ccounting Articles for Students
Relevant costs for decision-making by Bev Jay | Published on 10/24/2004
Commercial organisations usually make decisions with the objective of maximising the present value of f What is a relevant cost or benefit? A relevant cost or benefit is one that will be affected by the decision. This means that the following can b Fixed overheads. These will be incurred regardless of the decision. Notional costs. For example, notional rent - these costs are only a book exercise and do not represent Past or sunk costs. These have already happened, so they cannot be affected by a future decision. It i Book values. Similar to sunk costs. For example, the price paid for stock in the past is not a relevant co Many of the above are included in examination questions and should be rejected by candidates. It is imp Opportunity costs A company often has a choice of options. For example, does it choose to use a scarce resource for Cont In examination questions, the more d ifficult aspects of a question include opportunity costs. It is importan The examination approach Using the data in the illustration below, we can now apply the above principles in the manner expected b Always read the question carefully and make sure that you are comfortable with the requirement. In this il Illustration The managing director of Parser Limited, a small business, is considering undertaking a one-off contract.
Costs for special order
Notes
£
Direct wages
1
28,500
Supervisor costs
2
11,500
General overheads
3
4,000
Machine depreciation
4
2,300
Machine overheads
5
18,000
Materials
6
34,000 98,300
Notes 1. Direct wages comprise the wages of two employees, particularly skilled in the labour process for this Sub-contracting costs would be £32,000 for the period of the work. Other sub-contractors who are skill 2. A supervisor would have to work on the special order. The cost of £11,500 is made up of £8,000 nor 3. General overheads comprise an apportionment of £3,000 plus an estimate of £1,000 incremental ov 4. Machine depreciation represents the normal period cost, based on the duration of the contract. It is 5. Machine overheads (for running costs such as electricity) are charged at £3 per hour. It is estimated 6. Materials represent the purchase costs of 7,500kg bought some time ago. The materials are no long Because the business does not have adequate funds to finance the special order, a bank overdraft of £2 The managing director has heard that for special orders such as this, relevant costing should be used th Required Produce a revised costing schedule for the special project based on relevant costing principles. Fully exp 1. Direct wages Summary: There are two options. We can take the workers from their usual department, where it woul Both of these costs are future costs that will be affected by the decision and are therefore relevant. Th
2. Supervisor costs Summary: The supervisor's normal salary is £8,000 and this will be paid whether or not we take on the
3. General overheads Summary: Regardless of the decision, general fixed overheads remain constant. The apportioned rent,
4. Machine depreciation Summary: The machine depreciation has been charged at £2,300 which is what the accountant would
5. Machine overheads Summary: Taking the special contact will mean that the machine will run for 6,000 hours and as each h
6. Materials Summary: The 7,500kg of materials is already in stock. We do not know how much it cost and if we did There is an opportunity cost, as we have two courses of action to choose from. We can either use the
7. Overdraft interest Summary: If the company chooses to undertake the special project it will incur finance charges for the Revised cost schedule for the special contract
Costs for special order
Notes
£
Direct wages
1
31,300
Supervisor costs
2
1,000
General overheads
3
1,000
Machine depreciation
4
500
Machine overheads Materials
5 6
22,000 31,500
Interest charges
7
900 88,200
Bev Jay is an ACCA examiner.
ture cash flows. In order to ensure that the right opportunities are taken to do this, we need to be able
disregarded as they are irrelevant in the decision-making process:
a real cash flow. vital to note that relevant costs are always future costs. st to the decision. rtant to state that they are not relevant for decision-making rather than to simply omit them. Marks are
ract A instead of Contract B? If it does choose Contract A then Contract B will be deprived of the resou t that candidates take their time and employ a logical approach in order to gain maximum marks.
the examiner. It is vital that du ring the examination your work is clear, cross-referenced, and logical. llustration you are required to show all the relevant costs in a cost schedule and more importantly you
She has asked her inexperienced accountant to advise on what costs are likely to be incurred so that
job. They could be transferred from another department to undertake the work on the special order. T d in the special order techniques are also available to work on the special order. The costs associated mal payments plus a £3,500 additional bonus for working on the special order. Normal payments refer erheads. nticipated that £500 will be incurred in additional machine maintenance costs. that 6,000 hours will be needed for the special order. The machine has 4,000 hours available capacity. er used and are unlikely to be wanted in the future except for the special order. The complete stock of ,000 would be required for the project duration of three months. The overdraft would be repaid at the t also incorporates opportunity costs. She has approached you to create a revised costing schedule b
lain and justify each of the costs included in the costing schedule.
cost £32,000 to replace them. Or we could hire sub-contractors to do the special order at a cost of £3 choice between the two alternatives is relatively straightforward - either incur a £32,000 cost or a £31,
special contract. This is a fixed cost to the business and is unaffected by the decision. However, the £
rates, power etc, will be incurred whether the special contract is undertaken or n ot. Therefore, these a
normally charge for depreciation for this period of time. The accountant will charge this time-based de p
our incurs a running cost of £3, the relevant future cost will be £18,000. In addition, there is an opportu
it would not be useful as this is a sunk cost and therefore irrelevant. Neither is the replacement cost of aterial for the special contract or we can sell it and receive £4.20 per kg. The relevant cost is 7,500 x
hree month duration. This is a future cost due to the decision being made and therefore should be incl
to measure the relevant costs for decision-making. In examination questions (unlike real life) we can a
often available for this information.
rce that could have generated a contribution for the company. This is an example of an opportunity cos
arkers seek out marks to the best of their ability. However, this is difficult if markers are presented with re also required to explain why the costs are relevant. It is logical to deal with each of the costs separa
he can price at a profit. The following schedule has been prepared:
ey are fully occupied in their usual department and sub-contracting staff would have to be brought in t with this would amount to £31,300. to the fixed salary of the supervisor. In addition, the supervisor would lose incentive payments in his no
. The further 2,000 hours required will mean an existing job is taken off the machine resulting in a lost c materials (amounting to 10,000kg), or part thereof, could be sold for £4.20 per kg. The replacement co nd of the period. The company uses a cost of capital of 20% to appraise projects. The bank's overdraf sed on relevant costing principles.
1,300. 300 cost. As an accountant you will want to minimise costs and will choose to hire the sub -contractors
,500 additional bonus is relevant as it is dependent on the decision to take the special contract. In add
re not relevant costs and can be ignored for decision-making purposes. However, incremental overhea
reciation if we use the machine for the special contract and also if we do not. It is only a book value an
nity cost. If we choose to take the contract we will have to choose not to work on an existing job as ma
£33,375 relevant as it is not a future cost that will be incurred as a result of the decision (if we already 4.20 = £31,500 as this represents the benefit sacrificed by choosing to take the contract rather than s
ded as a relevant cost. £20,000 x 18% x 3/12 = £900.
sume that future costs and benefits are known with certainty and therefore we only have to apply the p
t, a relevant cost for decision-making. By definition, an opportunity cost is one which measures the cos
illegible scribbles and calculations which are not referenced. tely, using the headings given in the illustration. For each cost e lement, summarise in your own words
undertake the work left behind.
rmal work amounting to £2,500. It is not anticipated that any replacement costs relating to the supervis
ontribution of £2 per hour (before overheads are charged) t of material used would be £33,375. rate is 18%.
at £31,300.
ition, if we take the special contract we will not have to pay the £2,500 incentive payment. Therefore, th
ds are extra overheads, incurred as a direct result of undertaking the special project. These could inclu
does not represent a true cash flow to the business. Therefore it is not a relevant cost. However, if w
chine hours are a scarce resource and we only have enough hours free to do one job. Therefore, a rel
have it we will not need to buy it). However, this would be relevant if the material was in constant use b lling the materials.
rinciples correctly.
t of sacrificing one course of action in favour of another.
hat the note is telling you before you pronounce a cost as relevant or otherwise.
ors' work on other jobs would arise.
e net relevant cost to the business is £3,500 less £2,500 = £1,000.
de additional costs for power or premises. They are relevant costs to the project of £1,000.
do take the special contract and use the machine, we will incur maintenance costs of £500. These fut
vant cost to the special contract will be the benefit forgone from choosing the special contract over the
y the company.
re costs are a direct result of the decision and should be included within the costs.
existing job. This cost if the lost contribution of £2 per hour for 2,000 hours. We will lose £4,000 contrib
ution is we take the special contract. The total relevant cost therefore is £18,000 plus £4,000 = £22,00
