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Relevant costing
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10
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Joint Product Costing and Accounting: Fixed Costs, Apportionment, Relevant Costing, Study Guides, Projects, Research of Decision Making
The accounting and costing challenges associated with joint products, focusing on fixed costs, apportionment methods, and relevant costing. It covers topics such as the difference between fixed and directly attributable fixed costs, the concept of spare capacity, and the methods for apportioning common costs between joint products. The document also provides examples of joint products and their costing, as well as the importance of considering objectives, courses of action, and decision-making processes.
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Relevant costing
Chapter
10.1 Introduction to relevant costing
A relevant cost is a ‘future incremental cash flow’, arising as a direct consequence of a decision made.
A relevant cost is for a particular decision and will change if an alternative course of action is taken. Using this approach will simplify the decision making process as it will eliminate redundant data. Relevant costing is one of the best methods of making decisions in the short- term.
Typical examples of where relevant costing is used is in decisions being made as to whether to accept or reject a contract, pricing work that needs to be performed and cost benefit comparisons.
Fixed costs
Expenditure which cannot be economically identified with a specific saleable cost unit.
A cost incurred for an accounting period, that within certain output or turnover limits, tends to be unaffected by fluctuations in the level of activity (output or turnover). (CIMA)
Indirect overhead or fixed cost is a cost which cannot be easily identified or related to a cost per unit or activity of any kind e.g. a cost which remains constant when the production of a good or service within the organisation rises or falls. Examples could include a factory supervisor’s salary or factory rent and rates, or other non-production related expenses such as the cost of running the marketing, finance or human resource department.
Fixed cost may also be referred to as a period cost e.g. incurred for an accounting period regardless of sales or production levels. It is a cost that remains constant within certain limits of an activity e.g. production or sales.
Fixed costs generally are not relevant when a decision is made.
Avoidable costs are those costs that would be saved or avoided as a result of not doing an activity. For example the shutting down of a division or a department may save or avoid labour costs, rental costs, heating and lighting costs provided that these costs can be avoided and are not committed.
Differential or incremental costs are those costs which are the difference between alternative decisions. For example if the relevant cost to employ an English member of parliament (MP) is £1,000 and the relevant cost to employ a Scottish MP is £490 then it can be said that the differential or incremental cost is £510, being the extra cost to employ an English MP.
Relevant cost of labour
Labour will either be at full capacity meaning that every individual is participating in a productive activity for the organisation and so there is no one spare to do other new activities, or labour will not be at full capacity meaning that there is spare capacity within the labour force that can be used to carry out new activities.
The relevant cost of labour for a new contract will therefore be dependent on whether the labour force is at full capacity or has spare capacity.
If the labour force is at full capacity then the relevant cost will be the opportunity cost of lost contribution from existing production being stopped to carry out the work on the new contract.
If the labour force had spare capacity then the relevant cost will be nil as the idle labour force can be used to carry out the work on the new contrct as long as there is enough labour to do so, if not then some of the non-idle labour force would have to be used and as a result incurring opportunity cost of lost contribution from existing work.
Generally most labour cost is fixed (the modern thought), therefore paid regardless of whether labour is productive or not. Overtime payments or piecework payment schemes in decisions however can be relevant.
Full capacity (^) Spare capacity
Labour costs + variable costs + £Nil contribution lost from ceasing manufacturing of other goods.
Example 10.
Lady Gaga Plc is a renowned record manufacturing company and has received a one off order from Ginger Blears an English member of parliament to write and manufacture a song for her about how honourable she is. In addition to demonstrate her selfless efforts to public duty the record should be made from platinum, a more expensive material than the usual material used to manufacture records. Ms Blears is happy to pay for this record out of her expenses claiming it back from the taxpayer.
Currently Lady Gaga Plc’s work force is at full capacity and would have to stop work on existing songs in development such as “If you don’t know me by now” and “Everything I do, I do it for you” for other trustworthy members of parliament.
The following information is available for the usual manufacture of new songs.
Per song (£) Selling price 45, Material (5,000) Variable overheads (3,000) Labour (2,000) Contribution 35, Fixed overhead (1,500) Profit 33,
What is the lost contribution suffered by Lady Gaga Plc if it accepted the order from Ginger Blears?
Example 10.2 – Worked example (CIMA past exam question)
Z plc is preparing a quotation for a one off contract to manufacture an item for a potential customer. The item is to be made of steel and the contract would require 300 kgs of steel. The steel is in regular use by Z plc and, as a consequence, the company maintains an inventory of this steel and currently has 200 kgs in inventory. The company operates a LIFO basis of inventory valuation and its most recent purchases were as follows:
20 November 2006 150 kgs costing £ 3 November 2006 250 kgs costing £1,
The steel is easily available in the market where its current purchase price is £4.25 per kg. If the steel currently held in inventory was to be sold it could be sold for £3.50 per kg.
Calculate the relevant cost of the steel to be included in the cost estimate.
The steel needed for the one off contract is regularly used and therefore we use the current purchase price as the relevant cost to value the steel.
Therefore:
£4.25 x 300 kgs = £1,
Example 10.3 – (CIMA past exam question)
X plc intends to use relevant costs as the basis of the selling price for a special order: the printing of a brochure. The brochure requires a particular type of paper that is not regularly used by X plc although a limited amount is in X plc’s inventory which was left over from a previous job. The cost when X plc bought this paper last year was $15 per ream and there are 100 reams in inventory. The brochure requires 250 reams. The current market price of the paper is $26 per ream, and the resale value of the paper in inventory is $10 per ream.
Calculate the relevant cost of the paper to be used in printing the brochure.
Example 10.
GLS Plc have 1,000kg of high quality iron ore stock in a warehouse that has been sitting there for well over 4 months a recent quote from a scrap merchant offered about £2,200 for the entire lot about 2 weeks ago. The historical value of stock using a FIFO basis is £5,750.
The iron ore stock could also be used on a current batch of goods GLS are working on which would require the full amount of 1,000kg, but the batch does only need to use a lower quality of iron. This can be smelted down and used for manufacturing water cans, which have the following cost information.
Per unit (£) Selling price 15. Iron ore (2kg) (8.00) Labour (4.00) Contribution 3. Fixed overhead (1.00) Profit 2.
High quality iron ore can be currently purchased for £4.50 per kg. The £4.00 per kg above is the current market price for cheap iron ore.
A customer in desperate need for this stock rings up GLS and frantically offers £5,000 for the 1,000kg.
Should GLS accept such an offer?
Note: It is not just the financial implications the examiner will require it may be the qualitative factors as well (those factors which cannot be expressed numerically). It is also important to make assumptions in this form of question when information is uncertain.
10.2 The decision making process
Decisions are necessary when there is uncertainty and an alternative action could be taken. When this is the case the following process should be taken:
Identify your objectives
All organisations require objectives allowing them to serve the purpose they were designed for and so this is why it is the most important step in the decision making process. Objectives are derived from goals. Goals are what the organisation plans or intends to achieve; normally converted to objectives which have measurability and timescale. Objectives are a measurable description of a goal with a clearly defined desired result and timescale to achieve it.
Examples of goals may include maximising shareholder wealth, maximising profits, maximising sales or reducing costs, increasing efficiency, reducing the use of non-sustainable resources, improving the environment, and increase accessibility of essential services for the underprivileged.
Examples of objectives to achieve goals maybe to increase profits before tax by 15% over the next 2 years, cut indirect costs by 10% over the next 12 months, increase sales by 20% over the next 3 years, reducing hospital waiting lists by 30% over the next 10 years and reduce carbon emissions by 80% over the next 4 years.
Identify your objectives
Identify course of action to achieve objectives
Investigate, evidence and evaluate these courses of action
Select the best option
Compare the actual v budget and take corrective action if necessary
Identify course of action to achieve objectives
After deciding the objectives we then have to consider the courses of action that can be taken to achieve them. Examples of course of action that can be taken may include launching new products to increase sales and profitability, such as LCD or Plasma TVs, ceasing existing products that maybe making a loss and are out of favour with customers, such as video recorders, redevelopment of existing products which are not so popular, such as the same familiar chocolate bar becoming several new products this being brands like Kit Kat and Mars.
Investigate, evidence and evaluate these courses of action
Organisations cannot usually carry out all courses of action to achieve their objectives because there is simply not enough resources to do this, and so they must select only one course of action.
In this step each course of action is investigated and evaluated on its merits and demerits in achieving the desired objectives. Evidence is collected from both internal sources within the organisation (production capacity and budget costs) and external sources outside the organisation (market share and growth of competition) being both quantitative and qualitative.
Quantitative information is concerned with information that can be easily expressed in the form of numbers e.g. absolute measures, relative percentages, ratios, indices or fractions. Qualitative information is information that cannot be easily expressed in the form of numbers, information that would be hard to quantify e.g. soft opinions, preferences and feelings of customers about the perception of brands or product features offered to them.
There should also be an analysis of the probability of achieving the objectives through each of these courses of action. This would include understanding how realistic the assumptions are in all courses of actions.
Select the best option
This step assesses the courses of action presented and seeks to select the most effective course of action and then implement it. There should be a clear rationale and criteria used in arriving at the selected option and why the other courses of action were rejected.
Compare the actual v budget and take corrective action if necessary
Once the course of action is underway it is essential that is monitored frequently and regularly to ensure it is conforming to expectations. If this is not the case then corrective action should be taken. There are two type of corrective action that can be taken that being feed- forward control and feedback control.
Example 10.
M and A ‘Hair and Beauty’ are a company offering the highest standards of service for hair and beauty in Peterborough. They currently offer two basic services the cut, wash and blow dry and the pedicure/manicure. Financial details about these two services are as follows;
CWBD MP £ £ Price 75.00 35. Materials (10.00) (5.00) Wages (15.00) (5.00) Contribution 50.00 25.
Hours 1.5 0.
Maximum demand every week for the use of the MP services is 40 hours a week from customers.
M and A are thinking of revamping the side of their building, which they currently rent for £4,000 a year, however were going to sell it to the current tenants for £50,000 in one years time. This building will then be used to offer a third service the ‘massage and aromatherapy’ room, which M and A feel will have, they believe unlimited demand given the small capacity of the building. Each service will be charged at an average of £80 and will incur materials at an average cost of £12. It is likely that each service will use at least 1.5 hours of a beautician’s time. The revamp to the building and the extra equipment needed would be in the region of £30,000 all in.
Currently M and A have one of the worse reputations for industry wages in the area. They employ 7 hairdressers which also act as beauty consultants and are paid £10 an hour. Each hairdresser works a 6-day week for 7 hours a day for 48 weeks a year, no holiday pay is given. Hairdressers would be willing to put in an average of 8 hours a week overtime (at time and a half) each, however the manager Margaret, is not keen on working staff hard, as she believes it affects the standard of service.
Margaret is paid £26,000 a year to run the shop and is currently decorating the premises. If the extension does go ahead Margaret will stop to manage the project and therefore will have to hire a decorator to finish the current job at a cost of £1,000. Checking the order book shows the shop is already at full capacity and given the low rate of pay it is unlikely that any more staff can be recruited. Margaret will be helping supervise and market the new service and it has been agreed that 20% of her salary will be apportioned to the cost of running the new service.
3 of the current hairdressers have agreed to train over the next few months as masseurs and aromatherapists at a cost to the company of £10,000. At a recent meeting all staff thought it was a good idea and it was also agreed that the overtime rules would be relaxed when the new building is opened in order to alleviate the staff shortage. There will also be extra rates, power and heating costs for the new part of the building of £28,000 each year.
Assuming M and As order books are at full capacity, calculate whether on financial grounds M and A should go ahead with the proposal, also discussing any other factors M and A should take into account as to whether they should proceed with this new service or not?
10.3 Operating gearing
Measures the effect of fixed costs on operating profit.
Measured by operating gearing Contribution = % PBIT
Companies with very high fixed cost in comparison to total cost will find that their profits are more variable to sales volume changes.
If sales begin to fall then they will not be able to contract their fixed costs which they maybe committed to for a long time, for example a 10 year lease agreement for a warehouse. They will still have to make lease payments whether or not sales occur, and profits will begin to fall.
If sales begin to rise then they will have the spare capacity to be able to meet this demand as they have invested in fixed costs, for example a 10 year lease agreement for a warehouse, and profits will begin to rise.
Example 10.
High gear (£) Low gear (£) Sales 100 100 Variable cost (10) (60) Contribution 90 40 Fixed cost (60) (10) Profit 30 30
Evaluate the effect on profit due to a 20% drop in sales volume?
Final sales value method e.g. common cost apportioned using the sales value of the joint products after further processing, but ignoring any deduction for further processing cost of each product after split off. After further processing, often the sales value of joint products would increase.
Methods of apportioning common costs between joint products
Physical measurement
Common costs £3,
Two products are produced from the same process, details of which are;
JPM 750 Kg JPN 1,500 Kg 2,250 Kg
JPM 750 / 2,250 x £3,000 = £1, JPN 1,500 / 2,250 x £3,000 = £2, £3,
Sales value at split-off point
Common costs £3,
JPM £2.00 a unit selling price JPN £3.00 a unit selling price
750 x £2 = £1, 1,500 x £3 = £4, £6,
JPM 1,500 / 6,000 x £3,000 = £ JPN 4,500 / 6,000 x £3,000 = £2, £3,
Sales value at split-off point less further processing costs
Common costs £3,
JPM has further processing cost of £1 a unit. JPN has no further processing cost.
750 x (£2 - £1) = £ 1,500 x £3 = £4, £5,
JPM 750 / 5,250 x £3,000 = £ JPN 4,500 / 5,250 x £3,000 = £2, £3,
Weighted average method
Used when the joint products are not in the same physical state (solid, liquid or gas).
Common costs £3,
JPY 2,000 tonnes (weighting factor 2.5) JPZ 60,000 litres (weighting factor 0.5)
JPY 2,000 x 2.5 = 5, JPZ 60,000 x 0.5 = 30, 35,
JPY 5 / 35 x £3,000 = £ JPZ 30 / 35 x £3,000 = £2, £3,
Remember common costs are never shared amongst by-products and are irrelevant for decision making when considering processing joint products further
10.6 Shut down decisions
'Whether or not to discontinue a product or shut down a division or department?
So long as the contribution earned by the department, division or product is more than any product or site-specific fixed overhead, then the decision on financial grounds would be to keep it going.
Qualitative factors would weigh heavily on the decision as well.
Example 10.
Me ole cock spaniel Plc produces 3 products, apples pears and cockneys. Details of which are as follows;
Apples Pears Cockneys £000s £000s £000s Sales 10,000 20,000 40, Variable cost (5,000) (5,000) (7,000) Contribution 5,000 15,000 33, Fixed cost (8,000) (9,000) (12,000) Profit/(loss) (3,000) 6,000 21,
Head office apportioned overhead is allocated to each product at 100% of variable cost, the remaining overhead being product specific.
Should apples be discontinued?
Example 10.9 - (CIMA past exam question)
Z is one of a number of companies that produce three products for an external market. The three products, R, S and T may be bought or sold in this market. The common process account of Z for March 2007 is shown below:
Kg $ Kg $ Inputs: Material A 1,000 3,500 Normal loss 500 0 Material B 2,000 2,000 Outputs: Material C 1,500 3,000 Product R 800 3, Direct labour 6,000 Product S 2,000 8, Variable overhead 2,000 Product T 1,200 5, Fixed cost 1, Totals 4,500 17,500 4,500 17,
Z can sell products R, S or T after this common process or they can be individually further processed and sold as RZ, SZ and TZ respectively. The market prices for the products at the intermediate stage and after further processing are:
Market prices per kg:
$ R 3. S 5. T 3. RZ 6. SZ 5. TZ 6.
The specific costs of the three individual further processes are: Process R to RZ variable cost of $1.40 per kg, no fixed costs Process S to SZ variable cost of $0.90 per kg, no fixed costs Process T to TZ variable cost of $1.00 per kg, fixed cost of $600 per month
(a) Produce calculations to determine whether any of the intermediate products should be further processed before being sold. Clearly state your recommendations together with any relevant assumptions that you have made.
(b) Produce calculations to assess the viability of the common process:
(i) assuming that there is an external market for products R, S and T; and (ii) assuming that there is not an external market for products R, S and T.
State clearly your recommendations.