One-Off Contracts, Shutdown and Further Processing Decisions Using Relevant Costs

Three questions reach the management accountant almost every month. A customer offers a one-off order at a price below the usual one: should it be accepted? One product line is showing a loss in the monthly report: should it be closed? A joint process produces an intermediate product that could be sold as it is or processed further into something that sells for more: should it be processed?

Each of these decisions has a trap. The loss on the product line may be created by an allocation of overhead that would not disappear if the line closed. The cost of the one-off order may be overstated by absorbed overhead and understated by the opportunity cost of materials. The cost of the joint process is sunk by the time the further processing decision is made.

The same tool settles all three: relevant costs and revenues. This topic applies it to each decision, with worked examples, and then lists the non-financial factors that must be weighed alongside the figures. It builds on the earlier topic on make-or-buy and outsourcing decisions. The next topic covers reducing uncertainty through research, simulation and sensitivity analysis.

Applying relevant costing to three decisions

The rule behind all three

A relevant cost is a future cash flow that will occur as a direct consequence of the decision. It excludes sunk costs, committed costs that cannot be avoided, absorbed fixed overhead that is only an allocation, depreciation and anything that will happen whatever is decided.

It includes incremental costs, avoidable costs, differential costs between options, and opportunity costs, the benefit given up by choosing one course rather than the next best. The earlier topics on relevant costs and opportunity cost and relevant costs for specific decisions set out the rules for each type of resource; this topic uses them.

One-off contract decisions

A one-off contract is a job that will not be repeated, for example a special order from a customer when the company has spare capacity. If the extra revenue from the contract is higher than the relevant cost of doing the work, including any opportunity costs, the contract adds to profit and should be considered. The relevant cost of each input follows the usual rules:

• Materials in regular use. The relevant cost is the replacement cost, since stock used on the contract must be replaced for other work.
• Materials not in regular use. The relevant cost is the net resale or scrap value, or the cost avoided by using them as a substitute elsewhere. If they would otherwise have to be disposed of at a cost, the avoided disposal cost is a saving that reduces the relevant cost.
• Labour. If the workforce is paid a fixed wage and has idle time, the relevant cost is zero. If extra hours must be paid for, the cost is the overtime rate. If labour must be diverted from other work, the cost is the pay plus the contribution lost per hour. Where both overtime and diversion are possible, use the cheaper.
• Overhead. Variable overhead is a cash cost and is relevant. Fixed overhead absorbed per hour is relevant only to the extent that the contract causes extra fixed cash spending.
• Specific costs. Items bought only for the contract, such as a licence or the hire of a tool, are relevant in full. A rent that is already committed is not, but the rent that could have been earned by letting the space is an opportunity cost.

The result is the minimum price: at that price the company is no better and no worse off. A quotation will be higher, to earn a profit. The caution is that this method should not be used for most pricing, because a company must in total cover its fixed costs and earn a profit.

If all sales were priced at relevant cost, fixed costs would never be recovered, regular customers would demand the same price, and the lower price might damage the market for regular sales.

Shutdown decisions

A shutdown decision asks whether to close a part of the business, such as a product line, a branch or a department. In the short term, the question is whether the benefits of closing exceed its costs.

If a product is withdrawn, the company loses its contribution and saves the fixed costs that are directly attributable to it (for example the rent of a dedicated unit or the salary of its own supervisor). The decision rule is to close only if the fixed costs saved are greater than the contribution lost.

The share of general fixed overhead that the accounts allocate to the product is not saved by closing, because the cost remains and would be spread over the remaining products. A product can therefore show a loss after allocation while still making a positive contribution towards the general fixed costs, in which case closing it makes the company worse off.

Further processing of joint products

Joint products come from one common process. At the split-off point each can be sold as it is, or one of them can be processed further and sold at a higher price. The cost of the common process has been incurred or will be incurred whatever is decided, so it is irrelevant and its apportionment between the products is irrelevant too.

The decision compares, for the product in question: the revenue from selling it at split-off against the revenue from selling it after further processing less the extra costs of processing (variable cost per kilogram, and any fixed cost that is avoidable if the further processing is not done). Process further if the extra revenue exceeds the extra cost.

Because fixed costs may be avoidable only in total, the decision may depend on the volume: there is a break-even volume equal to the avoidable fixed cost divided by the net gain per kilogram.

Non-financial factors and the limits of the method

A recommendation based only on relevant costs is incomplete. Examiners expect the candidate to name the non-financial factors in the case, and to say what each implies.

• One-off contracts. Will regular customers hear of the low price and ask for it? Is the contract really a one-off, or will it lead to repeat business or a long-term customer? Does the work use capacity that would be needed for better orders? Is the customer reliable and will it pay? Does the work carry risk to quality or reputation, or require skills that stretch the workforce?
• Shutdown. Effect on staff morale, redundancy costs and the loss of skilled people; effect on customers who buy the other products too, particularly if the product is part of a range or a complement; damage to reputation and to relations with suppliers; the chance that the product will recover or is a future growth product; the use that could be made of the released space and capacity; and the legal duties to staff and customers.
• Further processing. Whether the market for the finished product is secure and the selling price reliable; the effect on quality and brand; the extra capacity and cash needed; whether the further processing can be stopped cheaply if the market weakens; environmental effects and waste.

The limits of the method are also worth stating:

• relevant costing looks at the short term and does not by itself show whether the company covers its total fixed costs
• estimates of future cash flows are uncertain
• a series of short-term decisions, each justified by relevant costs, may together damage the long-term position

Layouts for the three decisions

1. One-off contract. List each input: quantity, how it would be obtained, the relevant cost and the reason. Add them. Compare with the price. State the incremental profit or the minimum price.
2. Shutdown. For each product: contribution forgone; directly attributable fixed costs saved; net effect on annual cash flow. Close those with a positive net effect.
3. Further processing. Extra revenue per unit less extra variable cost per unit; times volume; less avoidable fixed cost; net effect. Break-even volume = avoidable fixed cost ÷ net gain per unit.

Money is in naira and each answer is rounded once, at the end.

Worked examples

1. M1.
   Regularly used, so replacement cost: 600 × 1,000 = ₦600,000.
   The original cost is sunk.
2. M2.
   No other use, so resale value: 400 × 300 = ₦120,000.
3. Skilled labour. Idle and paid anyway: ₦0.
4. Other labour.
   Overtime costs 500 × 1.5 = ₦750 an hour.
   Diversion costs 500 + 200 = ₦700 an hour.
   Diversion is cheaper: 500 × 700 = ₦350,000.
5. Overhead.
   Variable only: 1,500 × 100 = ₦150,000.
   The absorbed ₦200 an hour is ignored because no extra fixed cash is spent.
6. Tool hire. ₦90,000.
7. Total relevant cost.
   600,000 + 120,000 + 0 + 350,000 + 150,000 + 90,000 = ₦1,310,000.
   The incremental profit is 1,800,000 − 1,310,000 = ₦490,000; the minimum acceptable price is ₦1,310,000.
   Accept, subject to the non-financial factors.

1. Profit after allocation.
   A 900 − 500 − 250 = 150.
   B 120 − 210 − 150 = (240).
   C 640 − 300 − 200 = 140.
   Total ₦50,000.
   Only B shows a loss.
2. Effect of closing. A: lose 900, save 500, net (400). B: lose 120, save 210, net +90. C: lose 640, save 300, net (340).
3. Decision. Close B only. Annual cash flow improves by ₦90,000: contribution falls to 1,540, directly attributable fixed costs fall to 800, and the general fixed overhead of 600 remains and is borne by A and C. Profit rises from 50 to ₦140,000. A and C show profits after allocation, but even if they showed losses they would be worth keeping, because their contributions exceed the fixed costs that closure would save.

1. Gain per kg.
   Extra revenue 210 − 120 = 90
   less extra variable cost 55 = ₦35.
2. Annual effect.
   12,000 × 35 = ₦420,000
   less avoidable fixed costs 700,000 = ₦(280,000).
   Do not process further.
   The joint cost of ₦3,000 is ignored.
3. Break-even volume.
   700,000 ÷ 35 = 20,000 kg.
   At 30,000 kg the gain would be 30,000 × 35 = 1,050,000 less 700,000 = ₦350,000, so further processing would pay.

Expect variants: a question on a segment with a cash saving on closure, a contract with a scarce labour grade, a joint product split with a market-price apportionment of joint costs that must be ignored, or a requirement only to discuss the factors.

Techniques and principles for decision calculations

The technique normally used is marginal costing (contribution analysis), and the principle is relevant costing. Marginal costing is suitable when future fixed costs will be the same whatever is decided and the variable costs are future cash flows caused by the decision; it underlies limiting factor analysis and contribution techniques.

When those assumptions fail (a fixed cost that can be avoided on shutdown, a material in stock with an alternative use, redundancy pay), use relevant costs. A relevant cost is a future cash flow that occurs as a direct consequence of the decision:

• past costs are irrelevant
• costs that occur anyway are irrelevant
• notional costs such as depreciation, notional interest and absorbed fixed costs are irrelevant

Compare the net cash result of each option, including the option to shut down, and consider qualitative factors such as morale, customers and reputation.

Process losses, and selling at split-off against processing further

Process 1. Input 10,000 kg at ₦125 = ₦1,250,000; conversion ₦300,000; total ₦1,550,000. Normal loss 10% (1,000 kg) is sold as scrap at ₦50: ₦50,000. Good output 8,500 kg, so abnormal loss 500 kg. Cost per kg of expected output = (1,550,000 − 50,000) ÷ 9,000 = ₦166.67. Good output 8,500 × 166.67 = ₦1,416,667; abnormal loss 500 × 166.67 = ₦83,333, taken to the profit and loss account (less its own scrap value, if sold). Joint cost is shared by quantity: X 5,000 kg ₦833,333, Y 3,500 kg ₦583,333.

Sell or process further? The joint cost is sunk, so compare the extra revenue with the extra avoidable cost of further processing. X: split-off value ₦180 × 5,000 = ₦900,000; after processing ₦260 × 5,000 = ₦1,300,000; extra revenue ₦400,000 against extra wages ₦250,000: process, gaining ₦150,000. Y: split-off ₦120 × 3,500 = ₦420,000; after processing ₦150 × 3,500 = ₦525,000; extra revenue ₦105,000 against extra wages ₦160,000: do not process, avoiding a loss of ₦55,000. Production overhead treated as fixed is not relevant. Compare the whole-company profit under the two strategies.

Common mistakes

• Including absorbed fixed overhead in a contract or shutdown analysis.
• Using the original cost of stock instead of replacement cost or resale value.
• Closing a product because it shows a loss after allocation, without checking its contribution.
• Allocating the joint cost to decide on further processing.
• Treating the minimum price as the price to charge for all work.
• Omitting the non-financial factors that the case describes.

Quick revision

• Contract: price against relevant cost; replacement cost, resale value, zero for idle labour, pay plus lost contribution for scarce labour.
• Shutdown: contribution lost against directly attributable fixed costs saved; ignore allocated general overhead.
• Further processing: extra revenue against extra cost; joint cost irrelevant; break-even volume.
• Then add non-financial factors.

How the marks are earned

• Schedule: each cost with a reason, and the exclusions explained.
• Decision: the comparison and the recommendation.
• Discussion: factors tied to the case.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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