Relevant Costs for Decision-making bhawana

When you have completed these notes you should be able to:

• explain the importance of relevant costs in decision making

• identify relevant and non-relevant costs in various decision making situation
• evaluate decisions involving relevant and non-relevant costs.

Relevant costs and decision making

Relevance is one of the key characteristics of good management accounting

information. This means that management accounting information produced for each
manager must relate to the decisions which he/she will have to make.

‘Relevant costs’ are the costs that meet this requirement of good management
accounting information. The Chartered Institute of Management Accounting defines
relevant costs as:

‘the costs appropriate to a specific management decision’

This definition could be restated as ‘the amount by which costs increase and benefits
decrease as a direct result of a specific management decision’. Relevant benefits are
‘the amounts by which costs decrease and benefits increase as a direct result of a
specific management decision’.

Before the management of an enterprise can make an informed decision on any

matter, they need to incorporate all of the relevant costs which apply to the specific
decision at hand in their decision making process. To include any non-relevant costs
or to exclude any relevant costs will result in management basing their decision on
misleading information and ultimately to poor decisions being taken.

While the topics examined in these notes deal exclusively with relevant and non-
relevant costs, the ideas raised and discussed apply with equal force to the importance
and identification of the relevant and non-relevant’ benefits’ of various decisions.

Relevant costs and benefits only deal with the quantitative aspects of decisions. The
qualitative aspects of decisions are of equal importance to the quantitative and no
decision should be made in practice without full consideration being given to both
aspects.

Identifying relevant and non-relevant costs

The identification of relevant and non-relevant costs in various decision-making

situations is based primarily on common sense and the knowledge of the decision
maker of the area in which the decision is being made. Armed with these two tools
you should be able to sift through all the information that is available in respect of any
decision and extract those costs (and benefits) which are appropriate to the decision at
hand.
In identifying relevant costs for various decisions, you may find that some costs not
included in the normal accounting records of an enterprise are relevant and some costs
included in such records are non-relevant. It is important that you realise that there is
a substantial difference between recorded accounting costs and relevant costs for
decision making, and while the latter may be recorded in the former this is not always
the case. Accounting records are used to record the incidence of actual costs and
revenues as they arise. Decisions, on the other hand, are based only on the relevant
costs and benefits appropriate to each decision while the decision is being made. This
point is particularly appropriate when you come to examine opportunity costs and
sunk costs that are dealt with below.

In practice, you may also find that the information presented in respect of a decision
does not include all the relevant costs appropriate to the decision but the identification
of this omission is very difficult unless you are familiar with the area in which the
decision is being made.

Exercise

The more common types of costs which you will meet when evaluating different
decisions are incremental, non-incremental and spare capacity costs. Are these likely
to be relevant or non-relevant?

Suggested Solution

• Incremental costs: An incremental cost can be defined as a cost which is

specifically incurred by following a course of action and which is avoidable if
such action is not taken. Incremental costs are, by definition, relevant costs
because they are directly affected by the decision (i.e. they will be incurred if the
decision goes ahead and they will not be incurred if the decision is scrapped). For
example, if an enterprise is deciding whether or not to accept a special order for its
product, the extra variable costs (i.e. number of units in special order x variable
cost per unit) which would be incurred in filling the order are an incremental cost
because they would not be incurred if the special order were to be rejected.

• Non-incremental costs: These are costs which will not be affected by the decision
at hand. Non-incremental costs are non-relevant costs because they are not related
to the decision at hand (i.e. non-incremental costs stay the same no matter what
decision is taken). An example of non-incremental costs would be fixed costs
which by their very nature should not be affected by decisions (at least in the short
term). If, however, a decision gives rise to a specific increase in fixed costs then
the increase in fixed costs would be an incremental and, hence, relevant cost. For
example, in a decision on whether to extend the factory floor area of an enterprise,
the extra rent to be incurred would be a relevant cost for that decision.

• Spare capacity costs: Because of the recent advancements in manufacturing

technology most enterprises have greatly increased their efficiency and as a result
are often operating at below full capacity. Operating with spare capacity can have
a significant impact on the relevant costs for any short-term production decision
the management of such an enterprise might have to make.

2
 If spare capacity exists in an enterprise, some costs which are generally
considered incremental may in fact be non-incremental and thus, non-relevant, in
the short term. For example, if an enterprise is operating at less than full capacity
then its work force is probably under utilised. If it is the policy of the enterprise to
maintain the level of its work force in the short term, until activity increases, then
the labour cost of this work force would be a non-relevant cost for a decision on
whether to accept or reject a once-off special order. The labour cost is non-
relevant because the wages will have to be paid whether the order is accepted or
not. If the special order involved and element of overtime then the cost of such
overtime would of course be a relevant cost (as it is an incremental cost) for the
decision.

Two further types of costs that have to be considered are opportunity costs and sunk
costs.

• Opportunity costs: An opportunity cost is a level of profit or benefit foregone by

the pursuit of a particular course of action. In other words, it is the value of an
option, which cannot be taken as a result of following a different option. For
example, if an enterprise has a quantity of raw material in stock which cost $7 per
kg and it plans to use this material in the filling of a special order then you would
normally incorporate $7 per kg as part of your cost calculations for filling the
order. If, however, this quantity of material could be resold without further
processing for $8 per kg, then the opportunity cost of using this material in the
special order is $8 per kg; by filling the order you forego the $8 per kg which was
available for a straight sale of the material. Opportunity costs are, therefore, the
‘real’ economic costs of taking one course of action as opposed to another.

In the above decision-making situation it is the opportunity cost which is the

relevant cost and, hence, the cost which should be incorporated into your cost-
versus-benefit analysis. It is because the loss of the $8 per kg is directly related to
the filling of the order and the opportunity cost is greater than the book cost.
Opportunity costs are relevant costs for a decision only when they exceed the
costs of the same item in the option to the decision under consideration.

You may find the idea of opportunity costs difficult to grasp at first because they
are notional costs, which may never be included in the books and records of an
enterprise. They are, however, relevant in certain decision-making situation and
you must bear in mind the fact that they exist when assessing any such situations.

• Sunk costs: a sunk cost is a cost that has already been incurred and cannot be
altered by any future decision. If sunk costs are not affected by a decision then
they must be non-relevant costs for decision-making purposes. Common
examples of sunk costs are market research costs and development expenditure
incurred by enterprises in getting a product or service ready for sale. The final
decision on whether to launch the product or service would regard these costs as
‘sunk’ (i.e. irrecoverable) and thus, not incorporate them into the launch decision.
Sunk costs are the opposite to opportunity costs in that they are not incorporated
in the decision making process even though they have already been recorded in
the books and records of the enterprise.

3
Exercise

(a) An enterprise is considering replacing its professional legal advisers with its
own newly trained personnel. The relevant personnel are currently employed in
the secretarial department of the enterprise and will receive no pay increase
when taking up their new responsibilities. They will also be required to
continue to perform their old duties. The current annual salary bill of these
employees amounts to $100,000. Is the $100,000 a relevant cost in the decision
on whether to replace the professional advisers?

(b) An enterprise is considering the upgrading of its computer system. The

upgrading would result in the annual maintenance contract fee charged by the
suppliers rising from $30,000 to $40,000.

Is the maintenance fee a relevant cost to the upgrading decision? Briefly explain
your reasoning.

(c) The relevant cost of X in the filling of the special order is nil. The cost of the
200 kg of X in stock is a sunk cost and thus non-relevant. This is so due to the
fact that no amount of the purchase price appears to be recoverable through
either a straight sale of the material or by incorporating X in the manufacture of
a product (other than the special order) which could then be sold by the
enterprise.

Evaluating decisions involving relevant and non-relevant costs

When you are faced with making a decision, you have to perform two tasks before
making the final decision:

1. Evaluate the options in the decision on a monetary basis using cost versus
benefit analysis.

2. Take account of the qualitative factors associated with each option in the
decision.

The performance of the first task is dealt with in this section. Performance of the
second task is influenced by experience and common sense.

Nearly all decisions you will ever make will involve some relevant and non-relevant
costs. As stated earlier the hardest part of the evaluation process will be the
identification of the relevant costs for the decision at hand. This identification is often
required from a plethora of information that you will have to carefully sift through to
ensure the completeness of your evaluation.

Once the relevant costs are identified for each option you simply perform a cost
versus benefit analysis for each option and select the one that results in the greatest
gain or least cost to the enterprise.

4
Don’t forget that, in practice, qualitative factors can result in a different option being
selected than that suggested by the quantitative evaluation.

Exercise

The local authority of a small town maintains a theatre and arts centre for the use of a
local repertory company, other visiting groups and exhibitions. Management
decisions are taken by a committee which meets regularly to review the accounts and
plan the use of the facilities.

The theatre employs a full-time staff and a number of artists at costs of $4,800 and
$17,600 per month respectively. They mount a new production every month for 20
performances. Other monthly expenditure of the theatre is as follows:

$
Costumes 2,800
Scenery 1,650
Heat and light 5,150
Apportionment of administration costs of local authority 8,000
Casual staff 1,760
Refreshments 1,180

On average the theatre is half full for the performances of the repertory company.
The capacity and seat prices in the theatre are:

200 seats at $6 each

500 seats at $4 each
300 seats at $3 each

In addition, the theatre sells refreshments during the performances for $3,880 per
month. Programme sales cover their costs but advertising in the programme generates
$3,360.

The management committee has received proposals from a popular touring group to
take over the theatre for one month (25 performances). The group is prepared to pay
half of their ticket income for the booking. They expect to fill the theatre for 10
nights and achieve two-thirds full on the remaining 15 nights. The prices charged are
50 cents less than those normally applied in the theatre.

The local authority will pay for heat and light costs and will still honour the contracts
of all artists and pay full-time employees who will sell refreshments and programmes,
etc. The committee does not expect any change in the level of refreshments or
programme sales if they agree to this booking.

Note: The committee include allocated costs when making profit calculations. They
assume occupancy applies equally across all seat prices.

On financial grounds should the management committee agree to the approach from
the touring group?

5
Suggested Solution

To make a decision on the use of the theatre for one month the committee would
calculate the relevant cost or benefit of accepting the tour group’s offer as opposed to
continuing as is (i.e. with the repertory company).

Relevant benefits

Costs saved with touring group: $

- Costumes 2,800
- Scenery 1,650
- Casual staff 1,760

Relevant benefits 6,210

Relevant costs

Decrease in revenue with touring group:

Revenue with repertory company

200 x $6 1,200
500 x $4 2,000
300 x $3 900

4,100

$4,100 x ½ x 20 41,000

Revenue with touring company

200 x $5.5 1,100
500 x $3.5 1,750
300 x $2.5 750

3,600

($3,600 x 10) + ($3,600 x 15 x 2/3) = 72,000

Half kept by touring company leaving, 36,000

Relevant costs (41,000 – 36,000) 5,000
Net relevant benefit (6,210 – 5,000) 1,210

Therefore, the committee should accept the touring company’s offer as it results in a
net benefit to the theatre of $1,210 for that month.

Non-relevant costs were full time salaries, heat and light, apportionment of
administration costs and refreshments. ‘Re non-relevant benefits were refreshment
sales and advertising revenue. All of the above were non-relevant because they were

6
unaffected by the decision (i.e. they were the same whether the repertory or the
touring company occupied the theatre for the month).

The qualitative factors that might apply to this decision include:

The desirability of offering a range of activities in the theatre and thus to cater
for a wider audience fulfils an important social role.

The opinions of the artists who are employed by the theatre should be consulted.
They may welcome some months for rehearsal or personal development. But if
this were regular, the more talented people who were in demand may seek
opportunities elsewhere.

A different number of performances may have implications for predicted cost

levels and the accuracy of the theatre occupancy predictions should be
confirmed.

Exercise

Lombard Ltd. has been offered a contract for which there is available production
capacity. The contract is for 20,000 items, manufactured by an intricate assembly
operation, to be produced and delivered in the next financial year at a price of $80
each.

The specification is as follows:

Assembly labour 4 hours

Component X 4 units
Component Y 3 units

There would also be the need to hire equipment which would increase next year’s
fixed overheads by $200,000.

The assembly is a highly skilled operation and the work force is currently under-
utilised. It is company policy to retain this work force on full pay in anticipation of
high demand, in a few years time, for a new product currently being developed. In
the meantime, all non-productive time (about 150,000 hours per annum) is charged to
fixed production overhead at a current rate of pay of $5 per hour.

Component X is used in a number of other sub-assemblies produced by the company.

It is readily available. A small stock is held and replenished regularly. Component Y
was a special purchase in anticipation of an order which did not materialise. It is,
therefore, surplus to requirements and the 100,000 units which are in stock may have
to be sold at a loss. An estimate of alternative values for components X and Y
provided by the material planning department are:

7
 X Y

$ per unit $ per unit

Book value 4 10
Replacement cost 5 11
Net realisable value 3 8

Overhead costs are applied on a labour hour basis. Variable overhead is $2 per hour
worked. Provisionally, fixed overheads, before the contract was envisaged, were
budgeted next year at $3,560,000 for productive direct labour hours of 1,040,000.
There is sufficient time available to revise the budgeted overhead rate.

Analyse the information in order to advise Lombard Ltd. on the desirability of the
contract and briefly explain your reasoning.

Suggested solution

Advice on the contract will be based on the relevant costs or incremental costs
incurred for the contract using the values provided in the question.

$ per unit
Labour: 4 hours x 0 0
Component X: 4 units x $5 20
Component Y: 3 units x $8 24
Variable overhead: 4 x $2 8

Relevant cost per unit 52

Total relevant cost = ($52 x 20,000) + $200,000 = $1,240,000

Revenue = $80 x 20,000 = $1,600,000

A surplus of revenue over costs of $360,000 is revealed so the contract would appear
to be attractive.

The recommendation is based on the following reasoning: Labour will be paid

anyway as non-productive time so the incremental cost is zero. Component X will be
replenished at the current replacement cost. Component Y is costed at its opportunity
cost, that is, what could be obtained if sold at its disposable or realisable value. It is
already in stock and has no alternative use. Variable overhead is incurred in relation
to the direct labour hours worked. The only incremental fixed overhead is $200,000.
The remainder is common and unavoidable in all situations.