Relevant costs for decisions

by Mike Tayles
03 Feb 2001

Decision-making is the essence of all management activity and naturally accounting plays a role
in informing decisions. The firm’s costing system, for which the accountant is responsible, has
to report on the costs of products and services from which decisions to discontinue, redesign,
make or buy, etc. have to be made. The signals from the routine reports of costing systems have
to be noted, interpreted and perhaps confirmed by a more detailed ad-hoc analysis, undertaken
by the accountant. In accounting examinations, costs for decisions, in different degrees of
difficulty, feature at Foundation, Certificate and Professional level or, in Parts 1, 2 and 3 of the
new examination structure from December 2001.

This article will focus on management accounting information for decisions, making reference
to absorption, variable costing and ABC systems and their implications. These will be
developed with both a practical and examination focus. In the past few years the Management
Accounting section of Paper 8 (to become Paper 2.4) has featured, on a number of occasions,
problems which required the interpretation of an absorption costing statement, followed by
adaptation to a variable or relevant costing statement. These have been set in both a
manufacturing and a service sector environment and incorporated the implications of ABC. This
article is built round extracts used in typical examination questions; where past question styles
have been used the figures have been changed so readers can use the questions as practice.
Comments are added to explain the methodology and emphasise the practical relevance of the
question and answer. In a following article we will deal, in particular, with the identification and
extraction from the accounting system, of relevant costs.

The outputs from financial accounting systems often inform external decision makers about a
business and its performance. The financial accounts are also consulted by the management
inside the company to assess the implications of their decisions, but we will find that in some
cases the financial accounting structure is not always the best guide for decisions which need a
management accounting focus. Some would say that costs for decisions or relevant costs are at
the root of the distinction between financial and management accounting. Financial accounts are
based on a defined set of ‘rules’, often in a set format and are drawn from a system which has a
prescribed routine (for dealing with say, depreciation, cost allocation, and stock valuation). By
contrast relevant cost and revenue information is not routine and is drawn up for a specific set
of circumstances. It is decision specific; in a different set of circumstances different relevant
costs and revenues will apply.

Accounting students probably first encounter the idea of relevant costs for decisions through the
use of variable or marginal costs and the notion of contribution. We will start off with an
example which looks at this idea but which then develops to take account of other dimensions.
In only very simplified situations is contribution (sales minus variable costs) the only
consequence of a decision but it is a starting point. Because some fixed costs may also change
as a result of a decision we often invoke the concept of marginal cost (borrowed from the
economist) to deal with changing variable and fixed costs. What’s the best approach?

Let us now illustrate the basic idea of contribution with a simple scenario to which we shall add
issues of increasing complexity. Table 1 (a) shows the product performance of a Business Unit
in a typical financial accounting (absorption costing) layout and showing gross and net profit.
The results are divided amongst four product lines. Product Y shows a loss. You are informed
that: The loss being reported in the table against product Y is indicative of recent results and has
led the management to consider its withdrawal. It is estimated that if product Y were to be
withdrawn a saving of fixed factory and selling costs of £150,000 would occur. As the
accountant of ACCA you are asked to advise firstly, on financial grounds should Y be
withdrawn? And to briefly explain and qualify this.

TABLE 1(a) Product Performance – Absorption Costing

The ACCA Company manufactures a line of four related products in a single factory
which is currently operating below capacity. Annual sales and costs of the products
are shown below:

W X Y Z Total
£000 £000 £000 £000 £000
Sales 2,000 2,500 1,000 500 6,000
Factory cost of sales:
Materials 300 400 200 40 940
Labour 500 600 400 100 1,600
Overhead 600 800 500 100 2,000
1,400 1,800 1,100 240 4,540
Gross margin 600 700 (100) 260 1,460
Selling overhead 300 375 150 75 900
Operating profit/(loss) 300 325 (250) 185 560

The factory overheads costs allocated to products are based on predetermined overhead rates of
which 20% is estimated to be variable at the current operating volume. Selling overheads are
applied to products based on 15% of sales value, the variable component of this is
approximately 10% of sales value.

This style of presentation of a problem is, for students, commonly the initial introduction to the
importance of contribution rather than net profit for the support of short-term decisions. It is
intended to bring out the fact that any arbitrary allocation of fixed costs needs to be stripped out
of the statement to reach the short-term profit-maximizing decision. Additionally, however, in
this example it appears there are some specific or direct fixed costs, applicable to Y, which
would be saved if the product were discontinued, these need to be considered also. Note that the
proportion of variable costs is supplied in two slightly different ways. Related to factory costs
the proportion of the total overhead cost, that is variable, is indicated, whereas in the context of
selling overheads the variable selling overhead rate is indicated (i.e., 10%). It can quickly be
deduced that the implication is that variable selling overheads are two thirds of all selling
overheads at the volumes indicated.

Taking account of the analysis between variable and fixed costs produces a statement, Table
1(b). This shows that Y still generates a contribution of £200,000, to be precise this could be
termed variable contribution, i.e., contribution to all fixed costs. Remember we were informed
that if Y were discontinued £150,000 of fixed costs would be saved. In this particular scenario
then, the variable contribution from continuing the product, at the volume given, is higher than
the fixed costs which would be saved by discontinuing. Hence, it is worthwhile to continue with
the product from a financial point of view, it makes a net contribution to the other general fixed
overhead costs.

TABLE 1(b)
W X Z Sub-total Y Total
Product Performance – Contribution Analysis
£000 £000 £000 £000 £000 £000
Sales 2,000 2,500 500 5,000 1,000 6,000
Variable costs:
materials 300 400 40 740 200 940
labour 500 600 100 1,200 400 1,600
factory overhead 120 160 20 300 100 400
selling overhead 200 250 50 500 100 600
Total variable costs 1,120 1,410 210 2,740 800 3,540
Contribution 880 1,090 290 2,260 200 2,460
CS ratio 44% 44% 58% 52% 20% 41%
Less fixed costs: 1,750 1,900
Net profit 510 560

To answer the particular question that was posed does not require the full Table 1(b) to be
produced. All we need to identify is the variable and fixed costs applicable to Product Y.
Providing the full table to a manager places the results for Y into a wider context, however, and
is also the basis for a later part of the article. The profit which would arise if Y were to be
withdrawn is £510,000, that is £50,000 less than at present, representing the lost variable
contribution of £200,000 and the saved fixed costs of £150,000. To put this in relevant cost
terminology there are incremental net revenues (contribution) of £200,000 and incremental
fixed costs of £150,000 which would apply if the product was continued. These could also be
termed avoidable revenues and avoidable costs if the product was withdrawn.

Assumptions

There are, of course, a number of assumptions and limitations to this. To set them out briefly
they are: “that variable costs can be accurately identified by the percentages given in the
question. Labour costs are assumed to be variable, in other words there is some casual labour
which can be reduced with immediate effect and there are no other costs, for example
redundancy costs, related to the withdrawal of Y. The discussion regarding Y also assumes that
the current situation will continue, that is, there is no scope for price rises in the future or for
costs to be significantly reduced through efficiency or cost changes”.

You will see that in Table 1(b) I have added the contribution/sales (C/S) ratio. This shows quite
clearly that Y is the least profitable of the products. You will note, however, that the further
information given in Table 1(a) indicated that the company had spare capacity, this is a further
reason why it may choose to proceed with the product in the current situation. If capacity was
scarce then it is possible that this product would be the first candidate, from a financial
perspective, to be withdrawn or cut back. Such a situation would be addressed using
contribution per unit of limiting factor (say machine hours if they were the key resource). But
we shall not pursue that issue here.

Dealing with the longer-term

So far the content and context of the problem has been at an introductory or foundation (Part 1)
stage of the subject. Testing the level of understanding can proceed to an intermediate or
certificate (Part 2) stage if we develop discussion round the result above by posing questions
such as: Is it conceivable in the long run to keep Y in the product range? When would it be
appropriate to consider dropping it?

Responses to this question require the accountant, or exam candidate, to be creative and
‘applied’, bringing into his/her recommendation a business awareness and broader accounting
knowledge. There is no single ideal answer to this sort of an issue either in theory, an the exam
room, or in practice. A possible response to this question is as follows:

The long-term decision related to product Y turns on the incremental costs and incremental
revenues involved in producing and selling the product over the relevant time period. In the
present position of spare capacity and the fact that Y is making a contribution, in the short-term,
it should remain in the product line. If there are no other lump sum savings of expenditures by
withdrawing Y then it could be retained over the longer term on the basis that it is contributing
to profit.

Additionally, if its abandonment would cause the reduction in the sales of other products in the
line, then these implications should also be taken into account. However, to proceed too far with
this argument could be dangerous and the company could find it is using this reasoning to retain
a wide range of low volume/low contribution products. These would add to the complexity and
hence the costs of manufacture, but very little to the overall profit. It would be wise therefore
for the company to regularly examine the low volume/low contribution products in its range.
This is what, in part, is being shown by using the C/S ratio in Table 1(b).

If the company were able to develop another product, offering a better contribution, with similar
characteristics which would utilise the same plant as Y, then Y should naturally be re-evaluated.
If sales of the other existing products expand sufficiently to require the capacity currently
devoted to Y, then Y would be a candidate for withdrawal. Alternatively, if the company was
faced with significant capital expenditure to maintain its production capacity then consideration
could be given to withdrawing Y rather than incurring that expenditure. This expenditure would
give rise to a change in the product cost anyway, perhaps an increase in direct or specific fixed
costs because of deprecation and possibly a decrease in unit variable costs because of a change
in process efficiency. The overall picture would depend on the capacity involved, the amount of
the investment and the extent to which withdrawal of Y would affect sales of other products in
the line which in practice would have to be estimated and evaluated (this will be addressed
later).

You should also note that we do not have a wider picture of this product and its situation. For
example, we do not know about the pricing policy of the company though we are told the
situation has lasted for some time, so is it a permanent loss leader, we would guess not! In the
real world that would be a pertinent question, in an examination this would need to have been
indicated either directly or indirectly. We do not know anything about this product’s life cycle,
for example in an introductory stage a low price might help it to become accepted and hence
maximize its long-term market share, an example of penetration pricing.

Absorption or variable costing statement which is best?

You should be aware incidentally, that the presentation of data in Table 1(a), an absorption
costing statement, is not necessarily entirely wrong. The ability of a product to cover its costs,
including its somewhat arbitrarily allocated costs may be a useful general indicator to its
viability. In this situation however, it is perhaps a little unhelpful because it may lead an
uninformed reader to assume automatic deletion of product Y would increase the overall profit.
We have shown in the example that this would not be the case. If, however, the absorption
costing statement is being used only to ‘direct attention’ for a more detailed special study (using
the relevant costs of the circumstances) it is doing its job. Both Tables 1(a) and 1(b) have very
similar messages – Y is the weakest product and requires some attention!

One cannot conclusively say that, to highlight or direct attention to the problem, the absorption
costing statement is wrong and a contribution analysis statement is always right in the above
circumstances. Though it is necessary to consider the costs and revenues likely to change in
order to move towards a conclusive decision. That is also what practitioners think. In some
recent research, on which this writer has been engaged, almost 200 accountants in industry and
commerce were asked which figure (‘contribution’ or ‘a profit figure after some overhead
allocation’) was consulted to examine product profitability as a matter of routine. They were
approximately split evenly between 50% who used contribution and 50% who used a profit
figure involving some overhead allocation, for this sort of discontinuation decision (Drury and
Tayles 2000). It was then apparent that most carried out a more detailed analysis (of relevant
costs and revenues) before a final decision was made, just as we are doing with this problem.

Activity-Based Costing

This is not an article about Activity-Based Costing but ABC is an alternative costing system
which some companies employ so a comment is appropriate. Some would claim that the use of
ABC is attempting to bridge the gap between the use of a variable cost/contribution approach at
one extreme, and full absorption costing at the other. By using a variety of allocation bases (cost
drivers) it is attempting to attribute organisational indirect costs to products more appropriately.
In other words, ABC is capable of producing a product cost or profitability statement which is,
or can be, adapted to a closer approximation of a relevant cost. This would be carried out by
identifying the direct costs and, from the ABC system database, the overhead resources
consumed by products using a hierarchy of costs at the unit, batch, product and facility level.

Evaluation of a proposal to withdraw a product would require focus on the reduction in the
activity cost driver units that would result. This could assume that the withdrawal of the product
would result in the omission of some activities and as a consequence a cost saving. In the
example we have just been considering cost saving might apply to costs at the unit level, batch
level and product sustaining level of the organization but not to facility sustaining costs (which
represent fixed infrastructure costs) which would be incurred anyway. The cost and profit
prediction from the ABC system would be produced routinely and would be a closer
approximation, than traditional absorption costing, to the results of a one-off analysis of
relevant costs and revenues which we effectively carried out in Table 1(b).

Interdependency of Decisions – the effect of market factors

To conclude the illustration, the problem can be made more complex, and frankly more
realistic, by introducing more information which considers how the market may react to
deletion of product Y. See Table 1(c) for possible market considerations.This may still be a
simplified illustration of the issues being faced by accountants in the ‘real world’ when dealing
with this sort of situation. To solve it requires identification of the contribution and fixed cost
implications of the changes in demand for all products.

Table 1(c) Market considerations

Product Z may in some cases be a substitute for Y. If Y were to be withdrawn completely sales
of Z would increase by £300,000.

Products W and Y are complementary. Twenty per cent of Y is sold in conjunction with W.
These customers would not be able to substitute Z for Y and would be likely to move to other
companies for their supplies if product Y is dropped. As a consequence sales of W would drop
by 10% if Y were to be withdrawn completely. Product Y could however be retained as a
service to these specific product W customers only.

The saving of fixed costs achieved by the complete withdrawal of product Y would still be
£150,000. If product Y was to be retained as a service to product W customers only the saving
in fixed factory and selling costs would be £100,000.

It is these key issues, shown in Table 1(c), for which we need to develop financial
consequences. We shall do this by adjusting the total contribution applicable to the four
products in relation to the changes in volume of product sold. You should be aware that we are
developing here the incremental costs and opportunity costs and benefits of deleting product Y,
that is, the net revenue of W and Z and the fixed costs that would change if Y were partially or
totally withdrawn. Be warned that Table 1(c) has to be read very carefully to extract the various
implications of the market situation. It is very important when setting out the values in this, or
any relevant cost, evaluation to be explicit about the decision alternatives being considered and
hold that assumption about the decision alternatives to the end of that part of the analysis. Then
all of the values, costs and revenues, must be identified for that decision only. Do not
incorporate into the same analysis both the incremental costs that would apply if the decision
proceeded and the avoidable costs which would be saved if it did not. To do this would confuse
the whole decision analysis but is a slip that exam candidates often make. When this sort of
variation was incorporated into part of a question a few years ago candidates found it very
challenging, hence the explanation should be considered carefully. The decision alternatives are
to continue with Y, delete Y completely or continue Y as a service only to customers of product
W, the latter will require a volume of Y which is 20% of current sales. A revised evaluation of
the deletion of Product Y is now required. The financial aspects are contained in Table 1(d)
with the respective columns applicable to the various alternatives outlined.

The following will help to explain some of the columns of the table:

Column 2. If Y were to be continued the financial result would be the same as that indicated
above in Table 1(a) a profit of £560,000. This could be summarised in terms of the respective
contributions of the products and the total fixed costs in Table 1(d) column 2. The original
assessment of the deletion of product Y is shown in column 3, but this is not now applicable
given the additional market information available in Table 1(c).

Column 5. If Y were to be withdrawn completely the implications would be £300,000 (60%)

extra sales of Z and a reduction in the sales of W by 10%. Additionally, £150,000 fixed costs
would be saved, see Table 1(d) columns 4 and 5.

Column 7. If Y were to be retained to service only the customers for product W, this would
imply 20% of the present sales of Y would be achieved (i.e., 80% reduction). The extra
£300,000 (60%) sales of Z would continue and there would be no reduction in the sales of W
because these customers would be satisfied. The fixed costs saved would be only £100,000 in
this case as some manufacturing capacity of Y is retained see Table 1(d) columns 6 and 7.

Table 1(d)
– Contribution and Profit Analysis taking 2 3 4 5 6 7
Account of Market Factors 1
Product £000 £000 £000 £000
W 880 889 Less 10% 792 As original 880
X 1,090 1,090 Unchanged 1,090 Unchanged 1,090
Y 200 200 Withdrawn 0 Only 20% 40
Increase Increase
Z 290 290 464 464
60% 60%
Total Contribution 2,460 2,260 2,346 2,434
Fixed costs 1,900 1,750 1,750 1,800
Net Profit 560 510 596 634
On financial grounds it would appear that the best option for ACCA is to retain manufacture
and sale of product Y for the customers of product W only. There is the implication that Y has a
trend of poor profit performance in the recent past and no indication that this will change. The
opportunity cost of dropping Y completely, given the consequent loss of sales of W, is high and
this is the main reason for keeping it in the portfolio. It is still reasonable for the company to
look to develop a product with a better level of profit than Y and one which has the
characteristics suitable for product W customers. This would improve their profit position even
further.

Conclusion

This article has dealt at various levels with the analysis of relevant costs and revenues to
evaluate a possible product deletion. It started with a problem situation highlighted by a report
on product profitability using absorption costing. We found we needed to invoke the variable
and fixed cost dichotomy in order to strip out the costs that would change given predicted
volume changes on the proposal to discontinue the product. We can also say that with the
greater detail in a database of costs and activities of an ABC system, a clearer focus might be
possible on the costs that would change as a result of say a deletion decision. No costing system
can routinely incorporate the possible lost revenue (opportunity costs) applicable to the market
factors subsequently mentioned. We found that we had to make quite careful analysis of the
market implications to incorporate these factors in a series of ad-hoc analyses. No costing
system routinely records the opportunity costs1 of events or transactions, they have to be
extracted relating to the particular circumstances of the decision.

We have shown how we have moved from the attention directing of an absorption costing
statement into some contribution analysis to assess the financial implications of a product
deletion. This has introduced terms such as incremental and avoidable costs. We have briefly
mentioned how ABC might be an alternative to an absorption cost statement. Finally we have
shown how market factors can be incorporated into the analysis to give a wider and more
realistic set of the circumstances, this has involved us in considering opportunity cost. In the
following article we shall reinforce the relevant cost terminology used here and demonstrate
other situations where we have to depart from the routine financial reporting system to acquire
the values to be incorporated into relevant costs

References:

Drury, C. and Tayles, M., (2000), Cost System Design and Profitability Analysis in UK
Companies, CIMA, London.

1 A linear programming model can produce this information but there is little evidence of the
use of this in routine accounting or costing systems.