Relevant costing and Decision Making Techniques

Relevant costing and Decision Making Techniques

Relevant costing and Decision Making Techniques Overview

Definitions:

Relevant cost

  • A relevant cost is a future cash flow that will occur as a direct consequence of making a particular decision.
  • They cannot include any cost occurred in past.
  • Costs that occur whether or not a particular decision is taken are not relevant costs.
  • Relevant costs are cash flows. Notional costs such as depreciation, interest costs and absorbed fixed cost are not relevant cost.

Incremental cost

  • Any incremental cost, if a particular decision is taken, results in cash flow are relevant cost.

Differential cost

  • A differential cost is an amount by which future costs will be higher or lower. A differential cost is a relevant cost.

Avoidable and unavoidable cost

  • Avoidable costs are relevant costs
  • Unavoidable costs are not relevant.

Committed costs

  • Committed costs are unavoidable costs, therefore not relevant for decision making.

Sink costs

  • Cost that are already incurred/or committed by an earlier decision. Such costs are not relevant costs.

Opportunity costs

  • The relevant cost is the benefit that would be lost by switching to other work.

Identifying Relevant costs

Relevant costing and Decision Making Techniques

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When Material currently in inventory

Are material in regular use?

  • Yes

The relevant cost is the current Replacement cost.

  • No

The relevant cost is the current opportunity cost.
Opportunity cost is higher of;

  1. Net disposal/sales value/scrap value or;
  2. Net benefit from alternative use.

When Material not currently in inventory

In this case the relevant cost is simply the purchase value.

  • If the cost of labour is a variable cost and labour is not in restricted supply: The relevant cost is its variable cost.
  • If labour is a fixed cost and there is spare labour time available: The relevant cost of using labour is ‘zero‘. The spare time would otherwise be paid for idle time.
  • If labour is in unlimited supply: Relevant cost includes the opportunity cost of using the labour time for the decision instead of next most profitable way.
  • Normal rules of relevant costs are applied i,e Relevant costs are future cash flows.
  • Fixed overheads absorption rate are irrelevant. However the variable overhead hourly rate is treated as relevant cost.
  • The only overhead fixed costs that are relevant costs are the extra cash spending.

Decision Making Techniques

Relevant costing and Decision Making Techniques

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  • The concept of relevant costs can be applied for both ‘long term’ and ‘short term’ decisions.
  • The application is same for both types of decisions except for long term decisions ‘time value of money’ should be considered.
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Limiting Factor Decisions

  • Limiting factor are the factors that ‘restricts‘ operational capabilities, sales demand is normally the factor that sets a limit on volume of production. However the availability of scarce resources such as Direct material, skilled labour or machine capacity could be the limiting factor.
  • If the company makes just one product and a production resource is in limited supply, profit is maximized by making as many units of product as possible with limited resources.
  • However, if the company produces more than one product with same scarce resources then a budgeting problem is to decide how many of each product to make and sell in order to maximize Profit. In Such case select products for manufacture and sale according to the contribution per unit. The following steps are involved:
  1. Calculate the contribution per unit of each good produced.
  2. Identify scarce resources (e,g labour hours).
  3. Calculate the amount of scarce resources used by each good produced (e,g ‘X’ no. of labour hours)
  4. Now divide the contribution earned by each good by scarce resources used by that good to give the contribution per unit of scarce resources for that good.
  5. Rank each good in order of contribution per unit per scarce resources (highest contribution is ranked 1st).
  6. Construct a production plan based on ranking.

Assumptions of limiting factors:

  • Profit is maximized by maximizing contribution.
  • Variable costs are only the relevant costs.
  • Fixed cost will be the same whatever decision is taken. Therefore are not relevant.
  • The contract where the Job is once only and will not be repeated in future.
  • The one-off contract is under taken if extra revenue is higher than relevant costs.
  • The decision is to whether agree to do the Job at a Price offered by customer or decide a selling price (base on relevant costs).
  • Profit = Revenue – Relevant cost
  • One-off contract decisions might occur when a company has spare capacity and an opportunity arises to earn some extra profit.

Make-or-Buy decisions

  • A decision whether: to make an item internally or buy it externally. The decision should be based on relevant cost, the preferred option from a financial view point is the one with the lowest relevant costs.
  • A financial assessment of a make or buy decision involves a comparison of:
    • cost that would be saved; and
    • incremental cost of outsourcing
  • A situation may arises where entity is operating in full capacity, in order to overcome some restrictions on its output and sales, the entity may outsource some products.
  • The decision is about which item to outsource and which to retain in-house.
  • The profit maximizing decision is to which items to outsource.
  • Those items are outsource where cost of outsourcing is least.
  • To identify the Least-cost of outsourcing, it is necessary to compare:
    • additional cost of outsourcing; with
    • amount of resources need to make product in-house.

Make-or-buy decision non-financial considerations

Non-financial considerations will often be relevant to make-or-buy decision:

  • When work is outsourced, the entity loses some control over the work. It will rely on the external supplier. There may be some risk that external supplier will:
    • provide a lower quality.
    • fail to meet delivery on said dates.
  • The entity will lose some flexibility. If it needs to increase or reduce supply of the outsourced item at short notice.
  • Redundancy of employees may occur as a consequence of outsourcing affecting relations between management and other employees.

Shut-down Decisions

  • A shutdown decision is whether or not to shut down a part of the operations of a company.
  • From a financial view an operation should be shutdown if the benefits of shutdown exceeds relevant costs.

Example of such costs

  • Fixed costs may be saved, Employee redundancy cost.
  • Joint products are product manufactured from a common process.
  • The entity has a choice whether:
    1. selling joint product as soon as it is output; or
    2. processing it further before selling (at a higher price).
  • This is a short-term decision and financial assessment should be made using relevant cost and revenues. The financial assessment should compares:
    1. Revenue (less) selling cost from joint product as soon as it is output.
    2. The revenue that will be obtained if Joint product is processed further (less) incremental cost of further processing.

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Relevant costing and Decision Making Techniques

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