Chapter8: Relevant costing

Question 1

What are relevant costs?

Answer 1

Future incremental cash flows & opportunity costs as a result of a decision

= the cash position if accept proposal - cash position if reject proposal (and choose next best alternative instead)

Question 2

What does future mean?

Answer 2

only cash flows from a decision

Sunk costs (past costs) aren’t relevant

Question 3

What does incremental mean

Answer 3

only extra cash flows from the decision are considered
Fixed costs ignored (unless there’s an incremental FC from the decision)
Committed costs (unavoidable future costs) = ignored

INCLUDE OPPORTUNITY COSTS- look at next best alternative use of resource

Question 4

What is an irrelevant cost

Answer 4

Depreciation, sunk cost, apportioned fixed OH, financing cash flow e.g interest

Question 5

What is an opportunity cost

Answer 5

value of next best alternative (in the past) when a particular course of action is taken

Question 6

Relevant cost of materials

Answer 6

1) In stock or out of stock
out of stock= relevant cost (current purchase price)
2) In stock- regular use and replaced? or will not be replaced?
Will be replaced= Relevant cost (current purchase price)
Not replaced= relevant cost = opportunity cost e.g lost scrap value / lost contribution if use material here instead of elsewhere
3) If not replaced- are there alternative uses of material?
No= relevant cost= scrap/ disposal value
Yes= relevant cost= higher value in other use or scrap value

Question 7

What happens if a material is in short supply

Answer 7

To accept that proposal would have to deny another part of the organisation that resource

Relevant cost= normal material cost + lost contribution in other department

Question 8

What are the relevant costs of labour

Answer 8

1) Is there spare capacity or full capacity?
Spare= relevant cost= 0 (use the space reduce slack)
2) Full - hire more labour?
Yes- relevant cost= extra cost of labour e.g OT, more staff
No- relevant cost= opportunity cost of diverting labour i.e lost contribution and extra labour cost

Question 9

What are the relevant costs of non - current assets ?

Answer 9

1) New or existing asset?
New: relevant cash flows= Purchase price/ scrap or disposal proceeds
Existing asset: relevant cost= opportunity cost- Higher of either sales proceeds or lost contribution from use in other department

Question 10

What items are not relevant?

Answer 10

1) Depreciation
2) Profit/ loss on disposal incorporates accumulated depreciation - look at cash element only i.e scrap proceed
3) Original purchase price of existing machinery = sunk cost
4) carrying value of existing machinery= combination of original price (sunk) and accumulated depreciation (not a cash flow)

Question 11

What is the minimum contract price in a one-off contract

Answer 11

Total net relevant cash flow associated with the contract

Question 12

Comments on the minimum contract price

Answer 12

1) min price = break-even point
2) If contract price doesn’t cover cash flows= rejected
3) Any price higher than min= company better to accept than reject proposal

Question 13

Further considerations of the minimum contract price for one off contracts

Answer 13

1) Price can be acceptable for 1 off contract not all contracts
2) Min price using relevant costing= lower than typical market prices- can be reluctant to accept this price if it might affect future contract prices e.g hearsay of customers demanding lower prices
3) Company may be willing to accept a loss on this contract if it increases chances of winning subsequent contracts

Question 14

What is a make or buy decision

Answer 14

Whether a business should make components in house or buy from outside suppliers

Question 15

What’s the difference between making or buying

Answer 15

Buy: resources brought in so purchase cost is wholly marginal (direct)

Make: direct materials & wages costs + variable factory OH

Question 16

When is it uneconomic to make instead of buy

Answer 16

When the variable costs is greater than obtaining a similar components elsewhere

Question 17

What are the 2 make vs buy decisions

Answer 17

1) Make or buy decisions with no limiting factors
2) Make or buy decisions with limiting factors

Question 18

What is a make or buy decision with no limiting factors?

Answer 18

relevant costs are the differential costs between the 2 options

Question 19

What is a make or buy decision with a limiting factor?

Answer 19

1) Calc saving per unit of each product.
Saving = purchases price- variable cost to make

2) Divide the saving by no of scarce resources each product uses = saving per unit of the limiting factor

3) rank products. 1st product to make= highest saving per unit

4) Scarce resource allocated to the product in order of priorities until used up

5) Products with unsatisfied demand can be satisfied from an external source

Question 20

Other issues to consider in make vs buy

Answer 20

1) reliability of external supplier- meet quantity/ quality/ deliver on time/ price stability
2) Specialist skills- may not be available in house
3)Alternative use of resource- outsourcing frees up resources to be used elsewhere
4) social- does it reduce workforce? consider redundancy costs
5) legal- does it affect contractual obligations with suppliers/ employees
6) Confidentiality- risk of losing this if they provide similar work for rivals
7) Customer reaction- how they perceive products being made

Question 21

Dyson examples of make vs buy:

Answer 21

originally said to only produce in UK to maintain competitiveness
Now produce more in Asia (cheaper)

Question 22

Apple/ samsung example of make vs buy

Answer 22

R&D - outsource to Foxconn who manufacture
Relevant cost: cost of production
Not always a choice
w/o intellectual property apple has no value.
Foxconn has no advantage of stealing ideas as they are a manufacturer

Question 23

Advantages of outsourcing

Answer 23

1) increased flexibility
2) Lower investment risk
3) Improved cash flow
4) concentrates on core competence
5) Enable more advanced technologies to be used without making investment- someone else takes the risk

Question 24

Disadvantages of outsourcing

Answer 24

1) Possibility of choosing wrong supplier
2) Loss of visibility and control over process
3) Possibility of increased lead times

Question 25

What are the quantifiable costs/ benefits of closure?

Answer 25

1) Lost contribution from the area being closed (= relevant cost of closing)
2) savings in specific FC from closure (=relevant benefit of closure), known penalties, other costs from the closure e.g redundancy, compensation to customers
3) Known reorganisation costs (= relevant costs of closure)
4) known additional contribution from the alternative use for resources released (= relevant benefit of closure)

Question 26

What are the non-quantifiable costs/ benefits of closure?

Answer 26

1) penalties and other costs from closure e.g redundancy and customer compensation may be uncertain

2) Reorganisation costs may be uncertain

3) additional contribution from the alternative use for resources released may be uncertain

4) Knock on impact of shut down decision - e.g some stores sell products at a loss to entice into store where they buy further products at high margins

Question 27

What are joint products

Answer 27

manufacturing 1 product inevitably results in the manufacturing of another product

Where individual profits start becoming profitable= split off point
joint costs= costs incurred before split off point and shared between the products

Question 28

How to apportion joint costs

Answer 28

1) sales value of production ( aka market value)
2) production units
3) net realisable value

Question 29

What to know about future processing decisions

Answer 29

aim: process further or sell after split-off only future incremental cash flow

Consider:
1) difference in revenue and extra costs
2) joint costs are sunk (not relevant) unless we’re considering the whole process (relevant)