read with the following comments:a.Financial accounting costs and revenues are historical, their objective is to be preciseand hence be audited. They are a recording of transactions that have taken place andhence result in a measurement of profit. They are the result of allocations of costs bothover time and between products/departments, etc. Hence any unit cost produced as aresult of such an exercise is inevitably an average cost. The average is always adistortion from the point of view of relevant costs and is not helpful.
Management decision-making logic is about future costs and revenues, (we cannot makedecisions about the past), the key objective is relevance to the decision. The key promptfor relevance is the decision, i.e., if we take this decision the following costs/revenueswill be incurred and if we do not take the decision they will not. It is clear, therefore,that the unit being measured is the marginal cost/revenue not the average cost or revenue. It is often useful to think of relevant costs in terms of an overall change in cashflow. That is, will the decision give rise to a change in cash coming in or going out? If itwill then the value is relevant, if not it is not relevant, this is a very good test.
Figure 1: A contrast of financial accounting logic and management decision-makingor economic logic
Accounting LogicDecision Logic
Importance of cash flow
A number of my practitioner colleagues often speak of the importance of the identification of ‘cash flow’ within an organisation. One reason for this in practice is if a manager is suggesting‘savings’ in costs or increases in profits for his department, one test these accountants apply is“where will I see the cash?” In other words, prove to me that the cost or profit change is real not just a rearrangement of the figures within the rules of financial accounting. Often such arearrangement will make one part (product or department) look better at the expense of another.To ask about the cash flow is to look for real change in relevant costs at the company level, not just one part of the company. One test which can be applied in the identification of relevantcosts for a particular decision is will it make a difference to cash flow. If the answer is yes it islikely that the cost or revenue will be relevant to the decision.
A framework of analysis of costs and benefits for decisions
To help us move towards a framework it is helpful to build up a few rules. Within a businessthere will be a range of costs and benefits. If any of these are past costs/benefits, those that havealready been incurred, they are irrelevant. Past costs and benefits are always irrelevant. If rawmaterial has been acquired and held in the stock records at its purchase cost this will be for the purposes of the financial accounting records. This purchase cost is not the relevant cost for thematerial for any future decision. The relevant cost of the material will be determined bywhatever alternative courses of action are open to the company.Say a company is envisaging a new Project Alpha. If the material to be used on Alpha is inregular use the relevant cost is the future replacement cost, on the basis that once applied to the