Relevant costs for decision-making
by Bev Jay
27 May 2004
Commercial organisations usually make decisions with the objective of maximising the present value of future cash flows. In order to ensure that the right opportunities are taken to do this, we need to be able to measure the relevant costs for decision-making. In examination questions (unlike real life) we can assume that future costs and benefits are known with certainty and therefore we only have to apply the principles correctly.What is a relevant cost or benefit?
A relevant cost or benefit is one that will be affected by the decision. This means that the following can be disregarded as they are irrelevant in the decision-making process:
A company often has a choice of options. For example, does it choose to use a scarce resource for Contract A instead of Contract B? If it does choose Contract A then Contract B will be deprived of the resource that could have generated a contribution for the company. This is an example of an opportunity cost, a relevant cost for decision-making. By definition, an opportunity cost is one which measures the cost of sacrificing one course of action in favour of another.
In examination questions, the more difficult aspects of a question include opportunity costs. It is important that candidates take their time and employ a logical approach in order to gain maximum marks.
The examination approach
Using the data in the illustration below, we can now apply the above principles in the manner expected by the examiner. It is vital that during the examination your work is clear, cross-referenced, and logical. Markers seek out marks to the best of their ability. However, this is difficult if markers are presented with illegible scribbles and calculations which are not referenced.
Always read the question carefully and make sure that you are comfortable with the requirement. In this illustration you are required to show all the relevant costs in a cost schedule and more importantly you are also required to explain why the costs are relevant. It is logical to deal with each of the costs separately, using the headings given in the illustration. For each cost element, summarise in your own words what the note is telling you before you pronounce a cost as relevant or otherwise.
The managing director of Parser Limited, a small business, is considering undertaking a one-off contract. She has asked her inexperienced accountant to advise on what costs are likely to be incurred so that she can price at a profit. The following schedule has been prepared:
The managing director has heard that for special orders such as this, relevant costing should be used that also incorporates opportunity costs. She has approached you to create a revised costing schedule based on relevant costing principles.Required
Produce a revised costing schedule for the special project based on relevant costing principles. Fully explain and justify each of the costs included in the costing schedule.
Bev Jay is a marker for CAT Paper 7