ACC 115| Management Science
Module #11 Student Activity Sheet
Name: _________________________________________________________ Class number: _______
Section: ____________ Schedule: ________________________________ Date: ________________
Lesson title: Introduction to Relevant Costing and Materials:
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Differential Analysis Pen and non-scientific calculator
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Learning Targets: Strategic Cost Management by Cabrera
At the end of this module, you should be able to:
1. Summarize the decision making process. References:
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2. Identify relevant costs. Managerial Accounting by Hilton
3. Strategic Cost Management by Hansen
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and Mowen
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A. LESSON PREVIEW/REVIEW
Introduction
Decision making is a fundamental part of management. Decisions about the acquisition of
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equipment, methods of production, and pricing of products and services confront managers in all
types of organizations. This part of the subject covers the role of managerial accounting information
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in a variety of common decisions.
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B. MAIN LESSON
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Content Notes and Skill Building
Lesson Objective 1
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The Decision-Making Process
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1. Clarify the decision problem – Before a decision can be made, the problem needs to be clarified
and defined in more specific terms. Considerable managerial skill is required to define a decision
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problem in terms that can be addressed effectively.
2. Specify the criterion – Once a decision problem has been clarified, the manager should specify the
criterion upon which a decision should be made.
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3. Identify the alternatives – A decision involves selecting between two or more alternatives.
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Determining the possible alternatives is a critical step in the decision process.
4. Develop a decision model – A decision model is a simplified representation of the alternatives.
Unnecessary details are stripped away, and the most important elements of the problem are
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highlighted.
5. Collect the data – Selecting data pertinent to decisions is one of the managerial accountant’s most
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important roles in an organization.
6. Select an alternative – Once the decision model is formulated and the pertinent data are collected,
the manager makes a decision.
7. Evaluate decision effectiveness – After a decision has been implemented, the results of the
decisions are evaluated with the objective of improving future decisions.
Note: Decision problems involving accounting data typically are specified in quantitative terms. However,
qualitative characteristics of the alternatives can be just as important as the quantitative measures. Qualitative
characteristics are the factors in a decision problem that cannot be expressed effectively in numerical terms.
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ACC 115| Management Science
Module #11 Student Activity Sheet
Name: _________________________________________________________ Class number: _______
Section: ____________ Schedule: ________________________________ Date: ________________
Lesson Objective 2
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Characteristics of Information to Determine its Usefulness
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1. Relevance – Information is relevant if it is pertinent to a decision problem.
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2. Accuracy – Information that is pertinent to a decision problem must also be precise or it will be of
little use. Conversely, highly accurate but irrelevant data are of no value to a decision maker.
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3. Timeliness – Relevant and accurate data are of value only if they are timely, that is, available in time
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for a decision/ Some situations, involve a trade-off between the accuracy and the timeliness of
information. More accurate information may take longer to produce. Therefore, as accuracy improves,
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timeliness suffers, and vice versa.
Relevant Information
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Relevant information has the following criteria:
a. Affects the future – the consequences of decisions are borne in the future, not the past. To be
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relevant to a decision, cost or benefit information must involve a future event.
b. Differs among alternatives – costs or benefits that are the same across all the available alternative
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have no bearing on the decision.
Note: Benefits or costs must meet the two criteria in order to be classified as relevant. If only one of the criteria is
met, then the benefit or cost is considered irrelevant.
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Example:
1. Variable costs (such as direct materials, direct labor, and variable manufacturing overhead)
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a. When units are produced, direct materials, direct labor, and variable manufacturing overhead
will be incurred. When no units are produced, no direct materials, direct labor, and variable
manufacturing overhead will be incurred. That means that variable costs are generally considered as
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relevant costs because they affect the future and they differ among alternatives.
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b. Variable costs incurred in producing a product already sold are already considered irrelevant
costs. The reason is because the cost is already incurred in the past. It is already considered as sunk
cost.
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2. Fixed costs
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a. An example of a fixed cost is rent on a factory building. Whether the company produces a
product or not, it is still obliged to pay the rent on its factory building. Thus, fixed cost does not differ
among alternatives even though it affects the future. For that reason, fixed cost is generally
considered as irrelevant cost.
b. Imagine if the factory building will be closed. With its closure, the company will abandon the
building and will not be obliged to pay the rent on the building. In this case, the rent on the factory
building is considered as avoidable fixed cost. If fixed cost is avoidable, then, it will differ among
alternatives (pay the rent if not closed and not pay the rent if closed). If it differs among alternatives and
affects the future, then avoidable fixed cost is relevant to decision making.
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ACC 115| Management Science
Module #11 Student Activity Sheet
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Classification of Costs According to Relevance
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a. Relevant cost – cost that will differ among alternative courses and will affect the future.
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b. Opportunity cost – benefit forgone or given up when an alternative is chosen over the other/s.
Example: If a business chooses to use its building rather than rent it out to tenants. The
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opportunity cost would be the rent income that would have been earned had the business chose
to rent it out.
- Considered as relevant cost because the cost differs among alternatives and affects the
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future.
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c. Sunk cost – historical costs or costs that are incurred in the past and will not make any
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difference in making a decision. Example is money spent last year to buy a machinery.
- Considered as irrelevant cost because the cost does not affect the future
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d. Out-of-pocket costs – those that require the payment of cash or other asset as a result of their
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incurrence.
- Considered as relevant if it is variable cost and irrelevant if it is fixed cost
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Example: Out-of-pocket costs such as direct materials are considered relevant costs
Out-of-pocket costs such as fixed insurance payments are considered as irrelevant costs
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e. Avoidable cost – cost that is not incurred if the activity is not performed. For example, supply
expenses are avoidable costs. You can simply decide to not buy the supplies, and no expense
will be incurred.
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- Considered as relevant cost because the cost differs among alternatives and affects the
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future.
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f. Unavoidable cost – cost that is still incurred even if the activity is not performed. For example,
if a manufacturing plant shuts down, it still needs to incur depreciation for idle equipment,
property taxes, lease payments, etc.
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- Unavoidable fixed cost is considered irrelevant.
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g. Differential cost – the amount by which the costs differ under alternative actions. Example:
The difference in the cost of two vehicles.
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h. Marginal cost – extra cost incurred when one additional unit is produced.
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i. Incremental cost – total additional cost associated with the decision to expand output or to add
a new variety of product etc.
Illustration:
For The Ages Inc. produces solid-oak umbrella stands. Each stand is handmade and hand finished
using the finest materials available. The firm has been operating at capacity (2,000 stands per year)
for the past three years. Based on this capacity of operations, the firm's costs per stand are as
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ACC 115| Management Science
Module #11 Student Activity Sheet
Name: _________________________________________________________ Class number: _______
Section: ____________ Schedule: ________________________________ Date: ________________
follows:
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Material ₱ 50
Direct labor 40
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Variable overhead 10
Fixed overhead 30
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Total cost P130
All selling and administrative expenses incurred by the firm are fixed. The average selling price of
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stands is P230. Recently, a large retailer approached Bill Wood, the president of For The Ages,
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about supplying three special stands to give as gifts to CEOS of key suppliers. Wood estimates that
the following per-unit costs would be incurred to make the special stands ordered:
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Material ₱250
Direct labor 350
Variable overhead 90
Total direct costs 690
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To accept the special order, the firm would have to sacrifice production of 20 regular units.
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REQUIRED:
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Identify all relevant costs that Wood should consider in deciding whether to accept the special
order.
Solution:
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First, let us identify all the necessary costs to produce the special order. In order to produce 1
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unit, the firm will incur ₱690. The special order is 3 units, so the total costs for the special order is
₱2,070 (690 x 3).
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Second, observe if there are any opportunity costs. According to the problem, the firm would
have to sacrifice production of 20 regular units to accept the special order. That means the firm will
have to forgo income on not being able to sell 20 regular units. The opportunity cost is computed as
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follows:
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Selling price ₱ 230
Variable cost per unit 100
Contribution margin per unit 130
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Units forgone 20
Total opportunity costs 2,600
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Remember: The fixed cost is irrelevant in decision making because whether the special order is
accepted or not, it will always be incurred. Again, to reiterate the relevance of opportunity cost, If
the special order is not accepted, the firm can earn the contribution margin from the 20 units that it
will have to forgo. But when the special order is accepted, the contribution margin on the 20 units
will be lost.
To answer the requirement, the total relevant costs in the problem is ₱4,670 (₱2,070 + ₱2,600).
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Module #11 Student Activity Sheet
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Approaches in Analyzing Alternatives in Non-routine Decisions
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1. Incremental or Differential Analysis Approach or Relevant Cost Analysis – contrasts choices by
comparing differential revenues, differential costs and differential contribution margins. Only relevant
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amounts are shown and all sunk and non-differential items are disregarded.
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2. Total Approach or Comparative Statements Approach – shows all the items of revenue and cost
data (whether they are relevant or not) under the different alternatives and compares the net income
results. Comparative income statements under this approach are prepared in a contribution margin
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format.
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Note: The approaches mentioned above are illustrated in the following modules.
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Skill-building Activities
New Iberia Corporation makes and sells the "Tabasco Maiden”, a wall hanging depicting a magical
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pepper plant. The Tabasco Maidens are sold at specialty shops for ₱50 each. Costs to manufacture
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and sell each wall hanging are as follows:
Direct material ₱ 5.00
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Direct labor 6.00
Variable overhead 8.00
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Fixed overhead 10.00
Variable selling expenses 2.50
New Iberia Corporation has been approached by a Texas company about purchasing 2,500 Tabasco
Maidens. The company is currently operating at maximum capacity. The Texas company wants to
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attach its own Lone Star label, which increases costs by ₱.50 each. No selling expenses would be
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incurred on this order. The corporation believes that it must make an additional ₱1 on each Tabasco
Maiden to accept this offer.
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Required:
a. What is the opportunity cost per unit of selling to the Texas company?
b. What is the minimum selling price that should be set?
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ACC 115| Management Science
Module #11 Student Activity Sheet
Name: _________________________________________________________ Class number: _______
Section: ____________ Schedule: ________________________________ Date: ________________
Check for Understanding
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Cost Decision
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1. Allocated corporate overhead Closing a money-losing department
2. Cost of an old car Vehicle replacement
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3. Direct materials Make or buy a product
4. Salary of marketing manager Project discontinuance; manager to be
transferred elsewhere in the firm
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5. Cost of the roof Construction of a new home
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6. Unavoidable fixed overhead Plant closure
7. Research expenditures incurred Product introduction to marketplace
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last year, related to new product
8. ₱4 million advertising program Whether to promote product A or B with the
₱4 million program
9.
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Manufactured cost of existing Whether to discard the goods or sell them to a
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inventory third-world country
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Required:
Consider each of the nine costs listed and determine whether it is relevant or irrelevant to the decision
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cited.
1. 4. 7.
2. 5. 8.
3. 6. 9.
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C. LESSON WRAP-UP
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Frequently Asked Questions
1. Can variable costs be considered as irrelevant cost?
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Generally, variable costs are considered as relevant costs but variable cost which are part sunk costs
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are considered irrelevant in decision making.
2. Can fixed costs be considered as relevant cost?
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Generally, fixed costs are considered as irrelevant costs but fixed cost which are avoidable are
considered relevant in decision making
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3. Can sunk costs be considered as relevant cost?
No. Sunk costs are already incurred in the past and does not affect the future.
4. Are opportunity costs always relevant in decision making and are they recorded as part of financial
statements?
Yes, they are always relevant in decision making but they are not recorded and cannot be seen in the
financial statements. The information presented in the financial statements are result of past
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ACC 115| Management Science
Module #11 Student Activity Sheet
Name: _________________________________________________________ Class number: _______
Section: ____________ Schedule: ________________________________ Date: ________________
transactions while opportunity cost is a forgone benefit or benefit that will never occur. It is merely used
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for decision making.
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Thinking about Learning (5 mins)
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How do you feel today?
I feel (unsatisfactory/satisfactory/excellent) because_________________________________________
__________________________________________________________________________________
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What are your challenges in learning the concepts in this module? If you do not have challenges, what
is your best learning for today?
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__________________________________________________________________________________
_______________________________________________________________________________
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What are the questions/thoughts you want to share to your teacher today?
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__________________________________________________________________________________
_______________________________________________________________________________
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ANSWER KEY
Skill Building Activity
a. Opportunity cost = Selling price minus total variable costs ₱50 - (₱5 + ₱6 + ₱8 + ₱2.50) = ₱28.50
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b.
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Direct material (₱5.00 + ₱.50) ₱ 5.50
Direct labor 6.00
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Variable overhead 8.00
Opportunity cost 28.50
Extra amount required to accept offer 1.00
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Minimum price ₱49.00
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