ACCA F5 Performance Management - 2010 - Study text

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Chapter 5: Relevant costs and short-term decisions

Applications of relevant costing: make-or-buy decisions

 Make-or-buy decisions: outsourcing

 Make-or-buy decisions: non-financial considerations

 Make-or-buy decisions with scarce resources

3 Applications of relevant costing: make-or-buy

decisions

Relevant costs can be applied to both short-term and long-term decisions.

 Short-term decisions are decisions where the financial consequences occur soon

after the decision is taken. For example, a short-term decision may result in an

immediate increase in profit (additional net cash inflows), or an increase in

annual profits and cash flows.

 A long-term decision is one where a capital investment may be required and the

benefits of the investment will be obtained over a period of several years.

The concept of relevant costs is the same for both short-term and long-term

decisions, except that for long-term decisions the time value of money should also

be taken into consideration.

For the F5 examination, only short-term decisions are examinable.

3.1 Make-or-buy decisions: outsourcing

A make-or-buy decision is a decision about:

 whether to make an item internally or to buy it from an external supplier, or

 whether to do some work with internal resources, or to contract it out to another

organisation such as a sub-contractor or an outsourcing organisation.

The economic basis for the decision whether to make internally or whether to buy

externally (outsource production) should be based on relevant costs. The preferred

option from a financial viewpoint should be the one that has the lower relevant

costs.

A financial assessment of a make-or-buy decision typically involves a comparison

of:

 the costs that would be saved if the work is outsourced or sub-contracted, and

 the incremental costs that would be incurred by outsourcing the work.

Example

A company manufactures a component that is included in a final product that it also

manufactures. Management have identified an external supplier who would be

willing to supply the component.

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The variable cost of manufacturing the component internally is $10 and the external

supplier would be prepared to supply the components for $13 each. It has been

estimated that cash savings on general overhead expenditure will be $48,000 each

year if internal production is ended. The company needs 10,000 units of the

component each year.

Required

Should the company make or buy the component?

Answer

The annual relevant costs and benefits of a decision to buy the components

externally can be presented as follows:

Extra costs of purchasing externally (10,000 units × ($13 - $10))

(30,000)

Cash savings in overhead expenditures 48,000

Net benefit from external purchasing (outsourcing) per year 18,000

Conclusion: The company would increase its profit by purchasing externally instead of

making the items in-house. The recommendation on financial considerations is

therefore to buy (outsource production, not make internally.

3.2 Make-or-buy decisions: non-financial considerations

When relevant costs are used to make a decision, it is assumed that the decision

should be based on financial considerations and whether the decision will add to

profit (cash flows).

In reality, however, managers are likely to think about non-financial issues as well

as financial issues when making their decisions. The non-financial considerations in

any decision will depend on the circumstances, and will vary from one decision to

another. Non-financial considerations can influence a decision. In your examination,

be prepared to identify relevant non-financial issues in a particular situation, and

discuss their potential implications.

Non-financial considerations that will often be relevant to a make-or-buy decision

include the following.

 When work is outsourced, the entity loses some control over the work. It will

rely on the external supplier to produce and supply the outsourced items. There

may be some risk that the external supplier will:

- produce the outsourced items to a lower standard of quality, or

- fail to meet delivery dates on schedule, so that production of the end-product

may be held up by a lack of components.

 The entity will also lose some flexibility. If it needs to increase or reduce supply

of the outsourced item at short notice, it may be unable to do so because of the

terms of the agreement with the external supplier. For example, the terms of the

Chapter 5: Relevant costs and short-term decisions

agreement may provide for the supply of a fixed quantity of the outsourced item

each month.

 A decision to outsource work may have implications for employment within the

entity, and it may be necessary to make some employees redundant. This will

have cost implications, and could also adversely affect relations between

management and other employees.

 It might be appropriate to think about the longer-term consequences of a

decision to outsource work. What might happen if the entity changes its mind at

some time in the future and decides either (a) to bring the work back in-house or

(b) to give the work to a different external supplier? The problem might be that

taking the work from the initial external provider and placing it somewhere else

might not be easy in practice, since the external supplier might not be co-

operative in helping with the removal of its work.

The non-financial factors listed above are all reasons against outsourcing work.

There might also be non-financial benefits from outsourcing work to an external

supplier.

 If the work that is outsourced is not specialised, or is outside the entity’s main

area of expertise, outsourcing work will enable management to focus their

efforts on those aspects of operations that the entity does best. For example, it

could be argued that activities such as the management of an entity’s fleet of

delivery vehicles, or the monthly payroll work, should be outsourced because

the entity itself has no special expertise on these areas.

 The external supplier, on the other hand, may have specialist expertise which

enables it to provide the outsourced products or services more efficiently and

effectively. For example a company might outsource all its IT support

operations, because it cannot recruit and retain IT specialists. An external service

provider, on the other hand, will employ IT specialists.

3.3 Make-or-buy decisions with scarce resources

A different situation arises when an entity is operating at full capacity, and has the

opportunity to outsource some production in order to overcome the restrictions on

its output and sales. For example a company might have a restriction, at least in the

short-term, on machine capacity or on the availability of skilled labour. It can seek

to overcome this problem by outsourcing some work to an external supplier who

makes similar products and which has some spare machine time or labour capacity.

In this type of situation, a relevant costing approach is to assume that the entity will:

 seek to maximise its profits, and therefore

 outsource some of the work, provided that profits will be increased as a

consequence.

The decision is about which items to outsource, and which to retain in-house. The

profit-maximising decision is to outsource those items where the costs of

outsourcing will be the least.

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To identify the least-cost outsourcing arrangement, it is necessary to compare:

 the additional costs of outsourcing production of an item with

 the amount of the scarce resource that would be needed to make the item in-

house.

Costs are minimised (and so profits are maximised) by outsourcing those items

where the extra cost of outsourcing is the lowest per unit of scarce resource ‘saved’.

The examples below illustrate the relevant costing technique required.

Example

Superclean Company is a contract cleaning company. It provides three services;

daily office cleaning, intensive cleaning of office space and minor repairs. However it

has insufficient resources to do all the work available, and wishes to use a sub-

contractor to take on some of the work.

Information relating to the different type of work is as follows:

Average

labour

hours per

job

Variable

cost per

job($)

Budgeted

number of

jobs

Sub-

contractor

quote per

job ($)

Daily office cleaning 4 60 1,500 80

Intensive cleaning 6 108 400 150

Minor repairs 3 56 640 100

There are 8,000 labour hours available. Which services should be sub-contracted?

Answer

The company can do all three types of job more cheaply with its own staff than by

hiring the sub-contractor. However provided that it earns more than $80 for a daily

office cleaning job, $200 for an intensive cleaning job and $100 for a minor repairs

job, it is profitable to use the sub-contractor to make up the shortfall in in-house

resources.

The problem is to decide which work to outsource/sub-contract. The ranking

should be established as follows:

Daily office

cleaning

Intensive

cleaning

Minor

repairs

$ $ $

Cost of doing the work in-house 60 108 56

Cost of sub-contractor 80 150 100

Extra cost of outsourcing, per job 20 42 44

Chapter 5: Relevant costs and short-term decisions

Hours saved by sub-contracting 4 6 3

Extra cost per hour saved $5 $7 $14.67

Priority for outsourcing 1

Priority for doing work with own

resources

It is cheaper to sub-contract office cleaning than intensive cleaning. It is most

expensive to sub-contract minor repairs and this is the first choice of job to be

carried out in-house. The cost-minimising plan should be to carry out the following

work:

Budgeted

jobs

Total labour

hours

Total variable

cost

Minor repairs 640 1,920 35,840

Intensive cleaning 400

2,400 43,200

Office cleaning (balance) 920

3,680 55,200

–

–––––––––––––––––––

––

––––––––––––––––––––––––––––––––

––––––––––––––––––––––––––––––––––––

Maximum labour hours available 8,000

––––––––––––––––––––––––––––––––

Sub-contract: Office cleaning 580 46,400

––––––––––––––––––––––––––––––––––––––––

180,640

––––––––––––––––––––––––––––––––––––––––

Example

Wombat Company makes four products, W, X, Y and Z. All four products are made

on the same machines, and the machine capacity for the year at Wombat’s factory is

3,500 hours. However, it is able to obtain any of these products in unlimited

quantities from a sub-contractor.

Budgeted data is as follows.

Product W X Y Z

Annual sales demand (units) 4,000 6,000 3,000 5,000

$ $ $ $

Sales price per unit 15 20 18 17

Variable cost per unit, in-house manufacture 5 7 6 7

Cost of external purchase (outsourcing) 8 11.8 10.5 11

Machine hours per unit, in-house production 0.25 0.5 0.3 0.4

Which items should be produced in-house and which should be outsourced?

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Answer

The selling price for each product is higher than the variable cost of purchasing each

product externally; therefore profit will be maximised by making the products in-

house or purchasing them externally, up to the full amount of the annual sales

demand.

Product W X Y Z

$ $ $

Variable cost per unit, in-house manufacture 5.0

7.0 6.0 7.0

Cost of external purchase (outsourcing) 8.0

11.8 10.5 11.0

–––––––––––––––––––––––––––

Extra cost of outsourcing, per unit 3.0

4.8 4.5 4.0

–––––––––––––––––––––––––––

Machine hours per unit, in-house production 0.25 0.5 0.3 0.4

Extra cost of outsourcing, per machine hour

saved

$12 $9.6 $15 $10

Priority for outsourcing 3rd 1st 4th 2nd

Priority for in-house production 2nd 4th 1st 3rd

The cost-minimising and profit-maximising budget is as follows.

Product Units Machine hours

Total variable cost

In-house production:

Y 3,000 900 18,000

W 4,000 1,000 20,000

Z (balance) 4,000 1,600 28,000

–––––––––––––––––––––––––––––

3,500

–––––––––––––––––––––––––––––

Z 1,000 11,000

X 6,000 70,800

–––––––––––––––––––––––––––––

Total variable cost 147,800

–––––––––––––––––––––––––––––

Chapter 5: Relevant costs and short-term decisions

Other applications of relevant costing

 One-off contract decisions

 Shutdown decisions

 Joint product further processing decisions

4 Other applications of relevant costing

The principles of relevant costing can be applied to any type of management

decision, not just make-or-buy decisions. Examples of other types of management

decision where relevant costing may be used are:

 One-off contract decisions

 Shutdown decisions

 Joint product further processing decisions.

4.1 One-off contract decisions

Management might have an opportunity to carry out a contract or job for a

customer, where the job is ‘once only’ and will not be repeated in the future. The

decision is therefore to decide whether to agree to do the job at the price offered by

the customer, or to decide a selling price at which an incremental profit would be

made.

If it is a one-off contract, rather than regular production work, it would be

worthwhile undertaking the contract if the extra revenue from the contract is higher

than the relevant costs of doing the work (including any opportunity costs).

The incremental profit from the one-off contract is the revenue that would be

obtained minus the relevant costs.

One-off contract decisions might occur when a company has spare capacity, and an

opportunity arises to earn some extra profit. This type of analysis should not be

applied to most contract decisions, however, because a company must earn

sufficient profits in total to cover its fixed costs and make a profit. Relevant costs do

not help management to decide what the size of the profit margin should be, in

order to ensure that the company makes an overall profit from all its activities.

4.2 Shutdown decisions

A shutdown decision is a decision about whether or not to shut down a part of the

operations of a company. From a financial viewpoint, an operation should be shut

down if the benefits of shutdown exceed the relevant costs.

A shutdown decision may be a long-term decision when there are large initial

expenditures involved (for example, costs of making the work force redundant). For

the purpose of the F% examination, however, any shutdown decision will be a

short-term decision.

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Example

Company V makes four products, P, Q, R and S. The budget for next year is as

follows:

S Total

$000

$000 $000

Direct materials 300

500

400

700 1,900

Direct labour 400

800

600

400 2,200

Variable overheads 100

200

100

100 500

800

1,500

1,100

1,200 4,600

Sales 1,800

1,650

2,200

1,550 7,200

Contribution 1,000

150

1,100

350 2,600

Directly attributable fixed costs (400)

(250)

(300)

(300) (1,250)

Share of general fixed costs (200)

(200)

(300)

(400) (1,100)

Profit/(loss) 400

(300)

500

(350) 250

‘Directly attributable fixed costs’ are cash expenditures that are directly attributable

to each individual product. These costs would be saved if operations to make and

sell the product were shut down.

Required

State with reasons whether any of the products should be withdrawn from the market.

Answer

From a financial viewpoint, a product should be withdrawn from the market if the

savings from closure exceed the benefits of continuing to make and sell the

product. If a product is withdrawn from the market, the company will lose the

contribution, but will save the directly attributable fixed costs.

Product P and product R both make a profit even after charging a share of general

fixed costs. On the other hand, product Q and product S both show a loss after

charging general fixed costs, and we should therefore consider whether it might be

appropriate to stop making and selling either or both of these products, in order to

eliminate the losses.

Effect of shutdown P

R S

$000

$000 $000

Contribution forgone (1,000)

(150)

(1,100) (350)

Directly attributable fixed costs saved 400

250

300 300

Increase/(reduction) in annual cash flows

(600)

100

(800) (50)

Although product S makes a loss, shutdown would reduce annual cash flows

because the contribution lost would be greater than the savings in directly

attributable fixed costs.

Chapter 5: Relevant costs and short-term decisions

However, withdrawal of product Q from the market would improve annual cash

flows by $100,000, and withdrawal is therefore recommended on the basis of this

financial analysis.

Decision recommended: Stop making and selling product Q but carry on making

and selling product S.

4.3 Joint product further processing decisions

Joint products are products manufactured from a common process. In some

instances, a company might have a choice between:

 selling the joint product as soon as it is output from the common process, or

 processing the joint product further before selling it (at a higher price).

This is a short-term decision, and the financial assessment should be made using

relevant costs and revenues. The financial assessment should compare:

 the revenue that will be obtained (less any selling costs) from selling the joint

product as soon as it is output from the common process, and

 the revenue that will be obtained if the joint product is processed further, less

the incremental costs of further processing and then selling the product.

Applying relevant costing, the costs of the common process are irrelevant to the

decision, because these costs will be incurred anyway, whatever the decision. The

decision should be to further process the joint product if the extra revenue from

further processing exceeds the extra (relevant) costs of the further processing.

Example

A company produces two joint products from a common process. For every 100

kilograms of input to the common process, output consists of 40 kilograms of joint

product 1 (JP1) and 60 kilograms of joint product 2 (JP2). The costs of the common

process are $400 per 100 kilograms of input.

JP1 can be sold for $10 per kilogram and JP2 can be sold for $16 per kilogram.

Alternatively, JP1 can be processed to make a finished product, FP1. Costs of further

processing consist of variable costs of $6 per kilogram and fixed costs of $120,000 per

year. Of these fixed costs, $96,000 would be directly attributable to the further

processing operations, and the remaining $24,000 would be an apportionment of

general fixed overhead costs. The further processed product (FP1) would have a

selling price of $28 per kilogram.

It is estimated that 15,000 kilograms of JP1 will be produced each year. There are no

losses in any process.

Required

Should JP1 be sold as soon as it is produced from the common process, or should it

be further processed into Product FP1?

Paper F5: Performance management

Answer

The common processing costs are irrelevant to the further processing decision. The

annual relevant costs and benefits of further processing JP1 are as follows:

Revenue from selling FP1 (per kilogram) 28

Variable further processing cost (6)

Additional variable revenue from further processing 22

Opportunity cost: sales of JP1 forgone (10)

Benefit per kilogram from further processing 12

Number of kilograms produced each year 15,000

Total annual benefits before directly attributable fixed costs 180,000

Directly attributable fixed costs of further processing (96,000)

Net annual benefits of further processing 84,000

Recommendation: The joint product should be processed to make FP1, because this

will increase annual profit by $84,000.

ACCA F5 Performance Management - 2010 - Study text - Emile Woolf Publishing

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