4. Relevant Cost Analysis Flashcards
What is a relevant cost?
Those costs that are affected by specific management decisions.
What are the three criteria for relevant costs?
- Future costs - historical costs are not relevant since they’ve already been incurred.
- Incremental - any extra costs which would be incurred as a result of a decision.
- Cash flows (cash payments) - non-cash expenses represent expenditure already made hence they are not relevant. E.g. depreciation and profit or loss on disposal.
Define the following types of (relevant) costs:
1. Avoidable costs
2. Controllable costs
- Avoidable costs - those costs that would not exist if a particular course of action was taken.
- Controllable (managed) costs - these can be influenced by the actions of the person who controls the budget or the cost centre.
Identify 5 types of non-relevant costs.
- Sunk costs - costs that have already been incurred. E.g. R&D. They are not future costs.
- Committed costs - e.g. contract rental & lease payments. They are not incremental.
- Fixed costs - not incremental unless stepped.
- Depreciation/amortisation and carrying values - they are not incremental. Any realisable value of an asset would be relevant.
- Uncontrollable costs - can be influenced only indirectly by person in charge of budget or cost centre. E.g. management charges. Notional costs which do not increase as a result of the decision are irrelevant.
Define opportunity cost.
The cost of the next best alternative foregone. The value of the benefit sacrificed when one courses of action is chosen in preference to an alternative.
Which statement is true:
1. All opportunity costs are relevant.
2. All relevant costs are opportunity costs.
- True
- False
What are 4 difficulties in using opportunity costs?
- How to estimate future costs/revenues and hence the benefit sacrificed.
- Identifying alternative uses to know what is the best alternative forgone.
- Lack of accounting for effects on accounting profit (i.e. accounting profits do not include opportunity costs and revenues). A course of action that reduces the reported accounting profit may be considered unacceptable even though it is the best decision under opportunity cost principles.
- Also, as is true for any costing method, it ignores non-financial factors.
The minimum price that may be quoted on a contract is equal to the relevant cost. At this price no profit or loss would be made on the contract.
There are several reasons why a business might wish to know the minimum price of a contract, these include:
- It is useful for price negotiations to know the lowest price that can be charged for a contract; if a price is agreed to that is below the relevant cost the business would make a real loss.
- A business may be prepared to undertake a contract at relevant cost in the hope that this may bring additional business in the future.
- If a business has under-utilised resources during low season, it may be willing to take on additional contracts at this time (provided that no loss is made) as this may build up goodwill with potential customers.
For one-off contracts, what is the relevant cost of materials in the following scenarios:
- Materials required have not yet been acquired.
- Materials have already been acquired but is used regularly in the business.
- Materials are used regularly but cannot be replaced.
- Materials not used regularly but can be sold.
- Materials not used regularly and cannot be sold.
Where materials are required for a one-off contract, the following guidance can be used to determine the relevant cost:
If the materials required have not already been acquired, it will be necessary to buy them for the contract. The current market price is the relevant cost.
If the materials have already been acquired, it is necessary to consider whether they are used regularly in the business:
If used regularly, any materials consumed by the one-off contract will need to be replaced, so the replacement cost (which is also current market price) would be the relevant cost.
If used regularly, and replacements are not available, the relevant cost would be the opportunity cost, which would be the contribution foregone from regular production.
If not used regularly (e.g. they were acquired some time ago and there is no current use for them), the relevant cost is their opportunity cost. This is often their scrap value (i.e. disposal proceeds if the materials can be sold if not used in the contract). If there is no scrap value, the opportunity cost is $0. Or there could be an opportunity saving if the materials would otherwise have to be disposed of at a cost.
What is the relevant cost of labour in the following situations?
- The organisation has spare or idle labour time which can be used on the contract.
- If additional labour time is required and can be obtained without taking workers from other activities.
- If there is a limit on the amount of labour available a contract may require workers to be taken away from other profitable activities.
One-off contracts usually require some labour. The relevant cost of labour can be determined from the following situations:
If the organisation has spare (idle) labour time which can be used on the contract, the relevant cost is zero. This might arise, for example, where workers are being paid a fixed weekly wage and are currently underemployed.
If additional labour time is required and can be obtained without taking workers away from other activities, the direct cost of the labour is relevant. This may be paid at a higher rate if overtime is involved.
If there is a limit on the amount of labour available a contract may require workers to be taken away from other profitable activities. In this case, the relevant cost of labour is the direct cost plus the lost contribution from the other activities.
What is the relevant cost of non-current assets for one-off contracts in the following scenarios:
- PPE has to be rented.
- PPE has to be purchased.
- PPE is owned but has spare capacity.
- PPE is owned and is operating at full capacity.
Non-current assets, such as machinery, may be required for a contract. The relevant cost of such assets depends on how the organisation plans to obtain the use of it:
If the asset is to be rented (or hired) the rental costs over the period of use are relevant.
If the asset is to be acquired (purchased) for the contract, the cost of acquiring the asset (including related costs, such as delivery and installation) would be relevant. It may be that when the contract is completed, the asset can be sold. In this case, the expected proceeds from the sale will be relevant income that should be deducted from the total cost of acquiring the asset when calculating the relevant cost.
An asset such as the one that is required may already be owned. The relevant cost then depends on whether that asset is already operating at full capacity on other activities.
If the asset is not actually in use for any other purposes at the moment (or has spare capacity), the relevant cost is the fall in realisable value that will arise if the asset is used for the contract.
If the asset is already operating at full capacity its relevant cost is its deprival value.
What are some non-financial factors, management should consider when making shut down decisions?
- If closing a division would result in redundancies, this could lead to poor morale among remaining employees.
- The permanent loss of resources and specific skills may mean that it will not be possible to take advantage of future opportunities.
- Shutting down one division may affect demand for products produced by other divisions (e.g. if customers like to buy a range of products from one supplier, closing a particular division will limit the range that is available).
- It may be possible to bring a loss-making division back to profitability by developing new products or services.
- Shutting down a division may make it possible to sell assets such as buildings to raise finance for other divisions or to reduce debt.
What are the advantages of outsourcing?
- Lower cost - many companies have discovered that some goods or services may be purchased for less than it would cost to provide them internally. This may be assisted by the economies of scale enjoyed by the third-party provider.
- Services may become a variable cost rather than a fixed cost if outsourced. For example, the cost of outsourcing payroll services may be based on the number of personnel. If payroll services were sourced in-house, staff would have to be employed to provide this service (ie effectively a fixed, or stepped, cost).
- Outsourcing allows management to focus on the core competencies of the business without being distracted by managing peripheral areas.
- Better quality of the goods and services provided by a specialist third party.
- Access to a wider range of expertise as the provider deals with several clients. For example, a provider of IT services may have employees with a wider range of skills and knowledge than an internal IT function.
What are the disadvantages of outsourcing?
- The company relies on a third party to provide a reliable supply. It therefore loses control over a part of its business processes.
- Outsourcing may mean trusting a third party with confidential information about goods or services.
- Some costs may not be apparent (i.e. hidden) as anything not specifically covered by the contract is likely to incur additional charges.
- Quality may suffer especially if the contract price per unit is fixed (i.e. the third party can only increase its profit by reducing costs).
- Operational dependence on the outsourcing company is linked to its financial stability. If the third-party company fails, switching to another provider may be very costly.
- Outsourcing may demotivate the workforce if the decision to outsource is associated with job losses. (There may also be bad publicity where outsourcing is to another country.)
