10.1 Relevant costs and revenues

Question 1

Relevant costs and revenues are

Answer 1

• Those costs and revenues that change as a direct result of a decision taken
• Decisions will generally be based on taking the decision that maximises shareholder value

Question 2

Relevant costs and revenues have the following features

Answer 2

• They are future costs and revenues (not possible to change what happened in past)
• They are incremental or differential - only the change in costs and revenues that occur as a direct result of decision taken are relevant
• They are cash flows - they must be cash flows arising as a direct consequence of the decision taken, not profits, as profits can be manipulated (excludes items that don’t involve cash flows)

Question 3

Two specific types of relevant costs:

Answer 3

• Opportunity costs
• Avoidable costs

Question 4

Opportunity cost represents the

Answer 4

• Value of the best alternative that is forgone in taking the decision
• It emphasises that decision making is concerned with alternatives and the cost of taking one decision is the profits forgone by not taking another
• Therefore consideration must be given to profits or contributions which could be earned from alternative uses of resources
• Effects on cash flows of the whole org must be considered (not single department)

Question 5

Avoidable costs are

Answer 5

• Costs that would not be incurred if the decision did not go ahead
• Such as the costs that would be saved by shutting down a department (eg labour, rent, etc)

Question 6

Non relevant costs include

Answer 6

• Sunk costs
• Committed costs
• Fixed costs
• Depreciation
• Notional costs

Question 7

Sunk costs are

Answer 7

• Already incurred and therefore not relevant to decision making and should be ignored (can’t change the past)
• Aka irrecoverable costs and eg: costs incurred in developing a new product, money can’t be recovered if further development is abandoned

Question 8

Committed costs are

Answer 8

• Costs that will be incurred in the future as a result of decisions taken in the past that cannot now be changed (ie. unavoidable in the future)
• It will be incurred regardless of the decision being taken and therefore not relevant
• Eg ordered packing for new product will still need to pay for it even if decided not to proceed with product

Question 9

Fixed costs should be

Answer 9

• Treated as a whole and only where relevant
• Fixed overheads that are absorbed / charged / allocated / apportioned to a project should be ignored
• The amount of overhead to be absorbed by a particular cost unit might alter because of the decision, however this is as a result of the companys cost accounting procedures for overheads
• If the actual amount of overhead incurred will not alter then it is not relevant
• Only extra / incremental changes in fixed overheads should be included in decisions

Question 10

Depreciation is an

Answer 10

• Accounting adjustment to spread the original cost of an asset over its useful life but does not result in cash flows
• Depreciation / net book values should never be treated as a relevant cost for decision making

Question 11

Notional costs are

Answer 11

• Costs that will not result in an outflow of cash either now or in the future
• Eg head office charging theoretical rent to branches

Question 12

Incremental revenues are the

Answer 12

• Differences in revenue between the alternatives
• Matching the incremental costs against the incremental revenues will produce a figure for the incremental gain or loss between the alternatives

Question 13

The relevant cost of materials

Answer 13

• There are a number of alternative costs which could be relevant for materials, such as replacement cost, net realisable value or opportunity cost, depending on the relevant situation
• Are materials in inventory - No - Relevant cost = Cost of purchase
• Will they be replaced - Yes - Relevant cost = Replacement cost
• Will it be used for other purposes - Yes - Relevant cost = Opportunity cost; No - Relevant cost = Net realisable value

Question 14

The relevant cost of labour

Answer 14

• Key question is whether spare capacity exists
• If yes - Existing workforce are idle and being paid regardless = Nil
• If no and only option is to hire in additional workers = Cost to hire in workers
• If no and only option is to transfer existing workers from alternative projects = Opportunity cost (contribution)
• If no and choice of hiring in or transferring labour = Lowest cost

Question 15

The relevant cost of overheads

Answer 15

• Only relevant if they vary as a direct result of the decision taken

Question 16

The relevant cost of non current assets

Answer 16

• Such as plant and machinery are determined in a similar way to materials
• Will asset be replaced = Yes = Replacement cost
• Will asset be replaced = No = higher of:
  
  • If asset is not sold = Net cash flows from the use of the asset
  • If asset is sold = Net realisable value (sale proceeds)