Relevant costing
CONCEPT OF RELEVANT COSTING
A relevant cost is defined as future cash flow arising as a direct consequence of a
decision.
• The cost shall be incurred in future as result of decision. It means that any cost
that has already been incurred before initiation of decision is not relevant cost
and considered as “Sunk Cost”.
• The cost or benefit in relation to specific decision shall be in cash. There shall be
cash inflows or outflows as direct consequence of decision. The non-cash costs
like depreciation and apportioned overheads are treated as irrelevant cost.
• The cost shall be incremental means when decision is taken, the cost is incurred
otherwise not. Any cost that will happen anyway, regardless of the decision,
cannot be a relevant cost. For example, if committed to pay rent of machine for
next six months is irrelevant cost because it will not affect the decision. This cost
is termed as “Committed cost.
Use of relevant costing
Relevant cost principle is used when a decision has to be made and the
concern is whether the decision will increase profit or not. It is based
on minimum cost principle. Examples of application of relevant cost to
specific decisions are:
• Decision regarding acceptance of job or undertake some work at a
stated price that customer is willing to pay.
• Whether to sell joint products arising as result of common process, at
split off point or to sell it after processing further.
• Whether the products should be made in house or whether to
subcontract or outsource the work to external supplier.
Incremental: Example
A company has identified that each cost unit it produces has the following
costs:
Rs. (000)
Direct materials
50
Direct labour
20
70
Fixed production overhead
30
Total absorption cost
100
• The incremental cost of making one extra unit is Rs. 70,000. Making one
extra unit would not affect the fixed cost base. The fixed cost of Rs. 30,000
is irrelevant cost as it would not affect the decision.
Differential cost: Example
• A company needs to hire a photocopier for the next six months. It has
to decide whether to continue using a particular type of photocopier,
which it currently rents for Rs.2,000 each month, or whether to
switch to using a larger photocopier that will cost Rs.3,600 each
month. If it hires the larger photocopier, it will be able to terminate
the rental agreement for the current copier immediately.
• The decision is whether to continue with using the current
photocopier, or to switch to the larger copier. One way of analyzing
the comparative costs is to say that the larger copier will be more
expensive to rent, by Rs.1,600 each month for six months. The
differential cost of hiring the larger copier for six months would
therefore be Rs.9,600 (1,600 x 6).
Avoidable and unavoidable costs: Example
• A company has one year remaining on a short-term lease agreement on a warehouse.
The rental cost is Rs.100,000 per year. The warehouse facilities are no longer required,
because operations have been moved to another warehouse that has spare capacity.
• If a decision is taken to close down the warehouse, the company would be committed to
paying the rental cost up to the end of the term of the lease. However, it would save
local taxes of Rs.16,000 for the year, and it would no longer need to hire the services of a
security company to look after the empty building, which currently costs Rs.40,000 each
year.
• The decision about whether to close down the unwanted warehouse should be based on
relevant costs only. Avoidable costs are relevant costs. Unavoidable costs are not relevant
to a decision.
• Local taxes and the costs of the security services (Rs.56,000 in total for the next year)
could be avoided and so these are relevant costs.
• The rental cost of the warehouse cannot be avoided, and so should be ignored in the
economic assessment of the decision whether to close the warehouse or keep it open
for another year.
Committed cost (unavoidable costs): Example
• A company bought a machine one year ago and entered into a maintenance contract for
Rs.20,000 for three years.
• The machine is being used to make an item for sale. Sales of this item are disappointing
and are only generating Rs, 15,000 per annum and will remain at this level for two years.
• The company believes that it could sell the machine for Rs. 25,000.
• The relevant costs in this decision are the selling price of the machine and the revenue
from sales of the item.
• If the company sold the machine it would receive Rs. 25,000 but lose Rs. 30,000 revenue
over the next two years – an overall loss of Rs. 5,000
• The maintenance contract is irrelevant as the company has to pay Rs. 20,000 per annum
whether it keeps the machine or sells it.
• Leases normally represent a committed cost for the full term of the lease, since it is
extremely difficult to terminate a lease agreement.
Sunk costs: Example
• A company must decide whether to launch a new product on to the
market.
• It has spent Rs.900,000 on developing the new product, and a further
Rs.80,000 on market research.
• A financial evaluation for a decision whether or not to launch the new
product should ignore the development costs and the market
research costs, because the Rs.980,000 has already been spent and
would not be recovered regardless to go ahead with the launch or
not. The costs are sunk costs.
Opportunity costs: Example
• A company has been asked by a customer to carry out a special job. The
work would require 20 hours of skilled labour time. There is a limited
availability of skilled labour, and if the special job is carried out for the
customer, skilled employees would have to be moved from doing other
work that earns a contribution of Rs.60 per labour hour.
• A relevant cost of doing the job for the customer is the contribution that
would be lost by switching employees from other work. This contribution
forgone (20 hours × Rs.60 = Rs.1,200) would be an opportunity cost. This
cost should be taken into consideration as a cost that would be incurred as
a direct consequence of a decision to do the special job for the customer. In
other words, the opportunity cost is a relevant cost in deciding how to
respond to the customer’s request.
Relevant cost of materials:
Question:
X Co intends to print a catalogue for a one-off special promotion. The
catalogue requires 120 boxes of a particular type of paper that is not
regularly used by X Co although a limited amount remains in X Co’s
inventory from a similar job.
The cost when X Co bought the paper two years ago was $17 per box
and there are 50 boxes in inventory. The boxes could be sold for $14
each or could be purchased in the market for $22 each.
Required: What is the relevant cost of the paper to be used in printing
the catalogue (to the nearest whole number)?
Solution:
Scrap proceeds forgone of boxes held in inventory (50 × $14)
Purchase price of remaining boxes
(70 × $22)
Total
700
1,540
2,240
Relevant cost of labour and variable overheads
Question:
A Co is deciding whether to undertake a new contract.
15 hours of labour are required for the contract. Labour is currently at full
capacity producing X.
Cost card for X
$ per unit
Direct materials
(10kg @ $2)
20
Direct labour
(5 hours @ $6)
30
Selling price
75
Contribution
25
Required: What is the cost of using 15 hours of labour for the contract (to
the nearest whole number)?
Solution:
Variable cost of labour
Lost contribution from product X
Total
(15hrs @ $6)
(15hrs × $25/5)
$
90
75
165
Relevant cost of machinery
• Repair costs arising from use
• Hire charges
• Fall in resale value arising from use
Question:
J Co was intending to sell one of its production machines for $10,000 as it no
longer has a use for it. The machine is being depreciated at $2,000 per
annum. The variable running costs for the machine are $500 per annum.
The company has been approached by a new customer and asked to
manufacture one million components for a one-off order. These components
can only be manufactured on this machine and production will take place
over the coming year.
It has been estimated that the machine could be sold for $6,000 in one year’s
time.
Required: What is the relevant cost of using the machine to produce the
components (to the nearest whole number)?
Solution:
Reduction in sales proceeds of machine ($10,000 - $6,000)
Variable running costs of machine
Total
$
4,000
500
4,500