MGMTACT – Prelims Relevant Costing

Relevant Costs for Decision Making

Management Accounting (2017 edition) E.B. Cabrera

Managers should continually make decisions. In settling on these choices, they must gauge how
every choice could influence operating income. The management accountant’s part in this
procedure is to supply data on changes in expenses and incomes to encourage the decision
making process.

Relevant information is the expected future data that differ among alternative courses of
action. In decision making, income and expenses are regularly the key elements. These incomes
and expenses of one option must be looked at against incomes and expenses of different choices
as one stage in the decision making process.

A relevant cost can be defined as a cost that is applicable to a particular decision in the
sense that it will have a bearing on which alternative the manager selects.

The Decision Making Process

Decision making is the process of studying and evaluating two or more available alternatives
leading to a final choice.

An organized and systematic approach may be helpful to managers in making decisions. The
steps are outlined as follows:

1. Define strategies: business goals and tactics to achieve them

2. Identify the alternative choices or courses of action
3. Collect and analyze the relevant data on the choices
4. Choose the best alternative to achieve goals

Identifying Relevant Costs

Any cost that is avoidable is relevant for decision purposes. All costs are considered avoidable
except:
1. Sunk costs
2. Future costs that do not differ between the alternatives at hand

Relevant costs are future expected costs which differ between the decision alternatives.

Decision making process involves the following analytical steps:

1. Determine all costs associated with each alternative being considered
2. Drop those costs that are sunk or historical
3. Drop those costs that do not differ between alternatives
4. Make a decision based on the remaining costs
MGMTACT – Prelims Relevant Costing

Sunk or historical costs are never relevant in decisions because they are not avoidable and
therefore they must be eliminated from the manager’s decision framework.

Opportunity costs are the profits lost by the diversion of an input factor from one use to
another. They are the net economic benefit given up when an alternative is rejected.

Out-of-pocket costs involve either an intermediate or near-future cash outlay; they are usually
relevant to decisions.

Short Run vs. Long Run: Other Factors to Consider

In making the final decision, however, long-run factors should be such as:

1. What will be the impact on customers?

2. Should regular customers find out about the special price? Will they complain at paying
more?
3. How will competitors react?

Types of Decisions

1. Make or Buy
2. Add or Drop a Product or Other Segments
3. Sell Now or Process Further
4. Special Sales Pricing
5. Utilization of Scarce Resources
6. Shut-down or Continue Operations
7. Pricing

Make or Buy Decision

The make-or-buy decision is a management decision about whether an item should be

made internally or bought from an outside supplier.

Adding or Dropping Products/Segments

When management is considering dropping a product line or customer group, the only
relevant costs are those that a company would avoid by dropping the product or customer.

Sell Now or Process Further

Joint product costs is used to describe those manufacturing costs that are incurring is
producing the joint products up to the split-off point. The split-off point is that point in the
manufacturing process at which the joint product can be recognized as separate products.

Special Sales Pricing

MGMTACT – Prelims Relevant Costing

A special order is a one-time order that is not considered part of the company’s ongoing
business.

Utilization of Scarce Resources

When capacity becomes pressed because of a scarce resource, the firm is said to have a
constraint. Because of the constrained scarce resource, the company cannot fully satisfy demand,
so the manager must decide how the scarce resource should be used.

Contribution in Relation to Scarce Resources

A firm should not necessarily promote those products that have the highest contribution
margins per unit. With a single constrained resource, the important measure of profitability is the
contribution margin per unit of scarce resource used.

Shut down or Continue Operations

Shut down point = Fixed costs if operations are continued – Shut Down Costs
Contribution Margin per unit
Pricing Products and Services

In many situations, the firm is faced with the problem of selling its own prices. The
pricing decision can be critical because
1. The prices charged for a firm’s products largely determine the quantities customers are
willing to purchase and
2. The prices should be high enough to cover all the costs of the firm

Cost-Plus Pricing

Target Selling Price = [ Cost + (Mark-up Percentage x Cost) ]

Products may be cost in at least two different ways:

1. By the absorption approach where the cost base is defined as the cost to manufacture one
unit and therefore excludes all selling general and administrative expenses
2. By the contribution approach where cost base consists of all the variable costs associated
with a product including variable selling, general and administrative expenses (SGA).

Determining the Markup Percentage

Under the absorption approach to cost-plus pricing:

Markup percentage = Desired return on assets employed – SGA Expenses

Volume in units x Unit Manufacturing Costs

Under the contribution approach to cost-plus pricing:

MGMTACT – Prelims Relevant Costing

Markup percentage = Desired return on assets employed – Fixed Costs

Volume in units x Unit Variable Costs
Target Costing

Target Costing is the process of determining the maximum allowable cost for a new
product and then developing a sample than can be profitably manufactured and distributed for
that maximum target cost figure.

Target cost = Anticipated Selling Price – Desired Profit