DECISION MAKING:Avoidable Costs, Non-Relevant Variable Costs, Absorbed Overhead

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Cost & Management Accounting (MGT-402)

LESSON # 43

DECISION MAKING

Relevant Costs

Relevant costs are future cash flows arising as a direct consequence of a decision.

· Relevant costs are future costs

· Relevant costs are cash flows

· Relevant costs are incremental costs

Decision making should be based on relevant costs.

a. Relevant Costs are future costs. A decision is about the future and it cannot alter what has

been done already. Costs that have been incurred in the past are totally irrelevant to any

decision that is being made `now'. Such costs are past costs or sunk costs. Costs that have

been incurred include not only costs that have already been paid, but also costs that have

been committed. A committed cost is a future cash flow that will be incurred anyway,

regardless of the decision taken now.

b. Relevant costs are cash flows. Only cash flow information is required. This means that

costs or charges which do not reflect additional cash spending (such as deprecation and

national costs) should be ignored for the purpose of decision making.

c. Relevant costs are incremental costs. For example, if an employee is expected to have no

other work to do during the next week, but will be paid his basic wage (of, say, Rs. 100 per

week)( for attending work and doing nothing, his manager might decide to give him a job

which earns the organization Rs. 40. The net gain is Rs. 40 and the Rs. 100 is irrelevant to

the decision because although it is a future cash flow, it will be incurred anyway whether

the employee is given work or not.

Avoidable Costs

One of the situations in which it is necessary to identify the avoidable costs is in deciding

whether or not to discontinue a product. The only costs which would be saved are the

avoidable costs which are usually the variable costs and sometimes some specific costs. Costs

which would be incurred whether or not he product is discontinued are known as

unavoidable costs.

Differential Costs and Opportunity Costs

Relevant costs are also differential costs and opportunity costs.

· Differential cost is the difference in total cost between alternatives.

· An opportunity cost is the value of the benefit sacrificed when one course of action

is chosen in preference to an alternative.

For example, if decision option A costs Rs. 300 and decision option B costs Rs. 360, the

differential costs is Rs. 60.

Example: Differential Costs and Opportunity Costs

Suppose for example that there are three options, A, B and C, only one of which can be

chosen. The net profit from each would be Rs. 80, Rs. 100 and Rs. 70 respectively.

Since only one option can be selected option B would be chosen because it offers the biggest

benefit.

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Rs.

Profit from option B

100

Less opportunity cost (i.e. the benefit from the most profitable alternative, A)

Differential benefit of option B

The decision to choose option B would not be taken simply because it offers a profit of Rs.

100, but because it offers a differential profit of Rs. 20 in excess of the next best alternative.

Controllable and Uncontrollable Costs

We came across the term controllable costs at the beginning of this study text. Controllable

costs are items of expenditure which can be directly influenced by a given manger within a

given time span.

As a general rule, committed fixed costs such as those costs arising form the possession of

plant, equipment and buildings (giving rise to deprecation and rent) are largely uncontrollable

in the short term because they have been committed by longer-term decisions.

Discretionary fixed costs, for example, advertising and research and development costs can

be thought of as being controllable because they are incurred as a result of decision made by

management and can be raised or lowered at fairly short notice.

Sunk Costs

A sunk cost is a past cost which is not directly relevant in decision making. The principle

underlying decision accounting is the management decisions can only affect the future. In

decision making, managers therefore required information about future cots and revenues

which would be affected by the decision under review. They must not be misled by events,

costs and revenues in the past, about which they can do nothing.

Sunk costs, which have been charged already as a cost of sales in a previous accounting

period or will be charged in a future accounting period although the expenditure had already

been incurred, are irrelevant to decision making.

Example: Sunk Costs

An example of a sunk cost is development costs which have already been incurred. Suppose

that a company has spent Rs. 250,000 in developing a new service for customers, but the

marketing department's most recent findings are that the service might not gain customer

acceptance and could be a commercial failure. The decision whether or not to abandon the

development of the new service would have to be taken, but the Rs. 250,000 spent so far

should be ignored by the decision makers because it is a sunk cost.

Fixed and Variable Costs

Unless you are given an indication to the contrary, you should assume the following:

· Variable costs will be relevant costs.

· Fixed costs are irrelevant to a decision.

This need not be the case, however, and you should analyze variable and fixed cost data

carefully. Do not forget that `fixed' costs may only be fixed in the short term.

Non-Relevant Variable Costs

There might be occasions when a variable cost is in fact a sunk cost (and therefore a non-

relevant variable cost). For example, suppose that a company has some units of raw material

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in stock. They have been paid for already, and originally cost Rs. 2,000. They are now

obsolete and are no longer used in regular production, and they have no scrap value.

However, they could be used in a special job which the company is trying to decide whether

to undertake. The special job is a `non-off' customer order, and would use up all these

materials in stock.

a. In deciding whether the job should be undertaken, the relevant cost of the materials

to the special job is nil. Their original cost of Rs. 2,000 is a sunk cost, and should be

ignored in the decision.

b. However, if the materials did have scrap value of, say, Rs. 300, then their relevant

cost to the job would be the opportunity cost of being unable to sell them for scrap,

i.e. Rs. 300.

Attributable Fixed Costs

There might be occasions when a fixed cost is a relevant cost, and you must be aware of the

distinction `specific' or `directly attributable' fixed costs, and general fixed overheads.

Directly attributable fixed costs are those costs which, although fixed within a relevant range

of activity level are relevant to a decision for either of the following reasons.

a. They could increase if certain extra activities were undertaken. For example, it may be

necessary to employ an extra supervisor if a particular order is accepted. The extra salary

would be an attributable fixed cost.

b. They would decrease or be eliminated entirely if a decision were taken either to reduce

the scale of operations or shut down entirely.

General fixed overheads are those fixed overheads which will be unaffected by decisions to

increase or decreased the scale of operations, perhaps because they are an apportioned share

of the fixed costs of items which would be completely unaffected by the decision. General

fixed overheads are not relevant in decision making.

Absorbed Overhead

Absorbed overhead is a national accounting cost and hence should be ignored for decision

making purposes. It is overhead incurred which may be relevant to a decision.

The Relevant Cost of Materials

The relevant cost of raw materials is generally their current replacement cost, unless the

materials have already been purchased and would not be replaced once used. In this case the

relevant cost of using them is the higher of the following:

Their current resale value

The value they would obtain if they were put to an alternative use.

If the materials have no resale value and no other possible use, then the relevant cost of

using them for the opportunity under consideration would be nil.

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Cost & Management Accounting (MGT-402)

Question

Majeed Ltd. has been approached by customer who would like a special job to be done for him,

and who is willing to pay Rs. 22,000 for it. The job would require the following materials:

Total units Units

Book value

Realizable

Replacement

Material

required

already

in of units in

value

cost

stock

Rs./unit

1,000

600

2.50

1,000

700

2.50

200

6.00

Material B is used regularly by Majeed Ltd, and if units of B are required for this job, they would

need to be replaced to meet other production demand.

Materials C and D are in stock as the result of previous over-buying, and they have a restricted use.

No other use could be found for material C, but the units of material D could be used in another

job as substitute for 300 units of material E, which currently costs Rs. 5 per unit (of which the

company has no units in stock at the moment).

Required: Calculate the relevant costs of material for deciding whether or not to accept the

contract.

Answer

a. Material A is not yet owned. It would have to be bought in full at the replacement cost of

Rs. 6 per unit.

b. Material B is used regularly by the company. There are existing stocks (600 units) but if

these are used on the contract under review a further 600 units would be bought to

replace them. Relevant costs are therefore 1,000 units at the replacement cost of Rs. 5

per unit.

c. 1,000 units of material C are needed and 700 are already in stock. If used for the contract,

a further 300 units must be bought at Rs. 4 each. The existing stocks of 700 will not be

replaced. If they are used for the contract, they could not be sold at Rs. 2.50 each. The

realizable value of these 700 units is an opportunity cost of sales revenue forgone.

d. The required units of material D are already in stock and will not be replaced. There is an

opportunity cost of using D in the contract because there are alternative opportunities

either to sell the existing stocks for Rs. 6 per unit (Rs. 1,200 in total) or avoid other

purchases (of material E), which would cost 300 x Rs. 5 = Rs. 1,500. Since substitution

for E is more beneficial, Rs. 1,500 is the opportunity cost.

e. Summary of relevant costs:

Rs.

Material A (1,000 x Rs. 6)

6,000

Material B (1,000 x Rs. 5)

5,000

Material C (300 x Rs. 4) plus (700 x Rs. 2.50)

2,950

Material D

1,500

Total

15,450

The Relevant Cost of Labor

The relevant cost of labor, in different situation, is best explained by an example:

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Cost & Management Accounting (MGT-402)

Example: Relevant Cost of Labor

LW plc is currently deciding whether to undertake a new contract. 15 hours of labor will be

required for the contract. LW plc currently products product L, the standard cost details of which

are shown below.

STANDARD COST CARD

PRODUCT L

Rs./Unit

Direct Materials (10kg @ Rs. 2)

Direct Labor (5 hrs @ Rs. 6)

Selling price

Contribution

What is the relevant cost of labor if the labor must be hired form outside the

organization?

What is the relevant cost of labor if LW plc expects to have 5 hours spare capacity?

What is the relevant cost of labor if labor is in short supply?

Solution

Where labor must be hired from outside the organization, the relevant cost of labor will

be the variable costs incurred.

Relevant cost of labor on new contract = 15 hours @ Rs. 6 = Rs. 90.

It is assumed that the 5 hours spare capacity will be paid anyway, and so if these 5 hours

are used on another contract, there is no additional cost to LW plc.

Rs.

Direct labor (10 hours @ Rs. 6)

Spare capacity (5 hours @ Rs. 0)

Contribution earned per unit of Product L produced = Rs. 22

If it requires 5 hours of labor to make one unit of product L, the contribution earned per labor

hour = Rs. 22/5 = Rs. 4.40.

Rs.

Direct labor (15 hours @ Rs. 6)

Contribution lost by not making product L (Rs. 4.40 x 15 hours)

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It is important that you should be able to identify the relevant cost which are appropriate to a

decision. In many cases, this is a fairly straightforward problem, but there are cases where great

care should be taken. Attempt the following question:

Question:

A company has been making a machine to order for a customer, but the customer has since gone

into liquidation, and there is no prospect that nay money will be obtained from the winding up of

the company. Costs incurred to date in manufacturing the machine are Rs. 50,000 and progress

payments of Rs. 15,000 had been received from the customer prior to the liquidation.

The sales department has found another company willing to buy the machine for Rs. 34,000 once

it has been completed.

To complete the work, the following costs would be incurred.

Materials: These have been bought at a cost of Rs. 6,000. They have no other use, and if

the machine is not finished, they would be sold for scrape for Rs. 2,000.

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Cost & Management Accounting (MGT-402)

Further labor costs would be Rs. 8,000. Labor is in short supply, and if the machine is

not finished, the work force would be switched to another job, which would earn Rs. 30,000 in

revenue, and incur direct costs of Rs. 12,000 and absorbed (fixed) overhead of Rs. 8,000.

Consultancy fees Rs. 4,000. If the work is not completed, the consultant's contract would

be cancelled at a cost at Rs. 1,500.

General overheads of Rs. 8,000 would be added to the cost of the additional work.

Required:

Assess whether the new customer's offer should be accepted.

Answer:

Costs incurred in the past, or revenue received in the past are not relevant because they

cannot affect a decision about what is best for the future. Costs incurred to date of Rs. 50,000 and

revenue received of Rs. 15,000 are `water under the bridge' and should be ignored.

Similarly, the price paid in the past for the materials is irrelevant. The only relevant cost

of materials affecting the decision is the opportunity cost of the revenue from scrap which would

be forgone Rs. 2,000.

Labor costs Rs Labor costs required to complete work 8,000 opportunity costs:

Contribution forgone by losing other work Rs. (30,000 12,000)

18,000

Relevant cot of labor

26,000

The incremental cost of consultancy from completing the work is Rs. 2,500.

Rs.

Cost of completing work

4,000

Cost of canceling contract

1,500

Incremental cost of completing work

2,500

Absorbed overhead is a national accounting cost and should be ignored. Actual overhead

incurred is the only overhead cost to consider. General overhead costs (and the absorbed overhead

of the alternative work for the labor force) should be ignored.

Relevant costs may be summarized as follows:

Rs.

Revenue from completing work

34,000

Relevant Costs:

Materials:

Opportunity cost

2,000

Labor:

Basic pay

8,000

Opportunity Cost

18,000

Incremental cost of consultant

2,500

30,500

Extra profit to be earned by accepting the order

3,500

The Deprival Value of an Asset

The deprival value of an asset represents the amount of money that a company would have to

receive if it were deprived of an asset in order to be no worse off than it already is.

The deprival value of an asset is best demonstrated by means of an example.

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Cost & Management Accounting (MGT-402)

Example: Deprival Value of an Asset

A machine cost Rs. 14,000 ten years ago. It is expected that the machine will generate future

revenues of Rs. 10,000. Alternatively, the machine could be scrapped for Rs. 8,000. An equivalent

machine in the same condition would cost Rs. 9,000 to buy now. What is the deprival value of the

machine?

Solution

Firstly, let us think about the relevance of the costs given to us in the question.

Cost of machine = Rs. 14,000 = past/sunk cost

Future revenues = Rs. 10,000 = revenue expected to be generated

Net realizable value = Rs. 8,000 = scrap proceeds

Replacement cost = Rs. 9,000

When calculating the deprival value of an asset, use the following diagram.

Lower of

Replacement

Revenue

Cost

Expected

(Rs. 9,000)

(Rs. 10,000)

Higher of

NRV

(Rs. 10,000)

(Rs. 8,000)

Therefore, the deprival value of the machine is the lower of the replacement cost and Rs. 10,000.

The deprival value is therefore Rs. 9,000.

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