Answer to Question #295819 in Management for Beli

Question

1. ABC Company makes and sells 10,000 units of a certain product. The total manufacturing cost of goods made is Br400, 000. Suppose XYZ Company offered Br38 per unit for 1,000 units special order that:

• Would not affect the regular business in any way
• Would not affect fixed costs
• Would not require any additional variable selling and administrative expenses
• Would use some other wise idle manufacturing capacity

      Required

Should ABC Company accept the special order?

             The income statement of the company for the most recent period is given below:

Sales-------------------------------------------------------------500,000

Variable costs

Manufacturing----------------------------360,000

Selling and admin-------------------------30,000-----------390,000

Contribution margin-----------------------------------------110,000

Fixed costs

Manufacturing------------------------------40,000

Selling and admin--------------------------50,000-----------90,000

Operating income----------------------------------------------20,000

Answer 1

Managers must have tools at their disposal to assist them in distinguishing relevant and irrelevant costs so that the latter can be eliminated from the decisions framework. What costs are relevant in decision-making? The answer is easy. Any future cost that makes a difference between decisions alternative is relevant for decision purpose. All costs are considered relevant, except;

a) Sunk costs. A sunk cost is a cost that has already been incurred and that cannot be avoided regardless of which course of action a manager may decide to take. As such, sunk costs have no relevance to future events and must be ignored in decision-making.

b) Future costs that do not differ between the alternatives at hand. Relevant costs are avoidable costs. An avoidable cost can be defined as cost that can be eliminated as a result of choosing one alternative over another in a decision-making situation. In management accounting, the term avoidable is synonymous with differential cost. These terms are frequently used interchangeably. To identify the costs that are avoidable (differential) in a particular decision situation, the manager’s approach to cost analysis should include the following steps.

• Assemble all of the costs associated with each alternative being considered.
• Eliminate those costs that are sunk.
• Eliminate those that do not differ between alternatives.
• Make a decision based on the remaining costs. These costs will be the differential or avoidable costs, and hence the costs relevant to the decision to be made.