Relevant Cost for Decision Making

Short Term Non-Routine Decisions

 Identify the relevant and irrelevant costs and their significance in choosing
between/among alternatives.
 Determine whether to make or buy.
 Prepare an analysis on adding or dropping products/segments.
 Prepare a sell now or process further analysis for joint products.
 Analyze when to accept or reject a special order.
 Determine the most profitable use of constrained resources.
 Prepare an analysis on whether to shut down or continue operations.

Relevant Costs
Definition:
 Are expected future costs which will differ between alternatives.
Criteria to be met to be considered as relevant costs:
 Cost must be an expected future cost
 Cost must differ between alternatives.

Irrelevant Costs
Definition:
 Costs which stay the same, regardless of which alternative is chosen, are irrelevant
to the decision being made.
Relevant Cost and Irrelevant Cost- Main Differences:

Criterion Relevant Cost Irrelevant Cost

Nature Variable. Fixed
Operational or Capital or one-off
Coverage
recurring expenditures expenditures
Time Horizon Usually short term Usually long term
Incurred mainly by Incurred mainly by
Level
lower management top management
Usually related to
Usually related to a
Scope organization wide
division or section
activities
Daily or routine
Focus Non-routine activities
activities
Avoidance May be avoided Usually unavoidable
Effect of a New Affected by a Incurred irrespective
Decision new decision. of a new decision.
Future cash flows are Irrelevant costs do not
Effect on Future
affected by relevant affect future cash
Cash Flows
costs. flows.
Incremental costs, Committed costs, sunk
Type avoidable costs, costs, overhead costs,
opportunity costs, etc. non-cash expenses.
Example:

An avoidable cost is a cost that is not incurred if the activity is not performed.
Examples include labor cost, packaging, or materials.
These costs are often identified as variable costs, which vary based on production. ...
An unavoidable cost is a cost that is still incurred even if the activity is not performed.

For example, if you choose to close a production line, then the cost of the building in which it is
housed is now an avoidable cost, because you can sell the building.

Opportunity cost is the value of something when a particular course of action is chosen. Simply put,
the opportunity cost is what you must forgo in order to get something. The benefit or value that was
given up can refer to decisions in your personal life, in a company, in the economy, in the
environment, or on a governmental level.

Examples of Opportunity Cost

 Someone gives up going to see a movie to study for a test in order to get a good grade. The
opportunity cost is the cost of the movie and the enjoyment of seeing it.
 At the ice cream parlor, you have to choose between rocky road and strawberry. When you
choose rocky road, the opportunity cost is the enjoyment of the strawberry.
 A player attends baseball training to be a better player instead of taking a vacation. The
opportunity cost was the vacation.
 Jill decides to take the bus to work instead of driving. It takes her 60 minutes to get there on the
bus and driving would have been 40, so her opportunity cost is 20 minutes.
 This semester you can only have one elective and you want both basket-weaving and choir. You
choose basket weaving and the opportunity cost is the enjoyment and value you would have
received from choir.
 The opportunity cost of taking a vacation instead of spending the money on a new car is not
getting a new car.
 When the government spends $15 billion on interest for the national debt, the opportunity cost is
the programs the money might have been spent on, like education or healthcare.

Concept
Relevant costing attempts to determine the objective cost of a business decision. An objective measure of
the cost of a business decision is the extent of cash outflows that shall result from its implementation.
Relevant costing focuses on just that and ignores other costs which do not affect the future cash flows.

The underlying principles of relevant costing are fairly simple and you can probably relate them to your
personal experiences involving financial decisions.

For example, assume you had been talked into buying a discount card of ABC Pizza for $50 which entitles
you to a 10% discount on all future purchases. Say a pizza costs $10 ($9 after discount) at ABC Pizza and
it subsequently came to your knowledge that a similar pizza is offered by XYZ Pizza for just $8. So the next
time you would have ordered a pizza, you would have (hopefully) placed an order at XYZ Pizza realizing
that the $50 you have already spent is irrelevant (see sunk cost below).

Relevant costing is just a refined application of such basic principles to business decisions. The key to
relevant costing is the ability to filter what is and isn't relevant to a business decision.

Types of Relevant Costs Types of Non-Relevant Costs

Future Cash Flows Sunk Cost

Cash expense that will be incurred in the future Sunk cost is expenditure which has already been
as a result of a decision is a relevant cost. incurred in the past. Sunk cost is irrelevant
because it does not affect the future cash flows of
a business.

Avoidable Costs Committed Costs

Only those costs are relevant to a decision that Future costs that cannot be avoided are not
can be avoided if the decision is not relevant because they will be incurred irrespective
implemented. of the business decision bieng considered.

Opportunity Costs Non-Cash Expenses

Cash inflow that will be sacrificed as a result of a Non-cash expenses such as depreciation are not
particular management decision is a relevant relevant because they do not affect the cash flows
cost. of a business.

Incremental Cost General Overheads

Where different alternatives are being General and administrative overheads which are
considered, relevant cost is the incremental or not affected by the decisions under consideration
differential cost between the various alternatives should be ignored.
being considered.

Example
Rubber Tire Company (RTC) received a request to provide a price quote for an order for the supply of 1000
custom made tires required for industrial vehicles. RTC is facing stiff competition from its business rivals
and is therefore hoping to secure the order by quoting the lowest price. RTC plans to quote a price at 10%
above its relevant cost.

Following is the calculation of total cost in respect of the order:

 Relevant Cost

Rubber $10,000 The order requires a special type of rubber.

Only 25% rubber is currently available in stock. The rubber was

purchased 2 years ago at the cost of $3,000. If the rubber is not used
on this order, it will have to scraped at a price of $1,000.

Remaining quantity shall have to be procured at the price of $7,000.

Oil $1,000 All the required quantity of oil is currently available in stock. The cost of
oil that will be used on the order is $1,000.

The current market value of the required quantity of oil is $1,200. If oil
is not used on the order, it could be used in the production of other
tires.

Other Materials $2,000 All other materials will have to be procured.

Direct Labor $5,000 $5,000 represents the cost that would be paid to direct labor in respect
of the time that they work on the order.

If direct labor is not utilized on this order, they remain idle for the entire
time. Direct labor is paid idle time equal to 60% of the normal pay in
order to retain them.

Supervisor's $1,000 This represents the share of factory supervisor's salary for the number
Salary of days in which production for the order will take place.

Depreciation of $3,000 This represents the manufacturing equipment's depreciation for the
equipment number of days in which production for the order will take place.

Lease rental of $12,000 This represents the share of lease rentals of the factory plant for the
factory plant number of days in which production for the order will take place.

Electricity $8,000 The order would require 3000 units of electricity which is expected to
cost $8,000.

Overheads $6,000 This represents the apportionment of general and administrative

Allocation overheads based on the number of machine hours that will be required
on the order.

Total $48,000

Calculate the relevant cost for the order and the price RTC should quote.

Manufacturing Cost
Rubber $8,000 25% - Scrap Value $1,000
75% - Purchase Cost $7,000
Relevant Cost $8,000
The $3,000 paid two years ago is a sunk cost and should therefore be
ignored. $1,000 represents the opportunity cost of using the rubber
available in stock on this particular order.

Oil $1,200 The $1,000 cost of oil is a sunk cost.

The $1,200 current market value of the required oil is the relevant cost
because utilizing it on this order will require purchase of additional oil at
the market rates to meet the production needs of other tires.
Alternatively, the oil could be sold for $1200.

Other Materials $2,000 As these materials are not available in stock, these will have to be
purchased at the market price which is their relevant cost.
 Direct Labor $2,000 Since $3,000 (60% of $5,000) idle time pay will be incurred even if this
order is not taken, the relevant cost is the incremental cost of $2,000
($5,000 - $3,000).

Supervisor's - As supervisor's salary is a fixed cost unchanged by the work performed

Salary on this order, it is a non-relevant cost.

Depreciation of - Non-cash expenses are not relevant for decision making.

equipment

Lease rental of - Lease rentals are a committed cost which cannot be avoided by
factory plant withdrawing from this order which is why they should be ignored for the
purpose of this analysis.

Electricity $8,000 Electricity charges are incremental to this order and therefore relevant.

Overheads - General and administrative overheads that are not incurred directly as a
Allocation result of this order should be considered irrelevant.

Relevant Cost $21,200

of order

Profit Margin $2,120 10% of the relevant cost of $21,200

Price to be $23,320
quoted

Application & Limitations

While relevant costing is a useful tool in short-term financial decisions, it would probably not be wise to form
it as the basis of all pricing decisions because in order for a business to be sustainable in the long-term, it
should charge a price that provides a sufficient profit margin above its total cost and not just the relevant
cost.

Examples of application of relevant costing include:

 Competitive pricing decisions
 Make or buy decisions
 Further processing decisions

For long term financial decisions such as investment appraisal, disinvestment and shutdown decisions,
relevant costing is not appropriate because most costs which may seem non-relevant in the short term
become avoidable and incremental when considered in the long term. However, even long term financial
decisions such as investment appraisal may use the underlying principles of relevant costing to facilitate
an objective evaluation.

What is an incremental cost?

Definition of Incremental Cost

An incremental cost is the difference in total costs as the result of a change in some activity.
Incremental costs are also referred to as the differential costs and they may be the relevant
costs for certain short run decisions involving two alternatives.
Note: Incremental costs may include more than the change in variable costs.

Example of Incremental Cost

Let's assume that a company has the following experience:

 Total cost of manufacturing 8,000 units of Product X is $320,000, or $40 per unit
 Total cost of manufacturing 10,000 units of Product X is $360,000, or $36 per unit
From the above information, we see that the incremental cost of manufacturing the additional
2,000 units (10,000 vs. 8,000) is $40,000 ($360,000 vs. $320,000). Therefore, for these 2,000
additional units, the incremental manufacturing cost per unit of product will be an average of
$20 ($40,000 divided by 2,000 units). The reason for the relatively small incremental cost per
unit is due to the cost behavior of certain costs. For example, when the 2,000 additional units are
manufactured most fixed costs will not change in total although a few fixed costs could increase.

1. Strategic decisions:
Strategic decisions are major choices of actions and influence whole or
a major part of business enterprise. They contribute directly to the
achievement of common goals of the enterprise. They have long-term
implications on the business enterprise.

They may involve major departures from practices and procedures

being followed earlier. Generally, strategic decision is unstructured
and thus, a manager has to apply his business judgement, evaluation
and intuition into the definition of the problem. These decisions are
based on partial knowledge of the environmental factors which are
uncertain and dynamic. Such decisions are taken at the higher level of
management.

2. Tactical decisions:
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These decisions relate to the implementation of strategic decisions.

They are directed towards developing divisional plans, structuring
workflows, establishing distribution channels, acquisition of resources
such as men, materials and money. These decisions are taken at the
middle level of management.

3. Operational decisions:
These decisions relate to day-to-day operations of the enterprise. They
have a short-term horizon as they are taken repetitively. These
decisions are based on facts regarding the events and do not require
much of business judgement. Operational decisions are taken at lower
levels of management. As the information is needed for helping the
manager to take rational, well informed decisions, information
systems need to focus on the process of managerial decision making.