Relevant costs

(part 2)

F. M. Kapepiso
Learning objectives

At the end of the lecture, you should be able to:

• Calculate CVP in different pricing decisions
• Evaluate decision whether to add or eliminate a product
• Evaluate product mix and optimize use of scarce resources
• Describe cost indifference point for decisions
 Introduction - RECAP
CVP looks specifically at the relationship between the following five
elements: product prices, product mix, variable cost per unit, total
fixed costs and the level of activity in order to improve profitability.
CVP analysis is concerned with short term-decision making,
therefore it is useful to adopt the variable costing approach or
marginal costing
Relevant costs and revenues are costs and revenues that have
impact on the decision at hand
Irrelevant costs are costs that do not affect the decision at hand
and can consequently be excluded from the decision-making process
Short-term decisions include:
 Special order
 Process further or sale
 Make or buy
 Other short-term decisions includes: Add or eliminate a
product, Utilisation of scarce resources and CIP
Pricing Decision making
 Component of CVP model: S-V=C=F+P
 Accounting information is an important input
 Each possible price represents an alternative course of
action.
 To select the best price differential costs and differential
revenues are determined for all alternatives.
 The price, that increases the contribution margin by
greatest amount, is selected.
 Example 1 (pg.42)
Sober Drinks is selling 80000 bottles of its soft drink at N$4 per
bottle. The variable cost of the drink is N$2 per bottle and fixed
costs are N$150000 per year. In order to explore the market and
increase profit the company has done an extensive market survey
indicating the following possibilities.
Alternative Price (N$) Expected sales
1 3.25 160000 bottles
2 3.50 140000 ”
3 3.75 100000 ”
4 4.25 72000 ”
5 4.50 60000 ”
The company has unutilized capacity and fixed cost will not be
affected by any alternative. To select optimum course of action
(price), you should consider the following.

Required: Determine the optimum price using CVP model.

Solution to example 1
Adding or Eliminating Products
 Relate mostly to periodic analysis of profit
 Analysis will highlight unprofitable activities
 Management decision: add or eliminate

 In brief such decisions usually depends on the following :

 Increase or decrease in contribution margin
 Increase or decrease in fixed costs
 Opportunity costs , if any
Adding or Eliminating Products…
EXAMPLE 2
The owner of Millennium Café is worried about the declining
profits and requested you to suggest the way out of increasing
profits. The highly competitive market restricts any price
increase.
The Cost structure of three popular snacks sold by café is
given bellow:
Particulars
Pizza Burger Dosa
Cost per unit: (N$.)
Material and labour 10 7 8
Variable over head 5 3 4
Fixed overhead 5 2 4
Selling price (N$.) 30 8 15
Monthly sales (No.) 1000 1500 1200
Adding or Eliminating Products…
EXAMPLE 2…
At a meeting convened for decision on the matter, chief chafe,
cashier and sales man argue to eliminate both Burger and
Dosa and concentrate on Pizza only. However owner is not
willing to reduce a single product only.

Required: Suggest an optimum solution sales mix using CVP

Adding or Eliminating Products…
Solution
Adding or Eliminating Products…
Solution…
Proposed Position:
(A) Pizza & Dosa:
Monthly contribution (15000 + 3600) = 18600
Less: Total fixed cost ( 5000 + 3000+4800) = 12800
Profit 5800
(B) Pizza only:
Monthly contribution = 15000
Less: Total fixed cost = 12800
Profit 2200

Decision continue with two product (PIZZA and DOSA)

Adding or Eliminating Products…
Example 3
An organisation manufactures three products, Pawns, Rooks and
Bishops. The present net annual income from these is

The organisation is concerned about its poor profit performance,

and is considering whether or not to cease selling Rooks. It is felt
that selling prices cannot be raised or reduced without adversely
affecting net income. $5000 of the fixed costs of Rooks are direct
fixed costs which would be saved if production ceased. All other
fixed costs, it is considered, would remain the same.
Required: Advice the organisation whether Rooks should be
dropped or not, use relevant cost approach.
Utilization of Scarce Resources
• Short term decision as a result of sales demand in excess of
productivity capacity
• Identify resources responsible for limiting output
• The limiting factors are known as scarce resources
(advertising dollars, floor space, labor hours, machine hours
etc)
• Sometime the decision is not easy when all the products
yield positive contribution.
• In such a case relative contribution per unit of scarce
resource (limiting factor) forms the basis for decision.
• To maximize contribution, the product giving higher
contribution per unit of limiting factor should be preferred.
Utilization of Scarce Resources…
Steps in dealing with Utilization of scarce resource is
summarized below:
1. Calculate the contribution margin for one unit and divide
by the amount of scarce resource needed to produce that
unit.
2. Compare or rank all possible uses of the scarce resource.
3. The one that results in the largest Utilization Contribution
Margin (UCM) per scarce resource is the best possible use
of that scarce resource.
4. Calculate how the constrained resources will be utilised
5. Calculate the total profit generated in terms of the sales
mix calculated in step 4
Utilization of Scarce Resources…
Example 4
A timer is a specialised clock that is used to indicate or control the time for
a special event. We use timers on a daily basis e.g. watch etc. Time it Ltd is a
company that produces timers. Their product range consists of analoque
microwave timer and electronic geyser timer. The geyser timers have
become increasing popular and their demand has doubled in the last month.
Geysers increase electricity consumption drastically and with the increase
in electricity, most residence want to install geyser timers in an attempt to
reduce their electricity cost. The information bellow relate to the two
products:

The operating time for machine is limited to 30 000 hours.

Required: Calculate the product mix that will maximise profit and
calculate the value of profit generated
Cost Indifference Point
Choosing the best method of production on the basis of costs
involved.
When the alternative methods of production have different variable
and fixed cost patterns, such decision is based on cost indifference
point(CIP).
CIP=Where total cost of alternatives is equal.
Production(#) > CIP = Choose alternative with higher fixed cost
Production(#) < CIP = Choose alternative with lower fixed cost
Where, CIP = Difference in fixed cost/ difference in variable cost per
unit
Cost Indifference Point
Example 5
UCCB is planning to purchase a photocopier and considering
the following alternatives:

Machine X: cost: $90000, useful life: 3 years, cost per copy: 10

cents
Machine Y: cost $80000, useful life: 4 years, cost per copy: 15
cents
Cost per copy is different because of supplies used and power
consumption. Operator’s salary is estimated to be N$ 3000
per month in both cases
Required: 1. Calculate cost indifference point
Required 2. Which machine should be preferred if
UCCB plans to make 300000 copies per year and why?
Cost Indifference Point
Solution

CIP = 10000/0.05 = 200000 copies.

Cost Indifference Point
Solution…
Since requirement is more than CIP, machine X (having higher
fixed cost must be preferred as it will save N$ 5000 per year
as calculated under:
PRACTICE QUESTION
XT Ltd supplies the wholesale industry with two products X and T.
The products needs one raw material for production and go
through a labour intensive process to be converted into finished
products. Product X requires 5 litres of raw materials and 8 labour
hours, while T requires 10 litres of raw materials and 4 labour
hours. Additional information relating to the unit costs of the two
products is as follows:

Required: Calculate the product mix that will maximise

profit under each of the following independent
circumstances
a) Only 1500 litres of raw material are available
b) Only 1250 labour hours are available
Thanks