OVERVIEW OF RELEVANT COSTS AND REVENUES FOR

COST AND MANAGEMENT

UNIT 2 SECTION
ACCOUNTING 1
Unit 2, section
DECISION1: Overview
MAKING of relevant cost and revenue for decision making

Managers often adopt a personalised approach for deciding among different

courses of action. Accountants aim to supply managers with relevant data to
guide their decisions. This information is usually structured and acts as an
input to decision making which will rely also on other information forms.

In this session we will look at relevant costs and relevant revenues as the
most important decision-making concepts in business.

By the end of this session, you should be able to:

 differentiate relevant cost from irrelevant costs
 differentiate relevant revenues from irrelevant revenues.
 apply relevant costing and decision-making concepts in a variety of
business situations.

Now read on...........

Relevant Costs and relevant revenues

The decision-making approach emphasizes the importance of identifying
and using relevant costs. Relevant costs are future costs that differ across
alternative. All decisions relate the future; accordingly, only future costs can
be relevant to decisions. However, to be relevant, a cost must not only be a
future cost but must also differ from one alternative to another. If a future
cost is the same for more than one alternative, then it has no effect on the
decision. Such a cost is irrelevant. Likewise, relevant revenues are those
expected future revenues that differ among alternative courses of action.

In other words, the relevant cash outflows and inflows are respectively
called the relevant costs and relevant revenues. The two key aspects to the
definition are that the costs must occur in the future and that they must
differ among the alternative courses of action.

The focus is on the future because every decision deals with the future –
nothing can be done to alter the past. Past cash flows are used as a basis of
discussion but irrelevant since the past cannot be changed. Also, the future
costs must differ among the alternatives because if they do not, there will be
no difference in costs no matter what decision is made. Future costs or
revenues that are identical to the alternatives evaluated are not relevant for
the decision process because they do not help to distinguish the best
alternatives from the rest. However, if irrelevant costs or revenues are
included in the analysis, they will not affect the final decision. This is
because only the difference between the cash flows of the various
alternatives matters; adding or subtracting the same number from all the
alternatives does not change the difference between alternatives.

For instance, assuming the cost of direct labour to produce additional 400
speakers is GHC11,000. This is a future because producing the speakers

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requires the services of direct labours, who must be paid. A question may
be asked whether it differs across two alternatives, in order to fit into the
definition of relevant cost. If the speakers are purchased from an external
supplier, then a second shift, with its direct labour, would not be needed.
Thus, the cost of direct labour differs across alternatives (GHC11,000 for
the make alternative and GHC0 for the buy alternative). It is therefore, a
relevant cost.

Opportunity cost is a type of relevant costs. It is the benefit sacrificed or

forgone when one alternative is chosen over another. While an opportunity
cost is never an accounting cost, because accountants do not record the cost
of what does not happen, it is an important consideration in decision
making. For example, if you are deciding whether to work full time or to go
to school full time, the opportunity cost of going to school would be the
wages you give up by not working.

Steps to identify relevant costs and relevant revenues.

Step 1 List all the alternatives to a decision.
Step 2 Estimate the future cash flows that each alternative generates.
Step 3 Test whether cash flows differ across alternatives. Cash flows that
are the same across alternatives are irrelevant. They do not matter but bring
noise to the decision process.
Step 4 From an economic perspective, the alternative with the highest cash
flow is preferred. Other criteria might be considered.

Common relevant cost applications

Relevant costing is of value in solving many different types of problems.
Traditionally, these applications include decisions to make or buy a
component, to keep or drop a segment or product line, and to accept a
special order at less than the usual price.

Make-or-Buy Decisions
Managers are often faced with the decision of whether to make a particular
product or service, or to buy it from an outside supplier. A manufacturer
may need to consider whether to make or buy components in
manufacturing. A manger of a service firm may need to decide whether to
provide a service in house or to outsource it. Many services traditionally
performed within the company, such as payroll processing or human
resources, are now being outsourced. Make-or-buy decisions are those
decisions involving a choice between internal and external production.

Example 1.1
Simpa Manufacturing Ltd needed to determine if it would be cheaper to
make 10,000 units of a component in house or purchase them from an
outside supplier for GHC4.75 each. Absorption costing on internal
production includes the following:

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Total Cost Unit Cost

GHC GHC
Direct materials 10,000 1.00
Direct labour 20,000 2.00
Variable overhead 8,000 0.80
Fixed overhead 44,000 4.40
Total 82,000 8.20

Fixed overhead will continue whether the component is produced internally

or externally. No additional costs of purchasing will be incurred beyond the
purchase price.

Required:
a) What are the alternatives for Simpa Manufacturing?
b) List the relevant cost(s) of internal production and of external purchase.
c) Which alternative is more cost effective, and by how much?
d) Now assume that the fixed overhead includes GHC10,000 of cost that
can be avoided if the component is purchased externally. Which
alternative is more cost effective, and by how much?

Solution 1.1
a) There are two alternatives: make the component in house or purchase it
externally.
b) Relevant costs of making the component in-house include direct
materials, direct labour, and variable overhead. Relevant cost of
purchasing the component externally include the purchase price.
c) .
Alternatives Differential
Make Buy cost to make
GHC GHC GHC

Direct materials 10,000 -- 10,000

Direct labour 20,000 -- 20,000
Variable overhead 8,000 -- 8,000
Purchase cost 47,500 (47,500)
Total relevant cost 38,000 47,500 9,500

It is cheaper to make the component in house. This alternative is better by

GHC9,500

d)
Alternatives Differential
Make Buy cost to make
GHC GHC GHC
Direct materials 10,000 -- 10,000
Direct labour 20,000 -- 20,000
Variable overhead 8,000 -- 8,000

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Avoidable fixed overhead 10,000 -- 10,000

Purchase cost -- 47,500 (47,500)
Total relevant cost 48,000 47,500 500

Now, it is cheaper to purchase the component. This alternative is better by

GHC500.

Special-Order Decisions
A company may consider offering a product or service at a price different
from the usual price from time to time. Special-order decisions focus on
whether a specially priced order should be accepted or rejected. These
orders often can be attractive, especially when the firm is operating below
its maximum productive capacity.

Example 1.2
Aboakyir Company has been approached by a new customer with an offer to
purchase 20,000 units of soap at a price of GHC9.00 each. The new
customer is geographically separated from the company’s other customers,
and existing sales would not be affected. Aboakyir normally produces
100,000 units of soap per year but only plans to produce and sell 75,000 in
the coming year. The normal sales price is GHC14.00 per unit. Unit cost
information is as follows:
GHC
Direct materials 3.00
Direct labour 2.80
Variable overhead 1.50
Fixed overhead 2.00
Total 9.30

Fixed overhead will not be affected whether or not the special order is
accepted.

You are required to:

a) determine the relevant costs and benefits of the two alternatives (accept
or reject the special order).
b) determine by how much will operating income increase or decrease if
the order is accepted? (on unit basis)

Solution 1.2
a) relevant costs and benefits of accepting the special order include the
sales price of GHC9.00, direct materials, direct labour, and variable
overhead. No relevant costs or benefits are attached to rejecting the
order.

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b) .
Accept Reject Differential
benefit to accept
GHC GHC GHC
Price 9.00 -- 9.00
Direct materials (3.00) -- (3.00)
Direct labour (2.80) -- (2.80)
Variable overhead (1.50) -- (1.50)
Increase in operating income 1.70 0 1.70

Operating income will increase by GHC34,000 (GHC1.70 X 20,000 units) if

the special order is accepted

Keep-or-Drop Decisions
Often, a manager needs to determine whether or not a segment, such as a
product line, should be kept or dropped. Segmented reports prepared on a
variable-costing basis provide valuable information for these keep-or-drop
decisions. Both the segment’s contribution margin and its segment margin
are useful in evaluating the performance of segments. However, while
segmented reports provide useful information for keep-or-drop decisions,
relevant costing describes how the information should be used to arrive at a
decision.

Example 1.3
The roofing tile line of Adanso company ltd has a contribution margin of
GHC10,000 (Sales of GHC150,000 less total variable costs of
GHC140,000). All variable costs are relevant. Relevant fixed costs
associated with this line include GHC10,000 in advertising and GHC35,000
in supervision.

You are required to:

a) list the alternatives being considered
b) list the relevant benefits and costs for each alternative.
c) determine which alternative is more cost effective, and by how much?

Solution 1.3
a) The two alternatives are to keep the roofing tile line or to drop it.
b) The relevant benefits and costs of keeping the roofing tile line include
sales of GHC150,000, variable costs of GHC140,000, advertising cost of
GHC10,000, and supervision cost of GHC35,000.
c) .
Keep Drop Differential
amount to keep
GHC GHC GHC
Sales 150,000 -- 150,000
Less: variable expenses 140,000 -- 140,000
Contribution margin 10,000 -- 10,000

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Less: advertising (10,000) -- (10,000)

Supervision cost (35,000) -- (35,000)
Total relevant benefit (cost) (35,000) 0 (35,000)

The difference is GHC35,000 in favour of dropping the roofing tile line.

Well done! You have come to the end of the first Section of Unit 2. In this
Section, you have learnt about the distinction between relevant costs and
irrelevant costs, and relevant revenues and irrelevant revenues.

You learnt that relevant costs and revenues are relevant for decision making
whilst irrelevant costs and revenues are of no use and hence not considered
for decision making purposes.

You were also taught how to apply relevant costing and decision-making
concepts in a variety of business situations.

Exercise
1. List the four steps in identifying relevant costs and revenues.

2. Windy bay Manufacturing Company Ltd had always made its

components in house. However, Chocho component works had recently
offered to supply one component, QZ at a price of GHC12 each. Windy bay
uses 4,100 units of component QZ each year. The absorption cost per unit of
this component is as follows:
GHC
Direct materials 7.42
Direct labour 2.38
Variable overhead 1.75
Fixed overhead 3.00
Total 14.55

The fixed overhead is an allocated expense; none of it would be eliminated

if production of component QZ stopped

Required:
a) What are the alternatives facing Windy bay with respect to production of
component QZ
b) List the relevant costs for each alternative.
c) If windy bay decides to purchase the component from Chocho, by how
much will operating income increase or decrease? Which alternative is
better?

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