Relevant Costs Flashcards
What is the definition of a relevant cost?
The future cash flows arising as a direct consequence of the decision under consideration.
What are the key elements of a relevant cost?
- They should be future costs and revenues as it is not possible to change what has happened in the past.
- They should be incremental, only costs and revenues that occur as a direct result of the decision should be included.
- The should be cash flow based and so do not include accounting adjustments, such as depreciation.
Explain the types of non-relevant costs.
- Sunk Costs - have already been incurred and therefore is no longer relevant to the decision as the money has alerady been spent.
- Commited costs - as a result of a past event this cost will be incurred in the future
Should existing equipment with a NBV of $1m that will be used on the new project be included as a relevant cost?
No - the NBV is the orginal cost less any accumulated depreciation.
The orginal cost has already been incurred and so is a sunk cost which should be excluded. Depreciation is not a cash flow and so is not relevant.
Is depreciation a relevant cost?
No - this is an accounting adjustment to spread the cost of the asset over its useful economic life but will not effect cash flows.
What is Opportunity Cost?
The value of the best alternative that is foregone when a particular course of action is undertaken. It is a type of relevant cost and is simply what will be given up because of the decision.
What are the limitations of relevant costs?
- They do not consider the impact of the decision on the different stakeholders of the buisness, i.e. stress to employees
- They do not consider outside influences such as the economy, industry and competitors.
- It only considers the short-term financial benefit and does not take into account the long-term profitability for the company
- The financial impact can be difficult to quantify, for example adverse publicity which results in a fall in sales. While this is a drop in cash flow it is difficult to estimate in advance.
When it comes to the relevant cost of materials, what are the key questions that need to be asked to determine the value?
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Are the materials already in the inventory?
- if not then the relevant cost will be the purchase cost
- *2. Will they be replaced?**
- if yes then the cost of replacing them will be the relevant cost
- *3. Will they be used for other purposes?**
- if yes then the relevant cost will be the opportunity cost of the alternative use
- if no then the relevant cost will be the net realisable value
When it comes to the relevant costs of labour, what are the key questions to determine the value?
- *1. Is there spare capacity?**
- if yes then the relevant cost is nil
2. Can additional labour be hired?
- if yes then the relevant cost is this direct labour cost
- if no then the relevant cost is the direct labour cost plus the contribution foregone
Warehouse wages are currently $400,000. It is expected that some additional staff will need to be taken on for the new project. If the project goes ahead warehouse wages are anticipated to be $420,000.
How much labour should be incorporated into the relevant costs of the new project?
Rather than the total wages for the year, only the change should be included. The project would result in additional costs of $20,000.
Relevant costs should only include the incremental impact.
Warehouse overheads are currently $350,000 per annum (including $100,000 of apportioned overheads). With the additional facility, this is expected to become $450,000 (including $60,000 of apportioned overheads).
How much overhead should be included as a relevant cost to the project?
Any apportioned overheads will be incurred anyways, they are therefore not incremental and thus not relevant.
We should also only consider the incremental impact on the total overheads bill.
So in this case the relevant cost would $140,000. This has been calculated by excluding the apportioned overheads and calculating the incremental impact.
(450-60) - (350-100) = 140
