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Relevant Costs for Decisions Part 2

Relevant Costs for Decisions Part 2

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Relevant costs for decisions Part 2:identifying relevant costs
 by
Mike Tayles
03 Mar 2001 In the previous article we addressed the costs and revenues for decisions starting from anintroductorylevel. The explanation was based on taking information for decisions from costing systems. Wesaw that such systems could have been based on absorption costs (which were maintained for financial accounting purposes), variable costs or ABC. In that article we needed to carry out acontribution analysis and to take account of market factors. The variable/absorption costingdistinction is not the only dimension of relevant costs that should concern us when handlingfinancial accounting reports. For example, just as we should be wary about using, directly for decisions, the unadjusted profit statement which has been produced for financial accounting purposes, so we should treat with care the unit cost values for all resources that appear in thefinancial accounts.We will now look more closely at the extraction of ad hoc individual relevant cost values for decisions. We shall see that we must exercise great care in identifying the appropriate costvalues to use in decisions. It falls to the accountant or accounting student to arrange these toadvise the manager (who is faced with alternatives) on the financial consequences of thealternatives. We must appreciate that because each situation is unique there is no system within business to routinely deliver relevant costs, they are situation specific. We must focus on therelevant costs for decisions which are future costs and those which differ between alternativecourses of action.One of the problems with this subject area is that there is no unanimity of approach inaccounting texts to dealing with the terminology or recommending the layout of an answer style. Such a recommendation would be fraught with difficulty, however, given the ad hocnature of the decisions to be addressed by accounting decision-making information. Textbookswhich deal with this area often use a range of terms to describe their approaches to deal withindividual costs in a relevant cost problem. For example, incremental costs, avoidable costs,sunk costs or past costs and opportunity cost are variously used. During this article these will beused in the illustrations which follow in an attempt to bring out their meaning.In practice and in examination questions this issue can be challenging, in addition to relating todecisions like discontinuing a product, make or buy, etc., it can also feature in other area such asenvironmental accounting or quality costing. For example, the cost of wasted material will notnecessarily be the historical cost of that material based on the financial records, but what it willcost to acquire some more of it and the impact this waste will have on future sales prospects.Any involved question on relevant costs would occur at certificate and professional level, that isParts 2 and 3 of the new syllabus starting in December 2001.
Decision logic not financial accounting logic
Relevant cost notions are more strongly linked to economic notions of cost and value than to thedata contained in financial accounts. To make the contrast more vivid we will contrast the logiccontained in financial accounting with the logic which we need to make managerial decisions.Figure 1 shows a contrast between accounting logic and decision-making logic and should be
 
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.
b.
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
PerspectiveHistoricalFutureObjectiveVerifiabilityRelevancePromptTransactionDecisionResultProfitCash flowUnitAverageMarginal
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
 
chosen decision a further material purchase will be needed to restore the company to its originalstate (before the use of the material on the Project Alpha). If, on the other hand the companycannot conceive of a use for the material except for its use on Project Alpha (and the onlyalternative is a forced disposal for scrap) then the relevant cost to be used is the anticipateddisposal value of the material (realisable value) when evaluating and costing Project Alpha. Toincorporate this disposal value into a costing of Project Alpha is to use it as an opportunity cost.Finally, if the material cannot be disposed of and the only option is project Alpha then therelevant cost is zero, Project Alpha can use this material for nothing! Incidentally, if use onProject Alpha saved the company from having to pay for disposal of the material, maybe it istoxic, then the material would be a relevant revenue to Project Alpha. Notice in no case is theoriginal acquisition cost used, though this would feature in any summary report that is produced by the financial accounting department relating to the use of this material.It is important to appreciate that in all decision analysis ‘economic’ values are used nothistorical costs, as the use of the illustration above related to material costs has illustrated. Thatis to say, it will not be possible to extract this data directly from the financial accounts. Somevalues in the financial accounts will not be relevant. Indeed some relevant values, for exampleopportunity costs, will never get into the financial accounts because they relate to alternativesnot pursued. We shall further develop this point below when we make reference again, in aworked example, to the relevant cost of materials.Only future costs and benefits are relevant. If any of the future costs and benefits have applyingto them some contractual obligation this is not relevant. In other words, the company is alreadycommitted to them, say due to a past contract of some kind, then these committed future costsand benefits are not relevant to the decision at hand. The logic behind this is that they are notinfluenced by the decision, i.e., not incremental if the decision is taken and not avoidable if thedecision is avoided. If a contract exists for a company to take delivery of material at a predetermined price at some future time, then the relevant cost of the material is not affected bythe predetermined price. Likewise the company must take the material, it cannot change thesecircumstances by a future decision. The only decision the company can make is what to do withthe material once they have it and relevant costs for that are covered by the explanation givenabove. Only uncommitted future costs and benefits are relevant to the decision. That is they willoccur if the decision proceeds (they will be incremental) or put another way they are avoidableif it does not proceed. Concepts of cost and benefits for decisions, Figure 2, depicts therelationships discussed above. I first saw this diagram discussed by Coulthurst and Piper (1986).A cost of a machine which is already owned by the company (either its original cost or written

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