RELEVANT COSTING

CHAPTER 9

Presented by: Nicole Lieman

FNB 135

Relevant Costing: revision of key concepts

Remember the definition:

Future cash flows that differ between 2

options

Other definitions
Irrelevant
costs

Opportunity
costs

The next best

alternative given
up
Constraint

Common
costs
Unique costs

Sunk costs

Committed
costs

Relevant Costing: revision of key concepts

Two methods

Show all the relevant costs for the 2 options (2

columns)
Show only the incremental cash flows (1 column)

Consider only relevant cash flows

Always consider both qualitative and
quantitative factors
Types of decisions:

Special orders
Outsourcing (make or buy decisions)
Replacement of equipment
Discontinuation decisions (products or divisions)

Timing of decision

How should costs be measured for a range of nonroutine short-term and long-term decisions?

What is the difference?

Short-term Decision

Long-term Decision

Once-off orders, make or buy decisions

(outsourcing), discontinuation decisions,
and replacement of equipment. etc

Whether to make a long-term strategic

move ,set a selling price, introduce a new
product or service, discontinuance of a
product, purchase infrastructure, outsourcing

Identify relevant costs, sunk costs,

opportunity costs/incomes, incremental
costs and avoidable costs in a scenario
related to this decision. (Remember the
irrelevance of book values)

Use capital budgeting (NPV), a multi period

approach.

Selling Price decisions (Short-term)

Costs related to the decision may be different

as we view these costs from a long-term
perspective.
Selling Price decisions (Long-term)

Relevant incremental cost + a mark-up.

Full costs + company return (WACC)

Detailed knowledge
of relevant costing
is very important

NPV and capital

budgeting knowledge is
very important

Relevant Labour costs S/T

Capacity constraints

How can we get additional labour:

Overtime?

More expensive?
New staff? Training
Reduce production of something else

Now have an opportunity cost + relevant cost

Remember: will always go with the cheapest
option to source more labour

Salaries/wages
Partial capacity constraint

Cost of available capacity (eg usual labour rate)

Cost of overtime when need more capacity)

Example 1 labour costs

Relevant material costs: S/T

No alternative use

Materials used regularly in production

Sitting idle: no cost

What about the original

purchase price?

Irrespective of how much is on hand, will need to

be replaced: replacement cost

Have an alternative use

Used on another product, thus if use on order

cannot produce other product: opportunity cost
Could have been scrapped for a small income:
opportunity cost
Would have had to be removed at a cost:
opportunity saving

Example 2 materials

Short term vs long term

Variable costs / Fixed costs / Mixed costs

Long term:

more costs can be changed,

thus more costs will be relevant

Approach:

Consider all costs that would be relevant in

each period
NPV discounted at required return
Required return depends on what is being
analysed:
Company

WACC or divisional return

Example 3 S/T vs L/T

Consider
Head office allocated costs
Free space in factory
Lost or increased sales in another product
By-products
Redundancy costs
Book values
Depreciation allocation of past costs
Idle time
Alternative use for materials
Transfer pricing
Materials (historic cost/replacement cost/MV/NRV/opp cost)
Labour (Permanent salaried/Temporary hourly/No capacity,
opp cost

Qualitative factors to
consider

Decline in employee morale

Trade union reaction

Competitor reaction

Price elasticity

Availability of capacity, materials, labour

Better more lucrative alternatives available

Effect on environment / public outcry

Effect of low price on other customers

Price set now, when renegotiate later, bound to this

More qualitative factors to consider:

Repeat order?

Technical expertise

Timing of cash flows, financing

Reliability and reputation of customers

Tax consequences / allowances

Reliability of forecasts, information