Topic 2 - decision relevance

Question 1

what is a relevant cost?

Answer 1

Costs appropriate to a specific management decision. These are represented by future cash flows who magnitude will vary depending upon the outcome of the management decision made.
For example, scrap value of a machine bought last year. if the machine is sold, the firm can bank the scrap value, if it is kept to work on a new project, the scrap value is lost.

Question 2

What are irrelevant costs?

Answer 2

Cash flows, whether past, present or future that will not be changed by any of the decisions under consideration and so are irrelevant to them.
For example, the depreciation of the same machine as above, while this would be an ongoing accounting cost, the purchase money has already been spent, a sunk cost.

Question 3

what is an opportunity cost?

Answer 3

the value of the benefit sacrificed when one course of action is chosen, in preference to an alternative. The opportunity cost is represented by the foregone potential benefit from the best rejected Course of action.

Question 4

how does a cost stay relevant?

Answer 4

1. it must relate to the objectives of the business
2. It must be a future cost, as past costs cannot be relevant to decisions being made about the future
3. it must vary with the decision

Question 5

explain sunk costs and committed costs in terms of irrelevant costs

Answer 5

Sunk cost: past cost
Committed cost: where an irreversible decision has been made to incur the cost, usually due to a legally binding contract.

Question 6

What is sunk cost fallacy

Answer 6

the refusal to abandon an attatchement to an irrecoverable investment.
Often leads to making poor decisions for the future direction

Question 7

Explain how the relevant costs of labour are determined.

Answer 7

this will vary with whether the business is operating with spare capacity or whether its full capacity.

At full capacity: the relevant cost of labour will depend whether additional workers are employed to undertake the task, or whether workers currently spending time on another project are redeployed.
Page 306 and 307

Question 8

explain how the relevant costs of materials are determined?

Answer 8

will vary according according to whether the materials are held in inventories and whether there is an intention to replace them. Page 308 and 309 and the two flow diagrams on topic 2 notes.