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: Fixed overheads. These will be incurred regardless of the decision. Notional costs. For example, notional rent - these costs are only a book exercise and do not represent a real cash flow. Past or sunk costs. These have already happened, so they cannot be affected by a future decision. It is vital to note that relevant costs are always future costs. Book values. Similar to sunk costs. For example, the price paid for stock in the past is not a relevant cost to the decision. Many of the above are included in examination questions and should be rejected by candidates. It is important to state that they are not relevant for decision-making rather than to simply omit them. Marks are often available for this information. Opportunity costs 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. Illustration 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: Costs for special order Notes £ Direct wages 1 28,500 Supervisor costs 2 11,500 General overheads 3 4,000 Machine depreciation 4 2,300 Machine overheads 5 18,000 Materials 6 34,000 98,300 Notes Direct wages comprise the wages of two employees, particularly skilled in the labour process for this job. They could be transferred from another department to undertake the work on the special order. They are fully occupied in their usual department and sub-contracting staff would have to be brought in to undertake the work left behind. Sub-contracting costs would be £32,000 for the period of the work. Other sub-contractors who are skilled in the special order techniques are also available to work on the special order. The costs associated with this would amount to £31,300. A supervisor would have to work on the special order. The cost of £11,500 is made up of £8,000 normal payments plus a £3,500 additional bonus for working on the special order. Normal payments refer to the fixed salary of the supervisor. In addition, the supervisor would lose incentive payments in his normal work amounting to £2,500. It is not anticipated that any replacement costs relating to the supervisors' work on other jobs would arise. General overheads comprise an apportionment of £3,000 plus an estimate of £1,000 incremental overheads. Machine depreciation represents the normal period cost, based on the duration of the contract. It is anticipated that £500 will be incurred in additional machine maintenance costs. Machine overheads (for running costs such as electricity) are charged at £3 per hour. It is estimated that 6,000 hours will be needed for the special order. The machine has 4,000 hours available capacity. The further 2,000 hours required will mean an existing job is taken off the machine resulting in a lost contribution of £2 per hour (before overheads are charged) Materials represent the purchase costs of 7,500kg bought some time ago. The materials are no longer used and are unlikely to be wanted in the future except for the special order. The complete stock of materials (amounting to 10,000kg), or part thereof, could be sold for £4.20 per kg. The replacement cost of material used would be £33,375. Because the business does not have adequate funds to finance the special order, a bank overdraft of £20,000 would be required for the project duration of three months. The overdraft would be repaid at the end of the period. The company uses a cost of capital of 20% to appraise projects. The bank's overdraft rate is 18%. 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. Direct wages Summary: There are two options. We can take the workers from their usual department, where it would cost £32,000 to replace them. Or we could hire sub-contractors to do the special order at a cost of £31,300. Both of these costs are future costs that will be affected by the decision and are therefore relevant. The choice between the two alternatives is relatively straightforward - either incur a £32,000 cost or a £31,300 cost. As an accountant you will want to minimise costs and will choose to hire the sub-contractors at £31,300. Supervisor costs Summary: The supervisor's normal salary is £8,000 and this will be paid whether or not we take on the special contract. This is a fixed cost to the business and is unaffected by the decision. However, the £3,500 additional bonus is relevant as it is dependent on the decision to take the special contract. In addition, if we take the special contract we will not have to pay the £2,500 incentive payment. Therefore, the net relevant cost to the business is £3,500 less £2,500 = £1,000. General overheads Summary: Regardless of the decision, general fixed overheads remain constant. The apportioned rent, rates, power etc, will be incurred whether the special contract is undertaken or not. Therefore, these are not relevant costs and can be ignored for decision-making purposes. However, incremental overheads are extra overheads, incurred as a direct result of undertaking the special project. These could include additional costs for power or premises. They are relevant costs to the project of £1,000. Machine depreciation Summary: The machine depreciation has been charged at £2,300 which is what the accountant would normally charge for depreciation for this period of time. The accountant will charge this time-based depreciation if we use the machine for the special contract and also if we do not. It is only a book value and does not represent a true cash flow to the business. Therefore it is not a relevant cost. However, if we do take the special contract and use the machine, we will incur maintenance costs of £500. These future costs are a direct result of the decision and should be included within the costs. Machine overheads Summary: Taking the special contact will mean that the machine will run for 6,000 hours and as each hour incurs a running cost of £3, the relevant future cost will be £18,000. In addition, there is an opportunity cost. If we choose to take the contract we will have to choose not to work on an existing job as machine hours are a scarce resource and we only have enough hours free to do one job. Therefore, a relevant cost to the special contract will be the benefit forgone from choosing the special contract over the existing job. This cost if the lost contribution of £2 per hour for 2,000 hours. We will lose £4,000 contribution is we take the special contract. The total relevant cost therefore is £18,000 plus £4,000 = £22,000. Materials Summary: The 7,500kg of materials is already in stock. We do not know how much it cost and if we did it would not be useful as this is a sunk cost and therefore irrelevant. Neither is the replacement cost of £33,375 relevant as it is not a future cost that will be incurred as a result of the decision (if we already have it we will not need to buy it). However, this would be relevant if the material was in constant use by the company. There is an opportunity cost, as we have two courses of action to choose from. We can either use the material for the special contract or we can sell it and receive £4.20 per kg. The relevant cost is 7,500 x £4.20 = £31,500 as this represents the benefit sacrificed by choosing to take the contract rather than selling the materials. Overdraft interest Summary: If the company chooses to undertake the special project it will incur finance charges for the three month duration. This is a future cost due to the decision being made and therefore should be included as a relevant cost. £20,000 x 18% x 3/12 = £900. Revised cost schedule for the special contract Costs for special order Notes £ Direct wages 1 31,300 Supervisor costs 2 1,000 General overheads 3 1,000 Machine depreciation 4 500 Machine overheads 5 22,000 Materials 6 31,500 Interest charges 7 900 88,200 We have now worked through an entire exam standard question answering it in a format that will maximise the marks awarded. In the examination, candidates may feel less confident of their ability, but it is important to follow the above layout to produce a well-organised and logical answer. Bev Jay is a marker for CAT Paper 7