Outline
Modern business organisations face a number of challenges in their operations of importance, growth in revenues and cost management. Increased competition as a result of globalization has made it necessary to effectively manage costs. The following case study is a review of the importance of analysis of relevant costs for decision making.
Introduction
Classification of costs is vital to the management in decision making such as whether to increase prices or vary output levels (Ray 2002, P. 280). It also provides useful information for management such as the extent to which prices or output can be reduced without incurring losses. Further, through cost analysis, reasonable estimates can be determined of expected costs and revenues for a range of expected output levels. This is important in budgeting and planning as well as in making financial as well as production forecasts.
Cost analysis
Cincinnati Flow Technology (CFT) is facing a dilemma whether to continue purchasing pumps from Kobec Inc at the current price of $102 or whether to manufacture those pumps in the company. The analysis prepared of costs involved in production of the pumps is incorrect since it involved lumping fixed and variable costs. Dutta (2009) argues that in making a decision of whether to purchase or manufacture, only variable cost of production should be considered. Therefore, to carry out the analysis of costs associated with production of pumps, only incremental should have been considered as relevant for decision making. On the other hand, all fixed costs should be assumed irrelevant and therefore not taken into consideration in reaching the final conclusions. Production of pumps in CFT would require additional production employees to be hired.
However, there will be no need for additional equipment, space or supervision. As such, only cost of components relating to outside purchases and assembly labor costs are incremental costs. Therefore, these are the only relevant costs for decision making. Other costs such as manufacturing overhead and general administration overheads will not be influenced by production of pumps and therefore irrelevant for decision making. The analysis previously carried out made a mistake of not separating between the relevant and irrelevant costs. Based on classification of costs into relevant and irrelevant, the cost for production each pump has been determined as below.
As noted above, the total relevant cost per unit for production of each pump is $63. CFT is therefore better off manufacturing the pump rather than purchasing. Such a decision will lead to a saving of $59 ($102-$63) per pump. Other costs such as manufacturing overhead and general administrative overhead will not be affected by the decision whether to manufacture the pumps or purchase them from Kobec Inc. The recommendation made by CFT was therefore incorrect since it considered full costs instead of relevant costs.
This caused them to assess production cost per unit of $143.55 which would have favored purchase of pumps rather than manufacturing. A wrong decision would have therefore been reached resulting to loss of revenues. This decision would have caused the company to suffer a loss of $59 per pump and an aggregate loss of $590,000 ($59*10,000). There is therefore need to carry out proper classification of costs.
References
Dutta, M 2009. Cost accounting: principles and practice. India: Pearson Education.
Ray, F 2002. Business finance for managers: an essential guide to planning, control and decision making. London: Kogan Page Publishing.