COST AND MANAGEMENT ACCOUNTING

RELEVANT COSTING

Desmond Aboagye
March, 2020
 Chapter Learning Objectives
At the end of this chapter, you will be able to:
• Explain relevant and irrelevant cost and revenue for short term
decision making
• Identify relevant cost and revenue
• Apply relevant cost in make or buy decision, shutdown
decision, one-off contracts decisions and joint products further
processing decisions

@desmondaboagye2020
 Order of Presentation
1. Introduction

2. Minimum price of one-off order

3. Make-or-buy decision
4. Shut down decision

5. Further processing decision

@desmondaboagye2020
1.0 Introduction to Relevant Costing
• Short term decision making is inevitable in management.

• There is the need to consider the use of relevant costing in

evaluating management decision.
• Cost or Revenue (Cash flow) is relevant if it is a future,
incremental cash flow as a result of decision taken.
• This technique provide the quantitative implication of
alternative courses of action being considered by management
and their implication on profit and or cash

@desmondaboagye2020
1.0 Introduction to Relevant Costing
Features of Relevant Cash flow
• They are future cash flow
• They differ among alternative courses of action
• They consider opportunity cost
• They are controllable cash flow

@desmondaboagye2020
1.0 Introduction to Relevant Costing
Irrelevant cash flows

These are cash flows that do not vary with the decision taken.
Examples of irrelevant cash flow include:
– Notional (Imputed) Cost

– Sunk (Past) Cost

– Committed Cost

– Historical Cost and depreciation

– Absorbed Fixed Cost

@desmondaboagye2020
1.0 Introduction to Relevant Costing
Scenario 1a – Relevant Cost

a. Market Researcher salary – GHS 7,500 per month (Relevant);

incurred as a result of the production decision (Attributable
fixed cost)
b. Additional Running Cost – GHS 4,500 per month (Relevant);
cost is based on decision on machine. Fixed Overhead
Absorption – Irrelevant; absorbed fixed cost
c. Cleaning Cost – irrelevant; cost is committed

@desmondaboagye2020
1.0 Introduction to Relevant Costing
Scenario 1a – Relevant Cost (cont’d)

d. Expense Reimbursement – irrelevant; Sunk cost

e. Asset Cost – GHS 4,000 (Relevant); cost is sunk, NBV is a
combination of sunk and non-cash; Opportunity cost of not
using is selling of at GHS 4,000

@desmondaboagye2020
1.0 Introduction to Relevant Costing
Relevant Cost for Material

In regular use Relevant Cost =

and will be Current Purchase
replaced Price
Yes: Relevant
In stock cost = Higher
of other use
Is there an of Scrap
Will not be alternative value
Material replaced use for the
materials
No: Relevant =
Relevant Cost scrap value
Out of stock = Current
Purchase cost

@desmondaboagye2020
1.0 Introduction to Relevant Costing
Scenario 1b - Relevant Material Cost

A . Material X (600kg @ GHS 3.25/kg) = GHS 1,950

The material is regularly used by the company hence its relevant cost is the replacement
cost. Given that it can be purchased in units of 1,000kg and is regularly used and excess
can be sold for replacement cos hence relevant cost is for 600kg at GHS 3.25/kg

GHS
Sale Value of the 500kg 20,000
B. Replacement cost of the 300 kg (300@80) 24,000
Total Cost of Material 44,000

500kg is available with no other use and will be valued at sale value / scrap of
GHS20,000.The remaining 300kg would have to he purchased for the job and valued at
the replacement cost of GHS 80/kg.

@desmondaboagye2020
1.0 Introduction to Relevant Costing
Relevant Cost for Labour

Can hire more

Relevant Cost = Extra
labour (ie extra
labour cost
staff or overtime)
Full Capacity Relevant Cost =
Lost
Cannot hire contribution on
Labour more labour diverting labour
+ extra labour
cost
Relevant Cost =
Spare Capacity
Nil

@desmondaboagye2020
1.0 Introduction to Relevant Costing
Scenario 1d - Relevant Labour Cost
Relevant Cost of Labour Skilled Labour: The labour is fully
GHS utilised and has to be transferred for
Skilled Labour (1) 10,000 other jobs where contribution will be
Unskilled Labour (2) 400
lost. Cost will encompass the basic wage
10,400
(GHS 30/hr) and the lost contribution
(GHS 10/hr)
N1 Skilled Labour
Basic Wage (250hrs@GHS30/hr) 7,500
Unskilled Labour: 60 hrs of the required
Lost Contribution (250hrs@GHS10/hr) 2,500
100hrs available and idle hence no cost
10,000
attached. The remaining 40hrs extra will
N2 Unskilled Labour come at an incremental cost of GHS
60hr surplus labour (60hrs@GHS 0/hr) - 10/hr
Extra 40 hrs required (40hrs@GHS 10/hr) 400
400

@desmondaboagye2020
1.0 Introduction to Relevant Costing
Relevant Cost for overheads
• Variable Overhead (Relevant Cost); Relevant variable
overheads are the absorption rate at the actual activity
• Fixed Overhead (Irrelevant Cost); Irrelevant if cost remains
constant. Should fixed overheads vary due to the decision, the
difference is a relevant cost

@desmondaboagye2020
1.0 Introduction to Relevant Costing
Relevant Cost for Asset
RELEVANT CASH FLOW:

a. For purchase of new asset (Price and scrap/disposal proceed)

b. For existing asset to be use on project otherwise sold; relevant cash
flow = proceeds forgone
c. For and existing asset in use in another department; relevant cash
flow = lost contribution
d. For owned assets, hire charges; extra repairs; operating and
maintenance cost; and fall in resale value when used are relevant

@desmondaboagye2020
2.0 Minimum Price of an Order
• The total relevant cost for any order made is the minimum
price of that order
• The minimum price of an offer is effectively its break-even
point and will yield no gain or loss.
• This method is also useful in accessing special orders and one-
off contracts on whether to accept or not and provides an
overall view of the cost and profit implications
• Decision rule: Accept only offer at or above minimum cost.

@desmondaboagye2020
2.0 Minimum Price of an Order
Limitations in the use of minimum price of an order
• Acceptable for one-off/special contracts but not all products
• Minimum price might be lower than market price
• Minimum prices might affect future contract
• Profit reporting inconsistencies

@desmondaboagye2020
2.0 Minimum Price of an Order
Scenario 2a – Minimum Price of an Order
2a Revised Cost Statement fro Mr Smith
GHS
Material A (N1) 11,700
Material B (N2) 15,000
Material C (N3) 8,000
Material D (N4) (2,500)
Skilled Labour (N5) 25,000
Semi-skilled labour (N6) 11,250
Unskilled labour (N7) 6,000
Minimum tender price 74,450

Note Fixed overheads are non incremental cost

Cost of preparing contract is sunk cost
Profit is ignored since we are looking at minimum contract price

@desmondaboagye2020
2.0 Minimum Price of an Order
N1 Material A N4 Material D
1,000kg in stock, not in use but to be sold Material in stock but not in use and will cost (50lt @ GHS
at GHS 2/kg with a total selling cost of 50/lt) GHS 2,500 to dispose. Relevant cost savings
1,000kg to be procured and valued at Material D (cost savings) (2,500)
replacement cost of GHS 10/kg
GHS
N5 Skilled Labour
Old stock [(1000kg@GHS2/kg] - GHS 300) 1,700
Incremental labour cost @ GHS 25 per hr
New stock (1000kg@GHS 10/kg) 10,000 Skilled Labour ( 1,000hr@ GHS 25/hr) 25,000
11,700

N2 Material B
Material in stock but in regulare use hence
valued at replacement cost of GHS 15/kg
Material B (1,000kg@GHS 15/kg)
N6 Semi-Skilled Labour
2,000 hr required, 1,500hr available and not fully utilised;
the extra 500hrs will be paid at time-and-half
Semi-Skilled Labour (500@(15x1.5)) 11,250
15,000

N3 Material C
Could be sold for GHS 6,000 or used a
subsitutue and save GHS 8,000: Higher of
Material C (opportunity cost)
N7 Unskilled Labour
Unskilled Labour is fully employed: Cost to employ extra
will be GHS 20/hr; cost of diverting existing labour is
GHS 12/ hr( GHS 10 basi wage & GHS 2 lost
Contribution). Relevant cost is lower of two
8,000 Unskilled labour (500hr@GHS 12/hr) 6,000

@desmondaboagye2020
3.0 Make-or-Buy Decision
• It considers whether an entity should make a product or
purchase it from another entity
• It involves comparing the relevant cost of both decisions
• For made-in products, all incidental variable costs are relevant
• For bought-in products, purchase price and other incidental
cost are relevant
• Make or buy decisions can be made where capacity exists or
otherwise including instances of limiting factor.

@desmondaboagye2020
3.0 Make-or-Buy Decision
1. Where Spare capacity exists: Fixed cost and idle resources
are irrelevant; incidental cost are relevant

2. Where no spare capacity:

a. At full capacity with no limiting factor, incidental cost and
opportunity cost are relevant

b. At full capacity with limiting factor, chose option that gives highest
cost saving and rank production on cost savings per limiting factor

@desmondaboagye2020
3.0 Make-or-Buy Decision
In addition to the quantitative consideration, the following
qualitative considerations should be made:
– Reliability of external supplier

– Specialist Skills
– Alternative use of resources

– Social consideration
– Legal consideration

– Confidentiality

– Customer reaction

@desmondaboagye2020
3.0 Make-or-Buy Decision
Scenario 2b – Make or Buy
Make or Buy Decision
Here, the relevant cost to make is
i Relevant Production Cost compared with the relevant cost to
GHS buy-in. With the objective to
Direct material 20 maximise profit the least cost is
Direct labour 40
Variable overhead 10
preferred.
70
Fixed cost is not relevant to the
ii Relevant Purchase Cost decision as it remains constant for the
GHS
Purchase Price 75
various options exercised

The decision in this instance is to

make as you make a saving of GHS
5/unit

@desmondaboagye2020
4.0 Shut Down Decision
• Involves the decision to stop operating a unit, department or
product line(s) due to persistent losses or high running cost
• The relevant cash flows in this decision are:
1. Lost contribution form area closed = Cost
2. Known penalties and closure cost = cost

3. Savings in specific fixed cost from closure = Benefit

4. Additional contribution from alternative use of resources = Benefit

• Decision: Shut down of cost is above benefit

@desmondaboagye2020
4.0 Shut Down Decision
Other Considerations in Shut-down decision

1. Some cash flows may not be fully quantifiable at shut down

– Penalties and cost related to the closure (eg: redundancy and
compensation to customers)
– Reorganization cost

– Additional contribution from alternative use of resources

2. Knock-down impact of the shut down on other units

@desmondaboagye2020
 4.0 Shut Down Decision
Scenario 3a – Shut down decision The evaluation of the shutdown
i Compute gross and net contribution for center Z
GHS'000 decision will involve the entire
Sales 70,000 firm’s position with and without
Variable Costs
Direct Material (28,000) the department or unit in
Direct Labour (12,000)
(40,000) contention.
Contibution 30,000
Center Fixed Cost (16,000)
Net Contribution 14,000 A positive contribution is enough
ii Gain or Loss on operating Center Z grounds not to shut down even if
Net Contribution 14,000
Opportunity Cost of Closure (10,000)
the contribution does not cover the
4,000 fixed cost completely

@desmondaboagye2020
 4.0 Shut Down Decision
Scenario 3a – Shut down decision
iii Gain or loss on closing Center Z
X Y Total
GHS'000 GHS'000 GHS'000
Sales 80,000 85,000 165,000
Variable Costs
Direct Material (25,000) (22,000) (47,000)
Direct Labour (10,000) (8,000) (18,000)
(35,000) (30,000) (65,000)
Contibution 45,000 55,000 100,000
Center Fixed Cost (15,000) (10,000) (25,000)
30,000 45,000 75,000
Total Fixed Cost (20,000+20,000+10,000) (50,000)
Net Profit 25,000

Should centre Z be closed, the overall profit of the company falls by GHS 4
mil from GHS 29 mil to GHS 25 mil due to the lost contribution of Centre Z
Centre Z should not be closed
@desmondaboagye2020
6.0 Further Processing Decision
• Further processing decision will be applied when joint products
are produced
• The bases of apportionment of joint cost at the split point are:
– Sales value of product (also known as “market Value”)
– Production Units

– Net Realizable value

• When deciding whether to process a particular product further or

to sell after split-off , only incremental cash flow should be
considered

@desmondaboagye2020
6.0 Further Processing Decision
• When deciding on further processing decision, only
incremental cash flows are considered
• Joint cost are sunk cost at this stage are irrelevant to the
decision
Note: If we are considering the viability of the whole process,
then the joint cost would be relevant

@desmondaboagye2020
6.0 Further Processing Decision
Scenario 3b – Further processing
i Revenue and Cost for further processing
X Y Z
GHS'000 GHS'000 GHS'000
Sales upon further processing 980.00 120.00 600.00
Sales without further processing (200.00) (120.00) (160.00)
Additional value by further processing 780.00 - 440.00

Additonal cost on futher processing 800.00 - 400.00

ii Gain or Loss on further processing

X Y Z
GHS'000 GHS'000 GHS'000
Additional value by further processing 780.00 - 440.00
Additonal cost on futher processing (800.00) - (400.00)
Gain or Loss on further processing (20.00) - 40.00

• From the above it is only ideal to further process Z at that fives a gain from further
process of GHS 40,000 whiles X and Y should be sold without further processing to
prevent a loss on X of GHS 20,000

@desmondaboagye2020
5.0 Chapter Revision
At the end of the session, you are able to:
• Explain relevant and irrelevant cost and revenue for short term
decision making
• Identify relevant cost and revenue

• Apply relevant cost in make or buy decision, shutdown

decision, one-off contracts decisions and joint products further
processing decisions
Please refer to attached question pack to practice concepts

@desmondaboagye2020