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Lecture 43

Mgt 402 lec 33
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0% found this document useful (0 votes)
19 views9 pages

Lecture 43

Mgt 402 lec 33
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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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 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 to decide
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.
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
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 Rs. 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 ‘non-off’ customer order, and would use up all these
materials in stock.
a. In deciding whether the job should be undertaken, the relevant cost of the
materials to the special job is nil. Their original cost of Rs. 2,000 is a sunk cost,
and should be ignored in the decision.
b. However, if the materials did have scrap value of, say, Rs. 300, then their
relevant cost to the job would be the opportunity cost of being unable to sell
them for scrap, i.e. Rs. 300.

Attributable Fixed Costs


There might be occasions when a fixed cost is a relevant cost, and you must be aware of the
distinction ‘specific’ or ‘directly attributable’ fixed costs, and general fixed overheads.

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.

a. They 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.
b. They would decrease or be eliminated entirely if a decision were taken either to
reduce the scale of operations or shut down entirely.

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

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

The 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
recoverable amount will be its relevant cost.

Recoverable Amount:
Recoverable amount is the higher of realizable value or the value that will be used as an
alternative decision.
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.

PRACTICE QUESTION
Q:
ABC company performs a job for a manufacturing of an office tables and has been received
a special job by a customer who is willing to pay Rs. 82,000. The job will require the
following materials:

Material Total units Units Book value Realizable Replacement


Required already in of units in value (Rs.) cost (Rs.)
stock stock (Rs.)
Wood 4,000 Sq ft 0 ---- --- 200
Glue 1,000 Lbs 600 2 2.5 5
Bolts 1,000 Pcs 700 3 2.5 4
Polish 200 Lbs 200 4 6.00 9

• Glue is used regularly and if glue is required for this job it would need to replace d to
meet other production demand.
• Bolts and polish are in stock as the result of previous over buying and they have a
restricted use. No other use could be found for Bolts, but the Polish could be used in
another job as substitute for 300 lbs of paint, which currently cost 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
job.
Solution:
a) Wood has been purchased in full at the replacement cost of Rs. 200 unit.
= 4,000 x 200 = Rs. 800,000
b) Glue is used regularly by the company. There are existing stock 600 units if these are
used on the contract under review a further 600 units would be bought to replace
them. Relevant cost is therefore 1,000 units at the replacement cost of 5 per unit.
c) 1,000 units of Bolts 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 for
gone.
Realizable value = 700 x 2.5 = 1,750
Replacement cost = 300 x 4 = 1,200

Rs 2,950
d) The required units of polish are already in stock and will not be replaced
Realizable value Polish = 200 x 6 = 1,200
Value use in paint = 300 x 5 = 1,500
Higher recoverable amount 1,500
e) Summary of relevant cost:
Wood 800,000
Glue 5,000
Bolts 2,950
Polish 1,500
809,450
The price of project is Rs. 820,000. So accept the project.

The Relevant Cost of Labor


The relevant cost of labor, in different situation, is best explained by an example:

PRACTICE QUESTION: (RELEVANT COST OF LABOR)

ABC Company is currently deciding whether to undertake a new contract of 20 hours of


labor will be required for the contract. The company currently producing product S the
standard cost details of which are given below:
Standard Cost Card
Product S
Rs/unit
Direct Material 200
Direct Labor 300
Total variable cost 500
Selling Price 700
Contribution margin 200

Requirement:
a) What is the relevant cost of labor if the labor must be hired from outside the
organization?
b) What is the relevant cost of labor if the company expects to have 5 hours spare capacity?
c) What is the relevant cost of labor if the labor is in a short supply?

Solution:

a) Where labor must be hired from outside the organization, the relevant cost of labor
will be the variable cost incurred.
20 hours x 25 per hour = 500

It is assumed that the 5 hours spear capacity will be


b) Relevant cost of labor on new contract
Direct labor (15 hrs x 25) Rs. 375
Spare capacity (5 hrs x 0) 0
Relevant cost Rs. 375
c) Contribution margin earned per unit of product S produced = Rs 200
Rs 200 / 12 hrs = 16.67

Relevant cost of labor on new contract:


Direct labor (20 hrs x Rs 25)
500.00
Contribution margin lost by not making product (20 hrs x Rs 16.67)
333.33 833.33

PRACTICE QUESTIONS
Q. 1:
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 Units Book value Realizable Replacement


required already in of units in value cost
stock stock Rs./unit Rs./unit
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.

Solution:
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:
Particulars Amount (Rs.)
Material A (1,000 x Rs. 6) 6,000
Material B (1,000 x Rs. 5) 5,000
Material C (300 x Rs. 4) plus (700 x Rs. 2.50) 2,950
Material D 1,500
Total 15,450

Q. 2:
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

a. What is the relevant cost of labor if the labor must be hired form outside the
organization?
b. What is the relevant cost of labor if LW plc expects to have 5 hours spare capacity?
c. 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:

Q. 3:
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.
b) Further labor costs would be Rs. 8,000. Labor is in short supply, and if the machine
is not finished, the work force would be switched to another job, which would earn
Rs. 30,000 in revenue, and incur direct costs of Rs. 12,000 and absorbed (fixed)
overhead of Rs. 8,000.

c) Consultancy fees Rs. 4,000. If the work is not completed, the consultant’s contract
would be cancelled at a cost at Rs. 1,500.

d) General overheads of Rs. 8,000 would be added to the cost of the additional work.

Required:
Assess whether the new customer’s offer should be accepted.

Solution:

a) Costs incurred in the past, or revenue received in the past are not relevant because
they cannot affect a decision about what is best for the future. Costs incurred to date
of Rs. 50,000 and revenue received of Rs. 15,000 is ‘water under the bridge’ and
should be ignored.
b) Similarly, the price paid in the past for the materials is irrelevant. The only relevant
cost of materials affecting the decision is the opportunity cost of the revenue from
scrap which would be forgone – Rs. 2,000.

c) Labor costs
Rs.
Labor costs required to complete work 8,000
Opportunity costs:
Contribution forgone by losing other work (30,000 – 12,000)
18,000
Relevant cost of labor 26,000

d) The incremental cost of consultancy from completing the work is Rs. 2,500.
Rs.
Cost of completing work 4,000
Cost of canceling contract 1,500
Incremental cost of completing work 2,500

e) Absorbed overhead is a national accounting cost and should be ignored. Actual


overhead incurred is the only overhead cost to consider. General overhead costs
(and the absorbed overhead of the alternative work for the labor force) should be
ignored.

f) Relevant costs may be summarized as follows: Rs. Rs.


Revenue from completing work 34,000
Relevant Costs:
Materials: Opportunity cost 2,000
Labor: Basic pay 8,000
Opportunity Cost 18,000
Incremental cost of consultant 2,500 30,500
Extra profit to be earned by accepting the order 3,500

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