PM - Decision Making Techniques

Relevant Costing

DEFINITIONS:

Relevant cost may be defined as a future incremental cash flow.

Future cost is the expense that will be incurred in the future as a result of a decision. Any costs incurred in the
past, referred to as sunk costs, are ignored.

Incremental cost is the increase in total costs resulting from an increase in production or other activity. Costs
which are not specific or fixed are ignored.

Relevant costing is only concerned with cash flows. Non-cash flow items, such as depreciation, are not relevant.

RELEVANT COST OF MATERIALS:

Scenario 1:

A Ltd is considering a project which requires 100 kg of material. The material is in regular use within the
business. There are 400 kg of material in stock which were purchased for $1.40 per kg. The current purchase
price is $2 per kg. What is the relevant cost of the material to A Ltd?

Solution:

As the material is in regular use, whatever is taken from stock will ultimately need to be replaced. 100 kg of
material is needed, all of which is currently available in inventory. So, these 100 kg would need to be replaced at
$2 per kg meaning a total material cost of $200. This represents the future cash outflow in respect of material as
a result of the decision of A Ltd to undertake the project (i.e., it is the relevant cost of material)

The $1.40 is a sunk cost and is not relevant to the decision.

Scenario 2:

B Ltd is considering a project that requires 100 kg of material. The company has 500 kg in inventory, which were
purchased some years ago for $1.50 per kg. However, this material is no longer in use within the business. The
current purchase price is $2 per kg of material. B Ltd could sell each kg for $0.90. What is the relevant cost of
the material to B Ltd?

Solution:

As the material is no longer in use within the business, any stock taken will not need to be replaced. However,
taking 100 kg of inventory from the warehouse means that B Ltd will not receive the resale value (or scrap value)
of $0.90 for each kg. Thus, the cash flow impact of using 100 kg of material is $90 (being 100kg * $0.90 each).
This represents the relevant cost of the material to B Ltd.

The $1.50 is a past cost (or sunk cost) and is excluded from our analysis. Also, the current purchase price of $2
is not considered here.

Scenario 3:

C Ltd is considering a job that requires 100 kg of material. 350 kg of material are in inventory. The material is no
longer available to purchase and if it is not used by C Ltd on this proposed job it would be used in the
manufacture of product K. Each unit of product K uses 4 kg of material and generates a contribution of $10.
What is the relevant cost of the material to C Ltd?

Solution:

The material is in inventory but is no longer available to purchase. This means that the 100 kg required could not
be replaced. However if taken, then 25 units of product K (being 100 kg / 4kg per unit) would not be produced
and sold. This would result in lost contribution of $250 to C Ltd (25 units * $10 per unit). Thus, the future
incremental cash flow impact of using 100 kg of material for this job is $250.

RELEVANT COST OF LABOUR:

Scenario 1:

D Ltd is considering a project which requires 100 hours of labour. Currently, there are 180 hours of spare labour
capacity. Workers are paid $5 per hour. An agreement stipulates that staff cannot be laid-off. What is the
relevant cost of labour?

Solution:

If D Ltd decided to go ahead with the project the relevant cost of labour will be nil. As spare labour capacity
exists and labour is already paid, there is no future cash flow associated with putting that labour to work.

Scenario 2:

E Ltd is considering a job which requires 50 hours of labour. There is no spare labour capacity. However,
additional staff could be hired at a rate of $6 per hour for this project. What is the relevant cost of labour for this
job?

Solution:

The future cash outflow associated with this job is $300, being the 50 hours of required labour * by the rate of
pay of $6 per hour.

Scenario 3:

F Ltd is considering a project which requires 100 hours of labour. There is no spare labour capacity and it is not
possible to hire additional staff. Labour would have to be removed from the production of product T in order to
undertake this project. Currently, product T is sold for $50, incurs direct material cost of $10 and requires one
hour of direct labour at a cost of $8. What is the relevant cost of labour for this project?

Solution:
In this case, the relevant cost (being the future cash flow impact as a result of undertaking the project) would be
the opportunity cost of not producing product T. Staff would have to be diverted from producing product T in
order to work on F Ltd’s other project. As 100 hours are required for the project and product T needs 1 labour
hour for each unit, then 100 units of product T would not be completed. So the cash flow impact of diverting the
staff from product T would be the lost sales proceeds of $50 per unit less the material cost of $10 that would be
saved.

The opportunity cost of not producing 1 unit of T is $40, meaning a total opportunity cost (or relevant cost) of
$4,000 ($40*100 units) given that 100 units of T would now not be produced.

RELEVANT COST OF OVERHEADS:

An overhead is a relevant cost if:

- It is specific to or attributable to the decision being considered by the company;
- Incurred as a direct result of company’s decision to undertake a particular job.

Notes:
- Non-specific or general fixed costs are not incremental and are not relevant;
- If a fixed cost is set to be absorbed or allocated then this is usually indicative of that fixed cost being
general, not specific.

Example:

G Ltd is considering whether to add an extension to its building. If added, variable overheads of $10 per hour
would be incurred. The extension would also absorb building fixed overhead charges at an absorption rate of $8
per direct labour hour. What are relevant overhead costs per month if 9,000 labour hours are worked in each
month?

Solution:

The relevant cost of the variable overhead is $90,000 (being 9,000 hours * variable overhead per hour of $10).
The relevant cost of the fixed overhead is nil as no additional fixed cost is incurred (i.e., the cost is not
incremental or specific to the building extension). Hence the total relevant cost is $90,000.

RELEVANT COST OF NON-CURRENT ASSETS:

The relevant cost of a non-current asset can be referred to as the deprival value. The following formula will
determine a non-current assets deprival value:

Lower of the asset’s replacement cost and its recoverable amount, where

The recoverable amount is the higher of the asset’s net realisable value (Fair value less cost to sell) and its
Value in use, being the present value of its future cash flows.

Example:

H Ltd purchased a machine some years ago for $23,000. The machine could be sold today for $13,000. If it is
kept within H Ltd’s business it will generate $18,000. An identical machine could be purchased today for
$15,000. What is the relevant cost of using the machine on another job?
Solution:

The relevant cost of a non-current asset is the lower of its replacement cost and its recoverable amount. The
machine’s replacement cost is $15,000. The recoverable amount is the higher of the net realisable value of the
machine ($13,000) and its value in use ($18,000). So, $18,000 (being the higher amount) represents the most
that H Ltd could expect to recover from this asset (ie recoverable amount).

The relevant cost is the lower of the replacement cost $15,000 and the recoverable amount $18,000, meaning
the relevant cost of the non-current asset is $15,000. In other words, if H Ltd were deprived of this machine
today, then the least amount of cash it would need to receive in order to be no worse off than it currently is, is
$15,000.
 PM - Specialist cost and management
accounting techniques
Limiting Factors

In order to maximise the profit, businesses should ensure that they use scarce resources in the most effective
way.

Note: The main types of resources that could be scarce or limited are labour hours, machine hours, or materials.

When considering a scarcity of resources, the following steps must be performed:

1) To determine which resource is scarce by looking at total demand for each product they make and how
much of each resource is needed to meet that maximum demand. This will identify which resource does not;
this is considered the limiting factor.

2) To plan the production volumes in order to optimise the use of the resource, thereby maximising profits. In
order to determine how many of each product should be produced, they need to know its contribution per
limiting factor unit:

Contribution per unit = Selling price per unit - Variable costs per unit

Contribution per unit

Contribution per limiting factor unit = Number of limiting factor units needed to
produce a unit of product

Based on these figures, they can see the product that makes the best use of the available limiting factor units.

3) To calculate how many units of each product they can make with the available units of limiting factor, start
with the product with the largest contribution per limiting factor (A), then move to the product with the next
best contribution (B).

Demand for product A * Limiting factor per unit = Limiting factor units to produce product A

Total limiting factor units – LF units to produce A = Available LF units for product B
For the last product (C) that can be produced with the restricted number of limiting factor:

Available LF units
Production of product C (units) = Number of limiting factor units needed to
produce a unit of product C

4) To calculate the total contribution, multiply the contribution per unit by the number of units from the
production plan.
 PM - Decision Making Techniques
Linear Programming

Linear programming is a process used when there is more than one limiting factor and it is necessary to make
the best use of the limited resources continuing to maximise profits.

There are a number of steps we need to go through to calculate the maximum profit or contribution that can be
generated when there is more than one limiting factor:

1) The first step is to define the variables.

Let’s assume that we produce two products (F and G) and two types of resources (labour and materials) are
used, then:

𝑓 - number of units of product F;

𝑔 - number of units of product G;
𝐶 - total contribution;
𝑐𝑓,𝑔 – contribution per unit of product F or G;
𝐿 – available units of labour;
𝑀 – available units of materials;
𝑙𝑓,𝑔 – number of labour to produce 1 unit of F or G;
𝑚𝑓,𝑔 - number of materials to produce 1 unit of F or G.

2) The second step is to understand our constraints and turn this information into formulas:

- We cannot use more resources than we have.

Labour: 𝑙𝑓 ∗ 𝑓 + 𝑙𝑔 ∗ 𝑔 ≤ 𝐿
Materials: 𝑚𝑓 ∗ 𝑓 + 𝑚𝑔 ∗ 𝑔 ≤ 𝑀

- Number of units produced is always positive.

Non-negativity: 𝑔, 𝑓 > 0

- Demand for product G is larger than for product F (assumption).

Demand: 𝑔 > 𝑓
- Our objective of maximising contribution.
Maximise contribution: 𝐶 = 𝑐𝑓 ∗ 𝑓 + 𝑐𝑔 ∗ 𝑔

3) The third step is to produce a graph and identify a feasible region, which is the area of the graph within
which we meet all of the various constraints.

Assuming that we will use the full L units of labour, our constraint will look like this:

𝑙𝑓 ∗ 𝑓 + 𝑙𝑔 ∗ 𝑔 = 𝐿

To define plots for graphs, we:

Put 𝑔 = 0, then 𝑓1 = 𝐿 ÷ 𝑙𝑓 => first pair of coordinates (0; 𝑓1 ) ;

Put 𝑓 = 0, then 𝑔1 = 𝐿 ÷ 𝑙𝑔 => second pair of coordinates (𝑔1 ; 0).

We also follow the same idea with regards to materials. Now we have some parameters to put on the graph and
we need to plot these points.

Units
of
f
Dem
Material

f Feasible
Region (0,
A B
Labour

D
0
g g Units
of
When we have the constraint lines on the graph, we can determine the feasible region:

- We need to be to the right of the demand line, as we need to make more G than F (as per demand
assumption);
- We also need to be below the constraint lines for materials and for labour, as we cannot use more of the
resource than we have.

This gives us a feasible region of zero, A, B, and D, as highlighted in bold. Given the constraints we have, we
can make any combination of volumes of Franks and Gretas within this region, but we want to maximise
contribution; now, we need to add a further line to this graph - the contribution line.

4) The fourth step is to determine production volumes that will maximise total contribution. To draw the
 contribution line, we need two points:

We have D (𝑔2 ; 0), so we can use these parameters to define contribution:

𝐶 = 𝑐𝑓 ∗ 0 + 𝑐𝑔 ∗ 𝑔2
Then put 𝑔 = 0 , so 𝐶 = 𝑐𝑓 ∗ 𝑓 + 𝑐𝑔 ∗ 0 and 𝑓3 = 𝐶 ÷ 𝑐𝑓 => second pair of coordinates (0; 𝑓3 ).

Unit

f
Dem
f Material

A B OPTIMU
Labour

D
0
g g Units

Once we have plotted this line, we need to effectively slide the line up across the graph until we reach the
furthest point within the feasible region (as shown on a graph). Point B is the optimum point of production.
5) The final step is to determine how many units of F and G are recorded at the optimum point. By tracking
back to the f and g axes, we can see that this leads to an optimal production plan.

Units
of

A B
f

D
0
g g g Units
Now that we know the optimal production quantities, we can work out of contribution
the maximum that can be
generated using the contribution formula.
 PM - Decision Making Techniques
Pricing Decisions

There are 3 main approaches to pricing:

- Demand-based pricing;
- Cost-based pricing;
- Market-based pricing.

PRICING FACTORS:

When considering the best price for a product we also need to think about the following factors that influence
the price:

1) Price sensitivity. If a product is price sensitive it means that the volume of products sold will vary
dramatically as the price increases or decreases;
2) Price perception. It refers to the way in which customers react to price changes - for example, some
people perceive that a high price means that they are buying something a bit more exclusive or luxurious
than a lower priced similar item and are therefore prepared to pay the higher price for the kudos associated
with the product;
3) Quality. This is linked with price perception - some customers equate higher prices with better quality, and
again will be prepared to pay a higher price in order to buy what they consider to be a higher quality
product;
4) Competitors. Any business needs to consider what their competitors are charging and decide whether they
want to compete on price or compete based on other factors;
5) Inflation. It has an impact on the costs we are incurring and therefore a business will need to decide if they
want to pass the increased costs onto the customer by inflating their selling prices, or whether they would
prefer to keep prices as they stand and take a hit to their profit;
6) Newness. The new products, particularly in the technical sector, can often command a higher price as
customers are generally happy to pay a premium for being one of the first to adopt the new product;
7) Incomes. In the case of the general public, as disposable income increases people are happy to pay more
for goods and services;
8) Product range. If a business sells interrelated products they will need to think about the pricing strategy
across the range of products rather than item by item;
9) Ethics. A business needs to think about whether they wish to take advantage of shortages in a product or
service and increase their price given that demand will be high. This might have a negative impact on their
reputation so they need to weigh up the pros and cons of such a move before initiating any price change.

DEMAND-BASED PRICING:

The prices we set under this approach are based on the demand we expect, or have historically seen. It is
assumed that there is a linear and direct relationship between price and volume. How the volume is affected
depends on the price elasticity of the product or service.
% change in demand
Price elasticity of demand =
% change in selling price

PED > 1 Demand is price elastic

PED < 1 Demand is price inelastic

Note: A product that is more price elastic will show a big change in sales volumes as prices change, whereas a
product that is price inelastic will show a small change in sales volumes as prices change.

In order to estimate demand for a product we can use the demand equation:

𝑃 =𝑎 − 𝑏×𝑄

P - price of a product;
a - price where demand is zero;
b - demand line;
Q - quantity sold.

Using this demand line formula together with some more information we can find the optimal price for a product:

1) The first thing we need to do is calculate the demand line:

Change in price
Demand line =
Change in quantity

2) We then need to find the number of units we need to sell to maximise profit and this is the point at which the
marginal revenue equals the marginal cost:

𝑀𝑅 = 𝑎 − 2 × 𝑏 × 𝑄
3) As we already know a and b from the demand line calculation and we know the MR, we can then find the
quantity to sell at the optimum point and then substitute this back into the demand equation to find P - the
optimum price.

COST-BASED PRICING:

There are 3 costs bases we can use to calculate a selling price:

- The total or full cost (all fixed and variable costs, production and nonproduction costs);
- The total production cost (direct labour, direct materials and production overheads, both fixed and variable);
- The variable cost (being direct materials, direct labour and variable overheads).
By knowing how costs and revenues relate to each other we can then determine an optimal output and an
optimal selling price just as we did with demand-based pricing:

𝑌 =𝑎+𝑏×𝑋

Y - the total cost;

X - the number of units being made;
a - fixed costs;
b - the variable cost per unit.

This equation does assume that fixed costs won’t change as output levels increase and that the variable cost per
unit is the same regardless of changes in production volumes.

Once we have established the cost basis we then need to calculate the selling price by adding on a markup or
margin percentage.

Advantages Disadvantages

- It is easy to calculate and understand; - In order to find the full cost we need to
- It ensures that all costs are covered and absorb the fixed overheads into the cost
a profit is made; per unit and therefore a basis for
- Junior management can make pricing absorbing those costs needs to be
decisions based on figures and established;
percentages provided to them. - Budgeted output volumes will also need
to be established to perform the task of
overhead absorption;
- This strategy doesn’t guarantee a profit.
If sales are lower than forecast, fixed
costs may not be covered.

MARKET-BASED PRICING:
Organizations may use following marketing based pricing strategies:

1) Market-skimming pricing. This means that when a new product or service is launched higher prices are
charged to maximise profits in the short-term. In later stages of the product’s life cycle, the price will drop as
more companies start selling the same or similar products and as customer demand starts to drop.
Note: This type of pricing is particularly suited to high-tech products, like mobile phones and computers. It is
also a good strategy to follow if demand for a product is unknown - prices can always be reduced if demand
isn’t as strong as was hoped, but it is much harder to increase prices if demand is very high at lower prices.

2) Penetration pricing. Typically prices are set so that products are sold at a loss or minimal profit to
encourage consumers to buy the product in large volumes, the idea is that customers become accustomed
to buying that product and then they will continue to buy the product even when the price is increased to a
more profitable level;
3) Complementary-product pricing. We also need to consider other products or services that complement
the one that we are establishing a selling price for, to ensure that the price of all complementary products
work together;
4) Product-line pricing strategy. It is needed where there are a number of similar products in the same range
and therefore prices need to be similar, if not the same, across the product range;
5) Price discrimination strategy. It occurs when different prices are charged for the same product to different
groups of buyers. This can only really happen if customers are split into different market segments and
customers can’t buy at the low price and then sell on at a high price in a different market;
6) Relevant cost pricing. This is often used when pricing up a one-off contract, and when there is spare
capacity within the business. The spare capacity indicates that fixed costs have already been covered by
other products or contracts and therefore only the incremental costs of this contract need to be considered
when pricing it for the customer.
 PM - Decision Making Techniques
Limiting Factors - Shadow Prices

A Shadow price is:

1. The additional contribution generated from one additional unit of limiting factor.
2. The opportunity cost of not having the use of one extra unit
3. The maximum extra amount that should be paid for one additional unit of scarce resource.

A Shadow price is NOT the maximum price which should be paid, rather it is the maximum EXTRA that a
company would be willing to pay over and above the current purchase price for a limited resource.

Slack occurs when the maximum availability of a resource is not used. If the entire resource available is required
for the optimal solution the the company will be willing to pay a premium (shadow price) to obtain the additional
resource. If the company does not require all their available resources for the optimal solution then they will not
be willing to pay a premium and there would no no shadow price. This is when slack occurs.

Shadow prices can be calculated in a scenario where there is only one limiting factor or in a scenario where
there are multiple limiting factors. Both calculations will be explained in the following examples:

EXAMPLE 1 - SINGLE LIMITING FACTOR

A company makes two products X and Y. Sales demand of X is 10,000 units and 12,000 units of Y.

Direct labour and production are restricted to 60,000 direct labour hours. Direct labour is paid at $10 per hour.

It take 5 hours to produce 1 unit of X and 4 hours to produce 1 unit of Y. The contribution per unit of X is $8 and
per unit of Y is $6.

Based on the above information the optimal production plan would therefore be 10,000 units of X and 2,500
units of Y.

Requirement: What is the Shadow price per direct labour hour and for how many additional hours of labour
does this apply?

EXAMPLE 1 - SOLUTION:

Because we have met the demand of X in the optimal production plan, the company would use any additional
labour hours to manufacture Product Y.
The contribution that would be earned per additional unit of Y is $6. Therefore the additional contribution per
direct labour hour would be $6/4 = $1.50. This is the Shadow price (the maximum extra the company would be
prepared to pay for an additional hour of labour). The maximum price that the company would be willing to pay
would be $10 + $1.50 = $11.50. Once the company has met the demand of Y the labour would no longer be a
limiting factor - therefore once they have made an additional 9,500 units (38,000hours) of Y the shadow price will
no longer be applicable.

EXAMPLE 2 - MULTIPLE LIMITING FACTORS

In a linear programming problem to determine the contribution maximising production and sales volume for 2
products X and Y the following information is available:

PROD X PROD Y Total Available

Direct labour hours 2 hours 4 hours 10,000 hours

Material X 4kg 2kg 14,000 Kg

Contribution/unit $12 $18

Profit maximising level of output 3,000 1,000

What is the Shadow price of one additional hour?

EXAMPLE 2 - SOLUTION:

If one extra additional labour hour is available, the optimal solution will change to the point where:

(1) Direct Labour hours: 2x + 4y = 10,001

(2) Materials 4x + 2y = 14,000
Multiply (1) by (2)
(3) 4x + 8y = 20,002
Subtract (2) from (3) 6y = 6,002
y = 1000.33
Substitute in (2) 4x + (1,000.33 x 2) = 14,000
x = 2,999.833

Total contribution (given 1 additional hour) = (2,999.833 x $12) + (1,000.33 x $18) = $54,004
Total original contribution = 3,000 x $12 + 1,000 x $18 = $54,000

The Shadow price per direct labour hour is therefore $4.00