Chapter – 8
Relevant Costing
What is a relevant cash flow??
A relevant cash flow is a 'future incremental cash flow’.
Sunk costs are not relevant to the
decision, and therefore must be
ignored
Only cash items are relevant to the
decision. Non cash items are not
considered for decision making.
Only extra cash flows that occur as a result of the decision
should be considered.
Note that fixed costs should be ignored unless they are
incremental fixed cost arising as a result of the decision.
Committed costs: costs that are unavoidable in the future. These costs are not affected by the decision and hence must be ignored.
Opportunity costs: Cost of loosing the benefits from the next best alternative use of a resource. Hence, opportunity costs must be included.
Relevant costs associated with non-current assets
Relevant cash flows
•
Purchase price of any new machinery needed
•
In case an existing machine is to be used in the project that would otherwise have been sold, then
opportunity cost must be taken. Opportunity cost = sale proceeds foregone
•
In case an existing machine from another department is used, which is not replaced, then the opportunity
cost = the lost contribution from the other department
•
Scrap/disposal proceeds on new assets bought
Items that are not relevant
•
Depreciation
•
Profit or loss on disposal (only the sale proceeds are considered)
•
The original purchase price of existing machinery (which is a sunk cost)
•
The NBV of existing machinery
Make or buy decisions ??
Resources Bought: Their purchase cost is wholly marginal.
Resources manufactured: The costs of manufacturing will be the direct materials and wages costs,
plus the variable factory overhead.
Decision:
Outsource –
If the total variable costs of manufactured components
>
the cost of obtaining the components from outside
Make or buy decisions: Other issues to consider
❖
Reliability of external supplier (in terms of quantity, quality, time of delivery, price, etc.)
❖
Specialist skills of the external supplier
❖
Alternative use of resources, freed up because of outsourcing
❖
Social (in terms of impact of outsourcing on the firm’s workforce, which can be laid off, if required)
❖
Legal (in terms of the effect of outsourcing on the contractual obligations with suppliers or employees)
❖
Risk of loss of confidentiality (where the external supplier can perform similar work for rival companies)
❖
Customer reaction
Outsourcing: Pros and cons
Shut down decisions
The quantifiable impact of a closure
•
Lost contribution from the area that is being closed
•
Savings in specific fixed costs from closure
•
Known penalties and other costs resulting from the closure (e.g. redundancy, compensation to customers)
•
Known reorganisation costs
•
Known additional contribution from the alternative use for resources released (benefit of closure)
Close the division: If the relevant benefits of closure > the relevant costs of closure
Non-quantifiable costs and benefits of closure
•
Unknown penalties and other costs resulting from the closure
•
Knock-on impact of the shut-down decision
One – Off Contracts
The minimum contract price = the total net relevant cash flow associated with the contract
Further considerations:
❑
The price acceptable for a one-off contract may not be acceptable for all contracts and
products
❑
The minimum price obtained using relevant costing may be much lower than the average
market prices
❑
But, a company may be willing to accept a loss on such a contract if it increases the chances
of winning subsequent contracts, where the chances of charging a better price are good.
Further processing decisions
Some important terms:
1.
Joint products: Joint products arise where the manufacture of one product results in the
manufacture of other products.
2.
Split off point: The point at which individual products become identifiable
3.
Joint costs: Costs incurred before the split-off point are called joint costs. These costs are
shared between joint products produced.
4.
Further processing costs: After separation products may be processed further thereby
incurring costs which can be allocated directly to the product on which they are incurred.
Further processing decisions
Deciding whether to process a product further or to sell after split-off point:
Costs to be considered in a further processing decision:
❑ only future incremental cash flows
❑ the difference in revenue and any extra costs
Costs to be ignored in a further processing decision: Joint costs
Thank You