relevant costs and revenues for decision making

Question 1

define relevant costs and revenues

Answer 1

‘those future costs and revenues that will be changed by a decision’
- cash flows
- incremental costs
- avoidable costs
therefore a relevant cost is: a future, incremental cash flow

Question 2

what costs are NOT relevant?

Answer 2

• sunk costs
• committed costs
• unavoidable costs
• existing fixed costs
• depreciation

Question 3

what are sunk costs?

Answer 3

a cost that has been incurred from a previous decision

Question 4

what are committed costs?

Answer 4

costs that have not yet been incurred but will be incurred in the future due to previous decisions (also known as locked-in costs)

Question 5

what are unavoidable costs?

Answer 5

the incurrence of these cannot be saved

Question 6

long-run

Answer 6

• in the long-run the company needs to survive and therefore cover its long-run costs
• in the long-run most, if not all, costs are variable and therefore RELEVANT
• need a system in place that accurately reflects the costs of each product

Question 7

short-term decision making

Answer 7

in the long-run we have to cover all costs but…
- in order to respond to short-term opportunities and threats we look at MARGINAL/VARIABLE costing principles and only look at the costs and revenues that will change as a result of the decision in question

Question 8

what types of decisions do managers have to consider?

Answer 8

• special orders and selling price
• product mix
• replacement of equipment
• make or buy
• discontinuation

Question 9

what is special order selling price?

Answer 9

outside the market - typically one-time-only orders which are sold BELOW the current price the company sells at !

Question 10

what are the relevant costs/revenues when looking at special order selling price?

Answer 10

• it is the difference between the revenues, costs and profit which are relevant
• shows that there would be an increase/decrease in profit if you accept the special order

Question 11

what do you need to be mindful of when looking at special order selling price?

Answer 11

there is an assumption that there are no long-run consequences of accepting this order:
- it is assumed that the future ‘normal’ selling price will not be affected by this contract (i.e. lower than ‘normal’ price)
- if this is an incorrect assumption then a company’s competitors ,ay reduce their prices forcing the company to reduce it’s ‘normal’ price resulting in lower profits
- it has also been assumed that there is no alternative use for the unused resources which may yield a greater contribution
- assumed fixed costs are unavoidable in the short-term

Question 12

explain product mix

Answer 12

product mix decisions with capacity constraint..
- what happens when, in the short term, sales demand is in excess of our current production capacity?
- in this situation it is unlikely that we will be able to increase capacity

Question 13

how do you work out which products to make?

Answer 13

NOT the one with the greater profit !!!!
- first find out what limits our ability to produce more i.e. we need to look for the limiting factor, e.g. if we do not have enough labour hrs to produce the demand, then that is the limiting factor
- why? profit is maximised when we get the greatest amount of contribution per limiting factor

Question 14

what are the steps to calculate which product to make?

Answer 14

1. work out how much labour/machine hrs are required to make the product (do this by looking at unit cost for labour and dividing it by how much is paid per hr)
2. work out how much is demanded (do units demanded x hrs required)
3. work out how much hrs are available
4. see if it is a limiting factor = if there aren’t enough hrs to produce the product it is a limiting factor as it limits what we can do
5. work out the same for labour/machine hrs (do the one you havent done) and check if it is limiting - USE THIS METHOD IF THERE IS ONLY ONE LIMITING FACTOR!
6. identify relevant costs - costs that will change because of the decision (usually fixed costs can be ignored as they stay the same so would then need to find the contribution)
7. work out the contribution from unit costs
8. work out contribution per hour for each product and see which one has the highest (choose that product)
9. then calculate how many to make: do this by looking at how many hrs are available using the limiting factor
10. use up all the product with the highest cont. per hr and multiply by the hrs required to make product = gives us total hrs for the product
11. subtract hrs available by total hrs for product with highest cont. per hr
12. remaining hrs should be divided by the hrs required for other product which gives the amount of product to make for alternative product
13. work out total contribution for each product and sum up (do this by doing amount of product x contribution for each product)
14. can prove it makes higher contribution by calculating how much contribution it would have given us if we had chosen most profitable product

Question 15

what does product mix calculation show us?

Answer 15

shows that the greatest profit comes from making the products in order of their highest contribution per limiting factor !!

Question 16

replacing equipment

Answer 16

• this is a long-term and capital investment decision
• we need to look at what is relevant to our decision

Question 17

how would you decide if a company should replace equipment (steps)?

Answer 17

1. look at the irrelevant costs first and ignore them and identify the relevant costs
2. work out the difference in variable costs incurred (would it benefit the company or not? do they incur more VCs if they replace the equipment?)
3. add any sales proceeds from existing machine (i.e. how much would it sell for when scrapped?)
4. subtract cost of replacing machine
5. this gives us saving on purchasing a new machine
6. decide whether to replace equipment based on whether they save/lose money

Question 18

what are examples of irrelevant costs in the context of replacing equipment?

Answer 18

• the book value of the old machine = as it is a SUNK COST
• depreciation = not a cash item

Question 19

what are examples of relevant costs in the context of replacing equipment?

Answer 19

• purchase price of the new equipment
• difference between the VCs that would be incurred
• scrap value of the old equipment

Question 20

make or buy

Answer 20

• these decisions happen when we are establishing whether it would be more beneficial for an organisation to provide a product or serve in house or whether to purchase this product or service from an outside supplier
• if we decide to stop producing internally and buy from an external supplier this is known as OUTSOURCING

Question 21

what to do with a make or buy question?

Answer 21

1. look at how much the other company is offering if you outsource the parts/product (is the price for the part lower/higher than the total unit cost of making the product?)
2. look at what changes as a result of the decision: variable costs will be removed; % of fixed costs may also be removed (saving money); will have to pay £X per part to company thus total amount purchase would be £X
3. relevant costs would be the difference between the costs (e.g. direct materials, direct labour, variable manufacturing oH, etc.) we would have to pay if company makes it themselves or outsourced

Question 22

discontinuation decision

Answer 22

for these decisions we are assessing whether continuing with operations is worthwhile or whether we are better disposing on products/services/divisions etc.

Question 23

what examples of relevant costs would there be if you discontinue a product line?

Answer 23

• lose revenue from the product
• save money from marginal costs
• save % of FCs

Question 24

what is an opportunity cost?

Answer 24

the benefit sacrificed (loss contribution) by choosing one decision over another

Question 25

when do opportunity costs arise?

Answer 25

only arise when resources are limited/scarce and there are alternative uses for them
- when the alternative course is given up the financial benefits lost are known as the opportunity costs

Question 26

what do we do if we do not have any spare capacity of labour and we are trying to work out whether a job is worth doing or not?

Answer 26

• need to work out the opportunity cost of using the labour for potential contract