management accounting-relevant costing

Management AccountingDecision MakingStage-5

Rizwan Ahmad MalikFCMA, LLB, CFE

Relevant CostingDefinition Relevant costs are future cash flows arising as direct consequence of a decision. Relevant Costs are future Costs (includes committed costs) Relevant Costs are cash flows (ignore non-cash depreciation) Relevant Costs are Incremental Costs

Institute of Cost & Management Accountants- Management Accounting & Decision Making

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Relevant CostingRelevant Costs:A relevant cost for the decision has following characteristics, Relevant cost is a future cost. The cost which has been incurred in the past are called sunk costs and are not relevant for the decision. Relevant costs are incremental costs. Relevant cost arises as a direct consequence of a decision. Relevant costs are cash flows. These are always settled in cash. Non-cash expenses are never relevant. Different terminologies are used for different types of relevant and irrelevant costs. These are summarized as follows.Institute of Cost & Management Accountants- Management Accounting & Decision Making 3

Relevant CostingCertain Kinds of Costs

Differential Costs Opportunity Costs

Avoidable Costs

Sunk Costs4


Relevant CostingDifferential Cost Difference between the two cost alternatives Avoidable Costs Specific costs of an activity or sector of a business which would be avoided if that activity did not exist. Opportunity Costs The value of the benefit sacrificed when one course of action is chosen in preference to an alternative. Sunk Cost A sunk cost is a past cost which is not directly relevant in decision making.


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Relevant CostingIrrelevant Costs Sunk costs: Costs which have been incurred in the past prior to making any decision are called sunk costs. E.g. If the raw materials have been purchased prior making a decision about the new product, raw material cost is not irrelevant for this decision. Committed cost: The costs which have been committed to be incurred in future are called committed costs. Committed costs are sunk costs and irrelevant for the decisions. Unavoidable costs: Costs which can t be avoided by not taking a decision or project are called unavoidable costs. These costs do not arise a direct consequence of a decision hence irrelevant for a project decision. Examples: oGeneral overheads or absorbed overheads are considered unavoidable hence irrelevant for project decisions. oOther fixed costs which do not arise or change as a direct consequence of a project are considered unavoidable and irrelevant. Relevant Costs Avoidable costs: Costs which can be avoided by not accepting a project or by not making a decision are called avoidable costs. Avoidable costs are relevant for the project decisions. Examples: oMaterial, labor and variable overheads are considered avoidable and relevant cost for project decisions. oDirectly attributable fixed costs i.e. fixed costs which arise as a direct consequence of a project, are considered relevant cost. Opportunity cost: The benefit of the best alternative forgone by preferring one alternative over the other is called opportunity cost . Opportunity costs become relevant if the resources are scarce. Examples: oIf a project uses a building which can otherwise be rented or sold, the rent or the sale proceeds forgone is opportunity cost of using the building and is relevant for the decisions. oIf the raw material being used in the project can be sold or has an alternative use, its use value or scrape value will be its relevant costs.6


Relevant CostingRelevant Cost of Materials- Important to NoteRelevant Cost of Material is their current replacement cost, unless the materials have already been purchased and would not be replaced once used. In such case the relevant cost of using them is higher of the followingI. Their current sale value II. The value they may obtain, if put to an alternative use. Further, If the materials have no resale value and no other possible use, then the relevant costs of using them would be nil.Institute of Cost & Management Accountants- Management Accounting & Decision Making 7

Relevant CostingRelevant Costing- Basic Tips General Rule: items of income or expense are only relevant to the decision if they make the business richer or poorer when the business goes ahead with the decision. For example, non-cash items are non relevant (such as depreciation of fixed assets), since to become richer the business must receive cash as a result of their decision and to become poorer the business must spend cash. This would also help to explain the concept of opportunity cost- where another opportunity is foregone if the business goes ahead with the decision under consideration. The amount by which they would be poorer is relevant and is called the opportunity cost. It is important that you know which revenues and costs are relevant and which are non-relevant. Relevant Non-Relevant Cash Sunk costs Opportunity costs Committed costs Incremental cash flows Non-cash items Share of group-wide fixed overheads


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Relevant CostingExercise-1 The output of a process consists of two joint products A and B and a by-product. Product B can be further processed to in order to increase its sales price. To assist the management in making decision whether to carry out further processing which one of the following is relevant. (The option which may affect the decision to further process or not).A. The share of the total processing cost which has been allocated to Product B. B. The sales value of Product A. C. The physical quantities of each product produced from common process. D. The cost of further processing and increase in sales value of B.Institute of Cost & Management Accountants- Management Accounting & Decision Making 9

Relevant CostingExercise-2 RC Ltd is tendering for a six months contract which would require the use of a specialist machine. The machine was purchased four years ago for Rs. 9,000 and now has book value of Rs. 3,500. RC Ltd was about to sell the machine for Rs. 4,000 but if they used it on this contract , it can be sold at Rs. 2,500 after six months. The variable cost of operating the machine for six months would be Rs 6,000/The relevant cost of operating machine for six months isA- Rs. 7,500 B- Rs. 10,000 C- Rs. 12,500 D. Rs 15,000


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Relevant CostingApplication of Relevant Costing Concepts Special Selling Price Decisions Product Mix Decision- Capacity Constraint Equipment Replacement Decisions Outsourcing (Make or Buy Decision) Business Discontinuation Decisions


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Relevant CostingSpecial Selling Price DecisionsSpecial Pricing Decisions involve one time orders only or orders at below market price. At 1st instance it looks like that order should be rejected since the proposed selling price is less than the actual total cost. Some Conditions Future Price must not be affected by the order Company has unused capacity available which has no alternative usage. Short Term Horizon Relevancy and irrelevancy of any cost is subject to a particular situation.


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Relevant CostingSpecial Selling Price Example Current Cost Product A Units Sales Direct Labor Direct Materials V Ohs Fixed Ohs Marketing Ohs Profit 40 12 8 2 22 8 3 11 7 35,000 1,400,000 420,000 280,000 70,000 770,000 280,000 105,000 385,000 245,000 Cost after Additional Order 38,000 3,000 units at Rs. 20 1,460,000 420,000 304,000 76,000 800,000 280,000 105,000 385,000 275,000 Units in total Differential 60,000 24,000 6,000 30,000 30,000


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Relevant CostingEquipment Replacement DecisionRelevant cost principles is also applicable in case of Equipment Replacement Decisions. The note able point is that past or sunk cost is irrelevant in such cases. While doing calculations at this stage, we need to ignore the time value of money at this stage.

Example


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Relevant CostingEquipment Replacement DecisionsExample Question Old Equipment Purchase Price Life 3 years old machine zero salvage value straight line depreciation method present WDV Disposal Value New Equipment Cost Life Zero scrap value 70,000 3 years Capacity 20,000 units15 Institute of Cost & Management Accountants- Management Accounting & Decision Making

Rs 180,000 6 years Capacity 20,000 units Variable Cost per Unit Rs. 3 per unit

Rs 90,000 Rs 40,000 and zero in three years time

Variable Cost per Unit

Rs. 2 per unit

Relevant CostingSolutionNew Old Machine Machine Variable Cost 20,000 units for 3 yrs 180,000 90,000 120,000 Difference cost/ revenue Status (60,000) Relevant (90,000) Irrelevant

Old Machine Book Value For Depreciation Charge Old Machine W/O Old Machine Disposal Purchase of New Machine

90,000 (40,000) 70,000 270,000 240,000

90,000 Irrelevant (40,000) Relevant 70,000 Relevant (30,000) Saving16


Relevant CostingAlternate Method- The Correct Method of Presentation Saving on Variable Cost Rs 3 - Rs 2 Old Machine Disposal 60,000 Relevant

40,000

Relevant

Purchase of New Machine Savings

(70,000) 30,000

Relevant


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Relevant CostingOutsourcing- Make or Buy DecisionOutsourcing is the process of obtaining goods or services from outside suppliers instead of producing the same goods or providing the same services within the organization. We have to choose from the two options. Example 1


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Example- Outsourcing Make Buy DecisionCost of 10,000 components Direct Materials Direct Labor Variable Overheads Fixed Manufacturing Overheads Share of Non-Manufacturing Ohs

Relevant CostingCost in Rs 120,000 100,000 10,000 80,000 50,000 360,000 per unit 12 10 1 8 5 36

Option-Supplier Offer Rs. 30 for 3 years Situation A if opted, labor shall be free at zero cost Fixed cost of Rs. 10,000 can be saved Capacity has no other use Situation B if opted, Capacity can be used for Product B 10,000 units Variable Cost shall be same Additional Raw Material of Rs. 13 per unit required Fixed cost of Rs. 10,000 shall not be saved as in A Capacity has no other use


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Relevant CostingSituation A Direct Materials Direct Labor Variable Overheads Fixed Manufacturing Overheads Share of Non-Manufact OHS Own Production 120,000 100,000 10,000 12 10 1 Outsource for A - Relevant Relevant Relevant Only Rs. 10,000 relevant

80,000 50,000 360,000 360,000 Additional Cost

8 5 36 36

70,000 50,000 120,000 300,000 420,000 60,000

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Irrelevant

5 Irrelevant 12 30 Relevant 42

Outsourcing Cost Total Cost

Alternate Method Outsourcing Cost Direct Materials Direct Labor Variable Overheads Fixed Manufacturing Overheads Additional Cost

300,000 300,000 120,000 100,000 10,000 10,000 240,000 60,000

30 Relevant 12 Relevant 10 Relevant 1 Relevant 1 Relevant


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Relevant CostingOutsource A Situation B Direct Materials Direct Labor Variable Overheads Fixed Manufacturing Overheads Share of Non-Manufacturing Ohs Produce Component B 130,000 100,000 10,000 13 Relevant 10 Relevant 1 Relevant Only Rs. 10,000 Irrelevant relevant Irrelevant

-

-

80,000 50,000 370,000 300,000 670,000 340,000 330,000 360,000 30,000

8 5 37 -

Outsourcing Cost Total Cost Sales of Part-B Net Costs of Option- B Current Cost of Option- A Saving


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Relevant CostingAlternative Solution Product B Direct Materials Direct Labor Variable Overheads Fixed Manufacturing Overheads 130,000 100,000 10,000 10,000 250,000 340,000 90,000 (60,000) 30,000

Sale Savings from B Loss from A Net Saving by opting B


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management accounting-relevant costing

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