By Zachary Mitchell,2014-05-20 17:42
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    Ch18 Relevant costing and decision making


    Relevant costs

    Choice of product product mix Make or buy

    decisions decisions

    Shut down decisions One-off contracts

    1.Relevant Costs

     1A relevant cost is a future cash flow arising as a direct consequence of a decision.

     2Decision 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 n 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

    depreciation and notional costs should be ignored for the purpose of decision


     C.Relevant costs are incremental costs.

     3Other terms are sometimes used to describe relevant costs.

     Avoidable cost: whether or not to discontinue a product

     Differential cost is‘the difference on 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’.

     A sunk cost is a past cost which is not directly relevant in decision making.The

    principle underlying decision accounting is that management decisions can only affect the future. In decision making, managers therefore require information about future costs 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.

     Fixed and variable costs

     Variable costs will be relevant costs. Fixed costs are irrelevant to a decision.

     Controllable and uncontrollable costs


     Non-relevant variable costs

     1.12 There might be occasions when a variable cost is in fact a sunk cost and

    therefore a non-relevant variable cost.For example,suppose that a company has some

    units of raw material in stock.They have been paid for already,and originally cost

    2,000.They are now obsolete and are no longer used in regular production,and they have no scrap value.However,they could be used in a special job which the company is trying to decide whether to undertake.The special job is a ˊone-off ˊcustomer

    order,and would use up all these materials in stock.

     aIn deciding whether the job should be undertaken,the relevant cost of the materials to the special job is nil.Their original cost of 2,000 is a sunk cost,and

    should be ignored in the decision.

    bHowever,if the materials did have a scrap value of,say, 300,then their

    relevant cost to the job would be the opportunity cost of being unable to sell them for scrap,ie 300.

     Attributable fixed costs

     1.13 There might be occasions when a fixed cost is a relevant cost,and you must be aware of the distinction between ˊspecificˊor ˊdirectly attributableˊfixed

    costs,and general fixed overheads.

     1.14 Directly attributable fixed costs are those costs which,although fixed within a relevant range of activity level are relevant to a decision for either of the following reasons.

     aThey could increase if certain extra activities were undertaken.For example,it may be necessary to employ an extra supervisor if a particular order is accepted.The extra salary would be an attributable fixed cost.

     General fixed overheads

     1.15 General fixed overheads are those fixed overheads which will be unaffected by decisions to increase or decrease the scale of operations,perhaps because they are an apportioned share of the fixed costs of items which would be completely unaffected by the decisions.General fixed overheads are not relevant in decision making.

     Absorbed overhead is a notional accounting cost and hence should be ignored for decision making purposes. It is overhead incurred which may be relevant to a decision.

     1.16 Absorbed overhead is a notional accounting cost and hence should be ignored for decision-making purposes.It is overhead incurred which may be relevant to a decision.

     4The relevant cost of materials

     The relevant cost of raw materials is generally their current replacement cost, unless the materials have already been purchased and would not be replaced once used. In this case the relevant cost of using them is the higher of the following:

     Their current resale value

     The value they would obtain if they were put to an alternative use

     If the materials have no resale value and no other possible use, then the relevant cost of using them for the opportunity under consideration would be nil.

     Material B is used regularly by OˊReilly 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 5 per unitof which the company has no units in stock at the


     R equired

     Calculate the relevant costs of material for deciding whether or not to accept the contract.


     aMaterial A is not yet would have to be bought in full at the replacement cost of 6 per unit.

     bMaterial B is used regularly by the company.There are existing stocks 600

    unitsbut 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 5 per unit.

     c1,000 units of material C are needed and 700 are already in stock.if used for

    4 each.The existing stocks of 700 the contract,a further 300 units must be bought at

    will not be replaced.if they are used for the contraci,they could not be sold at 2.50

    each.The realizable value of these 700 units is an opportunity cost of sales revenue forgone.

     dThe 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 6 per unit ?!1,200 in

    total or avoid other purchasesof material E,which would cost 300×1,500.Since

    substitution for E is more beneficial, 1,500 is the opportunity cost.

     eSummary of relevant costs


     Material A1,000×6 6,000

     Material B1,000×5 5,000

     Material C300×4plus700×2.50 2,950

     Material D 1,500

     Total 15,450

     5Relevant cost of labor


     LW plc is currently deciding whether to undertake a new contract.15 hours of labour will be required for the contract.LW plc currently produces product L,the standard cost details of which are shown below.




     Direct materials10kg,!2 20

     Direct labour5 hrs ,!6 30


     Selling price 72

     Contribution 22

     aWhat is the relevant cost of labour if the labour must be hired from outside the organization?

     bWhat is the relevant cost of labour if LW plc expects to have 5 hours spare capacity?

    cWhat is the relevant cost of labour if labour is in short supply?

     1.20 SOLUTION

     aWhere labour must be hired from outside the organisation,the relevant cost of laboru will be the variable costs incurred.

     bIt 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.

     Relevant cost of labour on new contract


     Direct labour 10 hours ,!6 60