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
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
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:
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.
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.
D. OTHER FACTORS
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:
If any aspect of these calculations is confusing, please don?t
hesitate to ask for a clarification before rating this Google Answer.
Clarification of Answer by
09 Nov 2006 09:48 PST
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
-- 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
Clarification of Answer by
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.