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Q: Question about Relevant Costing ( Answered,   0 Comments )
Subject: Question about Relevant Costing
Category: Business and Money > Accounting
Asked by: stranger_uk123-ga
List Price: $100.00
Posted: 05 Nov 2006 10:03 PST
Expires: 05 Dec 2006 10:03 PST
Question ID: 780284
SBL produces special containers. They believe that if they outsource
them it would be much cheaper.

An outsourcing company EPC is prepared to supply new containers
(30,000) per annum for 1,150,000 per year. The contract will cover a
term of 5 years.

Irrespective of whether SBL outsource the containers or not, EPC will
undertake to carry out purely maintenance work on containers for a sum
of 580,000 per annum on the same contarct term.

SBL calculated the following figures which covered a years operation
producing containers.

Material 612,500
Labour (Cost expected to increase by 5% each yr) 250,000
Manager's Salary (expected to increase by 10% each yr)  50,750
Rent  37,700
Depreciation of Machinery 125,625
Maintenance of Machinery  25,650
Other departmental exp 137,550
Proportion of SBL general exp 188,450

* Please note that the manager's position is not in jeopardy

SBL put the proposal to the manager to which he replied;

"What will happen with the machinery? It cost 1,050,000 four yrs ago
and we would be lucky to get 175,000 for it now even though it should
last for at least another 5 yrs.

He further said "What about the lining material for containers? That
cost us 875,000 and, at the rate that we are using it now, it will be
sufficient for at least 4 more years - we used about one fifth of it
last year.

The figures of 612,500 for materials probably includes about 180,000
in respect of lining material.

We bought this lining material for 440 per ton and it cost no less
than 525 per ton today. If we were to sell it off, we would not get
any more than 350 per ton, net of disposal cost.

During this manufacturing a total of 74,375 a year in rent is being
paid towards a small warehouse few miles away from the company to
store the material. If we take on the contract we would not need that

That is a good point?, said GM, ?but I am a little concerned about the
workers if we close the department. I don?t think that we would find
room for anyone of them elsewhere in the firm. I could see whether EPC
could employ them but some of them are nearing retirement age.

For example: Lanchburg and Masters have been with us since they
finished school 40 years ago ? I would feel bound to give them a small
pension of, say, 13,500 a year each.

Department Manager showed some relief at these comments but indicated
that he was still not happy with SBL figures. ?What about this
188,450 for general administrative overhead,? he said ?you surely
don?t expect to sack anyone in the general office if my department
closed do you?? "NO" said accountant.

The company's general manager suggested that if we outsource the
production of containers and keep the maintenance to ourselves it may
be worth considering. We will not need any machinery and he would hand
over the supervisor to a foreman hence saving half the salary cost in
that case.

We will need only one fifth of the workers but we can keep the oldest.
We wouldnt save any space here or at the rented warehouse so the rent
would be the same. Other expenses would not be more than 56,900 per
annum and we use about 10% of the total material on maintenance.

What I require is;

a) What are the concepts of relavant costing and how it might apply to
manufacturing company. Illustrate with examples.

b) Without any calculations, identify the business options implicit in
the SBL case and comment on the possible costs and benefits of each

c) With the assistance of relevant calculations, determine and explain
which of that alternative identified in (b) above is most attractive.
justify the approach that you adopt.

(d) Discuss other factors with GM should consider before finalising
his decision and indicate how could he obtain the necessary

Request for Question Clarification by omnivorous-ga on 07 Nov 2006 13:53 PST
Stranger_uk123 --

This is a pretty straightforward Relevant Costing problem.  But
there's one aspect that needs be clarified and it is in these lines:

>We will not need any machinery and he would hand
>over the supervisor to a foreman hence saving half the salary cost in
>that case.

The paragraph seems to indicate that the "manager's salary" would be
halved to 25,375.  Is that the case or does the note that "the
manager's position is not in jeopardy" mean that this cost item
pertains to the General Manager, who remains in any case -- and the
firm will pay 50,750 annually, no matter what the decision.

Best regards,


Clarification of Question by stranger_uk123-ga on 08 Nov 2006 00:33 PST

yes that is right manager post is not in a trouble as he is going in
other department.

In the case of labour the manager informed that they will be paying
13250 as annual pension for two of his old labour and rest of tham
have to secrifice their post if the proposal has accpeted..
Subject: Re: Question about Relevant Costing
Answered By: omnivorous-ga on 08 Nov 2006 08:08 PST
Stranger_uk123 --

A.  One of the most common uses of Relevant Costing is in make-buy
decisions, such as this one.  It allows a company to see what direct
costs it incurs for a project, stripping away overhead charges and
depreciation that don?t really use cash ? making the firm more
competitive than a pro forma income statement would indicate.

Managerial accounting determines full costs for external reporting,
but includes factors that are really irrelevant for project decisions
like this one.  Relevant costs for projects include all identifiable
costs for the life of the project and are those that are incremental.

It is important to note that Relevant Costing may discount
depreciation in some examples (including this SBL case) but that full
project cost for capital equipment is important, thus it should be a
multiple-year analysis.

The University of Oregon description linked below provides a nice explanation:

?Relevant costs are costs that change with respect to a particular
decision. Sunk costs are never relevant. Future costs may or may not
be relevant. If the future costs are going to be incurred regardless
of the decision that is made, those costs are not relevant. Committed
costs are future costs that are not relevant. Even if the future costs
are not committed, if we anticipate incurring those costs regardless
of the decision that we make, those costs are not relevant. The only
costs that are relevant are those that differ as between the
alternatives being considered.?

University of Oregon
?Relevant Cost Analysis,? (Caplan, undated)

Another good description, complete with a case analysis is in Accountancy:
?Relevant costs for decision-making,? (Jay, Oct. 24, 2004)

Examples in the SBC case include:
?	ignoring depreciation charges, SBL?s allocated general expense and
the manager?s salary.  Depreciation is a non-cash charge simply being
allocated to container manufacture per accounting principles.  The
general expense allocation is also an ?arbitrary? number, one that
will be present whether containers are purchased or not.
?	though the capital purchase price of the machinery in this case is a
sunk cost, there is a future value to it, should we decide to
liquidate it.  In this case ?175,000 can be realized immediately by
selling it for salvage.
?	similarly, the company has already sunk ?875,000 into linings.  It
has an impact here in two ways: it is money that doesn?t have to be
spent for materials, reducing the annual charge.  And it can be
liquidated for ?556,818 if we?re not going to manufacture containers
any longer.

B.  There are three basic business options available to SBL in this
case, though the company can do A, B, C or combinations of A and B :
A.	outsource container manufacture
B.	outsource container maintenance
C.	continue to manufacture and/or maintain its products

In any case, looking at the direct costs of its two business segments
? container manufacture and contain maintenance ? enables the company
to identify the direct costs of each, as well as to examine its
overhead structure to see if it is competitive.  Currently SBL lumps
both businesses in one financial activity area, potentially leading to
bad decisions on both.

Outsourcing may have benefits in lowering per unit costs and
increasing reported profits.  However, outsourcing also reduces the
company?s ability to control costs long-term by changing
manufacturing.  It reduces the workforce and value-added that SBL
provides.  And it has longer-term strategic implications, such as
potentially enabling EPC to compete with SBL and removing SBL from the
quality-control feedback loop.

C.	 The SBL make-buy decision is summarized in this spreadsheet:

Here is an explanation of what?s included in the make-buy financial
analysis in that spreadsheet:

SBL Makes

Labour: included, with 5% increase each year
Material: reduced by the lining that is already in inventory.  (The
?buy? decision accounts for this by selling the lining.)
Machine maintenance: fully included
Rent: you incur it if you manufacture but not if you buy
Other: fully included

Not included: depreciation, manager?s salary, general expense
allocation ? though if we outsource we also get to sell the machinery
and that?s in the ?Buy from EPC? section.  But if we outsource, we
also have to pay pensions, so that?s a real cost that has to be added
to the ?Buy from EPC? case.

SBL Maintains

In the ?SBL Maintains? case many of the above items are not relevant ?
rent, machinery, machinery liquidation and even the pension, as
Lanchburg and Masters would stay on.

The direct cost of maintenance is: labour, materials, other expenses. 
There also is an opportunity cost related to selling the 10% of the
lining material that maintenance uses ? but it is minor and doesn?t
affect this case.

Comments on ?SBL Makes? and ?SBL Maintains?

It is cheaper in year 1 for SBL to outsource but over the project life
the costs are about ?706,000 higher.  Why would SBL even consider it? 
Probably because accounting is allocating more than ?188,450 extra for
overhead plus another ?125,625 for depreciation (not to mention the
manager?s salary) ? making internal production appear to be a losing

As you can see from the spreadsheet, ?SBL Maintains? is an even stronger case.


There are a large number of issues that this make-buy decision raises.
 The prime issue for the general manager is: ?How stable is the demand
for our containers going to be??  Both an increase or decrease in
demand of only 10% will incur very different expenses for the company
and we have no visibility for those likely possibilities.  If the
market were expected to grow dramatically for the containers over the
five-year period, the GM might consider a hybrid approach, outsourcing
to meet increased demand.  On the other hand, facing a shrinking
market, the GM might consider an exit strategy and possibly choose to
sell machinery and materials now before further declines in value.

The general manager is also likely to consider the overhead structure
that is adding more than ?188,000 in cost to this business unit.  If
the firm is finding that it is unprofitable, it may be that ?general
expenses? are uncompetitive.

In addition, some practices here appear grossly uncompetitive, such as
purchasing five years worth of lining materials.  Though it has
appreciated in value, normal inventory turns should be in the
neighborhood of 8 to 12 times per year for a factory, not once every
five years.  (This also implies that the company should be looking a
capital budgeting using present values of expenditures, but that?s
outside the scope of an accounting question.)

Google search strategy:
?relevant costing?


If any aspect of these calculations is confusing, please don?t
hesitate to ask for a clarification before rating this Google Answer.

Best regards,


Request for Answer Clarification by stranger_uk123-ga on 09 Nov 2006 09:23 PST
thanks for the answer. 
Please can you claryfuy the equation on SBL maintinance while buying from EPC.
EPC maintinance but SBL making.

Clarification of Answer by omnivorous-ga on 09 Nov 2006 09:48 PST
Stranger_uk123 --

I'll summarize the entries this way.  Let me know if it is adequate:

SBL Maintenance Cost (Maintain & Make Case)

SBL Maintenenance Costs

--  Labour: the case makes it clear that 10% of the materials are used
for maintenance, so outlays will be 10% of 432,500.  We already have
the lining -- but could liquidate it for 55,682 or 10%.  (There's
some danger of overestimating material expenses in this case but the
way assumptions were presented, I didn't think that we could reduce
line 7.  It doesn't SPECIFICALLY say that the material costs in
paragraph 5 of the question are Manufacturing + Maintenance.)
--  Manager: included in the labour cost reductions (that's why I
asked the clarification question: this might have picked up half of
the 50,750).
-- Direct labour: 20% of the 250,000, increasing by 5% per year
-- Other expenses: set at 56,900
-- Liquidate lining: 55,682.

Not relevant to this portion of the case: machine maintenance, rent,
machinery liquidation, pensions.

Note that in the "maintain only" case you might reduce the year 1 cost
by liquidating 90% of the lining and liquidating machine and adding
back pensions -- these are lines 18, 19, 20.

That would make the first year appear "free".  In fact, it would
provide 124,818 -- but the cost of years 2-5 would swamp it in that

Best regards,


Request for Answer Clarification by stranger_uk123-ga on 09 Nov 2006 11:42 PST
thanks for the clearification, please could you tell me 
1.the total cost if SBL make but out source the maintinance from EPC.

Clarification of Answer by omnivorous-ga on 09 Nov 2006 11:51 PST
Stranger_uk123 --

The total cost in this case is Line12 + Line37, or 4,446,833 +
2,844,318 = 7,291,151.

There's some confusion in this case about the separability of
materials AND labour in this case.  It would be reasonable to reduce
labour and materials -- but the case only really gives us "production"
numbers, so it is difficult to argue that production costs should fall
by the amounts in lines 27-29.

Best regards,


Request for Answer Clarification by stranger_uk123-ga on 13 Nov 2006 09:48 PST
please can you give the calculation of total cost for SBL making by
clearifying how the labour cost is like that.

also what will be the total cost for SBL to maitinance with buying from EPC

Request for Answer Clarification by stranger_uk123-ga on 13 Nov 2006 10:37 PST
please can you clearify how do you got the income od 55682 for buy
maintinance from EPC.

Clarification of Answer by omnivorous-ga on 13 Nov 2006 11:41 PST
> clearifying how the labour cost is like that.

Labour costs are given to be 250,000 "for producing containers," and
it increases at 5% per year.  So, on line 6 you're getting:

Year 1: 250,000
Year 2: 262,500
Year 3: 275,625
Year 4: 289,406
Year 5: 303,877

There are several holes in this question that could cause different
assumptions.  For example, year 1 costs might already be 5% higher if
you read this question a different way.

> what will be the total cost for SBL to maitinance with buying from EPC

SBL Maintains, Total Cost = 777,032
Buy from EPC, Total Cost = 5,153,182

But SBL will need to add the cost of the lining for maintenance to
that or 10% of net from "liquidate lining" = 55,682

So, the total is 5,985,896

> how do you got the income od 55682 for buy maintinance from EPC.<

A year ago we spent 875,000 or 440 per ton for lining.  We have used
180,000 of it, leaving 695,000 left.

That is 1,579.55 tons -- and we can sell it for 350 per ton, net of
disposal cost.  This needs be allocated for production AND 10% to
maintenance -- making 556,818 total -- and 55,682 for maintenance.

NOTE: you might change assumptions and cut the 556,818 down on line
16 by 55,682.  That way you'd properly have 90% of the lining
allocated to manufacturing and 10% to maintenance.

I did NOT do that in the original calculations, assuming what the case told us:
"Irrespective of whether SBL outsource the containers or not, EPC will
undertake to carry out purely maintenance work on containers."  That
makes the all of the lining disposable.

Best regards,

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