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RELEVANT COST
In the short term decision making the management will consider the relevant cost of the cost element and irrelevant cost of the cost element.
For decision making purposes cost can be classified into:
- Relavant cost
- Irrelevant cost
Relevant cost - Cost that should be used in decision making is called as relevant cost. Accordingly, relevant cost can be described as the cost suitable to a specific management decision.
In short term decision making the relevant cost could incur in following ways:
- Incremental cost/differential cost Incremental cost is the additional cost that should be incurred due to a management decision.These cost could be incremental variable cost and incremental fixed cost.
- Opportunity cost - Opportunity cost can be explained as the value of the next best alternative sacrificed when one course of action is chosen in preference of others. Opportunity cost will occur due to - Limited resources - Alternative uses are available for that resources
Irrelevant cost - Those cost that will be not affected by the decision is irrelevant cost. Accordingly, following cost is irrelevant cost:
- Sunk cost: These are the cost incurred in the past and cannot be affected by a future decision. Sunk cost is therefore, irrelevant cost for decision making. Eg Development cost which has been already incurred.
- Absorption of fixed cost/General fixed overheads: Overhead Costs absorbed by using predetermined overheads rates are irrelevant cost.
- Committed cost: The costs that are agreed to pay, as a result of past decisions. Committed cost is the future cost flow that will be incurred anyway whatever the decision is taken now on the alternative opportunities. Eg: Insurance premium, Rent.
- Notional cost /imputed cost – The cost used in product evaluation, decision making or performance evaluation to represent the cost of using resources which has no actual cost. Eg: Notional rent, Notional interest.
Identification of relevant cost in variable cost
Variable cost could be:
- Material
- Labour
- Using Machinery
1. Identification of relevant cost in material cost
Nature of cost Application of relevant cost (1) Material stock in regular use. Current replacement cost (2) Material stock has no other possible use and not replaced. Current resale value (3) Material stock has no other possible use and no resale value. No relevant cost
2. Identification of relevant cost in labour
Nature of cost Application of relevant cost (1) Unused labour is available No relevant cost (2) Additional labour is needed Cost of hiring (3) No unused labour is available and Contribution foregone from not no additional employees to be recruited being able to put the labour to its alternative use.
3. Identification of relevant cost of using machines
Using machinery will involve some incremental cost (1) Repair cost arising from user (2) Hiring charges (3) Fall in resale value of owned asset which results from their use
Monthly hire purchase payments are committed and therefore irrelavant cost.
Question No. 1
Following materials are needed for a special order:
Material Type
Total units required for Special order
Units already in stock
Book value of stock - Per unit (Rs.)
Realisable Value - Per unit (Rs.)
Replacement cost - Per unit (Rs.) A 1,000 - - - 5 B 500 300 2 3 4 C 750 400 1 4 3 D 400 400 4 6 8
- Material B is regularly used by the company and if needed purchased from the market.
- Material C and D are in stock as a result of excess purchases and they are restricted in use. No other use is available for C. However, Material D could be used as a substitute for 500 units of Material Y which could be purchased at Rs. 5/= per unit. (As Material Y is not available as stock).
Compute the relevant cost of materials for this job.
(2) Labour: Requirement is 27 hours per gate. The company expects to use 03 idle workers for the job. A worker is required to work 180 hours a month (20 working days) and is paid with a monthly salary of Rs.50,000/-. In addition, each worker is paid with an incentive commission of Rs.10,000/- per order. (3) Overhead: The budgeted overhead cost is Rs.100,000/- for a month and is absorbed at a rate of Rs.50/- per labour hour. It is estimated that monthly overhead cost of the company would increase by Rs.15, 000/- per gate with this order.
You are required to,
(1) Identify and Compute the relevant costs and irrelevant costs of each cost element with reasons.
(2) State whether the company should accept the order on the basis of relevant costs.
Solution to question No. 2
Materials – They are regularly used and available in stock also. If used for this order, the company has to purchase materials from the market at the rate of Rs. 7,000 per meter. (For 7 meters for 10 gates). Therefore, the current market value should be considered as the relevant cost for short term decisions such as accepting a special order.
Further Rs. 60,000/= worth of material in stock is a historical cost and it is a sunk cost and irrelevant for decision making.
Relevant cost considers future cost .If so the material cost for this special order is Rs. 490,000. ( Rs. 7,000710).
Labour- Currently 03 workers are in idle, therefore the labour cost of Rs. 150,000. (03 workers at the rate of Rs 50,000/=) has to be paid to these workers whether the order is accepted or not.
But incentive of Rs 10,000/= per order for 03 workers is an additional cost for this order. Therefore, the relevant cost of labor is Rs. 30,000. (10,000*3).
Overhead: The budgeted overhead cost is Rs.100, 000/- for a month and is a fixed cost. It does not increase with the order. Further the absorbed rate of Rs.50/- per labour hour is also irrelevant cost.
However as a result of this order, the incremental overhead is Rs. 150,000. (Rs.15,000 per gate for 10 gates)It is a relevant cost.
Accordingly, if the order is accepted,
(Rs.) Material cost 490, 000 Labor cost 30, 000 Overhead cost 150, Total incremental cost 670, Value of the order 800, Less: Total Incremental Cost 670, Profit of the order 130,
The company would get a profit of Rs. 130,000/- by accepting this order.
Question No. 3
Fair Ltd. is considering the introduction of a new product A that will be sold in a tube. The product will be sold to wholesalers at Rs.80/- per tube. Fixed costs of Rs.1,000,000/- will be absorbed by the product when allocating a fair share of the company’s present fixed costs to the new product.
Estimated production and sales for the first year will be 100,000 tubes.
Cost per unit including an empty tube is as follows: Rs. Direct Materials 30 Direct Labour 20 Total overheads 15
The company is considering purchasing empty tubes from an outside supplier at Rs.9/- per tube. If the empty tubes are purchased from outside, the direct labour and variable overheads would be reduced by 10% while direct material costs would be reduced by 20%. You are required to:
Assess whether the company should manufacture the empty tubes or buy the empty tubes from an outside supplier.
Solution to question No. 3
Current variable cost for making the product is as follows:
Rs. Direct Materials 30 Direct Labour 20 Variable overheads 5 55
Fixed overhead cost per unit is Rs.10 (1000, 000/100000) and it is irrelevant.
Cost of buying is as follows: Rs. Direct Materials 24. Direct Labour 18. Variable overheads 4. Cost of empty tube 9. Total cost of buying (^) 55.
Therefore, the company should manufacture the empty tubes.
Question No. 4
AC Products Ltd. manufactures a single product (Product x) and selling price per unit is Rs.750. The manufacturing cost per unit is given below: Cost Per Unit Direct Material A - 250g @ Rs.1, 000 per kg Direct Material B - 750g @ Rs.400/- per kg Direct Material C - 01 unit @ Rs.25/- per unit Skilled Labour - 5 minutes @ Rs.240/- per hour Unskilled Labour - 10 minutes @ Rs.150/- per hour Variable Overheads - Rs.30/- Total Fixed Overheads for a month is Rs.2, 880,000 and are absorbed based on machine utilization.
You are required to,
(a) Assess whether to manufacture product A or buy it from the market.
(b) Assess whether the offer should be accepted or not by the company, if an outside supplier offers a unit of product A at Rs. 4.
Solution to question No. 5
(a) Total variable cost of making the product A is Rs 5. (2.75+1.75+.50). The fixed cost is irrelevant cost. Cost of buying from the market is Rs 7. Therefore it is advised to make the product.
(b) Total variable cost of making the product A is Rs 5. (2.75+1.75+.50). The fixed cost is irrelevant cost. Cost of buying from the market is Rs 4. There is a saving of Rs. 1 in buying the product from the market. Therefore it is advised to buy the product from the market.
Question No. 6
TGL Ltd. received an order for T-shirts from overseas. These clothes are manufactured based on the specifications given by the customer. TGL Ltd recently received an order to manufacture 5,000 T-Shirts within 7 days at a price of Rs.300 per T-Shirt. The resource requirement for this order has been identified as given below:
- Material - 0.8 meters of material is required per T-Shirt. This material is not normally used by the company but there are 1,000 meters of material in the inventory which were purchased a few years ago at a cost of Rs.180/- per meter. If not used for this order, this quantity can be sold as scrap at Rs.50/- per meter. The current market price of this material is Rs.150/- per meter.
- Labour –30 minutes of labour time has been estimated for the completion of a T-Shirts. Since the order is urgent, TGL Ltd. needs to get the factory staff to work overtime for 1000 hours, for which they will be paid overtime at the rate of 1.5 times of the normal pay. The factory staff is currently paid a wage of Rs.200/- per hour. If this order is accepted, TGL Ltd. would need to postpone a regular order to the next week. In addition, the company needs to get the factory staff to work 400 overtime hours to complete the regular order on time.
- Supervisor - The factory staff is supervised by the Factory Supervisor of the company who is paid a fixed monthly salary of Rs.150,000/- per month.
- Overheads - The variable overheads are incurred at the rate of Rs.100/- per labour hour for this order. In addition as the design is different from regular orders, a special machine needs to be hired to complete the order at the rate of Rs.5,000/- per day for 7 days.
- Design cost - The design selected for this order was drawn few years ago incurring a cost of Rs.320,000/-.
You are required to:
- Assess whether TGL Ltd. should accept this order or not with supporting calculations. (Indicate clearly the relevant cost element and amount used in the computation.)
Solution to Question No. 6
Rs.
Revenue from the order Rs.300/- for 5000 T-Shirts 1,500, Less : Cost Materials – (Already purchased 1000 meters material at the price of Rs.180/- per unit is a sunk cost.) - Materials – Scrap value (1,000 m x 50) - opportunity cost (50,000) Material to be purchased [(3,000 x 150] (450,000) Labour: Overtime (200 x 1,000 hours x 1.5) (300,000) OT for regular order (400 hours x 200 x 1.5) (120,000) Supervisor – fixed salary (not relevant) - Variable overheads (2,500 x 100) (250,000) Machine hours (5,000 x 7) (35,000) Design cost – (sunk cost) - Profit 295,
