Module 13 : Relevant Costs in Decision Making

Lecture 1 : Relevant Costs in Decision Making

  Objectives
In this lecture you will learn the following
Decision Making
Introduction.
Relevant Vs. Sunk cost.
Make or Buy decision making.
Shutdown Cost.
Joint Product.
Joint Product Cost Allocation.
Introduction of new product.

 
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.
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.
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.
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.

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.

 
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.
E.g. cost incurred on research of a product will be irrelevant while making decision whether to undertake
production or not.
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.
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.
 
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.
Under such circumstances two factors are to be considered:
whether surplus capacity is available and
the marginal cost.

Elements of the "make“ analysis include:

Incremental inventory-carrying costs.
Direct labor costs.
 Incremental factory overhead costs.
Delivered purchased material costs.
Incremental managerial costs.
Any follow-on costs stemming from quality and related problems.
Incremental purchasing costs.
Incremental capital costs.
Ms. Keshav (Case).

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.

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.
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.
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.
 

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

Joint Product

When two or more products of equivalent importance are produced simultaneously, they are termed as
joint products.
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.
Joint Products usually require further processing.

Joint Products.

in Coke production, Coal is raw material with Coke, Sulfate of ammonia, light oil asjoint products.

E.g. Refining Process, where crude oil is raw material gives Petrol, Diesel, Gas as Joint Products.

Joint Product Cost Allocation

 
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.
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.
ex. of By-products

in coke manufacture - gas and tar in lumber mills - sawdust.

cotton cleaning process - cotton seed coconut oil industry - coca shells.

 
Terminology

Joint Product Process:

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

Joint product cost:

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

Split Off Point:

The point in the production process where the individual products become separately identifiable.

Joint Cost Allocation: Methods

Physical units method.
Relative Sales Value Method.
Sale value at split off point.
Net Realisable value method.