on radio and billboards
for advertising. Information on Mighty Mike's projected operations for the coming year follows:
Revenue per billable hour
Variable cost of professional labor
Material cost per billable hour
Allocated fixed costs per year
Projected billable hours
a.
b.

Audit

Taxes

P35
25
2
100,000
14,000

P30
20
3
200,000
10,000

What is Mighty Mikes projected profit or (loss)?

If P1 spent on advertising could increase either audit services billable time by 1 hour
or tax services billable time by 1 hour, on which service should the advertising dollar
be spent?

6.
The management of Whalen Industries has been evaluating whether the company should continue
manufacturing a component or buy it from an outside supplier. A P100 cost per component was determined as
follows:
Direct material
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead

P 15
40
10
35
P100

Whalen Industries uses 4,000 components per year. After Wilfert Corporation submitted a bid of P80 per
component, some members of management felt they could reduce costs by buying from outside and discontinuing
production of the component. If the component is obtained from Wilfert Corporation, Whalen Industries' unused
production facilities could be leased to another company for P50,000 per year.
Required:
a. Determine the maximum amount per unit Whalen Industries could pay an outside
supplier.
b.

Indicate if the company should make or buy the component and the total dollar
difference in favor of that alternative.

c.

Assume the company could eliminate one production supervisor with a salary of
P30,000 if the component is purchased from an outside supplier. Indicate if the

company should make or buy the component and the total dollar difference in favor
of that alternative.
7.
Baxter Corporation is working at full production capacity producing 10,000 units of a unique
product, JKL. Manufacturing costs per unit for JKL follow:
Direct material
Direct manufacturing labor
Manufacturing overhead

P2
3
5
P10

The unit manufacturing overhead cost is based on a variable cost per unit of P2 and fixed costs of P30,000 (at full
capacity of 10,000 units). The non-manufacturing costs, all variable, are P4 per unit, and the selling price is P20 per
unit. A customer, Jacksonville Company, has asked Baxter to produce 2,000 units of a modification of JKL to be
called RST. RST would require the same manufacturing processes as JKL. Jacksonville Company has offered to
share equally the non-manufacturing costs with Baxter. RST will sell at P15 per unit.
Required:
a. What is the opportunity cost to Baxter of producing the 2,000 units of RST (assume
that no overtime is worked)?
b.

The Graves Company has offered to produce 2,000 units of JKL for Brown, so
Brown can accept the Jacksonville offer. Graves Company would charge Baxter P14
per unit for the JKL. Should Baxter accept the Graves Company offer?

c.

Suppose Baxter had been working at less than full capacity producing 8,000 units of
JKL at the time the RST offer was made. What is the minimum price Baxter should
accept for RST under these conditions (ignoring the P15 price mentioned
previously)?

8.
The Samuels Company normally produces 150,000 units of Product LM per year. Due to an
economic downturn, the company has some idle capacity. Product LM sells for P15 per unit.
The firm's production, marketing, and administration costs at its normal capacity are:
Per Unit
Direct material
Direct labor
Variable overhead
Fixed overhead
(P450,000/150,000 units)
Variable marketing costs
Fixed marketing and administrative costs
(P210,000/150,000 units)
Total

P1.00
2.00
1.50
3.00
1.05
1.40
P9.95

Required:
a. Compute the firm's operating income before income taxes if the firm produced and
sold 110,000 units.
b.

For the current year, the firm expects to sell the same number of units as it sold in the
prior year. However, in a trade newspaper, the firm noticed an invitation to bid on
selling LM to a state government. There are no marketing costs associated with the
order if Davis is awarded the contract. The company wishes to prepare a bid for
40,000 units at its full manufacturing cost plus P 0.25 per unit. How much should it
bid? If Davis is successful at getting the contract, what would be its effect on
operating income?

c.

Assume that the company is awarded the contract on January 2, and in addition it
also receives an order from a foreign vendor for 40,000 units at the regular price of
P15 per unit. The foreign shipment will require the firm to incur its normal
marketing costs. The government contract contains a 10-day escape clause (i.e., the
firm can reject the contract within 10 days without any penalty). If the firm accepts
the government contract, overtime pay at 1 1/2 times the straight time rate will be
paid on the 40,000 units. In addition, fixed overhead will increase by P60,000 and

variable overhead will behave in its normal pattern. The company has the capacity to
produce both orders. Decide the following:
1.

Should the firm accept the foreign offer? Show the effect on operating income of
accepting the order.

2.

Assuming the foreign order is accepted, should the firm accept the government order?
Show the effect on operating income of accepting the government order.