DECISION MAKING IN MANAGEMENT ACCOUNTING:Spare capacity costs, Sunk cost

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Cost & Management Accounting (MGT-402)

LESSON # 41

DECISION MAKING IN MANAGEMENT ACCOUNTING

Relevant costs and decision-making

Relevance is one of the key characteristics of good management accounting information. This

means that management accounting information produced for each manager must relate to the

decisions, which he/she will have to make.

Relevant costs are the costs that meet this requirement of good management accounting

information. The Chartered Institute of Management Accounting defines relevant costs as:

The costs appropriate to a specific management decision

This definition could be restated as `the amount by which costs increase and benefits decrease as

a direct result of a specific management decision'. Relevant benefits are `the amounts by which

costs decrease and benefits increase as a direct result of a specific management decision'.

Before the management of an enterprise can make an informed decision on any matter, they

need to incorporate all of the relevant costs-which apply to the specific decision at hand in their

decision-making process. To include any non-relevant costs or to exclude any relevant costs will

result in management basing their decision on misleading information and ultimately to poor

decisions being taken.

Relevant costs and benefits only deal with the quantitative aspects of decision. The qualitative

aspects of decisions are of equal importance to the quantitative and no decision should be made

in practice without full consideration being given to both aspects.

Identifying relevant and non-relevant costs

The identification of relevant and non-relevant costs in various decision-making situations is

based primarily on common sense and the knowledge of the decision maker of the area in which

the decision is being making. Armed with these two tools you should be able to sift through all

the information that is available in respect of any decision and extract those costs (and benefits),

which are appropriate to the decision at hand.

In identifying relevant costs for various decisions, you may find that some costs not included in

the normal accounting records of an enterprise are relevant and some costs included in such

records are non-relevant. It is important that you and relevant costs for decision-making, and

while the latter may be recorded in the former this is not always the case.

Accounting records are used to record the incidence of actual costs and revenues as they arise.

Decisions, on the other hand, are based only on the relevant costs and benefits appropriate to

each decision while the decision is being made. This point is particularly appropriate when you

come to examine opportunity costs and sunk costs that are dealt with below.

In practice, you may also find that the information presented in respect of a decision does not

include all the relevant costs appropriate to the decision but the identification of this omission is

very difficult unless you are familiar with the area in which the decision is being made.

Incremental costs

An incremental cost can be defined as a cost which is specifically incurred by following a course

of action and which is avoidable if such action is not taken. Incremental costs are, by definition,

relevant costs because they are directly affected by the decision (i.e. they will be incurred if the

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decision goes ahead and they will not incurred if the decision is scrapped). For example, if an

enterprise is deciding whether or not to accept a special order for its product, the extra variable

costs (i.e. number of units in special order x variable cost per unit) that would be incurred in

filling the order are an incremental cost because they would not be incurred if the special order

were to be rejected.

Non-incremental costs

These are costs, which will not be affected by the decision at hand. Non-incremental costs are

non-relevant costs because they are not related to the decision at hand (i.e. non-incremental

costs stay the same no matter what decision is taken). An example of non-incremental costs

would be fixed costs, which by their very nature should not be affected by decisions (at least in

the short-term). If, however, a decision gives rise to a specific increase in fixed costs then the

increase in fixed costs would be an incremental and, hence, relevant cost. For example, in a

decision on whether to extend the factory floor area of an enterprise, the extra rent to be

incurred would be a relevant cost of that decision.

Spare capacity costs

Because of the recent advancements in manufacturing technology most enterprises have greatly

increased their efficiency and as a result are often operating at below full capacity. Operating

with spare capacity can have a significant impact on the relevant costs for any short-term

production decision the management of such an enterprise might have to make.

If spare capacity exists in an enterprise, some costs which are generally considered incremental

may in fact be non-incremental and thus, non-relevant, in the short-term. For example, if an

enterprise is operating at less than full capacity then its work force is probably under utilized. If it

is the policy of the enterprise to maintain the level of its work force would be a non-relevant cost

for a decision on whether to accept or reject a once-off special order. The labour cost is non-

relevant because the wages will have to be paid whether the order is accepted or not. If the

special order involved and element of overtime then the cost of such overtime would of course

be a relevant cost (as it is an incremental cost) for the decision.

Two further types of costs that have to be considered are opportunity costs and sunk costs.

Opportunity costs

An opportunity cost is a level of profit or benefit foregone by the pursuit of a particular course

of action. In other words, it is the value of an option, which cannot be taken as a result of

following a different option. For example, if an enterprise has a quantity of raw material in stock,

which cost Rs. 7 per kg and it plans to use this material in the filling of a special order then you

would normally, incorporate Rs. 7 per kg as part of your cost calculations for filling the order. If,

however, this quantity of material could be resold without further processing for Rs. 8 per kg,

then the opportunity cost of using this material in the special order is Rs. 8 per kg; by filling the

order you forego the Rs. 8 per kg, which was available for a straight sale of the material.

Opportunity costs are, therefore, the `real' economic costs of taking one course of action as

opposed to another.

In the above decision-making situation it is the opportunity cost which is the relevant cost and,

hence, the cost which should be incorporated into your cost-versus-benefit analysis. It is because

the loss of the Rs. 8 per kg is directly related to the filling of the order and the opportunity cost

is greater than the book cost. Opportunity costs are relevant costs for a decision only when they

exceed the costs of the same item in the option to the decision under consideration.

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You may find the idea of opportunity costs difficult to grasp at first because they are notional

costs, which may never be included in the books and records of an enterprise. They are,

however, relevant in certain decision-making situation and you must bear in mind the fact that

they exist when assessing any such situations.

Sunk cost

A sunk cost is a cost that the already been incurred and cannot be altered by any future decision.

If sunk costs are not affected by a decision then they must be non-relevant costs for decision-

making purposes. Common examples of sunk costs are market research costs and development

expenditure incurred by enterprises in getting a product or service ready for sale. The final

decision on whether to launch the product or service would regard these costs as `sunk' (i.e.

irrecoverable) and thus, not incorporate them into the launch decision.

Sunk costs are the opposite of opportunity costs in that they are not incorporated in the decision

making process even though they have already been recorded in the books and records of the

enterprise.

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