22nd November 2022

Relevant Costing and CVP

Lecture Week 9
Gary (Guanlin) Wang
Strategy, Finance & Accounting for
Management (SFAM)

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Learning objectives
Week 8 costing products & services:
• Total Absorption Costing
• Activity Based Costing
• Labour and Time
• Pricing Strategies

Week 9 short-term decision-making & pricing:

• Relevant Costing
• Cost Volume Profit Analysis

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Relevant Costing
• Make future decisions (special order, product mix, make or buy, replacement of equipment)

• A cost that has been incurred in the past is totally irrelevant for decision making

• Only consider those cash flows which will alter if the project is accepted. This includes cash
flows which would occur if the project does not go ahead (Opportunity Cost)

• Accept a project if it yields a higher net cash inflow than the best alternative course of action.

A relevant cost is defined as a future, incremental, cash flow.

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 Irrelevant Cost to Ignore
• Sunk costs which are costs that have already been incurred

• Committed costs which are costs that you will have to pay whether
you do the project or not

• Non incremental cash flows such as apportioned indirect overheads

• Non-cash flows such as depreciation

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Example: Parser Limited
The managing director of Parser Limited, a small business, is considering
undertaking a one-off contract. She has asked her inexperienced accountant to
advise on what costs are likely to be incurred so that she can price at a profit. The
following schedule has been prepared:
£
Direct wages 28,500
Supervisor costs 11,500
General overheads 4,000
Machine overheads 18,000
Total Costs 98,300

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 A special order
What is the Relevant Cost?
Are the current two skilled labour free?
Direct wages of £28,500 comprise the
wages of two employees, particularly skilled
in the labour process for this job. They could No
Yes
be transferred from another department to
undertake the work on the special order.
They are fully occupied in their usual £28,500 What to do?
department and sub-contracting staff would Irrelevant
have to be brought in to undertake the work Committed
left behind. Sub-contracting costs would be Use these Find two
Cost
£32,000 for the period of the work. Other two skilled special sub-
sub-contractors who are skilled in the workers and constructors
special-order techniques are also available find general
to work on the special order. The costs for this
sub- special
associated with this would amount to constructors
£31,300. project
for what they £31,300
are doing
However, how about the quality and customer
now
satisfaction?
£32,000 Relevant
Cost
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What is the Relevant Cost?
A supervisor would have to work on the special order. The cost of £11,500 is
made up of £8,000 normal payments plus a £3,500 additional bonus for working
on the special order. Normal payments refer to the fixed salary of the supervisor.
In addition, the supervisor would lose incentive payments in his normal work
amounting to £2,500. It is not anticipated that any replacement costs relating to
the supervisors' work on other jobs would arise.

Go to www.menti.com and use the code

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What is the Relevant Cost?
A supervisor would have to work on the special order. The cost of £11,500 is
made up of £8,000 normal payments plus a £3,500 additional bonus for working
on the special order. Normal payments refer to the fixed salary of the supervisor.
In addition, the supervisor would lose incentive payments in his normal work
amounting to £2,500. It is not anticipated that any replacement costs relating to
the supervisors' work on other jobs would arise.

• Salary of £8,000 is a committed cost

• For the Bonus:
• Bonus for special project is £3,500
• Bonus for existing work £2,500
• Incremental cash flow £1,000

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Are these Relevant Costs?

General overheads of £4,000 comprise an apportionment of £3,000 plus an

estimate of £1,000 incremental overheads.
The word ‘apportionment’ matters here. Also look out for allocation, absorption
and other costing technique language. It is not cash.
Incremental £1,000 is relevant

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What is the Relevant Cost?
Machine overheads of £18,000 (for running costs such as electricity) are
charged at £3 per hour. It is estimated that 6,000 hours will be needed for the
special order. The machine has 4,000 hours available capacity. The further
2,000 hours required will mean an existing job is taken off the machine resulting
in lost contributions to profits of £2 per hour.

6,000 Hours x £3 per hour = £18,000 These are variable costs (incremental)

4,000 hours spare capacity 2,000 hours busy on other work

Opportunity Cost: lost contribution to profits. 2,000 x £2 = £4,000

Therefore, the total relevant cost for machine overheads is £22,000

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To Sum up
The relevant costing schedule would compare to the original as follows:

Original Relevant Costing

Direct wages 28,500 31,300
Supervisor costs 11,500 1,000
General overheads 4,000 1,000
Machine overheads 18,000 22,000
Total Costs 98,300 88,200

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Relevant Costing Critique
Benefits
Enables visibility of the net
cash impact of decisions
Considers exactly what will
change within the company as
a result of the decision
Considers indirect
consequences of a decision
e.g. opportunity costs
Issues
Not easy for managers to
calculate
Not easy to collect all the costs
information
Cannot always see the indirect
consequences of a decision
Cost Volume Profit Analysis

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Recap: Fixed and Variable Costs

Total Cost =
Total Fixed Cost +
Total Variable Cost

Source: Atrill and McLaney (2019), 11th Edition, p. 257

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The Break-even point
Analysing the relationship between activity, costs and profit

Profit =
Total Revenue -
Total Cost

Break-even point is
the point that the
company neither
made profits or losses

Source: Atrill and McLaney (2019), 11th Edition, p. 258

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Margin of Safety
Margin of safety indicate
how much sales may
decrease before a loss
occurs

How far above or below

the break even point the
company is operating

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 Calculating the break-even point
Contribution Per Unit = Sales Price per unit – Variable Cost per unit

Break-even Point = Fixed Costs

(in units) Contribution Per unit
Assumptions:
• All costs can be defined as fixed or variable
• Fixed costs are constant
• Variable cost per unit is constant
• Selling price per unit does not change
• Level of activity is the only thing which affects costs
• Sales mix is constant

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Example break-even calculation
• Sales price £5 per unit
• Variable costs £3.50 per unit
• Fixed costs £30,000
Contribution = £5 - £3.50 = £1.50
Break Even = Fixed Costs £30,000 / £1.50 = 20,000 units

Sales £5 x 20,000 units £100,000

Variable costs £3.50 x 20,000 units (£70,000)
Fixed Costs (£30,000)
Profit £ 0

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Margin of Safety example
• Expected sales £200,000
• Expected sales volume 20,000 units
• Total costs £185,000
• Fixed costs included in above £45,000

£185,000 – £45,000 = £140,000 Variable Costs

Variable cost per unit = £140,000 / 20,000 sales = £7
Sales Price per unit = £200,000 sales / 20,000 units = £10
Break Even = 45,000 / (10 – 7) = 15,000 units
Margin of Safety = 20,000 units – 15,000 units = 5,000 units
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What if?
Net Profit = Total revenue – total cost
= Sales price per unit x units sold - (fixed costs +
variable costs per unit x units sold)

NP = px – (a + bx)
NP = Net profit
p = Sales price
x = volume / units sold
a = total fixed costs
b = variable costs / unit
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If a single product is made and sold…
• Direct material cost £6 per unit
• Direct labour cost £7 per unit
• Variable production overhead cost £10 per unit
• Sales price £28
• Fixed costs £58,000 per annum

REQUIRED: Determine the sales volume required if the company

wishes to make a profit of £25,000 per annum.

Go to www.menti.com and use the code

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If a single product is made and sold…
NP = Px – (a + bx)
25,000 = 28x – (58,000 + 23x)
25,000 = 28x – 58,000 – 23x
25,000 + 58,000 = 28x – 23x
83,000 = 5x
x (i.e. the number of units to make £25,000 profit) = 16,600 units

Sales £28 x 16,600 units 464,800

Variable cost £23 x 16,600 units (381,800)
Contribution 83,000
Fixed Costs (58,000)
Profit 25,000
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Determining a Price per unit
White Rabbit Limited wishes to sell 20,000 units of its product and wishes to
make a profit of £35,000. Costs are as follows:
• Direct material cost £15 per unit
• Direct labour cost £10 per unit
• Variable production overhead cost £20 per unit
• Fixed costs £85,000

NP = Px – (a + bx)
35,000 = P x 20,000 – (85,000 + 45 x 20,000)
35,000 + 85,000 + 900,000 = 20,000 P
Price = £51 per unit

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CVP Critique
Benefits Issues
Easy to calculate and Only fit for a single product or
understand constant sales mix
Help Company to set the price Hard to split costs into fixed and
of products to achieve target variable elements
profit Does not consider human
Consider margin of safety for behaviour and other alternatives
company to adjust of business strategy
Next Steps this week…

Complete the activities in the menu labelled Week 9:

• Attend your seminar to discuss your ABC and TAC analysis.
• Practice deciding which costs are relevant and cost volume profit analysis
using the exercises on BB
• Prepare for week 10 case study seminar on Shop Thursdays

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 Looking Ahead to week 10…

• Lecture: Investment Appraisal, Tuesday, F2F

• Seminar: Shop Thursdays Group Presentation on relevant costing and CVP

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