LESSON # 42

DECISION MAKING (Contd.)

Avoidable Cost:
This terminology is used where the decision is to be taken about discontinuing a product.
Avoidable costs are costs which would not be incurred if the activity to which they relate
did not exist.

Unavoidable Cost:
Cost which would be incurred whether or not the product is discontinued is known as
unavoidable cost.
Avoidable and unavoidable costs are incurred when we are going to drop a product.

Controllable cost:
Controllable cost are items of expenditure which can be directly influenced by a given
manager within a given time span.

Controllable cost

Committed Discretionary

Committed fixed cost:

Such type of costs that must be incurred, about them you have already committed that
these costs will have to be occurred.
For example, Depreciation and rent relating to property, plant and equipment costs

Discretionary fixed cost:

Such costs depends upon manufacturer will that either he allow to incur the costs or not.
For example, advertising and Research & development costs
Controllable and uncontrollable costs are incurred when we are increased a product or
when we expanding our production process.
Differential costs:
The difference of costs between two activity levels is named as differential costs
It can be incremental cost and avoidable Cost.
Incremental cost:
It is a difference because of increase in activity level
Avoidable cost:
It is a difference because of decrease in activity level

Example:
If X product whose cost is Rs. 700 has replaced with Y product whose cost is Rs. 800, the
differential cost will be Rs 100
If X product whose cost is Rs. 1,200 has replaced with Y product whose cost is Rs. 1,000 the
avoidable cost will be Rs 200
Opportunity cost:
An opportunity cost is the value of the benefit scarified when one decision is taken in
preference to an alternative decision.

Example:
x y z
Contribution Margin 800 1,000 700

In above mention example, the manufacturer will go for manufacturing the product Y
because of high contribution margin i.e. 1,000. In this example the contribution margin of
product X is treated as opportunity cost for product Y, because the manufacture has to
forgo the 800 benefit (contribution margin) of product X, if he manufactures the product
Y.

Sunk cost:
Sunk cost is such type of cost which has been charged already as a cost of production.
A sunk cost is a past cost which is not directly relevant in decision making.

Fixed & Variable Cost:

Rule of thumb:

Fixed cost Irrelevant cost to decision making

Variable cost Relevant cost to decision making

Scenario 01:
A raw material is available in store with Rs. 5,000 costing and it has no scrap value. This
raw material obsoleted and could not be used in any other project except the current
project. In such case this material (variable cost) is not relevant to our current decision.

Scenario 02:
Suppose above mention raw material which has worth of 5,000 can be sold out for Rs.
1000 as well. In such case relevant cost will be 1,000 not 5,000.

Allocation of overhead cost:

The allocation of overhead cost is always irrelevant; it is not relevant to the decision.

Fixed Cost

Specific/Directly Attribute General Fixed Overhead Cost

Relevant to decision making Irrelevant to decision making

Incremental Cost Avoidable Cost

Incremental Cost:
It increases with an increase in activity level.
Avoidable Cost:
This cost will decrease or entirely eliminate if a product drops or activity level reduce or
shut down the operations.
Replacement Cost:
Such cost which is incurred to replace the existing raw material with new one.
For example: A 5 kg having the cost of Rs. 10 per kg, regular used raw material is present
in the store room that can be either used for current product or any other product. If it
used in other product instead of current product then we have to purchase 5 kg new raw
material for current product which is available @ Rs. 12 per kg in market. In such case the
replacement cost (12 per kg) is our relevant cost not the historical cost (10 per kg)

Differential Costing for Short-Term Decision Making

The role of fixed costs
If the decrease or increase in the level of activity affects fixed costs then these costs should
be considered differential costs. It is generally accepted that if the plant has excess capacity
then new or additional volume may be accepted if the selling price is greater than variable
costs. In such a situation, fixed costs arc not relevant if they remain fixed at an increased
level of output. But if they are incurred because of the increased level of activity then they
are certainly variable. Once incurred, if they arc committed fixed costs, they become a
permanent feature and the company may find (hat it has capacity far in excess of
requirements.
The following illustration has been prepared so as to place particular emphasis on the role of
fixed costs.

PRACTICE QUESTION

Sena of London operates at 100 percent of normal capacity. At this volume it produces
50,000 units of a product.
Income statement

Sales (50,000 units at Rs. 10 each) Rs. 500,000

Prime cost (Rs. 5 per unit) Rs. 250,000
Rs. 250,000
Variable production overhead (Rs. 1 per unit) Rs. 50,000
Rs. 200,000
Fixed production overhead Rs. 100,000
Factory profit Rs. 100,000

The marketing director reports that an overseas customer has offered to pay Rs. 7.50 per
unit for an additional 20,000 units. To produce the additional order fixed costs would
increase by Rs. 25,000. Would you advise the company to accept the order?
Differential cost statement-method 1
Present With additional Difference
business business
Sales Rs. 500,000 Rs. 650,000 Rs. 150,000
Less: Prime cost 250,000 350,000 100,000
Less: Variable production 50,000 70,000 20,000
overhead
Less: Fixed production overhead 100,000 125,000 25,000
Factory profit Rs. 100,000 Rs. 105,000 Rs. 5,000

Differential cost statement – method 2

Present Additional Total

Sales Rs. 500,000 Rs. 150,000 Rs. 650,000
Prime cost 250,000 100,000 350,000
Variable production overhead 50,000 20,000 70,000
Fixed production overhead 100,000 25,000 125,000
Factory profit 100,000 5,000 105,000

Traditional statement for additional business

Sales (20,000 units at Rs. 7.50) Rs. 150,000

Prime cost (20,000 at Rs. 5) 100,000
Variable production overhead (20,000 at Rs. 1) 20,000
Joint fixed production overhead (using a
predetermined rate of absorption:
Rs. 100,000/50,000 = Rs. 2 (20,000 at Rs. 2) 40,000
Separable fixed costs 25,000
Loss on additional business (Rs. 35,000)

The traditional cost statement for additional business would cause management to reject the
offer.
Management may also not accept the offer because as computed under the traditional
method absorption costing the price offered per unit is less than the total cost per unit and
also because it is less than the current selling price of Rs. 10 per unit:

Price offered per unit Rs. 7.50

Cost per unit Rs.
Prime cost 5.00
Variable production overhead 1.00
Joint fixed costs 2.00
Separable fixed costs (Rs. 25,000/20,000) 1.25
Loss per unit Rs. (1.75)

In the differential cost statements (methods 1 and 2) the additional business has been
charged with differential cost only. It should be noted that the reason for the differential
profit is that the regular sales were not affected by the acceptance of additional business. If
the acceptance of additional business caused the price to be reduced to Rs. 7.50 per unit on
all sales then the result would be a loss of Rs. 20,000 for the company:
Revised income statement – all sales at 7.50

Sales (70,000 units at Rs. 7.50) Rs. 525,000

Variable costs (70,000 at Rs. 6) 420,000
Joint fixed production costs 100,000
Separable fixed production costs 25,000
Loss Rs. (20,000)

The role of variable costs

In differential cost studies, if the plant is not operating at practical capacity owing to lack of
orders, variable costs usually represent the differential cost whether they are incremental or
avoidable. The term refers to those costs that will change. It is often assumed that the
variable cost per unit will remain constant regardless of the level of activity.

One may question the validity of the above assumption. What if the variable cost per unit
does not remain constant at various levels of activity? An increased level of activity may
cause the variable cost per unit to change for a variety of reasons.

Examples are:
(a) At a higher level of output material cost per unit may be reduced by bulk buying
at lower prices;
(b) Direct labour cost per unit may increase as a result of overtime working if there
is a labour shortage;
(c) Greater spoilage and waste with increase production.

Illustration
Following illustration is emphasized on the role of variable costs.
Sena of London produces 40,000 units operating at 50 per cent capacity.

Production fixed costs Rs. 20,000

Other fixed costs Rs. 40,000
Variable cost per unit:
Direct material Rs. 3.00
Direct labour 2.00
Variable overhead 1.00
Rs. 6.00
Selling price per unit: Rs. 10
An overseas customers offer to buy increased quantities during the forthcoming year at the
following prices:
10,000 units at Rs. 9
20,000 units at Rs. 8
30,000 units at Rs. 7
40,000 units at Rs. 6
 If offer is accepted then variable cost per unit is expected to change as follows:
First 10,000 units Would cause a drop in the material cost per unit due to large scale
purchases
Next 10,000 A further reduction in the material cost per unit but an increase in direct
units wages
Next 10,000 Would involve some overtime and so variable overhead per unit would
units increase.
Next 10,000 A further reduction in material cost per unit, and increase labour cost
units per unit and variable cost per unit.

Summary of expected changes

Units 1st 2nd 3rd 4th

10,000 10,000 10,000 10,000
Material per unit (5%) (5%) - (5%)
Labour per unit - 5% + - 5% +
Variable overhead per unit - - 5% + 5% +

Variable cost per unit at various levels of activity (consider expected change table for
following working)

Normal Additional Additional Additional Additional

(Rs.) 10,000 20,000 30,000 40,000
Direct material 3.00 2.85 2.7075 2.7075 2.572
Direct labour 2.00 2.00 2.1000 2.1000 2.205
Direct expenses 1.00 1.00 1.0000 1.0500 1.1025
Variable cost per 6.00 5.85 5.8075 5.8575 5.8795
unit

Differential cost statement

Normal Additional Additional Additional Additional

40,000 10,000 20,000 30,000 40,000
Sales value per unit (given in question) Rs. 10 Rs. 9.00 Rs. 8.00 Rs. 7.00 Rs. 6.00
Variable cost per unit 6 5.85 5.8075 5.8575 5.8795
Contribution per unit Rs. 4 Rs. 3.15 Rs. 2.1925 Rs. 1.1425 Rs. 0.1205
Fund (CM X Units) 160,000 31,500 43,850 34,275 4,820