6 Relevant Costs Flashcards
Decisions types
- Accept or reject - merits of opportunity, would we even take this opportunity? (ie. NPV > 0) No need to compare with other opportunities,
- Ranking - choice of best opportunity among a few. Reasons for choice:
- not enough resources to pursue all of them,
- they are different means to the same end, no need to use more than one.
Steps in decision making process:
- Identify objectives,
- Search for alternative courses of action,
- Collect data about alternative courses of action,
- Select best (appropriate) course,
- Implement the decision,
- Compare actual and planned outcomes, take any necessary corrective action if planned results not achieved.
Absorption costing vs decision making
Information used for decision making differs from other uses in finance. Therefore, traditional absorption cost-accounting data is totally misleading for decision making.
Rules on costing use:
* absorption costing is misleading for one-off decisions or decisions re. marginal spare capacity,
* marginal costing is unsuitable for long-term pricing for all output (problem of covering fixed costs) BUT useful for decision-making. This is because fixed costs are not relevant in short term; so marginal cost, revenue and contribution are relevant.
Accounting principles vs decision making
accounting concepts are not consistent with decision making in areas such as:
- Accruals - relevant costs and revenues are calculated on cash basis and ignore past, non-cash and fixed costs,
- Reliability - future costs are never 100% certain,
- Relevance - what is or isn’t relevant differs from decision to decision,
- Completeness - only relevant items, everything else ignored,
- Comparability - all relevant costs included, all other excluded,
- Going concern - decision making may consider shutdown decisions + if all projects are decided on relevant cost basis, it may endanger organisation by not covering fixed costs. Only one-off, marginal decisions can be treated like that.
Maximizing contribution
The best option is the one that maximizes contribution. To identify contribution and understand cost behavior at different activity levels/options, costs need to be divided into fixed and variable components. For short-term decision making, the best cost distinction is:
* Purely variable - directly attributable,
* Variable costs fixed in short term - cannot be directly attributed but would be avoided,
* Fixed costs (change in long term or with sign. different activity level) - these are not relevant.
Decision making vs ABC costing: fixed costs irrelevant in short term vs. most fixed costs are variable in the long-term.
Relevant costs
costs that change with given management decision, represented by future cash flows. Key rules:
1. Future costs - they will be incurred in the future as a result of this decision,
2. They are cash flows - only costs that impact the future cash outcomes,
3. Incremental (differential) costs - difference between alternatives, costs on top of what would be paid anyway.
4. Avoidable costs - specific costs of activity or sector of business that would be avoided if this sector would not exist (useful for shutdown or disinvestment decisions).
* Attributable fixed costs - fixed within relevant range of activity, but would be avoided otherwise (ie. extra supervisor salary),
5. Opportunity costs - contribution lost compared to the best rejected course of action.
The summary of these costs needs to be smaller than incremental revenue to pass accept-or-reject decision. Also, relevant costs set minimum price quotations for special orders.
Non-relevant costs:
- past (historical) costs - useful for predictions, but not decision making,
- sunk costs - costs that have been irreversibly incurred (irrecoverable), ie. development costs already incurred,
- non-relevant variable costs - sometimes variable cost can be sunk, ie. raw material that has no further use and no scrap value. Historical and book values are irrelevant; if scrap value exists its the only (opportunity) cost for this material.
- committed costs - future cash outflow that will be incurred anyway,
- non-cash costs: depreciation, notional rent or interest, fixed O/H absorbed. Notional costs are costs used in evaluation, decision making and performance measurement to reflect use of resources that have no actual (observable) cost, ie. notional rent charged to subsidiary or cost/profit centre for use of accomodation or notional interest on capital employed in cost/profit centre.
- base (non-incremental) costs,
- general fixed costs - unaffected by decision.
//in exam, assume variable costs are relevant and fixed irrelevant unless indication to contrary.
Relevant costs - materials
distinction: do we have to buy it/do we have them and they will be replaced/sold for scrap/can’t be replaced/have no value.
Relevant costs - machines
extra maintenance, rent for job-specific machines, loss of resale value of current machines (cash). Depreciation, book value or pre-committed payments are irrelevant
Relevant costs - labour
depends whether labour works at full capacity. If at full capacity, important to include both labour cost and variable O/H cost (even if they would be paid otherwise) plus lost contribution (contribution left first has to cover these variables)
Relevant revenues
future + incremental + cash flows. Revenues received in the past, non-cash or on received regardless are not relevant
Relevant costs/revenues - Key assumptions
relevant costs/revenue are in the future, which makes them uncertain. Assumptions on which predictions are made need to be recognized:
- cost behavior patterns are known - important to challenge this in case study as a footnote, ie. can factory handle large increase in output/how would fixed costs change?,
- amount of fixed costs, unit variable costs, sales price and sales demand are known with certainty - apply risk and uncertainty analysis to assess what would happen if reality differs from assumptions,
- objective of decision making is to maximize ‘satisfaction’ (short-term profit) - other factors may influence decisions (discuss them in case study),
- information on which decision is based is complete and reliable - this is unrealistic and decision makers need to be aware of incompleteness and inadequacies of information used.
Non-quantifiable factors
there are other considerations that may be as, or more, important to organisation than just max contribution. These may drive management to take different option or change output/investment allocation. Examples:
- Availability of cash - can we afford to finance this project?
- Inflation - if costs rise and revenues are agreed upon (fixed), do we still make profit?
- Employees - how do we affect them (ie. shutdown), will they agree?
- Customers - how about their loyalty and demand, what about other products in portfolio?
- Competitors - how will they respond (enter market, start price war)?
- Timing factors - when do pursue the project? How do we coordinate many?
- Suppliers - how do we affect suppliers, their goodwill, will they stay in business?
- Feasability - do we have expertise and competence to carry it out?
- Flexibility and internal control - can we afford the inflexibility/lack of control (subcontract, long term contract), are there competencies we have to build internally?
- Unqualified opportunity costs - even when no opportunity cost is listed, it’s possible they are available. In CS, qualify a recommendation by stating that a given project appears to be viable on assumption that there aren’t more profitable opportunities,
- Political pressures - will there be political consequences of actions (disinvestment, redundancies)?
- Legal constraints - is the proposed course of action legal?
