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 an introductory level. The explanation was based on taking information for decisions from costing systems. We saw 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 a contribution analysis and to take account of market factors. The variable/absorption costing distinction is not the only dimension of relevant costs that should concern us when handling financial 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 the financial 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 cost values to use in decisions. It falls to the accountant or accounting student to arrange these to advise the manager (who is faced with alternatives) on the financial consequences of the alternatives. 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 the relevant costs for decisions which are future costs and those which differ between alternative courses of action. One of the problems with this subject area is that there is no unanimity of approach in accounting 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 hoc nature of the decisions to be addressed by accounting decision-making information. Textbooks which deal with this area often use a range of terms to describe their approaches to deal with individual 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 be used 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 to decisions like discontinuing a product, make or buy, etc., it can also feature in other area such as environmental accounting or quality costing. For example, the cost of wasted material will not necessarily be the historical cost of that material based on the financial records, but what it will cost 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 is Parts 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 the data contained in financial accounts. To make the contrast more vivid we will contrast the logic contained 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 precise and hence be audited. They are a recording of transactions that have taken place and hence result in a measurement of profit. They are the result of allocations of costs both over time and between products/departments, etc. Hence any unit cost produced as a result of such an exercise is inevitably an average cost. The average is always a distortion 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 make

decisions about the past), the key objective is relevance to the decision. The key prompt for relevance is the decision, i.e., if we take this decision the following costs/revenues will 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 cash flow. That is, will the decision give rise to a change in cash coming in or going out? If it will 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-making or economic logic Accounting Logic Decision Logic Perspective Historical Future Objective Verifiability Relevance Prompt Transaction Decision Result Profit Cash flow Unit Average Marginal 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 a rearrangement 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 relevant costs for a particular decision is will it make a difference to cash flow. If the answer is yes it is likely 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 business there will be a range of costs and benefits. If any of these are past costs/benefits, those that have already been incurred, they are irrelevant. Past costs and benefits are always irrelevant. If raw material 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 the material for any future decision. The relevant cost of the material will be determined by whatever 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 in regular 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 original state (before the use of the material on the Project Alpha). If, on the other hand the company cannot conceive of a use for the material except for its use on Project Alpha (and the only alternative is a forced disposal for scrap) then the relevant cost to be used is the anticipated disposal value of the material (realisable value) when evaluating and costing Project Alpha. To incorporate 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 the relevant cost is zero, Project Alpha can use this material for nothing! Incidentally, if use on Project Alpha saved the company from having to pay for disposal of the material, maybe it is toxic, then the material would be a relevant revenue to Project Alpha. Notice in no case is the original 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 not historical costs, as the use of the illustration above related to material costs has illustrated. That is to say, it will not be possible to extract this data directly from the financial accounts. Some values in the financial accounts will not be relevant. Indeed some relevant values, for example opportunity costs, will never get into the financial accounts because they relate to alternatives not pursued. We shall further develop this point below when we make reference again, in a worked example, to the relevant cost of materials. Only future costs and benefits are relevant. If any of the future costs and benefits have applying to them some contractual obligation this is not relevant. In other words, the company is already committed to them, say due to a past contract of some kind, then these committed future costs and benefits are not relevant to the decision at hand. The logic behind this is that they are not influenced by the decision, i.e., not incremental if the decision is taken and not avoidable if the decision 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 by the predetermined price. Likewise the company must take the material, it cannot change these circumstances by a future decision. The only decision the company can make is what to do with the material once they have it and relevant costs for that are covered by the explanation given above. Only uncommitted future costs and benefits are relevant to the decision. That is they will occur if the decision proceeds (they will be incremental) or put another way they are avoidable if it does not proceed. Concepts of cost and benefits for decisions, Figure 2, depicts the relationships 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

down value) is never a relevant cost, likewise the depreciation cost of the owned machine is never relevant to a decision about its use or non use. Only future costs and benefits are relevant. Hence the disposal value of the machine, through a sale or exchange is relevant, as is the cost of a new machine to be bought (say as a replacement). Likewise any future production from the machine which could be sold is relevant to a decision about the possible machine disposal. Very often the value of the contribution of the production is used as one of the costs (opportunity costs) applicable if the sale of the machine is being considered. That is to say that one of the costs (opportunity costs) of disposing of the machine is the net revenue it will not earn in the future. Worked example – equipment Let us work through a small example to demonstrate the irrelevance of the costs of already owned equipment. A machinery replacement scenario occurs in Table 2(a), a manager believes that replacement is not worthwhile. He/she believes that there is no benefit from replacement because the cost of the new system £40,000 plus the loss on the old system of £17,000 (£27,000 – £10,000), total £57,000 is exactly equal to the saving on replacement of £57,000 (5 x £11,400). Table 2(a) Machine replacement scenario Four years ago a computer system was purchased by a life assurance company, to support its administrative functions. The total capital cost was £47,000. A life of 9 years was predicted for the system with a residual value of £2,000. It has a book value now of £27,000 after charging £5,000 annual depreciation. With the increase in computer processing power it is now apparent that a new and improved system can be bought for £40,000. This new system is likely to save the company £11,400 in annual staff costs and other expenses of a computer bureau. It will last for 5 years and is expected to sell for £5,000 after that time. The old system will be taken over by the company installing the new system, at a trade-in price of £10,000. A manager has asserted that there is no benefit from replacement because the cost of the new system £40,000 plus the loss on the old system of £17,000 (£27,000 - £10,000), total £57,000 is exactly equal to the saving on replacement of £57,000 (5 x £11,400). The manager’s analysis is flawed, it confuses past costs and future costs and saving, it is not logical. The overall effect of replacing the system, taking all years together, can be summarised in Table 2(b). You will note that this has not used the depreciation, written down value or original cost of the old system. It only uses future costs and revenues which are the relevant costs and revenues, i.e., cash flows. No attempt is made to set this out for discounting as it is beyond the objective of this article. Table 2(b) Machine replacement - overall difference Computer system replacement, relevant values New system less trade-in (£40,000 – £l0,000) Savings from the new system (5 x £11,400) £ – 30,000 +57,000 Year(s) 0 1–5

Disposal of new system Disposal of old system, now forgone Net benefit of replacement

+ 5,000 – 2,000 +30,000

5 5

We can also show the annual profit differences between the replace and not replace alternatives, and that they sum to £30,000 over the five years of life, see Table 2(c). In this we have incorporated the depreciation figures both old and new to demonstrate the point. From a decision-making point of view the Table in 2(c) is not wrong but it does not concisely show the effect of replacement. It attempts to show the likely profit pattern if replacement goes ahead, but it does not model the cash flows. For the record it would be fundamentally wrong to attempt to discount the values in Table 2(c). Table 2(c) Machine replacement – profit differences of keep and replace (all figures are in £000s) 1 2 3 4 5 Year Keep old system Depreciation (5.0) (5.0) (5.0) (5.0) (5.0) Buy new system Saving Depreciation Loss on disposal Sub-total new Difference(new – old)

11.4 (7.0) (17.0) (12.6) (7.6)

11.4 (7.0) 0 4.4 9.4

11.4 (7.0) 0 4.4 9.4

11.4 (7.0) 0 4.4 9.4

11.4 (7.0) 0 4.4 9.4

You should note that the total position is identical in both tables hence demonstrating the point that past costs, written down values and depreciation of already owned equipment are irrelevant. We can reach the same conclusion without them. One important behavioural point that will occur to the reader of Table 2(c) is that the manager concerned would not be pleased to see a profitable replacement of equipment to be shown up as a loss in year one even though better profits are reported subsequently. This is yet another problem with the financial accounting reporting system and business decision-making. Unfortunately, as a result of a profitable replacement, the financial results for year one look worse than they would without replacement, because of the application of the concepts, conventions and rules of financial reporting. Labour costs Simple examples often assume direct labour costs are variable costs and incremental if a product is produced, avoidable if it is not. This makes the practical assumption that there is an element of casual labour available which can be ‘hired and fired’ at will, perhaps combined with this some flexibility of the remaining work force. However relevant cost logic also applies to labour costs in much the same way. Thus in a problem involving labour cost reduction it is worthwhile ensuring that there are no other employment costs involved such as redundancy, retraining, etc. In current times with the existence of contracts of employment and the acknowledged social responsibility of employers it is possible that reduction, removal or manipulation of a work force may not be easy or cost free. Remember also that relevant costs

must be viewed in the context of the whole company, not just part of it. So, for example, discontinuing one product in plant P and transferring the associated workers to plant Q will not make labour a relevant cost in this decision. It will not alter the cash flow of the company. If, however, plant Q has a need for more workers for one of its projects and would have set on some new workers if the transfer did not take place then the value of these workers is relevant, as overall some cash outlay has been saved. Worked example – relevant material costs Let us again reinforce the theoretical ideas discussed above with a question requiring identification and use of relevant costs. The intellectual challenges in the latter parts of the problem which follows are advanced (i.e., at final or professional level) but the whole question is briefer than a typical advanced level question. Firstly, consider the scenario outlined in Table 3(a) which is built around relevant costs of materials. Let us first identify, from the data, an example of a sunk cost, an incremental cost and an opportunity cost. l A sunk cost is expenditure that has taken place in the past and which will not be affected by the decision under consideration. The acquisition cost of the material of £40 or £44 is a sunk cost.

An incremental cost is expenditure which is incurred because a particular course of action is taken. It is avoided if the action is not taken. The repackaging cost of Product A of £60 per tonne is incremental, if Product A is sold. An opportunity cost is the value of a benefit foregone because an alternative was not chosen. It is often used to demonstrate the superiority of the chosen alternative. The revenue lost (i.e., £36 per tonne) because forced sale of this material will not take place, is an opportunity cost of using it to make Product A.

The company wants to generate a minimum price for Product X given the cost information in Table 3(a). We are required to suggest a range of relevant costs, to guide that pricing, applicable to various volume levels of X. Let us first gather our thoughts on the information. The alternatives for the product currently in bulk storage are forced sale in bulk to realise £36 per tonne or resale for £105 per tonne after incurring £60 incremental cost (net £45 per tonne). The company has 2000 tonnes available, 500 tonnes may be used for Product A. Product A is more financially attractive than bulk resale, (£45 per tonne is better than the £36 realisable value). It is the above alternative which dictates the ‘cost’ (opportunity cost) of the use of the resources in Product X. • For sales volumes of X up to 1500 tonnes there is sufficient volume already in stock to utilise the bulk sale material only. To make the sale of X worthwhile the revenue must exceed £80 incremental cost and £36 opportunity cost i.e., £116 per tonne. So the relevant cost is £116, any price which exceeds this figure is a worthwhile sale. For sales volumes above 1500 tonnes of X the company must cut back its sales of A. The price of X must compensate the company for the lost contribution related to A. The incremental cost of £80 and opportunity cost of £45 therefore apply, total £125 per tonne. Finally, for sales of X above 2000 tonnes the company will be forced to buy in further supplies at £48 per tonne. The relevant cost for sales above 2000 tonnes is therefore £48 plus £80, i.e., £128 per tonne. It is worth noting that the company should not buy in further supplies of material at £48 to develop Product A as this acquisition cost plus the

incremental cost exceeds the predicted selling price. Let us now give the problem a further twist, with a new development for the company in relation to Product B. Let us assume that it subsequently emerges that a market for 300 tonnes of Product B will develop. One tonne of product B will sell for £180 and attract additional cost of £40 per tonne. Let us examine how this is this likely to affect the cost information for pricing of the material for product X in terms of value and volume. Table 3 (a) Raw material relevant costs scenario A company in the food industry is currently holding 2000 tonnes of material in bulk storage. This material deteriorates with time and so in the near future it needs to be repackaged for sale or sold in its present form. The stock was acquired in two batches, 800 tonnes at a price of £40 per tonne and 1200 tonnes at a price of £44 per tonne. The current market price of any additional purchases is £48 per tonne. However, if this company were to dispose of the material it could sell any quantity but only for £36 per tonne. It does not have the contacts or reputation to command a higher price. Re-packaging of this bulk material may be undertaken to develop Product A, Product B or Product X. No weight loss occurs with repackaging, that is, one tonne of material will make one tonne of A, B or X. For Product A there is an additional cost of £60 per tonne after which it will sell for £105 per tonne. The marketing department estimates that 500 tonnes could be sold in this way. There is no firm information yet on Product B. In the development of Product X the company incurs additional costs of £80 per tonne for repackaging. A market price for X is not known and no minimum price has been agreed. The management are currently engaged in discussions over the minimum price which may be charged for Product X in the current circumstances. One general thought is that Product B is a very attractive proposition for the company. It offers a net contribution of £140 per tonne. If the company had no stock it would be financially worthwhile to buy in at £48 to sell this product. However, the opportunity cost of stock already held is below this price so the issue does not arise. • • • If 300 tonnes of B are required the relevant cost of £116 per tonne for product X shown above applies to only 1200 tonnes. For 1200 to 1700 tonnes the price of £125 applies and over 1700 tonnes £128 per tonne is appropriate. The contribution of Product B is of no consequence, the introduction of B affects the volume levels but not the values of the raw material resources. Diverting some material to Product B has implications only for the volume of material available to make Product X. Note that both the volume and price of X are not known so no statement of preference between X and B is possible at this time.

Conclusion In this second article we have focused on the extraction of relevant values for decisions. We have seen that rarely do they come directly from financial accounting reports or the historical financial records. They are based on economic values not historical costs and they are the uncommitted future values that make a difference if the decision is pursued. In relation to asset replacement, we have demonstrated that, the original cost, written down value and annual

depreciation of already owned assets is not relevant. When considering cost of material the relevant cost depends on the various alternatives for the use of the material not the acquisition cost. We also saw with labour costs that relevance is determined in relation to the whole company not just one department. To summarise, the figures produced by the financial accounting system may be taken by some as ‘attention-directors’ for issues to receive more detailed attention. However, when carrying out ad hoc analysis for future decisions we should be wary of using directly the values contained in historical financial accounting reports. Reference Coulthurst and Piper (1986), ‘The Terminology and Conceptual Basis of Information for Decision-Making’. Management Accounting, May 1986, pp 34-38. Mike Tayles is the Co-Examiner for Paper 8

Sign up to vote on this title
UsefulNot useful