Module 13.

Relevant Costs
in Decision
Making
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Decision Making

 Introduction
 Relevant Vs. Sunk cost
 Make or Buy decision making
 Shutdown Cost
 Joint Product
 Joint Product Cost Allocation
 Introduction of new product

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Relevant Cost

Cost which are relevant for a

particular business decision. They
are not historical cost but future
costs to be associated with different
inputs and activities related a
particular business decision.

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Relevant Cost

Relevant cost is expected future cost

which differs for alternative course.
Usually variable costs are relevant
while fixed cost are non-relevant.
Ex. Make or Buy, Special Pricing

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Relevant Cost

However, It is not essential that all

variable cost are relevant and all
fixed cost are irrelevant. Fixed or
variable costs that differ for various
alternatives are relevant costs.

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Relevant costs draw our alternation
to those elements of cost which are
relevant for decision.
e.g. 1) Fixed Cost for project X is Rs.
5 lakhs and for alternative project Y
it is 7 lakhs.
therefore fixed cost is relevant in
this example.
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E.g. 2) Direct material under
alternative I- Rs. 150 per Kg.
Direct material under alternative II-
Rs. 150 per Kg.
therefore variable cost is not
relevant in this example.
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SUNK COSTS

Sunk costs are all costs incurred or

committed in the past that cannot
be changed by any decision made
now or in the future. Sunk costs
should not be considered in
decisions.
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SUNK COSTS

E.g. cost incurred on research of a

product will be irrelevant while
making decision whether to
undertake production or not.

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Sunk Cost

Sunk costs have been incurred and

cannot be reversed. Historical costs
are sunk costs. They play no role in
decision making in the current
period.

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Sunk Cost do not affect future costs
and cannot be changed by any
current or future action, hence these
costs are irrelevant in decision
making.
Ex. Spending on advertising during
product launching is sunk for taking
a decision on continuance of product
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Make / Buy

Very often make-or-buy

decision is the act of making
a tactical choice between
producing an item internally
and buying it from an outside
supplier.
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Make / Buy

Under such circumstances

two factors are to be
considered:
 whether surplus capacity is
available and
 the marginal cost.
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 Elements of the "make“ analysis
include:
 Incremental inventory-carrying
costs
 Direct labor costs
 Incremental factory overhead costs
 Delivered purchased material costs
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 Incremental managerial costs
 Any follow-on costs stemming from
quality and related problems
 Incremental purchasing costs
 Incremental capital costs
 Ms. Keshav (Case)

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 Cost considerations for the "buy"
analysis include:
 Purchase price of the part
 Transportation costs
 Receiving and inspection costs
 Incremental purchasing costs
 Any follow-on costs related to quality
or service

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Shutdown Cost

Some times it becomes necessary for

a company to temporarily close down
the factory or unit because of trade
downturn with view to reopening it in
the future. In this situation decisions
are based on the variable cost
analysis.

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Shutdown Cost

If selling price is above the variable

cost then it better to continue
because the losses are minimized.
By closing the manufacturing
activity, some extra fixed expenses
(e.g. Security) may be incurred and
certain fixed expenses can be
avoided (e.g. maintenance cost of
plant). Such costs are also relevant.
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The decision is based on as to
whether the contribution is more
than the difference between
fixed expenses incurred in
normal operation and the fixed
expenses incurred when the
plant is shut down.

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Introducing new Product

There are two reasons why a

commercial enterprise should
undertake the time, effort, and
expense of introducing a new
product or service:
(1) customers have shown interest

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(2) demand is sufficient and
sustainable enough for the proposed
product to make a profit.
In other words, successful
enterprises sell what customers want
to buy rather than what the
entrepreneur wants to sell.

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Introducing
new Product
All relevant costs should be
recovered over a period of product
life.

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Joint Product

When two or more products of

equivalent importance are
produced simultaneously, they
are termed as joint products.

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Joint Product

In other words two or more

products separated in course of
the same processing operation,
each product being in such
proportion that no single product
can be designated as a major
product.

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Joint Products usually
require further processing.

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Joint Products.
in Coke production, Coal is raw
material with Coke, Sulfate of
ammonia, light oil asjoint
products.
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E.g. Refining Process,
where crude oil is raw
material gives Petrol, Diesel,
Gas as Joint Products.

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 Joint Product Cost
Allocation
Separate Final
Joint Processing
Costs Sale
Petrol Separate
Separate
Processing
Processing Costs
Costs
Joint
Crude Production
Oil Process
Separate Final
Processing
Sale
Diesel
Separate
Separate
Split-Off Processing
Processing Costs
Point

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 By Product

By Product is product of relatively

small total value that is produced
simultaneously with a product of
greater total value. The product with
the greater value (Main product), is
usually produced in greater
quantities than the By Product.

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 By Product

In other words, when two or more

products are separated in course of
the same processing operation,
where one of the products being in
such proportion/ value that it can be
designated as a Main product, while
others are considered as By
Products.
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 By Product

ex. of By-products
in coke manufacture - gas and tar
in lumber mills - sawdust.
cotton cleaning process - cotton seed
coconut oil industry - coca shells

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Terminology

Joint Product Process: A

process that results in
production of two or more
products, which are termed
as joint products.

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Terminology

Joint product cost: The

cost of the raw
materials/input and the joint
production process.

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Split Off Point: The point in
the production process
where the individual
products become separately
identifiable.

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Joint Cost
Allocation:
Methods
• Physical units method
• Relative Sales Value Method
• Sale value at split off point
• Net Realisable value method

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Allocating
Joint Costs
Allocation based on
Physical Units a physical measure
Method of the product
produced eg Weight

Allocation based
Sales Value/ on the sales
Relative Sales values /relative
Value Method sales values of the
products at the
split-off point.
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 Allocation is based
Constant Gross
on estimated sales
Margin method
value at split off
point

Allocation based on
Net- sales value less
Realizable- post-separation
Value Method processing costs

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