Chapter VIII.

Relevant Costs to Decision Making

Relevant cost is a managerial accounting term that describes avoidable costs that are
incurred when making business decisions. The concept of relevant cost is used to eliminate
unnecessary data that could complicate the decision-making process. As an example, relevant cost
is used to determine whether to sell or keep a business unit. Assume, for example, a passenger
rushes up to the ticket counter to purchase a ticket for a flight that is leaving in 25 minutes, and
the airline needs to consider the relevant costs to make a decision about the ticket price. Almost
all of the costs related to adding the extra passenger have already been incurred, including the
plane fuel, airport gate fee, and the salary and benefits for the entire plane’s crew. Because these
costs have already been incurred, they are not relevant. The only additional cost is labor to load
the passenger’s luggage and any food that is served, so the airline bases the ticket-pricing decision
on just a few small costs.

A big decision for a manager is whether to close a business unit or continue to operate the
company division, and relevant costs are the basis for the decision. Assume, for example, a chain
of retail sporting goods stores is considering closing a group of stores catering to the outdoor sports
market. The relevant costs are the costs that can be eliminated due to the closure, as well as the
revenue lost when the stores are closed. If the costs to be eliminated are greater than the revenue
lost, the outdoor stores should be closed.

The Differences Between Make vs. Buy Decisions

Make vs. buy decisions are often an issue for a company that requires component parts to
create a finished product. For example, a furniture manufacturer is considering an outside vendor
to assemble and stain wood cabinets, which are then finished by adding wood handles and other
details. The relevant costs are the variable costs incurred by the manufacturer to make the wood
cabinets and the price paid to the outside vendor. If the vendor can provide the component part at
a lower cost, the furniture manufacturer outsources the work.

Factoring in a Special Order

A special order occurs when a customer places an order near the end of the month, and
prior sales have already covered the fixed cost of production for the month. If a client wants a price
quote for a special order, management only considers the variable costs to produce the goods,
specifically material and labor costs. Fixed costs, such as a factory lease or manager salaries are
irrelevant, because the firm has already paid for those costs with prior sales.

Cost of Labor
The cost of labor is the sum of all wages paid to employees, as well as the cost of employee
benefits and payroll taxes paid by an employer. The cost of labor is broken into direct and indirect
(overhead) costs. Direct costs include wages for the employees that produce a product, including
workers on an assembly line, while indirect costs are associated with support labor, such as
employees who maintain factory equipment. When a manufacturer sets the sales price of a product,
the firm takes into account the costs of labor, material and overhead. The sales price must include
the total costs incurred; if any costs are left out of the sales price calculation, the amount of profit
is lower than expected. If demand for a product declines, or if competition forces the business to
cut prices, the company must reduce the cost of labor to remain profitable. To do so, a business
can reduce the number of employees, cut back on production, require higher levels of productivity
or reduce other factors in production cost.

The Differences Between Direct and Indirect Costs of Labor

Assume that XYZ Furniture is planning the sales price for dining room chairs. The direct
labor costs are those expenses that can be directly traced to production. XYZ, for example, pays
workers to run machinery that cuts wood into specific pieces for chair assembly, and those
expenses are direct costs. On the other hand, XYZ has several employees who provide security for
the factory and warehouse; those labor costs are indirect, because the cost cannot be traced to a
specific level of production.

Examples of Fixed and Variable Costs of Labor

Labor costs are also classified as fixed costs or variable expenses. For example, the cost of
labor to run the machinery is a variable cost, which varies with the firm's level of production. XYZ
also has as a contract with an outside vendor to perform repair and maintenance on the equipment,
and that is a fixed cost.

Factoring in Undercosting and Overcosting

Since indirect labor costs can be difficult to allocate to the correct product or service, XYZ
Furniture may underallocate labor costs to one product and overallocate labor costs to another.
This situation is referred to as undercosting and overcosting, and it can lead to incorrect product
pricing.

Assume, for example, that XYZ manufactures both dining room chairs and wooden bed
frames, and that both products incur labor costs to run machinery, which total $20,000 per month.
If XYZ allocates too much of the $20,000 labor costs to wooden bed frames, too little is allocated
to dining room chairs. The labor costs for both products are incorrect, and the sale price cannot be
calculated accurately.

Cost of Labor vs. Cost of Living

While the cost of labor refers to the sum of all wages paid to employees, it should not be
confused with the cost of living. The cost of living is the cost needed to maintain a certain standard
of living by a consumer in a specific geographic location. This includes housing, food,
transportation, entertainment, etc. These rates can sometimes be much higher than the cost of labor,
especially in highly metropolitan areas. For example, the cost of living is higher in New York City
than in a suburban city. Demand for housing and food is higher, which means higher prices for
consumers.

Unit Cost
A unit cost is a total expenditure incurred by a company to produce, store, and sell one
unit of a particular product or service. Unit costs are synonymous with the cost of goods sold and
cost of sales.

This accounting measure includes all of the fixed and variable costs associated with the
production of a good or service. Unit cost is a crucial cost measure in the operational analysis of a
company. Identifying and analyzing a company’s unit costs is a quick way to check if a company
is producing a product efficiently.

Variable and Fixed Unit Costs

Successful companies seek ways to improve the overall unit cost of their products by
managing the fixed and variable costs. Fixed costs are production expenses which are not
dependent on the volume of units produced. Examples are rent, insurance, and equipment. Fixed
costs, such as warehousing and the use of production equipment, may be managed through long-
term rental agreements.

Variable costs vary depending on the level of output produced. These expenses have further
division into specific categories such as direct labor costs and direct material costs. Direct labor
costs are the salaries paid to those who are directly involved in production while direct material
costs are the cost of materials purchased and used in production. Sourcing materials can improve
variable costs from the cheapest supplier or by outsourcing the production process to a more
efficient manufacturer. For example, Apple outsources its iPhone production to Foxconn of China.

Fast Facts

 Generally, unit costs represent the total expense involved in creating one unit of a product
or service.
 Goods-centric unit cost measures will vary between businesses.
 A large organization may lower the unit cost through economies of scale.
 Companies recognize product unit costs on the income statement.
 The cost is useful in gross profit margin analysis and forms the base level for a market
offering price.
 Companies seek to maximize profit by reducing unit costs and optimizing the market
offering price.
Unit Cost on Financial Statements
A company’s financial statements will report the unit cost. These reports are vital for
internal management analysis. The reporting of unit costs can vary by the type of business.
Companies that manufacture goods will have a more clearly defined calculation of unit costs while
unit costs for service companies can be somewhat vague.

Both internal management and external investors analyze unit costs. These individual item
expenses include all of the fixed and variable expenses directly associated with a product’s
production such as workforce wages, advertising fees, and the cost to run machinery or warehouse
product. Managers closely monitor these costs to mitigate rising expenses and seek out
improvements to reduce the unit cost. Typically, the larger a company grows, the lower the unit
cost of production becomes. This reduction is because of economies of scale. Production at the
lowest possible cost will maximize profits.

Accounting for Unit Costs

Private and public companies account for unit costs on their financial reporting statements.
All public companies use the generally accepted accounting principles(GAAP) accrual method of
reporting. These businesses have the responsibility of recording unit costs at the time of production
and matching them to revenues through revenue recognition. As such, goods-centric companies
will file unit costs as inventory on the balance sheet at product creation. When a sales event occurs,
unit costs will then be matched with revenue and reported on the income statement.

The first section of a company’s income statement focuses on direct costs. In this section,
analysts may view revenue, unit costs, and gross profit. Gross profit shows the amount of money
a company has made after subtracting unit costs from its revenue. Gross profit and a company’s
gross profit margin (gross profit divided by sales) are the leading metrics used in analyzing a
company’s unit cost efficiency. A higher gross profit margin indicates a company is earning more
per dollar of revenue on each product sold.

Productivity And Costs

Productivity and costs refer to an economic data set that measures future inflationary trends
with two indicators. Productivity is the indicator that measures labor efficiency in producing goods
and services in the U.S. economy. Costs is the indicator that measures the unit labor costs of
producing each unit of output in the U.S. economy. Together, productivity and costs monitors
inflationary trends in wages, which usually affect trends of inflation in other areas.

Breaking Down Productivity And Costs

Both the bond and equity markets seem to be affected in the same direction by productivity
data. Because a more efficient workforce can lead to higher corporate profits, equity markets enjoy
seeing good productivity growth. The bond markets, which enjoy a low inflationary situation, also
prefer to see high productivity due to its role in keeping inflationary pressures low. As productivity
growth occurs, inflation is stemmed, because the economy can sustain higher growth than could
be possible with inefficiencies in the labor markets.

The Productivity and Costs Report

The Productivity and Costs Report is released quarterly by the Bureau of Labor Statistics
(BLS). It measures output achieved by businesses per unit of labor. In this context, output is
measured by using previously-released gross domestic product (GDP) figures; input is measured
in hours worked and the associated costs of that labor. The unit labor costs that are provided take
into account more detail than is provided in the earlier labor reports, including the effects of
employee benefit plans, stock options expensing and taxes.

Changes in percentage, presented in annualized rates, are the key figures released with this
report. Separate productivity rates are released for the business sector, non-farm business sector
and manufacturing. Manufacturing is kept separate because, unlike the rest of the data, total
volume output is used instead of GDP figures, and it also shows the highest volatility of any of the
industry groups.

Productivity figures are provided across the economy as a whole, as well as for major
industry groups and sub-sectors—it is a very thorough and detailed release, which is the main
reason for the long time lag between period end and data release. The BLS will begin with total
GDP figures, then remove government production and non-profit contributions to arrive at a GDP
component that represents just "corporate America."

Importance of the Productivity and Costs Report

Strong productivity gains have been one of the most important reasons that the U.S.
economy has expanded for the past 25 years. Productivity gains have historically led to gains in
real income, lower inflation and increased corporate profitability. A company that is increasing
output with the same number of hours worked will likely be more profitable, which means that it
can raise wages without passing that cost on to customers, which keeps inflation pressures down,
while adding to GDP growth.