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LESSON # 43
DECISION MAKING (Contd.) Relevant Costs
Relevant costs are future cash flows arising as a direct consequence of a decision.
Relevant costs are future costs Relevant costs are cash flows Relevant costs are incremental costs Decision making should be based on relevant costs. a. Relevant Costs are future costs. A decision is about the future and it cannot alter what has been done already. Costs that have been incurred in the past are totally irrelevant to any decision that is being made ‘now’. Such costs are past costs or sunk costs. Costs that have been incurred include not only costs that have already been paid, but also costs that have been committed. A committed cost is a future cash flow that will be incurred anyway, regardless of the decision taken now. b. Relevant costs are cash flows. Only cash flow information is required. This means that costs or charges which do not reflect additional cash spending (such as deprecation and national costs) should be ignored for the purpose of decision making. c. Relevant costs are incremental costs. For example, if an employee is expected to have no other work to do during the next week, but will be paid his basic wage (of, say, Rs. 100 per week)( for attending work and doing nothing, his manager might decide to give him a job which earns the organization Rs. 40. The net gain is Rs. 40 and the Rs. 100 is irrelevant to the decision because although it is a future cash flow, it will be incurred anyway whether the employee is given work or not.
Avoidable Costs
One of the situations in which it is necessary to identify the avoidable costs is in deciding whether or not to discontinue a product. The only costs which would be saved are the avoidable costs which are usually the variable costs and sometimes some specific costs. Costs which would be incurred whether or not the product is discontinued are known as unavoidable costs.
Differential Costs and Opportunity Costs
Relevant costs are also differential costs and opportunity costs. Differential cost is the difference in total cost between alternatives. An opportunity cost is the value of the benefit sacrificed when one course of action is chosen in preference to an alternative.
For example, if decision option A costs Rs. 300 and decision option B costs Rs. 360, the differential costs is Rs. 60.
Example: Differential Costs and Opportunity Costs Suppose for example that there are three options, A, B and C, only one of which can be chosen. The net profit from each would be Rs. 80, Rs. 100 and Rs. 70 respectively. Since only one option can be selected option B would be chosen because it offers the biggest benefit.
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Rs. Profit from option B 100 Less opportunity cost (i.e. the benefit from the most profitable alternative, A) 80 Differential benefit of option B 20
The decision to choose option B would not be taken simply because it offers a profit of Rs. 100, but because it offers a differential profit of Rs. 20 in excess of the next best alternative.
Controllable and Uncontrollable Costs
We came across the term controllable costs at the beginning of this study text. Controllable costs are items of expenditure which can be directly influenced by a given manger within a given time span. As a general rule, committed fixed costs such as those costs arising form the possession of plant, equipment and buildings (giving rise to deprecation and rent) are largely uncontrollable in the short term because they have been committed by longer-term decisions. Discretionary fixed costs, for example, advertising and research and development costs can be thought of as being controllable because they are incurred as a result of decision made by management and can be raised or lowered at fairly short notice.
Sunk Costs
A sunk cost is a past cost which is not directly relevant in decision making. The principle underlying decision accounting is the management decisions can only affect the future. In decision making, managers therefore required information about future cots and revenues which would be affected by the decision under review. They must not be misled by events, costs and revenues in the past, about which they can do nothing. Sunk costs, which have been charged already as a cost of sales in a previous accounting period or will be charged in a future accounting period although the expenditure had already been incurred, are irrelevant to decision making.
Example: Sunk Costs An example of a sunk cost is development costs which have already been incurred. Suppose that a company has spent Rs. 250,000 in developing a new service for customers, but the marketing department’s most recent findings are that the service might not gain customer acceptance and could be a commercial failure. The decision whether or not to abandon the development of the new service would have to be taken, but the Rs. 250,000 spent so far should be ignored by the decision makers because it is a sunk cost.
Fixed and Variable Costs
Unless you are given an indication to the contrary, you should assume the following: Variable costs will be relevant costs. Fixed costs are irrelevant to a decision. This need not be the case, however, and you should analyze variable and fixed cost data carefully. Do not forget that ‘fixed’ costs may only be fixed in the short term.
Non-Relevant Variable Costs
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Question Majeed Ltd. has been approached by customer who would like a special job to be done for him, and who is willing to pay Rs. 22,000 for it. The job would require the following materials:
Material Total units required
Units already in stock
Book value of units in stock Rs./unit
Realizable value Rs./unit
Replacement cost Rs./unit
A 1,000 0 - - 6
B 1,000 600 2 2.50 5
C 1,000 700 3 2.50 4
D 200 200 4 6.00 9
Material B is used regularly by Majeed Ltd, and if units of B are required for this job, they would need to be replaced to meet other production demand.
Materials C and D are in stock as the result of previous over-buying, and they have a restricted use. No other use could be found for material C, but the units of material D could be used in another job as substitute for 300 units of material E, which currently costs Rs. 5 per unit (of which the company has no units in stock at the moment). Required: Calculate the relevant costs of material for deciding whether or not to accept the contract.
Answer a. Material A is not yet owned. It would have to be bought in full at the replacement cost of Rs. 6 per unit. b. Material B is used regularly by the company. There are existing stocks (600 units) but if these are used on the contract under review a further 600 units would be bought to replace them. Relevant costs are therefore 1,000 units at the replacement cost of Rs. 5 per unit. c. 1,000 units of material C are needed and 700 are already in stock. If used for the contract, a further 300 units must be bought at Rs. 4 each. The existing stocks of 700 will not be replaced. If they are used for the contract, they could not be sold at Rs. 2.50 each. The realizable value of these 700 units is an opportunity cost of sales revenue forgone. d. The required units of material D are already in stock and will not be replaced. There is an opportunity cost of using D in the contract because there are alternative opportunities either to sell the existing stocks for Rs. 6 per unit (Rs. 1,200 in total) or avoid other purchases (of material E), which would cost 300 x Rs. 5 = Rs. 1,500. Since substitution for E is more beneficial, Rs. 1,500 is the opportunity cost. e. Summary of relevant costs: Rs. Material A (1,000 x Rs. 6) 6, Material B (1,000 x Rs. 5) 5, Material C (300 x Rs. 4) plus (700 x Rs. 2.50) 2, Material D 1, Total 15, The Relevant Cost of Labor The relevant cost of labor, in different situation, is best explained by an example:
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Example: Relevant Cost of Labor LW plc is currently deciding whether to undertake a new contract. 15 hours of labor will be required for the contract. LW plc currently products product L, the standard cost details of which are shown below. STANDARD COST CARD PRODUCT L Rs. /Unit Direct Materials (10kg @ Rs. 2) 20 Direct Labor (5 hrs @ Rs. 6) 30 50 Selling price 72 Contribution 22
c. What is the relevant cost of labor if the labor must be hired form outside the organization? d. What is the relevant cost of labor if LW plc expects to have 5 hours spare capacity? e. What is the relevant cost of labor if labor is in short supply?
Solution
a. Where labor must be hired from outside the organization, the relevant cost of labor will be the variable costs incurred. Relevant cost of labor on new contract = 15 hours @ Rs. 6 = Rs. 90. b. It is assumed that the 5 hours spare capacity will be paid anyway, and so if these 5 hours are used on another contract, there is no additional cost to LW plc. Rs. Direct labor (10 hours @ Rs. 6) 60 Spare capacity (5 hours @ Rs. 0) 0 60 c. Contribution earned per unit of Product L produced = Rs. 22 If it requires 5 hours of labor to make one unit of product L, the contribution earned per labor hour = Rs. 22/5 = Rs. 4.40. Rs. Direct labor (15 hours @ Rs. 6) 90 Contribution lost by not making product L (Rs. 4.40 x 15 hours) 66 156 It is important that you should be able to identify the relevant costs which are appropriate to a decision. In many cases, this is a fairly straightforward problem, but there are cases where great care should be taken. Attempt the following question:
Question: A company has been making a machine to order for a customer, but the customer has since gone into liquidation, and there is no prospect that nay money will be obtained from the winding up of the company. Costs incurred to date in manufacturing the machine are Rs. 50,000 and progress payments of Rs. 15,000 had been received from the customer prior to the liquidation. The sales department has found another company willing to buy the machine for Rs. 34,000 once it has been completed. To complete the work, the following costs would be incurred. a. Materials: These have been bought at a cost of Rs. 6,000. They have no other use, and if the machine is not finished, they would be sold for scrape for Rs. 2,000.
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Solution Firstly, let us think about the relevance of the costs given to us in the question. Cost of machine = Rs. 14,000 = past/sunk cost Future revenues = Rs. 10,000 = revenue expected to be generated Net realizable value = Rs. 8,000 = scrap proceeds Replacement cost = Rs. 9, When calculating the deprival value of an asset, use the following diagram.
Lower of
Therefore, the deprival value of the machine is the lower of the replacement cost and Rs. 10,000. The deprival value is therefore Rs. 9,000.
Replacement Cost (Rs. 9,000)
Higher of (Rs. 10,000)
NRV (Rs. 8,000)
Revenue Expected (Rs. 10,000)
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