Question

Kindly provide an explanation as to what are the main concepts pertaining to arriving at relevant costing and discuss how these principles might apply to a manufacturing company.

Answer:

A relevant cost is a current or future cost that will differ among alternatives. For example, relevant cost of material is the raw material cost that needs to be considered while taking a managerial decision. Relevant cost of material may be in the form of incremental cash flows or opportunity cost. The historical cost of material is irrelevant because it cannot be altered by new decisions

• Differential Costs: These costs represent the difference in total cost between the two alternatives. In computing future costs the difference between individual items of relevant costs for each alternative is noted. The sum of these differences is the differential cost, also referred to as the incremental cost or the net relevant cost. This cost plays an important part in management’s decision-making between alternative courses of action. Complementing differential cost is the corresponding concept of differential income or revenue. For example, if the cost of alternative A is $10,000 per year and the cost of alternative B is $8,000 per year. The difference of $2,000 would be differential cost.
• Opportunity Costs: The decision to use a particular resource in one way rather than another means that management has given up the opportunity to use it in the alternative way. An opportunity cost is the potential benefit that is given up (foregone) when the choice of one action precludes a different action. The lost opportunity is a cost that must be taken into account when making a decision. It should be emphasised that oopportunity costs are relevant costs and should not be overlooked. For example, a company has a $40,500 rent expense. The opportunity cost of $40,500 could have been spent on production machinery.
• Sunk Costs: The term sunk cost is often used to define costs incurred
  in the past. The important point to be made about a sunk cost in the context of decision making is that it is irrelevant to a decision, since decisions are about future actions. Sunk Costs have already been incurred; they do not affect any future cost and cannot be changed by any current or future action. They are therefore irrelevant to decisions. An example of a sunk cost is the book value of an asset. This value is the acquisition cost of an asset minus accumulated depreciation to date. Whichever alternative is eventually chosen in the decision-making process, the book value of the old asset (e.g. piece of equipment) will be an expense or loss in the next year. The current book value of old equipment is a sunk cost and irrelevant to future actions. For example research and development expenses incurred for the production of a new product.
• Avoidable and Unavoidable Costs: In certain circumstances, a company may need to make a decision regarding the maintenance or elimination of a particular good or service. In making that decision, management would need to consider the costs that will continue to be incurred even when the product or service is eliminated and those that will no longer be incurred.

Comment on the answer above; agree/disagree with reasons with supplement information, providing help/suggestions/improvements.

Answer 1

Making business decisions involves choosing between alternative courses of action. Many factors affect business decisions, yet analysis typically focuses on finding the alternative that offers the highest return on investment or the greatest reduction in costs. In all situations, managers can reach a sounder decision if they identify the consequences of alternative choices in financial terms

· A relevant cost is a current or future cost that will differ among alternatives. For example, relevant cost of material is the raw material cost that needs to be considered while taking a managerial decision. Relevant cost of material may be in the form of incremental cash flows or opportunity cost. The historical cost of material is irrelevant because it cannot be altered by new decisions.

Most financial measures of revenues and costs from accounting systems are based on historical costs. Although historical costs are important and useful for many tasks such as product pricing and the control and monitoring of business activities, we sometimes find that an analysis of relevant costs, or avoidable costs, is especially useful. Three types of costs are pertinent to our discussion of relevant costs: sunk costs, out-of-pocket costs, and opportunity costs.

A sunk cost arises from a past decision and cannot be avoided or changed; it is irrelevant to future decisions. An example is the cost of computer equipment previously purchased by a company. Most of a company’s allocated costs, including fixed overhead items such as depreciation and administrative expenses, are sunk costs. An out-of-pocket cost requires a future outlay of cash and is relevant for current and future decision making. These costs are usually the direct result of management’s decisions. For instance, future purchases of computer equipment involve out-of-pocket costs.

· Differential Costs: These costs represent the difference in total cost between the two alternatives. In computing future costs the difference between individual items of relevant costs for each alternative is noted. The sum of these differences is the differential cost, also referred to as the incremental cost or the net relevant cost. This cost plays an important part in management’s decision-making between alternative courses of action. Complementing differential cost is the corresponding concept of differential income or revenue. For example, if the cost of alternative A is $10,000 per year and the cost of alternative B is $8,000 per year. The difference of $2,000 would be differential cost.

To determine whether to accept or reject an order, management needs to know whether accepting the offer will increase net income. If management relies on per unit historical costs, it would reject the sale because it yields a loss. However, historical costs are not relevant to this decision. Instead, the relevant costs are the additional costs, called incremental costs. These costs, also called differential costs, are the additional costs incurred if a company pursues a certain course of action. So incremental costs are those related to the added volume that this new order would bring.

· Opportunity Costs: The decision to use a particular resource in one way rather than another means that management has given up the opportunity to use it in the alternative way. An opportunity cost is the potential benefit that is given up (foregone) when the choice of one action precludes a different action. The lost opportunity is a cost that must be taken into account when making a decision. It should be emphasised that oopportunity costs are relevant costs and should not be overlooked. For example, a company has a $40,500 rent expense. The opportunity cost of $40,500 could have been spent on production machinery.

An opportunity cost is the potential benefit lost by taking a specific action when two or more alternative choices are available. An example is a student giving up wages from a job to attend summer school. Companies continually must choose from alternative courses of action. For instance, a company making standardized products might be approached by a customer to supply a special (nonstandard) product. A decision to accept or reject the special order must consider not only the profit to be made from the special order but also the profit given up by devoting time and resources to this order instead of pursuing an alternative project. The profit given up is an opportunity cost. Consideration of opportunity costs is important. The implications extend to internal resource allocation decisions. For instance, a computer manufacturer must decide between internally manufacturing a chip versus buying it externally. In another case, management of a multidivisional company must decide whether to continue operating or close a particular division.

· Sunk Costs: The term sunk cost is often used to define costs incurred in the past. The important point to be made about a sunk cost in the context of decision making is that it is irrelevant to a decision, since decisions are about future actions. Sunk Costs have already been incurred; they do not affect any future cost and cannot be changed by any current or future action. They are therefore irrelevant to decisions. An example of a sunk cost is the book value of an asset. This value is the acquisition cost of an asset minus accumulated depreciation to date. Whichever alternative is eventually chosen in the decision-making process, the book value of the old asset (e.g. piece of equipment) will be an expense or loss in the next year. The current book value of old equipment is a sunk cost and irrelevant to future actions. For example research and development expenses incurred for the production of a new product.

A sunk cost arises from a past decision and cannot be avoided or changed; it is irrelevant to future decisions. An example is the cost of computer equipment previously purchased by a company. Most of a company’s allocated costs, including fixed overhead items such as depreciation and administrative expenses, are sunk costs.

· Avoidable and Unavoidable Costs: In certain circumstances, a company may need to make a decision regarding the maintenance or elimination of a particular good or service. In making that decision management would need to consider the costs that will continue to be incurred even when the product or service is eliminated and those that will no longer be incurred.

Besides relevant costs, management must also consider the relevant benefits associated with a decision. Relevant benefits refer to the additional or incremental revenue generated by selecting a particular course of action over another. For instance, a student must decide the relevant benefits of taking one course over another. In sum, both relevant costs and relevant benefits are crucial to managerial decision making.

Relevant costs are useful in making decisions such as to accept additional business, make or buy, and sell as is or process further. For example, the relevant factors in deciding whether to produce and sell additional units of product are incremental costs and incremental revenues from the additional volume.

So a relevant cost is a cost that only relates to a specific management decision, and which will change in the future as a result of that decision. The relevant cost concept is extremely useful for eliminating extraneous information from a particular decision-making process

Ø Managers experience many different scenarios that require analyzing alternative actions and making a decision. Such as:

1- Make or buy decision

Companies apply make or buy decisions to their services. Many now outsource their payroll activities to a payroll service provider. It is argued that the prices paid for such services are close to what it costs them to do it, and without the headaches.

2- Scrap or Rework decision

Managers often must make a decision on whether to scrap or rework products in process. Remember that costs already incurred in manufacturing the units of a product that do not meet quality standards are sunk costs that have been incurred and cannot be changed. Sunk costs are irrelevant in any decision on whether to sell the substandard units as scrap or to rework them to meet quality standards.

3- Sell or process decision

The managerial decision to sell partially completed products as is or to process them further for sale depends significantly on relevant costs.

4- Sales Mix Selection

When a company sells a mix of products, some are likely to be more profitable than others. Management is often wise to concentrate sales efforts on more profitable products. If production facilities or other factors are limited, an increase in the production and sale of one product usually requires reducing the production and sale of others. In this case, management must identify the most profitable combination, or sales mix of products. To identify the best sales mix, management must know the contribution margin of each product, the facilities required to produce each product, any constraints on these facilities, and its markets.

5- Segment Elimination

When a segment such as a department or division is performing poorly, management must consider eliminating it. Segment information on either net income (loss) or its contribution to overhead is not sufficient for this decision. Instead, we must look at the segment’s avoidable expenses and unavoidable expenses. Avoidable expenses, also called escapable e xpenses, are amounts the company would not incur if it eliminated the segment. Unavoidable expenses, also called inescapable e xpenses, are amounts that would continue even if the segment is eliminated.

6- Qualitative Decision Factors

Managers must consider qualitative factors in making managerial decisions. Consider a decision on whether to buy a component from an outside supplier or continue to make it. Several qualitative decision factors must be considered. For example, the quality, delivery, and reputation of the proposed supplier are important. The effects from deciding not to make the component can include potential layoffs and impaired worker morale. Consider another situation in which a company is considering a one-time sale to a new customer at a special low price. Qualitative factors to consider in this situation include the effects of a low price on the company’s image and the threat that regular customers might demand a similar price. The company must also consider whether this customer is really a one-time customer. If not, can it continue to offer this low price in the long run? Clearly, management cannot rely solely on financial data to make such decisions.