Relevant Costing

Question 1

What is an opportunity cost?

Answer 1

This is the value of the best alternative that is foregone used to recognise that a choice regarding a project may result in a sacrifice of loss else where.
E.g. New project will use a machine which would other wise be sold for $4000.
The Cost and NBV of the asset are ignored as they are sunk costs/non cash costs.

Cost of the opportunity (relevant cashflow) = Income from machine for project - income from sale of asset = -$4000.

Question 2

How is the relevant cost of Raw material determined?

Answer 2

Using a form of decision tree:

1. Is the material in Stock? Yes - next question, No - relevant cost = current purchase price. This is a future cost.
2. Is the material in regular use and will be replaced? No - next question, Yes - relevant cost = current purchase cost (Future cost)
3. Is there an alternative use for the materials? -
   
   1. Yes - relevant cost = higher of value in other use or scrap value.
   2. No - relevant cost = scrap disposal value.

Question 3

How is the relevant cost of labour determined?

Answer 3

As with materials this is a type of decision tree:

1. Is there spare labour capacity? - No next question, Yes - relevant cost = $0
2. Can more labour be acquired (OT/Extra staff) - No, next question, Yes - extra cost of labour.
3. Relevant cost = opportunity cost of diverting labour - lost contribution and extra labour cost.

Question 4

How is a make or buy decision approached with a limiting factor?

Answer 4

1. Calculate the cost per unit of making in house and buying in, difference between the two = saving per unit of making in house.
2. Look at scarce resource required for each product and divid saving by scarce resource required. = saving per unit of limiting factor.
3. Rank the products by saving per unit of limiting factor highest to lowest.
4. Allocate the scarce resource in order of rank.
5. Purchase remaining resource from external source.

Question 5

What other issues may impact a make or buy decision?

Answer 5

• Reliability of external supplier - Quality, Quantity, timeliness, price stability
• Specialist Skills - available from supplier but not in house?
• Alternative use of Resource - use for other internal process with higher contribution?
• Social - would workforce need to be reduced, consider redundancy costs.
• Legal - what impact will outsourcing have on contractual obligations to suppliers and/or employee’s
• Confidentiality - what if outsource also carries out work for competitors?
• Customer reaction - do customers attach importance to products being made in house?

Question 6

What are the advantages and disadvantages of outsourcing?

Answer 6

Advantages

• Flexibility - different services can be bought in as and when required.
• Lower investment risk - costs for new technology, equipment, staff training are minimised or avoided.
• Improved cash flow - Services are paid for on the basis of what was needed/used, cheaper than having the provision available but not fully utilised.

Disadvantages

• May choose the wrong supplier - if the supplier is now up to the standard required this will impact negatively on business performance.
• Loss of visibility and control over process - this can impact quality and cost and brings in a level of uncertainty.
• Increased lead times - think the likes of Lupofresh.