Chapter 5 - Blackhall Publishing

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Chapter 5

Relevant Costs and Revenues for Decision-making

Relevant costs and revenues for decision-making

Each decision point is a unique opportunity, which often requires relevant specialist information to back the decision. The primary role of the accountant in the decision making process is to provide this information which may be constructed or revised to fit a specific problem.

Relevant costs and revenues

‘Costs and revenues appropriate to a specific management decision’

Relevant costs and revenues as defined by CIMA Official Terminology Historic and sunk costs Incremental costs Opportunity costs Replacement costs

Historic / Sunk costs

‘Cost that has been irreversibly incurred or committed and cannot therefore be considered relevant to a decision’

Sunk cost as defined by CIMA Official Terminology

Example 5.1: Historic / sunk costs

Sunk costs (machinery) should be ignored.

Food Land Limited is €5,000 better off by altering rather than selling immediately.

Incremental costs

‘Incremental costs are the changes in future costs and revenues that occur, as a result of decisions’

Example 5.2: Incremental costs and revenues

Example 5.2: Incremental costs and revenues

At first it would seem foolish to accept the deal offered by Duncan Tours.

However by accepting the tour company’s offer, the fixed costs will not change in total. Only sales and variable cost will change. Sales will increase by €20 per bed-night taken up and variable costs will increase by €15 per bed-night taken up. These are the incremental costs and benefits.

As the benefits outweigh the costs, the offer should be accepted. The business would lose out on extra profit of €9,750 (1,950 rooms x €5 (€20 €15)) if all the spare capacity (rooms) were not taken up by the tour company.

Opportunity cost

‘The value of the benefit sacrificed when one course of action is chosen in preference to an alternative’

Opportunity cost as defined by CIMA Official Terminology

Example 5.3: Opportunity costs

Replacement cost

‘Cost of replacing an asset’

Replacement cost as defined by CIMA Official Terminology

Example 5.4: Replacement cost

Accounting for business decisions Decision to outsource Decision to discontinue a department Decision for partial closure Special pricing decisions Decision-making with Limiting Factors

Example 5.5: Outsourcing decision

Fixed overhead will not change irrespective of the decision and is irrelevant. The relevant costs are materials, labour and supervision amounting to €157,000. Comparing this to the cost of outsourcing at €175,000, the hotel should retain its cleaning department.

Example 5.6: Closing an unprofitable department

Example 5.6: Closing an unprofitable department As the department has a positive contribution it should remain open By closing the baby department, overall profit fall by €30,000 the lost contribution from the Baby department

Example 5.7: Close in the off-season decision

Example 5.7: Close in the off-season decision

The analysis shows that the business should stay open based on financial criteria alone. The cost of closing would be the loss in revenue of €25,000 with the benefits of closing (the cost savings) only coming to €23,800.

Example 5.8: Special pricing decisions

Example 5.8: Special pricing decisions

At first it would seem that Monaghan Clothing should reject the order as the offer price of €20 is 43 per cent below their normal supply price and does not exceed the full cost price of producing the tracksuits. However focusing on the cost estimates, the fixed overhead of €280,000 will not change and the variable overhead will not change as a result of the order. Also direct labour is not expected to change as the company is presently working at 70 per cent of capacity. As these are the non-incremental costs for this order, they should be ignored in the decision process. The only costs that are incremental are the materials cost of €5.00 and the extra adjustment costs of €1.00, thus the company should accept the order. The relevant costs and benefits relating to the decision are as follows:

Limiting factors

‘Anything which limits the activity of an entity’

Limiting factor as defined by CIMA Official Terminology Sales demand.

Operating capacity.

Shortage of labour.

Shortage of materials.

Lack of available finance.

Limited distribution channels.

Limiting factors

Step 1 - Establish if a constraint actually exists.

Step 2 - Establish the contribution per unit.

Step 3 - Establish the contribution per limiting factor and rank in order of the highest contribution per limiting factor.

Step 4 - Establish the optimum plan.

Step 5 - Calculate the profit based on this plan.

Example 5.9: Limiting factors

Example 5.9: Limiting factors

Example 5.9: Limiting factors

Example 5.9: Limiting factors

Qualitative factors

Customers Employees Competitors Legal constraints Creditors / suppliers: Atkinson, Berry and Jarvis (1995)

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