BACT 302 MANAGEMENT ACCOUNTING

TOPIC:
RELEVANT COSTS
 Relevant Costs

RELEVANT COSTS
• As a management accountant you are to provide information to
management for decision making. If yougive them irrelevant
information,you will wasting their time and affect their ability to make
effective decisions. So one of the skills you must master is how to
identify relevant costs.
• Relevant costs are costs appropriate for a specific management decision.
• Relevant costs that are directly incurred or saved by decisions being
made.
• As a rule relevant costs should be :
– Future costs
– Incremental
– Cash-based

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 Relevant Costs

Future costs
For costs to be relevant for current decision-making , they should be
costs yet to be incurred. Costs already incurred in the past (Sunk
Costs) are irrelevant for current decion-making.Likewise costs we are
already committed to incur (committed costs) are irrelevant.
Incremental
For costs to be relevant for current decision-making, costs should
result in additional spending.
Cash-based
For costs to be relevant for current decision-making they must result
in cash flow,otherwise they are not relevant. Non-monetary costs eg,
depreciation are not relevant.

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 Relevant Costs

Opportunity costs(the value of the next best alternative

forgone) are however an exception to the rule. They are not
future costs, incremental or cash-based, but are still
considered relevant for current decion making.

Eg. If you transfer key workers to work on a new project, it

means you can’t use them on current projects and therefore
you loose their contribution to the current project.This lost
contribution is the opportunity cost of removing the workers
from the current project and is considered a relevant cost in
decision-making on the new project.

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 Relevant Costs

NON-RELEVANT COSTS
• Non-relevant costs are costs that will not change because of a
decision being made. These include:
Sunk Costs
Committed Costs
Book values /historical Costs
Non-monetary Costs
Notional Costs

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 Relevant Costs

Sunk Costs
• These are costs that have already being paid and hence will not
change as a result of decisions being made. Accordingly, they are
not relevant when evaluating the costs of a decision.
Committed Costs
• Committed costs are costs that must be paid regardless of any
decision we take. They usually arise from legally binding
contracts. They are irrevant for decision making because they will
not change as aresult of the decision we are taking. Eg. costs of
rental/lease agreements- these are on-going costs that must be
honored within the contracted period.

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 Relevant Costs

Book values /historical Cost

• They are not relevant for decision-making because they are out of date
and have no effect on decisions being taken now.
Non-monetary Costs
• These include accounting valuations and estimates such as depreciation
and amortisation. They are irrelevant for decision making because they
don’t result in cash flows.
Notional Costs
• Notional costs are costs that you make up in order to evaluate a project.
This is because the resources involved have no actual observable cost.
Eg. Notional rent, notional interest rate for departments within an
organisation when they are treated as profit centers.

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 Identifying Relevant Costs

Material Costs
• Generally the relevant cost of raw materials is their current replacement
cost. Unless they wont be replaced, in which case,the relevant cost is
the higher of current resale value and the value obtainable if put to
alternative use.
• Where material has no resale value or no other use is possible, its
relevant cost is ‘nil’ ie. It is irrelevant.
• So if in a question you are told an organisation used material it had in
inventory for a contract,but the material has no resale value or other
use, the relevant material cost for this contract is ‘0’. i.e irrelevant.
• If the material is not in inventory and you have to buy it for a job, the
cost of the material is a relevant cost. And the amount to consider is the
current replacement cost.

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 Identifying Relevant Costs

• If the material is in inventory and in continual use and so you

have to replace it when you use it, the relevant cost is the
current replacement cost.
• If the material is in inventory but has no other use and
therefore if you use it you won’t replace it, the relevant cost is
the current resale value.
• But if the material is scarce and can’t be replaced, its relevant
cost is the opportunity cost- what you loose by deciding to use
it for the current job.

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 Identifying Relevant Costs
• Eg. DNL has been approached by a client to do a special job for
him. The client is willing to pay GHS 22,000.The job will require
the materials as specified below. Material B is used regularly
and have to be replaced if used.Materials C&D are instock . C
has no other use, D can be used in another job as substitute for
300 units of E which costs GHS 5/unit. Company has no E in
stock.What is the relevant cost of material?
In stock Book value Realisable value Replacement cost
GHS GHS GHS
A 1,000 0 - - 6.00
B 1,000 600 2.00 2.50 5.00
C 1,000 700 3.00 2.50 4.00
D 200 200 4.00 6.00 9.00

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COMMENT MATERIAL RELEVANT COST
We need 1,000 . We have to buy it because we have none in stock. A 1000 X 6 GHS = 6,000 GHS
So we multiply replacement cost by quantity needed.

Identifying Relevant Costs

We need 1,000. We use the 600 in stock and buy 400 . We have to B 1,000 x 5GHS = 5,000GHS
replace the 600 anyway so we buy 1,000@5GHS/unit replacement
cost.
• Solution
We need 1000. we already have 700 in stock. We dont have to C (300 X 4GHS) +(700X 2.5GHS)
replace it if we use it but we have to count what we could have got
for it- GHS 2.5 /unit. We obtain the remaining 300 from the market =2,950 GHS
at replacement cost of GHS 4/unit.

We need 200 and we have it in stock but we could have sold it for D 300 X 5GHS = 1,500 GHS
GHS 6/unit. Hence relevant cost is GHS 6 X 200 =1200GHS or save
the cost of 300 units of E @ GHS 5/unit =1500 GHS. We chhose the 15,450GHS
higher of the two.

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 Identifying Relevant Costs
Relevant costs for Machines
• The relevant cost of a maschine depends on
whether the maschine can be used for another purpose or
whether it was acquired specifically for the job
• If it was acquired specifically for the job,the relevant cost is the
acquisition cost.
• If it can be used for other purposes,the relevant cost is the
opportunity cost- contribution lost for using it for the current
job rather than the other purpose.
• Incremental costs of using the maschines are also relevant
costs viz.,repair costs,hire charges,fall in sale value due to
use(NB. This is not depreciation).

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 Identifying Relevant Costs

• Eg. A special cutting maschine has to b hired for 3mths for a job.hire
charges are $75/month with a minimum of $300
• Other maschines are obtained on hire purchase for $500/month ($450
capital repayment, $50 interest).
• These maschines are specialised and can’t be used for any other purpose.
• There is no immediate market for the maschine .
• It is estimated the maschine will loose $200 in its eventual sale value after
being used for the job.
• The last hire purchae payment remains outstanding and is to be made in
2months time
• The cash price of the maschines was $9000 2yrs ago. It has useful life of
36 months. Depreciated at $200 per month on traight line basis.
• What is the relevant cost of the maschinery?

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 Identifying Relevant Costs

Solution
• The cutting maschine will incur incremental cost of $300 , the
minimum hire charge.
• Historical costof other maschines is irrelevant.
• Depreciation is irrelevant-non cash flow
• Outstanding hire purchase costs are irrelevant-commited costs
• Loss on maschine resale value of $200 relevant
Summary of relevant costs: $
– Incremental hire cost 300
– Loss on resale value 200
500

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 Identifying Relevant Costs

Relevant costs for Labour

• The relevant cost for labour depends on whether labour is working at full
capacity or not.
• If labour is working at full capacity, it would have to be taken away from
another activity for the new project we are deciding on. This will create an
opportunity cost - the cost of removing them from the existing project tothe
new-their contribution to the existing project we would be loosing-hence
the relevant cost is the lost contribution.
• If labour is working at full capacity, additional work can’t be taken. More
staff will have to be hired for new project, hence the relevant cost is what we
will pay the additional staff-the current rate of pay.
• If more staff can’t be hired,current staff will be moved to the new project we
are planning to undertake. Hence the relevant cost will be – lost contribution
of these staff to the existing project.

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 Identifying Relevant Costs

• If there is current spare labour capacity,additional work can be

undertaken by current staff. No need to pay them extra. Their
salary is a committed cost. Therefore, relevant cost is ‘nil’.
• Where there are associated variable overheads to the cost of
labour, these are also relevant.

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 Identifying Relevant Costs

• Eg. A company has been offered GHS21,000 by a prospective

customer to make some purpose built equipment. The extra
cost of the maschine would be GHS 3,000 for materials .
• There would also be a requirement for 2,000 labour hours.
Labour wages are ghs 4 /hr, variable overhead is GHS 2 per
hour and fixed overhead is absorbed at the rate of GHS 4 /hr.
• Labour however is limited in supply and if the job is
accepted,workers would have to be diverted from other work
which is expected to earn a contribution of GHS 5 /hr towards
fixed costs and profit.
• Assess whether the contract should be undertaken.

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 Identifying Relevant Costs

• Solution
GHS GHS

Materials 3,000

Labour(2,000hrs @ghs 4/ labour hr) 8,000

Variable overhead (2000 hrs @ GHS 2/hr) 4,000 15,000

OPPORTUNITY COST:

Contribution forgone (2000 hrs x ghs 5/ hr) 10,000

Total costs 25,000

Revenue 21,000

Net loss on contract (4,000)

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 Identifying Relevant Costs

• The extra cost of the equipment GHS 3000 is relevant

• Ideally, Labour cost of GHS 8,000 and variable overhead of GHS
4000 are irrelevant because the workers are being moved from an
existing job -these workers would have been paid anyway –
committed cost. Our decision would not change these costs.
Therefore they are irrelevant.
• However in this case , this doesnt hold. The GHS 8000 and GHS
4000 are relevant costs because the workers were moved from
another job earning contribution of GHS 5. This means labour and
variable overheads would have already being taken into account. So
if you are moving them you are loosing the contribution -10,000 as
well as the labour and variable overhead that were being covered.

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 Identifying Relevant Costs

Relevant fixed costs

• Generally, fixed costs are irrelevant for decision making
because they will be incurred with or without the decision
being made. Eg. Rent-whether you take the job or not you still
have to pay your rent.
• Only incremental fixed costs are relevant i.e. if the decision
being taken would result in additional fixed costs being
incurred, these additional fixed costs are the relevant costs for
the decision.

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 Assumptions in relevant costing

Cost behaviour patterns are known.eg. Fixed costs will remain the
same when out put increases.
- this is not necessarily true. It could change beyond a certain level of activity.
The amount of fixed costs, unit variable costs.sales price and sales
demand are known with certainty.
– What will happen is the future is not certain
The objective of decision-making in the short run is to maximise
‘satisfaction’ ie short-term profit.
– This may not necessarily be true. There could be other short-term objectives.
The information on which a decision is made is compete and reliable.
– This is not realistic. Managers need to be made aware of inadequacies of
information given to them.

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BACT 302 MANAGEMENT ACCOUNTING
TOPIC:
SHORT TERM DECISIONS
 OUTLINE

• Make or buy decisions

• Contract Pricing
• Accept or reject decisions
• Shut-down decisions

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 ACCEPT /REJECT DECISIONS

• ACCEPT /REJECT DECISIONS

• Focuses on whetehr a special one off contract should be accepted
• The decision rule is that, if it increases contribution i.e variable
costs are less than the sales price- accept.Otherwise reject.
• Relevant costs and revenues to consider include:
– Prive paid by customer
– Variable costs
– Additional fixed costsdirectly related to the contract
• Where there is no capacity the decision rule is:
Accept only contracts whose contribution exceed that of the contracts
withdrawn to cater for the new contract.

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 ACCEPT /REJECT DECISIONS

• Eg.
• HP makes a single product which sells for $20. the variable cost is $12 and
consist of: $
– Direct material 4
– Direct labour (2hrs) 6
– Variable overhead (2hrs) 2
12
• Labour force is currently working at full capacity producing a product that earns
contribution of $4 /labour hour
• A customer has approaced the company ,willing to pay $5,500 for a special contract
which will need:
• Direct materials $2000
• Labour hours 500

• Should the contract be accepted?

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 ACCEPT /REJECT DECISIONS

• Solution
• NB. Labour force is working at full capacity so there is
opportunity cost- lost contribution- if we pull workers from
another job.It is assumed variable overhead varies with direct
labour hours.
$ $
Value of contract 5,500
Cost of contract:
Direct materials 2,000
Direct labour 1,500
Variable overhead 500
Opportunity cost 2,000
Relevant cost of contract 6,000
Loss incurred by (500)
accepting contract

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 ACCEPT /REJECT DECISIONS

• NB though th contract earns a contribution of $1500, the lost

contribution of $2000 elsewhere results in an overall loss for
the company, hence the contract can’t be accepted.
• Other considerations must however be taken into account:
– Relationship with existing customers
– Possibility of further business opportunities
– Existing business- should we jeopardise it for a one –off contract?

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 Make or buy decisions

• This involvesdeciding whether it would be more profitable to

outsource production to an external organisation as compared to
producinh in-house.
• Decisions should not be solely based on cost considerations
• The make option gives management more direct control but buy
option could result in the firm benefiting from specialist skills and
expertise.
• Other issues to consider:
– Can resulting spare capacity freed up by out-sourcing b e used more
profitably?
– Can the decision to use an outside supplier cause an industrial dispute? TUC .
Labour issues.
– Would the sub contractor be reliable?

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 Make or buy decisions

• Where there are no scarce resources,and the firm has freedom

of choice, the relevant costs in a make or buy decision are the
differential costs between the make and buy options.
• Usually the variable cost of producing in-house is less than
buying outside. However, the firm must consider savings in
directly attributable fixed costs that will arise from out-
sourcing.

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 Make or buy decisions

• Eg. An organisation makes 4 components W,X,Y &Z. the costs

are as ffs:
W X Y Z

Production Units 1,000 2,000 4,000 3,000

Unit marginal costs $ $ $ $

Direct material 4 5 2 4

Direct labour 8 9 4 6

Variable production overheads 2 3 1 2

14 17 7 12

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 Make or buy decisions

• Directly attributable fixed costs per annum and committed fixed

costs are as follows: $
• Incurred as a direct consequence of making W 1,000
• Incurred as a direct consequence of making W 5,000
• Incurred as a direct consequence of making W 6,000
• Incurred as a direct consequence of making W 8,000
• Other fixed costs(committed) 30,000
50,000
• A sub contractor can supply units of W,X,Y,Z for $12,
$21, $10, & $14 respectively.
Should the organisation make or buy the components?
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 Make or buy decisions

Solution
• The relevants costs are the differential costs between making
and buying.These consist of diffrences in variable costs and
directly attributable fixed costs.
W X Y Z
$ $ $ $

unit variable cost of making 14 17 7 12

Unit variable cost of buying 12 21 10 14
Annual requirements(unit) (2) 4 3 2
Extra variable cost s of buying 1,000 2,000 4,000 3,000
Fixed costs saved by buying(per (2000) 8,000 12,000 6,000
annum) 1000 5,000 6,000 8,000
Extra total cost of buying (3,000) 3,000 6,000 (2,000)

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 Make or buy decisions

• The company will save 3,000 p.a subcontracting W( purchase

cost is less than marginal cost per unit to make internally. and
2000 p.a subcontracting Z due to savings in fixed cost of 8,000.
• Other important considerations
– Spare capacity profitably used?
– Reliability of delivery times
– Whether company wants better controlover its operations

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