5102013_195546_f002_relevant cost
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7/27/2019 5102013_195546_F002_Relevant Cost
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relevant costing and
decision making
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Mr. Pravat is the Cluster Head in HDFC in Bhubaneswar.
Following the declaration of one week vacation for puja,
he is faced with and important decision : Should he drive to
Chennai for puja vacation, or should he fly?
If he drives, he will leave on Saturday, stay in a hotel in
Rajamuhundry Saturday night, and arrive in Chennai late
Sunday evening. This option will allow him to enjoy five fulldays in Chennai (Mon to Fri). However, he would have to
leave the Following Saturday, and spend another Saturday
night in a Hotel in Rajamuhundry in order to arrive back in
Bhubaneswar Late Sunday evening.
If he flies, he will leave on Saturday afternoon and arrive in
Chennai in the evening. This option will allow him to relax
in Chennai for full seven days before flying back to
Bhubaneswar the following Sunday.
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Relevant factors affecting his decisions :
• Average cost per night to stay in a hotel is Rs.2,000.
• Cost to have someone watch Tommy (Pravat’s dog) is
Rs.150 per day.
• Eating out costs approximately Rs.400 per day.
• In August, Pravat paid Rs.9,200 for annual car insurancepremium.
• Pravat’s Santro is showing 16 kms mileage.
• Distance between Bhubaneswar and Chennai is 1237 kms.
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Relevant information
in Business Decisions
All business decisions involve choosing among alternative
courses of action. The only information relevant to a decision
is :
that which varies among the possible courses of action being considered.
Costs, revenues and other factors that do not vary among the
possible courses of action are not relevant to the decision.
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RedStar Ketchup Company
RedStar is closed for a labour strike. During the strike,
company is incurring costs of approximately Rs.1,50,000per week for utilities, interest and salaries of non-striking
employees.
A major film production company has offered to rent thefactory for a week at a price of Rs.1,00,000 to shoot several
scenes of a new action movie. If the factory is rented,
RedStar’s management estimates that its cleaning costs will
amount to nearly Rs.20,000.
Would it be profitable to rent the ketchup factory to the
Film company?
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Relevance of Opportunity Costs,
Sunk Costs, and Out-of-Pocket Costs
in making Business Decisions
Opportunity Costs
The benefit that could have been obtained by pursuingan alternative course of action.
Assume labour strike ends just before filming begins. As a
consequence RedStar must forego any profit that the factorycould’ve earned during the week that filming is in process.
Thus, if operating profit could have totaled Rs.2,50,000,
The opportunity cost of renting to the film company is
Rs.2,50,000 foregone.
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Sunk Costs
That has already been incurred and can not be changed
by future decisions.
RedStar’s investment in its ketchup factory is a sunk cost .
This cost will not change regardless of whether RedStar
rents the factory, resumes operations, or lets the buildingstand vacant.
The only cost relevant to a decision are those that vary
among the courses of action being considered. Sunk costs
are not relevant because they can not be changed regardlessof what decision is made.
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Out-of-Pocket Costs
The costs that have not yet been incurred and that may vary
among the possible courses of action.
RedStar’s estimated cleaning expenditure are considered
Out-of-Pocket Costs.
This is normally identified as relevant in most business
Decisions.
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Incremental Analysis in Common Business Decisions
Special Order Decisions
Dhawan Sports Co. Ltd. manufacturers table tennis balls
that it distributes exclusively through professional sports
shops in India. Although the company has capacity toproduce 2 million balls per month, its current sales volume
requires that only 8,00,00 units be produced. At this level
of output, monthly manufacturing costs average approximately
Rs.48,00,000 as follows:
Variable Costs @ Rs.2 per ball…………Rs.16,00,000
Fixed Costs………………………………. 32,00,000
Total Mfg. Costs 48,00,000
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Dhawan Sports
Dhawan Sports receives a special order from ORBIT, a
company that sells sports products in Srilanka, for
5,00,000 ‘special level’ tennis balls per month. The balls will
be imprinted with the ORBIT name and logo and would not
in any way be identified with Dhawan Sports.
To avoid direct competition with regular customers of Dhawan Sports, ORBIT has agreed not to sell these balls
outside of Srilanka. However, it is willing to pay Dhawan
Sports only Rs.25,00,000 per month for the special order.
However, the regular sales price per ball charged by
Dhawan Sports is Rs.12.50.
Would it be profitable for Dhawan Sports to accept this
order?
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Incremental Analysis in Common Business Decisions
Production Constraint Decisions
Bangla Art Gallery creates three products viz.
a. Water Color Paintings
b. Oil Paintings
c. Custom Frames
Total output is however limited to what can be produced in
6000 hours of direct labour.
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Bangla Art Gallery
Water Col Oil CustomPainting Painting Painting
Selling Price per unit (Rs) 9000 16000 3500
Variable Cost per unit (Rs) 3000 6000 1500
Direct Labour Hours
required per unit 2 hrs 4 hrs 1 hr
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Incremental Analysis in Common Business Decisions
Make or Buy Decisions
The management of Ultrasonic is considering whether to
buy a component (required for its main product) Rs.50 per unit that costs the company Rs.60 per unit to produce.
The monthly cost data of producing 10,000 units (normal
required volume) of that component are given in the next
slide:
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Ultrasonic
Monthly Production : 10,000 units
Amount (Rs)
Direct Material 80,000
Direct Labour 1,25,000
Variable Overhead 1,00,000
3,05,000
Fixed Overhead per month 2,95,000
Total Mfg Costs per month 6,00,000
Avg Unit Mfg Cost (Rs.) 60
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Incremental Analysis in Common Business Decisions
Sale, Scrap, or Rebuild Decisions
Renovo Ltd. has its inventory 500 computers that cost
Rs.32,50,000 to produce. Unfortunately their processorsnow are considered technologically obsolete.
What to do with these computers?
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Renovo Ltd. The management is considering the following options to
deal with these machines :
a. Sell the computers ‘as is’ to Television Shopping
Network (TSN) for Rs.25,00,000.
b. Sell them for Rs.23,50,000 to the schools of the
nearby districts for use in their computer lab.
c. Scrap the existing processor in each machine
and replace it with a faster, state-of-the-art chip ata total cost of Rs.19,00,000. If this option is
selected, the rebuilt computers could be sold for
Rs.Rs.45,00,000.
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Incremental Analysis in Common Business Decisions
Joint Product Decisions
CharCore mixes together wood chips and pine oil. After
joint manufacturing costs of Rs.20,000 the mixtureseparates into two saleable products
a. Granulated Charcoal (sales value Rs.50,000)
b. Methyl Alcohol (sales value Rs.90,000)
How should the Rs.20,000 in joint costs be allocated
between these products?
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Charcore Ltd. The company may sell its charcoal and alcohol after the
split-off point without further processing or it may continueprocessing either of these products.
Charcore can use the granulated charcoal to manufacture
air filters and the methyl alcohol to make cleaning solvent.
The sales value of air filters and cleaning solvents
produced after further processing of given quantity of
charcoal and methyl alcohol (as produced in the first case)
are as follows:
Air filters (sales value Rs.1,50,000)
Cleaning solvent (sales value Rs.1,40,000)
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