Module 6 Differential Costing

Module 6: Non-Routine Decision Making
At the end of this module, you should be able to:

1. Describe the nature of decision making and the related process as applied
into business
2. Differentiate between relevant and irrelevant financial data in decision
making
3. Depict the process of making a make or buy decision
4. Determine whether to accept or reject a special order
5. Resolve whether a segment will be drop or maintained
6. Demonstrate how a sell or process further decision is made
7. Illustrate how to solve limited capacity problem.
Decision Making in Business

Decisions are the determination of future actions from a given set of alternatives.
Decisions pertain to the future and most of the time, in some aspect, will depend on
predicting how future events will occur. However, predicting future events are
usually based on data retrieved from historical events and how these historical
events is expected to be constant or altered. Making decisions is something that
cannot be taken lightly for it can make or break a business. One erroneous decision
can make a financially healthy company bankrupt in just a flick of a finger. In
business, managerial activities always require decision making. During the planning
phase, the selection of an objective, strategy and plan of actions needs decision
making. Under the execution phase, to whom a particular task will be assigned and
how the employees will be motivated, the same with the controlling phase, deciding
whether a particular variance is worth analyzing and the corrective action related to
such variance requires decision making. All managerial activities require decisions
and this is the reason why they are called managers, they manage by determining
the courses of actions to be taken.
There are two types of decision for managers, routine and non-routine. Routine
decisions are made under a specific process and certainty. Decisions are recurring
and there are already sets of programmed responses. Valuable time and resources
should not be expended each time routine decisions are to be made. Thus, usually,
companies create a manual of procedure to guide managers on how to deal with
routine decisions. Examples of Routine Decisions includes replenishment of
inventory, sending delinquency notes to customers, and giving employees raised
among others. Generally, routine decisions are activities that are part of the
normal operating cycle or the day-to-day activities in business. Non-Routine
Decisions are made using the discretion of the decision maker in addressing
situations that are uncommon and isolated. It is quite risky wherein bad decision is
irrevocable and causes material damages. Usually, when critical non-routine
decisions are made, the normal operating cycle of the company is being altered. For
example, when a company is contemplating whether to make or buy a particular
product or materials, it is actually deciding whether to be a manufacturer or a
merchandiser which has a different operating cycle. Another will be, if management
1 | Non-Routine Decision Making
is evaluating whether to drop or to maintain a segment of the company might

increase or decrease the number of business unit that is being managed.
The Scientific Process
Since non-routine decisions are critical to the survival and success of businesses,
the trial-and-error and wait-and-see approach cannot be utilized in this kind of
situation. A proven, tried-and-tested, approach will be more appropriate that stems
out of years of study, from researches and debates of scholars and seasoned
business managers, which is often called the scientific approach. It is composed of
the following step:
1. Define the Problem: The root cause or hidden problem of variances in a
companys operation is identified. There are a lot of business model like the
fish bone, pareto method, etc. that can be used in order to define the
problem.
2. Specify the criteria: Determine the perspective that will be used as the basis
for the solution. Usually, the main functional business area are the basis for
the criteria; finance, marketing, operations and/or production, and human
resource. In determining the criterion, it is about identifying the objectives,
for example maximizing profit, increasing market share, better social
services, etc.
3. Identify different alternatives: Courses of actions or Options that can be taken
to address the problem by achieving the objectives. Courses of actions should
consider situations of both internal and external environment. The availability
of resources, capacity of the management and work-force, competitors
action, economic and political stability among other things that should be
considered in developing alternative courses of actions.
4. Develop the decision model: Simplify the problem, define what will be
relevant and irrelevant, and then bring together all elements of the problem
criteria, constraints, and alternatives.
5. Gather Data: This is to facilitate objectivity in the decision making process.
Data may be primary or secondary. It must be up-to-date, timely and
accurate. Data are gathered in order to provide information that will support
or negate the different alternative courses of actions.
6. Evaluate the different alternatives: the best options that can address the
objective/s set. It should be based on the decision model and criteria created.
7. Make a conclusion/decision: A well defined solution will include an action plan
that identify the step-by-step activities, the people involve, resources
required, and the timeline of each activities.
It is to be noted that although business decisions involve both qualitative and
quantitative aspect, we will focus on quantitative, specifically, the financial aspect
of decision making. Since the basic role of controllers is to provide quantitative
information that can be used by managers in their decision making capacity, we will
focus more on how different costs affects decisions made by managers.
Relevant and Irrelevant Costs
One of the critical steps in the scientific approach is the gathering of data, for the
data acquired can be used in order to support or contradict a propose alternative
course of action, hence, an erroneous information caused by irrelevant and
unreliable data can result to wrong decisions. The key to prevent providing
erroneous information from happening is classifying costs as relevant and irrelevant
costs. Relevant Costs are any expected future cost which will differ among
alternative courses of actions while irrelevant costs are either future costs that will
not change or past cost that was already incurred. There are two types of relevant
cost, differential costs and opportunity costs while irrelevant costs can be classified
as committed (unavoidable) fixed cost and sunk costs.
Differential Costs
These are costs that differ among alternative courses of actions. It can also
be called as incremental or avoidable costs depending on the perspective of
the decision to be made. Incremental costs are costs that will be incurred or
will increase if a decision is made while an avoidable cost are cost that will be
prevented from being incurred if a decision is made. In a decision whether to
buy a car or not, the fare being incurred from jeepneys, taxis, and other
means of transportation can either be an incremental or avoidable cost. If
you are on the perspective of buying a car, the fare will be considered as an
avoidable cost since if a person bought a car and use it, he does not have to
pay for any fare. However, if you are on the perspective on not buying a car,
the fare is an incremental cost since not having a car will require a person to
commute, hence the need to pay for the different fare. As a rule of thumb,
whatever costs that were classified as incremental in one perspective will be
classified as avoidable in the other perspective.
Opportunity Costs
These are benefits foregone when a particular alternative courses of action is
not chosen. For an item to be considered as an opportunity costs it has to be
a possible benefit in an alternative. A benefit in accounting literature is
anything that increases cash either through additional revenue or cost
savings. In a decision whether to get a job or continue studying, under the
alternative of getting a job, possible benefits exist like the salary that can be
earned, and the amount of tuition fee and allowances that can be saved. Cost
savings is no different from avoidable costs. However, tuition fees and
allowances will be classified as incremental costs under the alternative of
continue studying while the salaries that can be earned will be classified as
opportunity cost.
Committed Fixed Costs
These are on-going fixed costs which cannot be altered or affected by a
particular decision because a company will continue to incur the fixed cost
that is committed regardless of which decision alternative is selected. For
example, the amount of monthly rental payment to be made in a decision
whether to accept or reject a special order from a one-time customer
especially if the company has enough excess idle capacity. The rental
payment is a committed fixed cost since it will remain to be the same
amount, due and outstanding regardless whether the order was accepted or
rejected.
Sunk Costs
These are cost which was incurred in the past and cannot be altered or
affected by a particular decision. Sunk costs, like committed costs, will
continue to have been incurred by the company regardless of which of the
available courses of action the company may choose to take in the future. In
relation to the special order decision in the previous section, the amount
spent by the company in researching and developing its product is a sunk
cost since it has already been incurred and the company will not be able to
avoid or incur additional research and development costs.
Before solving or rendering any decision, it is very important that a solid foundation
on identifying relevant and irrelevant cost has been attained. The different cost
classification will be used alternately in analyzing and solving the different
problems. Generally, managements non-routine decisions fall into, but not limited
to, the following categories:
1. Make or Buy decision or Outsourcing decision
2. Accept or Reject Decision of Special Orders
3. Dropping or Maintaining a Business Segment which can also include
temporary shut-down decisions
4. Sell or Process Further after the joint processing
5. Addressing Limited Capacity Problems
As a general rule or a good rule of thumb, the following are to be assumed:
1. Generally, variable costs and changes in fixed costs are differential costs
2. Additional revenues and the current market value of old properties and
equipments are opportunity costs
3. Depreciation, Original Purchase Price of the Old Equipment and Net Book
Value are considered to be Sunk Costs
4. Unchanged Fixed Costs are considered to be committed costs.
Make or Buy Decision

This kind of decision present a situation in which a company must decide whether it
should manufacture a component part for its own use or purchase this part from an
outside supplier. It also include decision pertaining to setting up service
departments like security, maintenance, accounting, etc. or contracting external
business processing companies to perform such services for the company. Thus,
make or buy decision it is also called as Outsourcing Decision. The key in solving
these problems is to exclude all committed fixed costs as being irrelevant to the
analysis and then compare the alternatives presented based on the incremental
revenues and incremental costs of each alternative. Remember the general
objective in this kind of decision is to select the alternative that will result to a lower
cost. The following table shows how cost can generally be considered in the
decision analysis.
Cost to Make
Direct Materials
xx
Cost to Buy
Purchase Price
xx
Direct Labor
Variable Overhead
Incremental Fixed Overhead
(if any)
Opportunity Cost (if any
alternative usage of the
space)
TOTAL
xx
xx
xx
xx
Other directly
attributable cost of
buying the material
(i.e. Freight,
Inspection, Ordering
Cost, etc.)
xx
TOTAL
xx
xx
To illustrate: Tarlac Corporation is now making a small part that is used in one of
its products. The companys accounting department reports the following per unit
costs of producing the part internally:
Direct Materials
P15.00
Direct Labor
10.00
Variable Manufacturing Overhead
2.00
Fixed Manufacturing Overhead, traceable
9.00
Depreciation of the production equipment specifically used for the production of the
small part represents two-thirds of the traceable fixed manufacturing overhead cost
with indirect labor representing the balance. The indirect labor could be avoided if
production of the part were discontinued. An outside supplier has offered to sell the
part to Tarlac Corporation for P32 each, based on an order of 5,000 parts per year.
In determining whether to make or buy the small part, it is very important to
determine whether the cost is relevant or irrelevant. As a guide, we have to identify
whether the cost is incremental or avoidable. Under the make decision, if the Tarlac
will decide on making the small part itself, direct materials, direct labor, and
variable overhead will be classified as incremental costs so as the indirect labor
since it was specifically stated that it will be avoided if production of the small part
will be stopped, thus it is an incremental cost when making the small part, while
these costs will be considered as avoidable if we will change our perspective to the
buy decision. The depreciation on the production is sunk costs while the purchase
price from the outside supplier is an incremental cost on the point of view of buying
decision while an avoidable cost on the point of view of a make decision.
The analysis of the decision in two perspectives, make decision and buy decision as
follows:
Make Decision
Incremental Costs:
Direct Materials
Direct Labor
Variable Overhead
(indirect labor: P9 x 1/3%)
Total incremental cost to
(15.0
0)
(10.0
0)
( 2.0
0)
( 3.0
0)
(30.0
Buy Decision
Incremental Costs:
Purchase Price
(32.0
0)
Less: Avoidable Cost:

Direct Materials
15.00
Direct Labor
Variable Overhead
10.00
2.00
Incremental Fixed
make
Less: Avoidable Cost
(Purchase Price)
Advantage of Making (per
unit)
0)
32.00
2.00
Overhead
(Indirect labor: P9 x 1/3%)
Disadvantage of Buying
(per unit)
3.00
( 2.0
0)
The total advantage of making is P 10,000 or 5,000 units multiplied by the

advantage per unit of P2.00. Incidentally, the highest purchase price that Tarlac can
accept in order for it to favor buying the small part is P30.00 or equal to the total
incremental cost per unit. Anything that is higher than that will result to a higher
cost of buying, while any price that is lower than that will provide an advantage on
the perspective of buying.
Effect of Opportunity Costs
Supposing that Tarlac Corporation has an option to rent out the facility that it
currently uses to manufacture the small part for an annual fee of P 15,000 if Tarlac
will decide to purchase the small part instead of making it, will it still be
advantageous for the company to make the small part?
In this situation, a change in the analysis will be required due to the fact that since
the company is making the small part, it was actually incurring an opportunity cost
in the form of the rental fee that it cannot earn unless Tarlac purchase the small part
and stop production. Thus, the revised analysis/solution will be as follows:
Make Decision
Incremental Costs:
Direct Materials
Direct Labor
Variable Overhead
(indirect labor: P9 x 1/3%)
Opportunity Cost
(P15,000/5,000 units)
Total Relevant cost to make

Less: Avoidable Cost
(Purchase Price)
Disadvantage of Making (per
unit)
(15.0
0)
(10.0
0)
( 2.0
0)
( 3.0
0)
( 3.0
0)
(33.0
0)
32.00
( 1.0
0)
Buy Decision
Incremental Costs:
Purchase Price
(32.0
0)
Avoidable Cost:
Direct Materials
15.00
Direct Labor
Variable Overhead
10.00
2.00
Incremental Fixed
Overhead
(Indirect labor: P9 x 1/3%)
3.00
Additional Rental Revenue
3.00
Advantage of Buying (per

unit)
1.00
In the presence of an alternative usage or income-generating activity for the facility

that will be abandoned once a buying decision is made, the analysis now favors a
buying decision for a per unit advantage of P1.00 or total advantage of buying the
small part amounting to P 5,000 or (5,000 units x P1.00)
Accept or Reject a Special Order

This kind of decision often arises when a company receives from a potential
customer a special one-time order at a selling price which is below the companys
regular selling price. A special order is a one-time order that is not considered part
of the companys normal ongoing business and is not expected to recur and be part
of the normal operating cycle.
To address this kind of situation, the key usually is to exclude any committed cost as
being irrelevant in the analysis and then compare the available courses of action
based on the additional or incremental revenues and costs that will result under
each alternative. When analyzing a special order, only the incremental costs and
benefits are relevant. Since the existing fixed manufacturing overhead costs would
generally not be affected by the decision to accept or reject the order, they are
considered to irrelevant. In analyzing the situation, the general objective is to
determine whether the incremental revenue (Special offer price) would be higher
than the incremental cost to be incurred. The following table shows how cost can
generally be considered in the decision analysis.
Incremental Revenue (Sales)
Less: Incremental Cost to Make and Sell
Direct Materials
Direct Labor
Variable Selling and Administrative (if
required)
Special Equipment and other
requirements (if any)
Lost Contribution Margin if required to
sacrifice regular sales due to lack of
capacity.
Incremental Income
xx
xx
xx
Xx
Xx
Xx
Xx
(xx
)
xx
To illustrate: Angeles Corporation sells its product for P35 per unit. The companys
unit product cost based on the full capacity of 400,000 units is as follows:
Direct materials
Direct labor
Variable manufacturing
overhead
Fixed Manufacturing
overhead
P 8
10
4
8
Unit product cost
P 30
A special order offering to buy 40,000 units has been received from a foreign
customer for P30 per unit. The only selling costs that would be incurred on this
order would be P6 per unit for shipping. The company has sufficient idle capacity to
manufacture the additional units.
Should Angeles accept the order? Just like in the make or buy decision, one of the
key factor in solving this problem is to identify the relevant cost, however, this time,
we will focus more on the incremental cost rather than the avoidable cost. In the
given problem, direct materials, direct labor, variable overhead and variable selling
cost will be considered as incremental cost, thus relevant, while fixed manufacturing
overhead will be disregarded since this will be considered as a committed cost that
will remain to be incurred regardless whether the special order is accepted or
rejected. The complete solution will be as follows:
Incremental Revenue per unit
Direct Materials
Direct Labor
Variable Selling and Administrative
Incremental Income per unit
Multiply by: Number of Units Ordered:
Total advantage of accepting the order
P 30
P
8
10
4
6
(28)
P 2
x
40,000
P
80,000
Effect of Special Costs

Supposing that the order of the foreign customer will be needing a unique labeling
that will require a special engraving tool equipment that cost P 60,000 and will have
no other use for Angeles after it has serve the special order, should Angeles still
accept the special order?
The incremental cost, that is, the purchase price of the additional machine that will
be specifically acquire for this order will be spread out to the number of units to be
ordered and will be added as part of incremental cost to make and sell. The revised
solution for this special order problem follows:

Direct Materials
P 30.00
P
Direct Labor
required)
requirements
(P60,000/40,000 units)
Incremental Income per unit
Multiply by: Number of Units Ordered:
8.00
10.00
4.00
6.00
1.50
(29.50)
0.50
x
40,000
P
20,000
Total advantage of accepting the order
Alternatively, the Total advantage of P 20,000 can be determined by simply

deducting the P 60,000 purchase price to the original advantage of P 80,000.
Effect of Lack of Idle Capacity
Supposing that aside from the P 60,000 special engraving tool, Angeles Corporation
currently is already able to sell 370,000 units. Should Angeles still accept the
special order?
In this kind of situation, we are to determine if the company has enough excess
capacity to accommodate the special order being made by the customer, this is
done through comparing the companys idle capacity and the number of units being
ordered. The companys idle capacity is simply computed by deducting the current
sales level by the total or normal capacity. Thus,
Total capacity (in units)
Current sales level (in units)
400,000
(370,00
0)
30,000
(40,000
)
(10,000
)
Idle Capacity (in units)

Number of units being ordered
Shortage in Idle Capacity
The shortage in idle capacity can be addressed by either buying additional

equipment or sacrificing regular sales. Since we have already discussed the effect of
required additional cost in the form of special equipment, we will assume the
second alternative which is sacrificing regular sales which will result to loss
contribution margin, an opportunity cost. First, we need to determine the amount of
the regular contribution margin per unit; second, we multiply such amount to the
number of shortage unit to determine the total contribution margin loss.
Regular Selling Price
Less: Variable Cost
Direct Materials
Direct Labor
P 35.00
P
8.00
10.00

required)
Regular Contribution Margin per unit
Multiply by: Number of Shortage Units (see
above)
Total Loss Contribution Margin
4.00
6.00
28.00
7.00
x 10,000
P 70,000
The analysis whether to accept or reject the special order will be revised as follows:
Direct Materials
Direct Labor
required)
requirements
Lost Contribution Margin
(P70,000/40,000)
Disadvantage per unit
Number of Units Ordered
Total Disadvantage if the order is accepted
P 30.00
P
8.00
10.00
4.00
6.00
1.50
1.75
(31.25)
(1.25)
40,000
P
(50,000)
The negative P 50,000 can also be computed by simply deducting the purchase
price of the special equipment and the total loss contribution margin to the original
total advantage of accepting the order, thus, it is simply the P 80,000 P 60,000 P
70,000 = P (50,000). Hence, the company should not anymore accept the special
order.
Drop or Maintain a Segment

This situation arises when a particular segment, a product line, a branch, or a
business unit, seems to be incurring operating losses and management would like
to determine whether it still worth keeping the segment open and operational or will
the company be better off without such segment. There are two approaches in
analyzing this type of decision, the traditional approach and opportunity approach.
Traditional Approach
In analyzing this type of decision, the key is to exclude committed fixed costs
as being irrelevant and then compare the alternatives presented based on
the incremental revenue and incremental cost f each available alternative.
To illustrate, Pampanga Corporation sells two (2) different product lines in its
retail store. Pampangas operating income results last year were as follows:
Sales
Variable Costs
Contribution
Margin
Fixed Costs
Profit
Product A
P 100,000
60,000
40,000
Product B
P 200,000
100,000
100,000
Total
P 300,000
160,000
140,000
60,000
(20,000)
50,000
50,000
110,000
30,000
Pampanga is considering discontinuing Product A because it is unprofitable. If

Pampanga does decide to discontinue Product a, the P35,000 fixed cost
representing salaries of sales personnel for product A will be eliminated, but
the remaining fixed costs of renting, heating, and lighting the store will be
unaffected by this decision. Should Pampanga eliminate Product A?
Before making the decision, we need to re-compute Product As profit that
does not include any committed cost. Based on the illustration, only the P
35,000 out of P 60,000 of total fixed cost for Product A will be eliminated,
meaning P 25,000 will remain regardless of the decision to be made. Thus, in
determining whether to drop or maintain product A, we re-compute its profit
as follows:
Sales
Variable Costs
Contribution Margin
Avoidable Fixed Costs
Decrease in profit if Product A is
eliminated
P 100,000
60,000
40,000
35,000
P 5,000
Alternatively, the P 5,000 opportunity cost (since it is a profit that will be

foregone if Product A is dropped) can be computed as follows:
Net Loss
Add Back: Committed Fixed Costs
Decrease in profit if Product A is
eliminated
(20,000)
25,000
P 5,000
Hence, Pampanga should not drop product A since it will result to a decrease
in profit by P5,000.
Opportunity Cost Approach
Although a lot of managerial accounting books presents problem and
solutions on the perspective of traditional approach, another approach can
still be used which focuses on the two types of opportunity cost, loss
contribution margin and the avoidable cost. The focus is determine whether
in dropping a segment, is a company losing more contribution margin rather
than avoiding costs or will it be the other way around. In the case that the
company will lose more contribution margin than avoiding more cost, the
segment should be kept open.
Using the same situation under the traditional approach, Pampangas analysis
using the opportunity cost approach follows:
Loss Revenue
Avoidable Variable Costs
Disadvantage of eliminating Product
A
(100,000)
60,000
35,000
(5,000)
As you can see, the same amount of disadvantages has been arrived at using
two different approaches.
Effect of Incremental Costs

Closing a segment is not as simply as just telling people that the segment will
be closed, separation pay for employees, penalties for contracts that will be
violated, disposal cost of some resources among other things will be incurred,
thus, should be considered in the drop or maintain decision.
Assuming that Pampanga will be incurring a total of P 10,000 in closing cost if
it will decide to close Product A down. Using the opportunity cost approach,
the analysis will be as follows:
Loss Revenue
Incremental Cost (Closing Cost)
Disadvantage of eliminating Product
A
(100,000)
60,000
35,000
(10,000)
(15,000)
As we can see, the incremental cost further increase the disadvantage of

eliminating Product A since Pampanga will be incurring this cost if Product A
will be dropped.
Effect of Complimentary Products
Complimentary Products are those products that are purchased together, like
toothpaste and toothbrush, bread and butter, flashlight and batteries, are just
among the hundreds of the product pairing that compliments each other. For
management considering dropping a product line, it must consider the effect
of dropping the product to its complimentary product. Usually, as a product is
eliminated, its complimentary product will drop in sales creating loss revenue
for the company. But, as what we have already established in the previous
module, as sales decreases, total variable cost also decreases, thus creating
an avoidable cost.
To illustrate, disregarding the closing cost discussed in the previous section,

what if Product A and B are complimentary and if Product A is dropped,
Product Bs total sales will decreased by 20%, should product A still be
dropped? The analysis of this decision will be as follows:
Loss Revenue Product A
Loss Revenue Product B (P200,000 x 20%)
Avoidable Variable Costs Product B
(P100,000 x 20%)
Disadvantage of eliminating Product A
(100,000)
60,000
35,000
(40,000)
20,000
(25,000)
Product B being a complimentary product of Product A further increases the

total disadvantage of eliminating Product A to P 25,000. Notice the same
percentage decreased in Product Bs total sales and total variable costs since
the assumption is that sales and variable costs are constantly proportionally
related.
Effect of Substitute Products

A substitute product is those that can replace another product and still satisfy
the needs that the original product was intended to address. Example of
substitutes includes rice and bread, juices and soft drinks, blank CD and USB
among other things. Unlike complimentary product, if a substitute is
eliminated, it will increase the sales and variable cost of the other product.
To illustrate, disregarding both the closing cost and Product B being a
complimentary product that were provided in the previous sections, assume
now that Product B is a substitute of Product A, and Product Bs sale will
increased by 20% if product A will be dropped. What action should Pampanga
take?
Loss Revenue Product A
Incremental Revenue Product B (P200,000 x
20%)
Incremental Variable Costs Product B
(P100,000 x 20%)
Advantage of eliminating Product A
(100,000)
60,000
35,000
40,000
(20,000)
15,000
Notice now that from a disadvantage it now becomes an advantage for

Pampanga to eliminate product A. Also, it is worth pointing out that although
the same amount was involve in the increase of Product Bs sales and
variable cost, the treatment was reversed since the point of view changes,
from a complimentary to a substitute. Incremental revenue, which will
increase cash inflow, is shown as a positive item while an incremental cost,

which will increase cash outflow, is shown as a negative item.
Shutdown or Continue Operating and the Shutdown Point

This is applicable for companies with products that have seasonal, cyclical or
random variation in demand. It is also applicable to those companies that are in the
process of restructuring its operation. This is a kind of situation wherein regardless
of the alternative chosen, the company will incur loss. Thus, the main objective here
is to choose the alternative that will result to the lower loss or as a popular saying
goes choosing the lesser evil.
The concept in this section is no different from the drop or maintain concept in the
previous section, the major difference between the two is under the shutdown or
continue decision, if a shutdown decision was arrived at, the shutdown is temporary
in nature and operation will resume in the very near future. In a drop or maintain
decision, if a drop decision was made, such is considered to be permanent.
In analyzing the situation, just like the drop or maintain decision, we can use to
approaches, the traditional approach which is analysis approach through exclusion
of committed fixed cost or the opportunity cost approach which is simply comparing
the lost revenue to the avoidable costs.
To illustrate: Bataan Corporation manufactures and sells a single product, Taco. At
normal capacity of 50,000 units per annum, the unit cost of manufacturing and
selling the product is:
Manufacturing Costs
Direct materials
P 5.40
Direct labor
P 5.60
P 2.40
Fixed Manufacturing Overhead
P 4.00
Total Production Cost per unit
P 17.40
Selling Costs
Variable Selling
P 1.60
Fixed Selling
P 1.00
Total Selling Cost per unit
P 2.60
Due to the increasing competition, the company expects to be able to sell only
20,000 units at a reduced selling price of P20.00 each, next year. The company is
restructuring its operations for a better competitive position. In the meantime,
management is faced with the problem of whether to shut down completely or
continue limited operations at a loss. In the event of a shut down, it is expected that
all fixed costs can be reduced by about 60%. Additional costs of shutting down and
re-opening the plant for one year are estimated at P 80,000.
Traditional Approach
Under this approach only incremental and avoidable costs are considered in
the computation of the expected operating income or loss and excluding any
committed fixed cost.
Continue Operating
Sales (20,000 @ P20)
400,00
0
Variable Cost (20,000 @ P
(300,00
15.00*)
0)
Contribution Margin
100,00
0
(250,000**x60%)
(150,00
0)
Incremental Operating Loss
(50,000
)
Shutdown
Sales
-0-
Variable Cost
-0-
Contribution Margin
-0-
Fixed Costs
Shutdown Costs
Incremental Operating
Loss
-0(80,000
)
(80,000
)
*add all variable cost (direct materials, direct labor, variable overhead and variable selling)
**add the two fixed costs per unit and multiply by the normal capacity of 50,000 units.
Bataan should continue operation even though the expected result is a

negative figure since it has a lower loss as compared to shutting down. Hence
there is an advantage of P30,000 or 50,000 less 80,000 in favor of continuing
operations. The P100,000 committed fixed cost (total fixed cost x 40%) was
not considered in any of the alternative since it will not differ and will still be
incurred regardless of the decision to be made.
Opportunity Cost Approach
As ready been discussed in the previous section, this approach focuses on the
two types of opportunity costs, loss revenues and avoidable costs or cost
savings. We will be solving the situation on the point of view of shutting
down.
Shutting Down
Loss Revenue (20,000 @ P20)
Avoidable Cost
Variable Cost (20,000 @ P15)
Fixed Cost
Incremental Cost of Shutting Down
(400,000)
300,000
150,000
( 80,000
)
Disadvantage of Shutting Down
( 30,000
)
What if Bataan can only sell 10,000 units, should Bataan stay open and
operate or should it temporarily shut down its operation?
Using the traditional approach, there will be a total disadvantage of P 20,000
will be incurred if the company will continue operating since the incremental
loss under continue operating will now be P 100,000 while the incremental
loss under shutdown will remain the same. The computation follows:
Continue Operating
Sales (10,000 @ P20)
200,00
0
Variable Cost (10,000 @ P
(150,00
Shutdown
Sales
-0-
Variable Cost
-0-
15.00)
Contribution Margin
(250,000**x60%)
Incremental Operating Loss
0)
50,000
(150,00
0)
(100,00
0)
Contribution Margin
Fixed Costs
Shutdown Costs
Incremental Operating
Loss
-0-0(80,000
)
(80,000
)
Using the opportunity approach, the same amount of disadvantage will be

computed as follows:
Shutting Down
Avoidable Cost
Fixed Cost
Advantage of Shutting Down
(200,000)
150,000
150,000
( 80,000
)
20,000
The Shut Down Point

If the company will be able to sell 20,000 units, it must remain open for an
advantage of P30,000, if it will be able to only sell 10,000 units, it must
shutdown to avoid a disadvantage of P20,000, the question is what is the
minimum number of units that the company must be able to sell for its
decision to be indifferent between continue operating and shutting down?
This is called the shutdown point. The shutdown point will act as the
threshold or the point of reference of knowing when to continue operating or
when to shutdown. It is the level of sales were in the advantage of continue
operating or shutting down is equal to zero. To illustrate the computation:
Shutting Down
Loss Revenue (__________ @ P20)
Avoidable Cost
Variable Cost (___________ @ P15)
Fixed Cost
?
?
150,000
( 80,000
)
-0-
As you can see in the pro-forma solution, we are yet to determine the loss
revenue and avoidable variable cost since they will depend on the number of
units to be sold. While avoidable fixed cost and incremental cost of shutting
down will remain the same regardless of the number of units to be sold. We
can express the table in the following formula. Let x be number of units to be
sold.
20 x +15 x+150,00080,000=0
Solving for X;
20 x15 x=150,00080,000
5 x=70,000
x=
70,000
5
x=14,000 units
To prove that at 14,000 units there will be no advantage or disadvantage;
Shutting Down
Avoidable Cost
Fixed Cost
(280,000)
210,000
150,000
( 80,000
)
-0-
Knowing that at 20,000 units (above the shutdown point) the company will be
better off continue operating while at 10,000 units (below the shutdown
point) the company must shutdown, we can form a general conclusion that
any sales level that is above the shutdown point, the company must continue
operating while any level below the shutdown point will already require the
company to shutdown.
Sell or Process Further

This is a situation that arises when management must decide whether to sell the
products at split-off or, alternatively, incur additional cost beyond split-off (called
separable cost) and then sell the goods for a higher price. This happen in a
manufacturing environment that has a joint production process, which is the result
of the commingling manufacturing of two or more products, called joint products.
The joint products become identifiable from each other at the split-off point.
Imagine manufacturing donuts, a basically they have the same process of dough
preparation but after the donut is formed, the management may choose to sell it at
its current state or add flavoring to the donut. The following diagram illustrates the
flow of joint production cost, the split-off point and further processing.
Split-off
Point
Further
Processing
Joint
Production
The key in addressing this kind of situation is to segregate sunk cost and consider
only incremental revenue and incremental cost. Joint costs incurred prior to split-off
are not relevant when making the sell-at-split-off or-process-further decision, since
such cost is assumed to have already been incurred before the need for the decision
arises. Remember, it is only after the joint production process was finished that the
need to make the decision arises. The correct decision is made by comparing the
separable cost incurred against the amount of increased sales revenue.
The pro-forma solution guide in solving this kind of situation follows:
Sales after further processing
Sales at Split-off point
Incremental Revenue
Cost to be incurred when process further
(Incremental Cost)
Net Incremental Profit (if positive)
xx
(xx
)
xx
(xx
)
xx
To illustrate, Laguna Company produces donuts. The production phase begins with
a joint process that cost P 7,000 and each product can be sold at split-off or
processed further. Details of producing the three donut flavors from a standard
batch are as follows:
Strawberry
Bavarian
Choco Nut
Filled
Crumble
Joint Production costs
allocated to each product
P 4,000
P 1,000
P 2,000
up to split-off
Sales value at split off
2,000
6,000
8,000
Sales value if processed
4,800
9,000
14,000
further
Processing cost beyond
1,600
3,500
5,000
split-off
As already been discussed, the joint production cost will be disregarded since it is a
type of sunk cost in as far as this type of decision is concern. The first step is to
determine the incremental revenue by simply comparing the sales value at split off
and after further processing.
4,800
Strawberry
Filled
9,000
Bavarian
Crumble
14,000
(2,000)
2,800
(6,000)
3,000
(8,000)
6,000
Choco Nut
Sales value if processed
further
Sales value at split off
Incremental Revenue
The second step is to compare the incremental revenue computed to the

incremental cost which is the processing cost to be incurred for processing the
products further to determine the total advantage or disadvantage of further

processing the products.
Choco Nut
Incremental Revenue
Incremental Cost
Advantage/(Disadvantage)
2,800
(1,600)
1,200
Strawberry
Filled
3,000
(3,500)
( 500)
Bavarian
Crumble
6,000
(5,000)
1,000
As we can see, processing Choco Nut and Bavarian Crumble further will provide an
advantage of 1,200 and 1,000 respectively while Strawberry Filled will have a 500
disadvantage if process further, hence, it will be wise for Laguna not to further
process strawberry filled donut.
Limited Capacity Problem

This situation arises when a constraint exist. A constraint or a bottleneck is any
limitations under which a company must operate, such as limited available direct
labor or machine time or raw materials, which restricts the companys ability to
satisfy demand. A constraint or bottleneck limits a companys ability to grow by
limiting the total output of the entire system. Limited capacity problem may involve
the use of limited labor hours, limited materials, and limited machine time.
The main decision criterion in this type of problem is that when only one limited
resource is present, a company should focus on products that would be maximizing
the profit in relation to the given scarce/limited resource.
To illustrate, Leyte Company produces wooden plaques and trophies, the following
limited information about the two products follows:
Selling Price Per Unit
Variable Cost Per Unit
Contribution Margin Per
Unit
Plaques
P 36
24
P 12
Trophies
P 30
15
P 15
The company only has one sander that is being used to sand the wood which is the
main component for both the plaques and the trophies. Generally, the wood
required for each plaque takes 2 hours to sand, while the wood required for each
trophy takes 3 hours to sand. Currently, the sander can only be used for a total of
900 hours, which of the two products should Leyte prioritize?
If the contribution margin per unit will be the basis, then it will be Trophies that will
be prioritize since a unit of Trophy will yield P15 as compared to a unit of Plaques
which only earns P12. However, the constraint here is not the units but rather the
machine time of the sander, and knowing that a unit of Plaque and Trophy requires
2 and 3 hours, respectively, in the sanding machine, we have to determine which of
the two products will be providing the highest contribution margin in relation to the
constraint. We can do this by simply assuming that the total machine time will be
devoted to one product and computing the total number of units that can be
produced and multiplying it to the contribution margin per unit to determine the
total contribution margin.
Total Sanding Hours Available
Divided by: Hours required per unit
Maximum number of units that can be
produced
Multiplied by: Contribution Margin Per
Unit
Total Contribution Margin
Plaques
900
2
450
Trophies
900
3
300
P 12
P 15
P 5,400
P 4,500
As we can see, assuming that all the available sanding time will be devoted to
plaques, the maximum earnings that the company will earn is P 5,400 while, if it will
be devoted to Trophies, the company will only earn P 4,500. Another way of looking
at it is the amount of contribution margin earned per available sanding time, for
plaques, it will be P6 or (P 5,400/900) while it will be P5 (P 4,500/900) for Trophies.
This means that a plaque will contribute more than a trophy on per sanding hour
basis. This means that Leyte should prioritize Plaques rather than Trophies in order
for the company to maximize profit. An alternative and easier way of determining
the contribution margin per hour is simply dividing the contribution margin per unit
by the hours required per unit.
Contribution Margin Per Unit
Divided by: Hours required per unit
Contribution Margin per Constrained
Resource
Total Contribution Margin
Plaques
P 12
2
P 6
Trophies
P 15
3
P 5
900
P 5,400
900
P 4,500
Effects of Market Sales Limit

Sometimes, a product has a maximum demand, meaning the company can only sell
as many as what the market demand, thus, there is no point of producing more than
what is being demanded by the market since we cannot force the market to buy our
product. This is called the Saturation Point.
If the product line with the highest contribution margin per constrained resource has
a maximum market demand limit, the remaining limited resources still left may be
devoted to the other product line. Assuming that Leyte can only sell 150 plaques
and 300 trophies, how many of each product should Leyte produce and sell?
Since plaques has a higher contribution margin per constrained resources, it will be
prioritize, the only problem is that although Leyte can produce as many as 450
plaques, it can only sell 150 plaques, hence, there is no sense of producing all 450
plaques. Some of the available sanding time should also be given to Trophies. The
allocation will be as follows:

Hours required for Plaques (150 Plaques x 2 hours
per plaque)
Total Sanding Hours Available for Trophies
Divided by the Hours required per Trophy
Number of Trophies to be produced
900
(300)
600
3
200
As the solution shows, Leyte will be producing 150 plaques and 200 trophies.
Chapter Summary
1. Describe the nature of decision making and the related process as applied
into business
Decision making is necessary for managerial activities. There are two types
of decision, routine and non-routine. Routine decisions are those that are
recurring and already have programmed set of responses which is usually
included in a companys procedures manual. Non-Routine Decisions are
results of uncommon situation and may materially affect how a business
operates. Non-routine decisions must be sold using the scientific approach.
2. Differentiate between relevant and irrelevant financial data in decision
making
Relevant Costs are those that should be considered when making decisions,
there are two types of relevant costs, differential and opportunity costs, while
irrelevant costs should be disregarded. Committed and Sunk Costs are the
two types of irrelevant costs.
3. Depict the process of making a make or buy decision
Also called outsourcing decision, make or buy decision arises when a
company needs to determined whether it should continue making its own
materials or simply buy from a supplier. The important decision criterion is to
determine the total relevant cost to make and comparing such to the total
relevant cost to buy.
4. Determine whether to accept or reject a special order
Accept or Reject Decisions exist when a company receives a special order
from a one-time customer. To make this kind of decision, the company needs
to determine whether the special price, which is usually lower than the
regular price, is higher than the total relevant cost to make and sell.
5. Resolve whether a segment will be drop or maintained
A segment, which can be a product line, a branch or a business unit, should
only be drop if the total loss revenue will be lower than the total avoidable
cost. Additional dropping costs, complimentary and substitute products
should also be considered.
6. Demonstrate how a sell or process further decision is made
A decision of whether processing a product further coming from a joint

production process or selling it immediately at split-off will be made by
determining if the incremental revenue of further processing will be higher
than the incremental costs. Any joint production costs is considered to be a
sunk cost, thus, irrelevant in the decision.
7. Illustrate how to solve limited capacity problem.
Limited Capacity is a result of constraint or bottleneck. When such condition
exists, a company must choose which of its product it should prioritize by
referring to the contribution margin per constrained resources which can be
computed by dividing the total contribution margin per unit to the required
constrained resource per unit.
Chapter Exercises
Problem 1: Multiple Choice Theory Question
1. The cost of a machine purchased last year and used in the production process is
called a(n):
a. opportunity cost
c. incremental cost
b. relevant cost
d. sunk cost
2. Which of the following would NOT be relevant in a make-or-buy decision?
a. direct materials
c. direct labor
b. factory depreciation
d. variable overhead
3. Which of the following should not be considered for every option in the decision
process?
a. Incremental Revenues
c. Future costs
b. Historical costs
d. Opportunity costs
4. Which of the following is not a correct use of the term opportunity cost?
a. Opportunity costs are considered period costs rather than inventoriable
costs for accounting purposes.
b. Opportunity costs must be considered by managers when making
decisions.
c. Opportunity cost plus the incremental future revenues and costs equal the
relevant revenues and costs of any alternative when capacity is
constrained.
d. The opportunity cost of holding inventory is the income forgone by tying
up money in inventory and not investing it elsewhere.
5. What is always the question to ask to determine if revenues or costs are
relevant?
a. What is the time frame for achieving results?
b. What difference will an action make?

c. Who will be responsible?
d. How much will it cost?
6. Differential cost is:
a. Relevant revenue from one alternative minus relevant cost from that
alternative
b. Relevant revenue for the companys product minus cost of goods sold
c. Relevant cost from one alternative minus relevant cost from another
alternative
d. Relevant cost of one alternative minus actual cost of another alternative
7. In the decision to replace an old machine with a new machine, which of the
following would be considered a relevant cost?
a. The book value of the old equipment
b. Depreciation expense on the old equipment
c. The loss on the disposal of the old equipment
d. The current disposal price for the old equipment
8. The decision to drop a product line should be based on:
a. the fact that the product line shows a net loss over several periods
b. the ability of the firm to eliminate some fixed costs as a result of dropping
the product
c. whether the fixed costs that can be avoided by dropping the product line
are less than the contribution margin that will be lost
d. whether the fixed costs that can be avoided by dropping the product line
are greater than the contribution margin lost
9. To maximize total contribution margin, a firm should:
a. promote those products having the highest unit contribution margins
b. promote those products having the highest contribution margin ratios
c. promote those products having the highest contribution margin per unit of
a constrained resource
d. promote those products having the highest contribution margins and
contribution margin ratios
10. Two or more products produced from a common input are termed:
a. common costs
c. joint products
b. joint costs
d. by-products
11. In a decision to sell or process further beyond the split-off point, a manager
should base the decision on
a. the amount of joint product costs allocated
b. the incremental revenue attainable beyond the split-off point
c. the incremental cost incurred beyond the split-off point
d. the incremental operating income attainable beyond the split-off point
12. Costs that are always relevant in decision-making are
a. Avoidable costs
c. Fixed Costs
b. Sunk Costs
d. Variable Costs
13. The managers of a firm are in the process of deciding whether to accept or reject
a special offer for one of its products. A cost that is not relevant to their decision
is the
a. common fixed overhead that will continue if the special offer is not
accepted
b. direct materials
c. fixed overhead that will be avoided if the special offer is accepted
d. variable overhead
14. For decision making, a listing of the relevant costs:
a.
b.
c.
d.
15. When
a.
b.
c.
will help the decision maker concentrate on the pertinent data

will only include future costs
will only include costs that differ among alternatives
All of these answers are correct.
making decisions:
quantitative factors are the most important
qualitative factors are the most important
appropriate weight must be given to both quantitative and qualitative
factors
d. both quantitative and qualitative factors are unimportant
16. Opportunity costs are:
a. not used for decision making
c. the same as variable costs.
b. the same as historical costs
d. relevant to decision making.
17. Freestone Company is considering renting Machine Y to replace Machine X. It is
expected that Y will waste less direct materials than does X. If Y is rented, X will
be sold on the open market. For this decision, which of the following factors is
(are) relevant?
a. Cost of direct materials used
c. Both a and b
b. Resale value of Machine X
d. None of the above
18. In a sell or process further decision, which of the following costs are relevant?
a. A variable production cost incurred prior to the split-off point.
b. An avoidable fixed production cost incurred after the split-off point.
c. Both a and b
d. Neither a nor b
19. VIGAN Corporation is contemplating dropping a product because of ongoing
losses. Costs that would be relevant in this situation would include variable
manufacturing costs as well as:
a. Factory depreciation
c. Corporate administrative costs.
b. Avoidable fixed costs
d. Unavoidable fixed costs.
20. Which of the following statements regarding relevant costs and sunk costs is
incorrect?
a. A serious drawback associated with the incremental approach of relevant
cost study is that the incremental approach is cumbersome if more than
two alternatives are considered.
b. The type of cost presented to management for an equipment replacement
decision should be limited to relevant costs.
c. A sunk cost is a cost which cannot be avoided because it already has been
incurred.
d. Relevant costs can be studied using an incremental approach but should
not be considered with a full project approach.
Problem 2: Relevant and Irrelevant Costs

Required: Identify whether the cost is a relevant or irrelevant cost. If a cost is a
relevant cost, identify whether it is a differential or an opportunity costs, if it is an
irrelevant cost, identify whether it is a committed or sunk cost.
a) Rental Fee to be earned as alternative usage of plant space
b) Joint production costs incurred
c) Research and development costs incurred in the prior months
d) Cost of special device that is necessary if a special order is accepted
e) Cost of obsolete inventory acquired several years ago.
f) Purchase price of the old machine
g) Current Market Value of the old machine
h) Executive Managers Salaries

i) Real Property Taxes of the Plant/Factory
j) Direct Materials and Direct Labor
k) Additional Fixed selling Costs to be incurred due to increase in sales
l) Utilities, Indirect Materials and Indirect Labors
m) Depreciation of the production equipment
n) Cost of Further Processing a product after the joint production process
o) Shutdown cost to be incurred if a factory will be temporarily closed
Problem 3: Relevant and Irrelevant Costs
A number of costs are listed below that may be relevant in a decision faced by the
management of Bulacan Company. Bulacan normally runs at capacity and the old
Model Printing machine is the companys constraint. Management is considering
purchasing a new printing machine, and the old one will be sold. The new machine
is more efficient and can produce 20% more units than the old one. Demand for
Bulacans product is greater than what they can supply. If the new machine is
purchased, there should be a reduction in maintenance costs however the new
machine is very costly and the company will need to borrow money in order to make
the purchase. The increase in volume will be large enough to require increases in
fixed selling expense, but general administrative expenses will remain unchanged.
Required: For each cost listed determine whether the cost is relevant or irrelevant to
the decision to replace the old printing machine.
a) Sales Revenue
b) Direct materials
c) Direct labor
d) Variable manufacturing overhead
e) Rent on the factory building
f) Janitorial salaries
g) Presidents salary
h) Book Value of CY1000
i) Cost of CY1000
j) Cost of CZ4000
k) Interest on money borrowed to make purchase.
l) Shipping costs
m) Market value of old machine CY1000
n) Insurance on factory building
o) Salaries paid to personnel in sales office
Problem 4: Make or Buy
Tarlac Corporation is now making a small part that is used in one of its products. The
companys accounting department reports the following per unit costs of producing
the part internally:
Direct Materials
P15.00
Direct Labor
10.00
2.00
Fixed Manufacturing Overhead, traceable
4.00
Fixed Manufacturing Overhead, allocated
5.00
Depreciation of special equipment represents 75% of the traceable fixed
manufacturing overhead cost with supervisory salaries representing the balance.
The special equipment has no resale value and does not wear out through use. The
supervisory salaries could be avoided if production of the part were discontinued.

An outside supplier has offered to sell the part to Tarlac Corporation for P30 each,
based on an order of 5,000 parts per year and Tarlac will be incurring an additional
P2 per unit for quality inspection of incoming parts.
Required:
1. Should Tarlac accept this offer, or continue to make the parts internally?
2. Assuming that if Tarlac accept the offer it will have enough idle capacity to
produce another product that will have a contribution margin of P 15,000,
should Tarlac accept the offer or continue to make the parts internally?
Abra Corporation makes the 1-gallon plastic milk jugs used to package its premium
goats milk. The company has been approached by a plastic molding company with
an offer to produce the milk jugs at a cost of P14.00 per thousand jugs. Abra
Corporations president believes the company should continue to produce the jugs
and the plant manager has recommended accepting the offer because the cost to
produce the jugs is greater than the purchase price. The companys cost to produce
one thousand jugs is as follows:
Direct materials
P4.00
Direct labor
2.75
Variable manufacturing overhead
3.50
Fixed manufacturing overhead, traceable
3.00
Fixed manufacturing overhead, common
2.50
Total production cost
P15.75
One-half of the traceable fixed manufacturing costs represent supervisory salaries
and other costs that can be eliminated if the milk jugs are purchased. The balance
of the traceable fixed manufacturing costs is depreciation of manufacturing
equipment that has no resale value. Some of the space being used to produce the
milk jugs could be used to store empty jugs, eliminating a rented warehouse and
reducing common fixed costs by 20%. The rest of the space could be rented to
another company for P 30,000 per year. Abra Corporation produces 10,000,000 milk
jugs per year.
Required: Should Abra Corporation make or buy the milk jugs?

Cebu Corporation makes steel blades for lawn mowers that is heat treats,
assembles, and sells. The cost accounting system gives the following data:
Direct Materials
P 50,000
Direct Labor
P 30,000
Variable Factory Overhead
P 60,000
Fixed Factory Overhead P 90,000
Units Produced
100,000 units
Cebu has an opportunity to purchase its 100,000 blades from an outside supplier at
a cost of P2.20 per blade. Inspection of the purchased blades will cost an additional
P 5,000 in the quality assurance department. Certain leased equipment, which costs
P 30,000 and is included in fixed overhead, can be avoided if the blades are
purchased. The released space could be used to make a part that is not purchased,
which would net Cebu a savings of P 46,000.
Required: Should Cebu buy the blades from the outside suppler?
The Tagaytay Company is now producing a sub-assembly that does into its final
product. The company reports the following costs of producing the sub-assembly:
Per unit
8,000
units
Direct materials
P 3
P 24,000
Direct labor
4
32,000
Variable overhead
4
32,000
Fixed overhead, direct
5
40,000
Fixed overhead, common ( but
8
64,000
allocated)
TOTAL
P 24
P192,000
The Tagaytay Company has received an offer from a supplier who will provide 8,000
sub-assemblies a year at a firm price of P21 each. The space now being used to
produce the sub-assemblies could be used to produce a new product line that would
generate a segment margin of P50,000 net per year:
Required: The president asks your opinion on whether or not Tagaytay, should stop
producing the sub-assemblies and start purchasing them from the suppliers.
Problem 8: Accept or Reject
Pampanga Corporation manufactures two pizzas, Hawaiian and Italian. Direct
material is the only variable manufacturing cost because the production process is
fully automated. The only variable selling cost is a 5% commission on the selling
price. All other manufacturing, selling, general and administrative costs are fixed
and the production capacity is limited to 235,000 machine hours. Budgeted
information for the year:
Hawaiian
Italian
Budgeted sales (units)
100,000
90,000
Regular selling price
P300
P450
Direct materials
P100
P160
Machine time per unit
1 hour
1.4 hours
Manufacturing costs, other than direct materials, budgeted for the year are P
1,590,000 and are allocated to Hawaiian and Italian based on units. Selling, general
and administrative costs, other than commission, budgeted for the year are P
3,895,000 and are allocated to Hawaiian and Italian based on sales revenue.
Required:
1. Buyer Ltd. has approached Pampanga Corporation and would like to purchase
10,000 customized units of the Hawaiian for P 440 each. Because of capacity
concerns, possible opportunity costs, and a one-time setup cost of P 100,000, the
manager of sales is willing to cut the commission from the regular 5% to 3% on this
special order. The opportunity cost in accepting the special order is:
2. If Pampanga Corporation accepts the special order, its income will increase/
(decrease) by:

KFC Corporation has the following cost per unit information about its only product
Zinger:
Direct Materials
P 40.00
Direct Labor
30.00
Variable Overhead
20.00
Fixed Overhead
10.00*
Other Costs:
Variable Selling Expenses
15.00
Fixed Selling Expenses
50,000
*Based on 10,000 units of normal production
The company is currently operating at 90% of normal capacity. A prospective
customer has approach management offering to buy 1,500 units at a special price
of P 95.00 instead of the regular price of P130.00. The company will be able to save
on variable selling expenses while variable overhead will decrease by 25% but will
be required to purchase special equipment amounting to P 10,000 which will have
no other use after the order has been served.
Required:
1. What should be the minimum price of the special order for KFC to accept such?
2. What should have been the current operating capacity of in the company in order
for the decision to be indifferent?
BATANGAS Corporation manufactures and sells a type of knife. The company has
never been able to sell all it can produce (which is 50,000 knives, meaning it has
enough excess capacity). The cost sheet for the knife appears below:
Direct material
P 6.00
Direct labor
7.00
Overhead @ 100% of direct labor
7.00
TOTAL COST
P 20.00
Variable overhead is P2.00 per unit and variable selling and administrative expense
is P1.00 per unit. The company received an order from a new customer for 5,000
knives at a special price of P 18.00 instead of the regular price of 25.00.
Required:
1. Based on the foregoing information, how much is the net advantage
(disadvantage) if the company accepts the special order?
2. What if the company is currently able to sell 48,000 knives to its regular
customers, how much is the net advantage (disadvantage) of accepting the
special order?
3. What if the company has enough excess capacity but the special order
requires a special tool worth P 30,000 that will have no other use after the
order has been served, how much is the net advantage (disadvantage) of
accepting the special order?
The Samar Corporation has an annual plant capacity of 25,000 units. Predicted data
on sales and costs are given below:
Sales (20,000 units @ P50)
P 1,000,000
Manufacturing costs:
Variable (materials, labor, and overhead)

P 40 per unit
Fixed overhead
P 30,000
Selling and administrative expenses:
Variable (sales commission P 1 per unit)
P 2 per unit
Fixed
P 7,000
A special order has been received from outside for 6,000 units at a selling price of P
45 each. This order will have no effect on regular sales. The usual sales commission
on this order will be reduced by one-half. However, special equipment costing P
12,000 will be needed to be acquired by Samar to make the special features that
the outside customer is requesting.
Required: Should the company accept the order?
Problem 12: Drop or Maintain
Sophisticates' Corner sells clothing, shoes, and accessories at a suburban location
near Boston. Information for the just concluded calendar year follows.
Clothing
Shoes
Accessori
es
Sales
P
P P 150,000
850,000 320,000
Less: Variable Costs
P
P
P 82,500
510,000 270,000
Fixed Costs
290,000
70,000
42,000
Operating Income
50,000 (20,000)
P 25,500
Management is considering closing the shoe operation because of the loss and to
permit expanding the space that is currently devoted to accessories sales. A
salaried salesperson in the shoe department who earns P 45,000 will be terminated;
however, all other departmental fixed costs will continue to be incurred.
Sophisticates' Corner will spend P 16,000 on remodeling costs and anticipates that
accessories sales will increase by P 70,000. This additional sales revenue is
expected to generate a 35% contribution margin for the firm. Finally, because
clothing customers often purchased shoes and feel strongly about "one-stop
shopping," clothing sales are expected to fall by 15% if the shoe department is
closed.
Required: Determine whether the shoe department should be closed.
Rustic Shoe Company produces and sells shoes to domestic retailers. For one brand
of shoe, the company sells 10,000 pairs in the general market and 10,000 pairs to a
single customer. The market price is P13 per pair and the price to the single
customer is P10 per pair. The production and selling costs are as follows:
Variable production cost
P6.50 per pair
Variable selling costs
P1.75 per pair (market sales)
P0.75 per pair (single customer)
Fixed production costs
P 34,000
Fixed selling costs
P 20,000
Capacity
20,000 pairs
The company is considering not selling the 10,000 pairs to the single customer, but
instead also selling these pairs in the general marketplace. It is confident that the
market can absorb the additional 10,000 pairs. In order to sell to the general
marketplace, the companys variable selling expenses on the additional pairs will be
the same as they are now. An increase of P 5,000 in fixed selling expenses will also
be necessary.
Required:
1. What is the advantage (disadvantage) of discontinuing selling to a single
customer?
2. Disregarding capacity, determine the number of units the single customer should
order in order for the companys managements decision to be indifferent.
Romblon Corporation produces and sells shoes to domestic retailers. For one brand
of shoe, the company sells 10,000 pairs in the general market and 10,000 pairs to a
single customer. The market price is P13 per pair and the price to the single
customer is P10 per pair. The production and selling costs are as follows:
Variable production cost
P6.50 per pair
Variable selling costs
P1.75 per pair (market sales)
P0.75 per pair (single customer)
Fixed production costs
P 34,000
Fixed selling costs
P 20,000
Capacity
20,000 pairs
The company is considering not selling the 10,000 pairs to the single customer, but
instead, also selling these pairs in the general marketplace. Romblon Corporation is
confident that the market can absorb the additional 10,000 pairs. In order to sell to
the general marketplace, the companys variable selling expenses on the additional
pairs will be the same as they are now. An increase of P5,000 in fixed selling
expenses will also be necessary.
Required:
1. What is the advantage (disadvantage) of discontinuing selling to a single
customer?
2. Disregarding capacity, determine the number of units the single customer
should order in order for the companys managements decision to be
indifferent.
Camarines Company currently operates 3 departments: Bedding, Furniture and
Kitchen departments. The income statement of the company for the year ended
March 2012 shows the Furniture department is making a loss as follows:
Bedding
Furniture
Kitchen
Sales
P
500,000
600,000
800,000
Cost of Sales
600,000
420,000
400,000
Gross Margin
200,000
80,000
200,000
Less: Operating costs
Head office overhead
120,000
64,000
80,000
Selling overhead
30,000
20,000
20,000
Administrative
20,000
27,000
10,000
overhead
Net Profit/(Loss)
P 30,000
P P 90,000
(31,000)
The losses that Furniture department made had lowered down the overall
companys profit to P89,000. He suggests that the department be closed
permanently. The effect of the closure is studied and the following information is
available:
a) All costs of sales are variable and all of the selling overheads in the Furniture
department will be eliminated
b) The sales in Bedding department is expected to increase by 20%. However,
Kitchen department sales is expected to be reduce by 5%
c) The other departments will share the head-office overhead of the Furniture
department equally
d) Only P12,000 of the administrative costs in furniture department can be
avoided because the staffs of the department will be transferred to Kitchen
department
e) The company will incur an additional cost to close down department
amounting to P29,000
Required: Should Furniture department be closed down?
Problem 16: Shut Down Point
BATAAN Corporation manufactures and sell a single product. At normal capacity of
100,000 units per annum, the unit cost of manufacturing the product is:
Direct materials
P 2.20
Direct labor
P 2.80
P 1.20
Fixed Manufacturing Overhead
P 2.00
Total Production Cost per unit
P 8.20
Variable selling and administrative expenses amount to P0.80 per unit. Fixed selling
and administrative costs are P 40,000 annually. Due to the increasing competition,
the company expects to be able to sell only 40,000 units at a reduced selling price
of P10.00 each, next year. The company is re-organizing its operations to be able to
regain competitive position. In the meantime, management is faced with the
problem of whether to shut down completely or continue limited operations at a
loss. In the event of a shut down, it is expected that all fixed costs can be reduced
by about . Additional costs of shutting down the plant for one year are estimated
at P15,000.
Required:
1. What would be the net advantage (disadvantage) to the company if
management decides to shutdown? (Hint: You are looking for the option that
will result in a lower loss)
2. What if the company can only sell 14,000 units, should the company continue
or shutdown?
3. Using the original data, compute for the shutdown point in units.
Problem 17: Shut Down Point
Manila Corporation normally produces and sells 50,000 units of RG-6 each month.
RG-6 is a small electrical relay used as a component part in the automotive
industry. The selling price is P28.00 per unit, variable costs are P22.00 per unit,
fixed manufacturing overhead costs total P420,000 per month, and fixed selling
costs total P88,000 per month. Employment-contract strikes in the companies that
purchase the bulk of the RG-6 units have caused Manila Corporations sales to
temporarily drop to only 26,000 units per month. Manila Corporation estimates that
the strikes will last for two months, after which time sales of RG-6 should return to
normal. Due to the current low level of sales, Manila Corporation is thinking about
closing down its own plant during the strike, which would reduce its fixed
manufacturing overhead costs by P120,000 per month and its fixed selling costs by
10%. Start-up expenses at the end of the shutdown period would total P2,000.
Since Manila Corporation uses just-in-time (JIT) production methods, no inventories
are on hand.
Required:
1. Assuming that the strikes continue for two months, would you recommend
that Manila Corporation close its own plant? Explain. Show computations in
good form.
2. At what level of sales (in units) for the two-month period should Manila
Corporation be indifferent between closing the plant or keeping it open? Show
computations. (Hint: This is a type of break-even analysis, except that the
fixed cost portion of your break-even computation should include only those
fixed costs that are relevant [i.e., avoidable] over the two-month period.)
Problem 18: Sell or Process Further
Palawan Company makes two products, Wuho and Puho, in a joint process. At the
split-off point, 50,000 units of Wuho and 60,000 units of Puho are available each
month. Monthly joint production costs are P290,000. Product Wuho can be sold at
the split-off point for P5.60 per unit or P8.30 if Wuho will be further processed
costing P2.50 per unit. Product Puho either can be sold at the split-off point for
P4.75 per unit or it can be further processed and sold for P7.20 per unit. If Puho is
processed further, additional processing costs of P3.10 per unit will be incurred.
Required:
1. Which of the two products should be processed futher?
2. What would the selling price per unit of Product Puho need to be after
processing in order for Palawan Company to be economically indifferent
between selling Puho at the split-off point or processing P further?
Pampanga Corporation produces a fish product which can be sold after the cleaning
process, or it can be smoked and then sold. For next month, the company has
scheduled production of 80,000 kilos which, if sold unsmoked, would bring a selling
price of P4.60 per kilo. Costs associated with producing the unsmoked product are
P2.40 per kilo plus fixed facilities costs of P 60,000 for the month. If 80,000 kilos are
produced, the entire slaughtering capacity will be used. If the 80,000 kilos are
smoked, smoking capacity, which would otherwise be idle, will be used entirely also.
The additional variable costs, mainly for heat and smoking ingredients, are
estimated to be P0.80 per pound; and a selling price of the smoked product is P6.60
per pound. The monthly committed fixed costs on the portion of the facility used for
smoking the meat amount to P 16,000, and avoidable fixed costs are P10,000.
Required: Should Pampanga smoked or not the 80,000 kilos of fish?
Balanga Corporation purchased a cow but the municipal government has demanded
that the company get rid of it since it is a violation of a municipal ordinance. The
cow cost P2,000 and weighed a ton. The company is considering the following
options:
Option 1 Sell the whole cow to the Meat Market for P 2,500
Option 2 Make Hamburger. Processing costs of P200 and revenue of P
2,600.
Fatten cow, make Kobe beef (a Japanese delicacy).
Processing costs of P 3,900 and revenue of P 5,800.
Option 4 Feed cow (Cost P 1,000 including the municipal fines), take
cow to football games not revenue but lots of fun.
Required: Choose the best option for Balanga.
Option 3

Valenzuela Corporation presses cherries producing raw cherry juices. The cost of
producing a batch of cherry juice is P 10,000 including the cost of the cherries. From
one batch comes 10,000 gallons of juice. This can be sold on the market for P
15,000. The owner is considering various all natural products that would give
alternative uses for the juice. Estimated revenues, costs, and volumes for each
option are:
Optio
Additional
Product
Quantities
Market Value
n
Costs
Outputs
A
P 4,000
Cough
2,000 gallons P 6 per gallon
medicine
1,000 gallons P 4 per gallon
Coffee
500 pounds
P 10 per
Substitute
pound
Cherry
Powder
B
P 15,000
Frozen
14,000 cans
P 2 per can
Concentrate
C
P 20,000
Muscle
2,000 cases
P 15 per case
Ointment
1 pound
P 500 per
Hair growth
ounce
Grease
Required: Choose the best option for Valenzuela.
Problem 22: Limited Capacity
McDonalds has been producing burgers for a number of years now. A regular burger
can already be sold at P 100.00 or it can be further processed into a cheese burger
which sells for P 150.00, a Big Mac which sells for P 180, and the famous Mushroom
Melt which can be sold for P 240. A regular burger can be produced at a total per
unit cost of P 80.00.
Cheese Burger
Big Mac
Mushroom Melt
Additional Processing
P 40.00
P 120.00
P 90.00
Costs
Current Unit Sales
5,000
3,000
2,000
Required:
1. By how much was the company losing for further processing unprofitable
product line?
2. If the unprofitable product line will be dropped and all units sales of such will
be transferred to the most profitable product line, by how much would the
companys net income increase/(decrease)?
Data for the four (4) products of Global Corporation are given below:
North
South
East
West
Selling Price
P 13
P 20
P5
P 25
Variable Costs
5
7
2
16
Allocated Fixed
4
8
1
3
Costs
Units produced per
4 units
2 units
10 units
3 units
hour
Maximum Sales
5,000
5,000
10,000
No limit
limit
units
units
units
Minimum
1,000
None
2,000
1,200
Requirements
units
units
units
Total capacity is 6,000 hours. Minimum requirements meet existing sales
commitments. Marketing has provided a best estimate of maximum sales
expected for each product.
Required: Based on the above data, chose the best product combination.
The Bird Toy Company manufactures a line of dolls and a doll dress sewing kit.
Demand for the dolls is increasing, and management requests assistance from you
in determining an economical sales and production mix for the coming year. The
company has provided the following data:
Direct
Demand Next Selling Price Materia Direct
Product
Year (units)
per Unit
ls
Labor
Barbie
80,000
$34.40 $4.80 $ 8.00
Winona
50,000
18.00
1.00
5.00
Baby Jane
40,000
39.80
6.20 12.00
Ken
45,000
28.00
1.80
8.00
Sewing kit
340,000
20.00
2.90
4.00
The following additional information is available:
a. The companys plant has a capacity of 150,000 direct labor-hours per year on a
single-shift basis. The companys present employees and equipment can
produce all five products.
b. The direct labor rate of $20.00 per hour is expected to remain unchanged during
the coming year.
c. Fixed costs total $530,000 per year. Variable overhead costs are $6.00 per direct
labor-hour.
d. All of the companys nonmanufacturing costs are fixed.
e. The companys finished goods inventory is negligible and can be ignored.
Required:
1. Determine the contribution margin per direct labor-hour expended on each
product.
2. Prepare a schedule showing the total direct labor-hours that will be required
to produce the units estimated to be sold during the coming year.
3. Examine the data you have computed in (1) and (2) above. How would you
allocate the 150,000 direct labor hours of capacity to Bird Toy Companys
various products?
Recto Company is a small family business that produces wooden plaques and
trophies:
Plaques
Trophies
Selling price per unit
P 18
P 15
Variable cost per unit
12
8
Contribution margin per unit
P 6
P 7
The company only has one machine, a sander, to sand the wood that is used for the
plaques or the trophies. Generally, the wood required for each plaque takes 0.25
hour to sand, while the wood required for each trophy takes 0.50 hour to sand.
Required:
1. If the total available machine hours are 100 hours and there were no market
limitation on both products, what would be the maximum profit that the
company can earn given the said constraint?
2. Supposing that the maximum number of Plaques that can be sold each period
200 Plaques, what would be the maximum profit that the company can earn
given the said constraint?
3. Supposing that the maximum number of Plaques that can be sold each period
is 400 Plaques however, due to a purchase commitment contract, Trophies
required to be sold is around 50 Trophies, what would be the maximum profit
that the company can earn given the said constraint?

Module 6 Differential Costing

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Module 6: Non-Routine Decision Making

At the end of this module, you should be able to:

Decision Making in Business

1 | Non-Routine Decision Making

is evaluating whether to drop or to maintain a segment of the company might

Relevant and Irrelevant Costs

2 | Non-Routine Decision Making

Make or Buy Decision

5 | Non-Routine Decision Making

Less: Avoidable Cost:

The total advantage of making is P 10,000 or 5,000 units multiplied by the

Total Relevant cost to make

6 | Non-Routine Decision Making

Additional Rental Revenue

Advantage of Buying (per

In the presence of an alternative usage or income-generating activity for the facility

Accept or Reject a Special Order

Unit product cost

Effect of Special Costs

Incremental Revenue (Sales)

Total advantage of accepting the order

Alternatively, the Total advantage of P 20,000 can be determined by simply

Idle Capacity (in units)

The shortage in idle capacity can be addressed by either buying additional

Variable Manufacturing Overhead

Drop or Maintain a Segment

Pampanga is considering discontinuing Product A because it is unprofitable. If

Alternatively, the P 5,000 opportunity cost (since it is a profit that will be

Effect of Incremental Costs

As we can see, the incremental cost further increase the disadvantage of

12 | Non-Routine Decision Making

To illustrate, disregarding the closing cost discussed in the previous section,

Product B being a complimentary product of Product A further increases the

Effect of Substitute Products

Notice now that from a disadvantage it now becomes an advantage for

increase cash inflow, is shown as a positive item while an incremental cost,

Shutdown or Continue Operating and the Shutdown Point

Bataan should continue operation even though the expected result is a

Using the opportunity approach, the same amount of disadvantage will be

The Shut Down Point

Sell or Process Further

The second step is to compare the incremental revenue computed to the

18 | Non-Routine Decision Making

products further to determine the total advantage or disadvantage of further

Limited Capacity Problem

Effects of Market Sales Limit

Total Sanding Hours Available

A decision of whether processing a product further coming from a joint

b. What difference will an action make?

23 | Non-Routine Decision Making

will help the decision maker concentrate on the pertinent data

Problem 2: Relevant and Irrelevant Costs

h) Executive Managers Salaries

supervisory salaries could be avoided if production of the part were discontinued.

Problem 6: Make or Buy

26 | Non-Routine Decision Making

27 | Non-Routine Decision Making

Problem 9: Accept or Reject

Variable (materials, labor, and overhead)

Problem 21: Sell or Process Further

35 | Non-Routine Decision Making

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