What is Management Accounting?

Management accounting provides information to managers so that they can effectively and
efficiently manage an organization. In this first chapter, we will look at what managers do,
the information that they need, the general business environment in which managers
function, and the importance of business ethics.

Key Functions of Management Accountants

All managers carry out three major activities – planning, directing and motivating, and
controlling.

Planning: Planning involves selecting a course of action and specifying how the action will
be implemented. The first step in planning is to identify the various alternatives. Next the
alternative that does the best job of furthering the organization’s objectives is selected.
Management’s plans are usually expressed in budgets. Typically, budgets are prepared
annually under the direction of the controller, who is the manager of the accounting
department.

Directing & Motivating: In addition to planning for the future, managers must oversee day-
to-day activities to keep the organization running smoothly. Much of a manager’s daily
routine involves directing and motivating employees. Managers make work assignments,
resolve conflicts, solve on-the-spot problems, and make many small decisions that affect
both employees and customers.

Controlling: In carrying out the control function, managers seek to ensure that the plan is
being followed. Feedback, which signals whether operations are on target, is the key to
effective control. One type of feedback that is very helpful to mangers is called a
performance report. Budgets are compared to actual results in performance reports to
determine if operations are proceeding as planned.

Difference between Financial Accounting and Management

Accounting
There are seven key differences between management accounting and financial accounting:

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 i. Financial accounting reports are prepared for external users. Management
accounting reports are prepared for internal users.

ii. Financial accounting summarizes past transactions. Management accounting

has a strong emphasis on the future.

iii. Financial accounting data should be objective and verifiable. Management

accounting data should be relevant for the decision at hand, even if it is not
completely objective and verifiable.

iv. Financial accounting focuses on precision. Management accounting aids

decision makers by providing good estimates as soon as possible rather than
waiting for precise data at some later time.

v. Financial accounting is concerned with reporting for a company as a

whole. Management accounting focuses on segments of a company such as
product lines, sales territories, divisions, and departments.

vi. Financial accounting must conform to generally accepted accounting

principles (GAAP). Management accounting is not bound by GAAP.

vii. Financial accounting is mandatory because outside parties such as the

Securities and Exchange Commission and tax authorities require periodic
financial statements. Management accounting is not mandatory.

How Does Management Accountants Fit in a Business?

The work of management is summarized in the planning and control cycle shown on your
screen. The process is a continuous loop in many organizations. Once plans are made, they
are implemented. The controlling process starts with measuring actual performance and
then comparing those results with planned performance. Corrective action may be
necessary if actual results differ significantly from the plan. In some cases, new information
may result in altering the plan before the cycle is repeated. Note that decision making is
involved in all management activities.

Core Reading: Garrison, Ray, H., Noreen, Eric, W., & Brewer, Peter, C. (2015).
Managerial Accounting. [15th Edition]. The McGraw-Hill, New York, USA.

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 What is a Budget? – Understanding Budgetary Functions

Budget

A budget is a detailed plan for the future that is usually expressed in formal quantitative
terms. Individuals sometimes create household budgets that balance their income and
expenditures for food, clothing, housing, and so on while providing for some savings.

Once the budget is established, actual spending is compared to the budget to make sure the
plan is being followed. Companies use budgets in a similar way, although the amount of
work and underlying details far exceed a personal budget.

The act of preparing a budget is called budgeting. The use of budgets to control an
organization’s activities is known as budgetary control.

Advantages of Budgeting

1. Budgets communicate management’s plans throughout the organization.

2. Budgets force managers to think about and plan for the future. In the absence of the
necessity to prepare a budget, many managers would spend all of their time dealing with
day-to-day emergencies.

3. The budgeting process provides a means of allocating resources to those parts of the
organization where they can be used most effectively.

4. The budgeting process can uncover potential bottlenecks before they occur.

5. Budgets coordinate the activities of the entire organization by integrating the plans of its
various parts. Budgeting helps to ensure that everyone in the organization is pulling in the
same direction.

6. Budgets define goals and objectives that can serve as benchmarks for evaluating
subsequent performance.

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Responsibility Accounting

The basic idea underlying responsibility accounting is that a manager should be held
responsible for those items—and only those items—that the manager can actually control
to a significant extent. Each line item (i.e., revenue or cost) in the budget is the
responsibility of a manager who is held responsible for subsequent deviations between
budgeted goals and actual results.

In effect, responsibility accounting personalizes accounting information by holding

individuals responsible for revenues and costs. This concept is central to any effective
planning and control system. Someone must be held responsible for each cost or else no
one will be responsible, and the cost will inevitably grow out of control.

Core Reading:

Garrison, Ray, H., Noreen, Eric, W., & Brewer, Peter, C. (2015). Managerial Accounting. [15th Edition].
The McGraw-Hill, New York, USA.

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 What is a Budget? – Factors in Budgeting

Budget Period

Operating budgets ordinarily cover a one-year period corresponding to the company’s fiscal year.
Many companies divide their budget year into four quarters. The first quarter is then subdivided into
months, and monthly budgets are developed. The last three quarters may be carried in the budget
as quarterly totals only. As the year progresses, the figures for the second quarter are broken down
into monthly amounts, then the third-quarter figures are broken down, and so forth. This approach
has the advantage of requiring periodic review and reappraisal of budget data throughout the year.

Continuous or perpetual budgets are sometimes used. A continuous or perpetual budget is a 12-
month budget that rolls forward one month (or quarter) as the current month (or quarter) is
completed. In other words, one month (or quarter) is added to the end of the budget as each month
(or quarter) comes to a close. This approach keeps managers focused at least one year ahead so that
they do not become too narrowly focused on short-term results.

Self-Imposed Budgets

A self-imposed budget or participative budget is a budget that is prepared with the full
cooperation and participation of managers at all levels.

Advantages

Self-imposed budgets have a number of advantages:

1. Individuals at all levels of the organization are recognized as members of the team whose
views and judgments are valued by top management.

2. Budget estimates prepared by front-line managers are often more accurate and reliable
than estimates prepared by top managers who have less intimate knowledge of markets
and day-to-day operations.

3. Motivation is generally higher when individuals participate in setting their own goals than
when the goals are imposed from above. Self-imposed budgets create commitment.

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4. A manager who is not able to meet a budget that has been imposed from above can
always say that the budget was unrealistic and impossible to meet. With a self-imposed
budget, this claim cannot be made.

Limitations

Self-imposed budgeting has two important limitations.

First, lower-level managers may make suboptimal budgeting recommendations if they lack
the broad strategic perspective possessed by top managers.

Second, self-imposed budgeting may allow lower-level managers to create too much
budgetary slack. Because the manager who creates the budget will be held accountable for
actual results that deviate from the budget, the manager will have a natural tendency to
submit a budget that is easy to attain (i.e., the manager will build slack into the budget).

Human Factors in Budgeting

The success of a budget program depends on three important factors:

1. Top management must be enthusiastic and committed to the budget process.

2. Top management must not use the budget to pressure employees or blame them
when something goes wrong.
3. Highly achievable budget targets are usually preferred when managers are rewarded
based on meeting budget targets.

Core Reading:

Garrison, Ray, H., Noreen, Eric, W., & Brewer, Peter, C. (2015). Managerial Accounting. [15th Edition].
The McGraw-Hill, New York, USA.

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 Overview of Master Budgets

What is Master Budget?

The master budget consists of a number of separate but interdependent budgets that
formally lay out the company’s sales, production, and financial goals. The master budget
culminates in a cash budget, a budgeted income statement, and a budgeted balance sheet.

10 Questions

1) How much sales revenue will we earn?

2) How much cash will we collect from customers?

3) How much raw material will we need to purchase?

4) How much manufacturing costs will we incur?

5) How much cash will we pay to our suppliers and our direct laborers, and how much
cash will we pay for manufacturing overhead resources?

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 6) What is the total cost that will be transferred from finished goods inventory to cost
of good sold?

7) How much selling and administrative expense will we incur and how much cash will
be pay related to those expenses?

8) How much money will we borrow from or repay to lenders – including interest?

9) How much operating income will we earn?

10) What will our balance sheet look like at the end of the budget period?

Estimates and Assumptions in Master Budgets

Sales budget:

1. What are the budgeted unit sales?

2. What is the budgeted selling price per unit?

3. What percentage of accounts receivable will be collected in the current and subsequent
periods?

Production budget:

1. What percentage of next period’s unit sales needs to be maintained in ending finished
goods inventory?

Direct materials budget:

1. How many units of raw material are needed to make one unit of finished goods?

2. What is the budgeted cost for one unit of raw material?

3. What percentage of next period’s production needs should be maintained in ending raw
materials inventory?

4. What percentage of raw material purchases will be paid in the current and subsequent
periods?

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Direct labour budget:

1. How many direct labour-hours are required per unit of finished goods?

2. What is the budgeted direct labour wage rate per hour?

Manufacturing overhead budget:

1. What is the budgeted variable overhead cost per unit of the allocation base?

2. What is the total budgeted fixed overhead cost per period?

3. What is the budgeted depreciation expense on factory assets per period?

Selling and administrative expense budget:

1. What is the budgeted variable selling and administrative expense per unit sold?

2. What is the total budgeted fixed selling and administrative expense per period?

3. What is the budgeted depreciation expense on non-factory assets per period?

Cash budget:

1. What is the budgeted minimum cash balance?

2. What are our estimated expenditures for noncurrent asset purchases and dividends?

3. What is the estimated interest rates on borrowed funds?

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Budgeted Income Statement

***You just need to copy and paste the numbers from other budget as mentioned in the
above computations.

Practice Exercise: 8-8, 8-17 (2), 8-18 (2)

Flexible Budgets

Planning budgets are prepared for a single, planned level of activity. Thus, performance
evaluation is difficult when the actual results differ from the planned budgets. Therefore,
we need to find something in between which is called a flexible budget.

Why is a Flexible Budget Important?

- It helps a manager to control costs

- It also helps a manager to keep track on the activities to evaluate performance

Case Illustration

Assuming, Larry’s planned revenues will be based on 500 units which is Q.

Larry's Lawn Service

For the Month Ended June 30

Revenue/Cost Planning
Formulas Budget
Number of lawns (Q) 500
Revenue ($75Q) $ 37,500
Expenses:
Wages and salaries ($5,000 + $30Q) $ 20,000
Gasoline and supplies ($9Q) 4,500
Equipment maintenance ($3Q) 1,500
Office and shop utilities ($1,000) 1,000
Office and shop rent ($2,000) 2,000
Equipment Depreciation ($2,500) 2,500
Insurance ($1,000) 1,000
Total expenses 32,500
Net operating income $ 5,000

*** Wages and Salaries = $5,000 is fixed cost and $30 per unit variable costs. So, I have
applied a mixed cost formula (chapter 2), y = a + bx.

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**** Gasoline and maintenance, there are no fixed expenses so only variable expenses.
However, Office, depreciation, and insurance have only fixed expenses.

Larry's Lawn Service

For the Month Ended June 30

Actual
Results
Number of lawns 550
Revenue $ 43,000
Expenses:
Wages and salaries $ 23,500
Gasoline and supplies 5,100
Equipment maintenance 1,300
Office and shop utilities 950
Office and shop rent 2,000
Equipment Depreciation 2,500
Insurance 1,200
Total expenses 36,550
Net operating income $ 6,450

***The above is the actual result which will be given to you. You need to use that 550 units
for your flexible budgets purpose.

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Variances

Larry's Lawn Service

For the Month Ended June 30

Revenue/Cost Actual Planning

Formulas Results Budget Variances
Number of lawns (Q) 550 500
Revenue ($75Q) $ 43,000 $ 37,500 $ 5,500 F
Expenses:
Wages and salaries ($5,000 + $30Q) $ 23,500 $ 20,000 $ 3,500 U
Gasoline and supplies ($9Q) 5,100 4,500 600 U
Equipment maintenance ($3Q) 1,300 1,500 200 F
Office and shop utilities ($1,000) 950 1,000 50 F
Office and shop rent ($2,000) 2,000 2,000 -
Equipment Depreciation ($2,500) 2,500 2,500 -
Insurance ($1,000) 1,200 1,000 200 U
Total expenses 36,550 32,500 4,050 U
Net operating income $ 6,450 $ 5,000 $ 1,450 F

F = Favourable Variance

U = Unfavourable Variance

Revenue = It will be favourable when actual revenues are higher than planning budget and
vice versa.

Costs = It will be unfavourable when actual costs are higher than planning budget and vice
versa.

To prepare a flexible budget (FLEX), the following must be remembered: -

▫ Total variable costs change in direct proportion to changes in activity.

▫ Total fixed costs remain unchanged within the relevant range.

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Revenue and Spending Variances

Actual Revenues – Flexible Budget Revenues = Revenue Variances

Actual Cost – Flexible Budget Costs = Spending Variances

Larry's Lawn Service

For the Month Ended June 30

Revenue and
Revenue/Cost Actual Flexible Spending
Formulas Results Budget Variances
Number of lawns (Q) 550 550
Revenue ($75Q) $ 43,000 $ 41,250 $ 1,750 F
Expenses:
Wages and salaries ($5,000 + $30Q) $ 23,500 $ 21,500 $ 2,000 U
Gasoline and supplies ($9Q) 5,100 4,950 150 U
Equipment maintenance ($3Q) 1,300 1,650 350 F
Office and shop utilities ($1,000) 950 1,000 50 F
Office and shop rent ($2,000) 2,000 2,000 -
Equipment Depreciation ($2,500) 2,500 2,500 -
Insurance ($1,000) 1,200 1,000 200 U
Total expenses 36,550 34,600 1,950 U
Net operating income $ 6,450 $ 6,650 $ 200 U

Practice Exercise: 9-19 (2), 9-17, 9-16, 9-15 (3), 9-13, 9-14, 9-3
Decentralisation

 In a decentralized organization, decision-making authority is spread throughout the

organization rather than being confined to a few top executives.
 Organizations do differ, however, in the extent to which they are decentralized.
 In strongly centralized organizations, decision-making authority is reluctantly
delegated to lower-level managers who have little freedom to make decisions.
 In strongly decentralized organizations, even the lowest-level managers are
empowered to make as many decisions as possible.
 Most organizations fall somewhere between these two extremes.

Advantages

1. By delegating day-to-day problem solving to lower-level managers, top management can

concentrate on bigger issues, such as overall strategy.

2. Empowering lower-level managers to make decisions puts the decision-making authority

in the hands of those who tend to have the most detailed and up-to-date information about
day-to-day operations.

3. By eliminating layers of decision making and approvals, organizations can respond more
quickly to customers and to changes in the operating environment.

4. Granting decision-making authority helps train lower-level managers for higher-level

positions.

5. Empowering lower-level managers to make decisions can increase their motivation and
job satisfaction.

Disadvantages

1. Lower-level managers may make decisions without fully understanding the company’s
overall strategy.

2. If lower-level managers make their own decisions independently of each other,

coordination may be lacking.

3. Lower-level managers may have objectives that clash with the objectives of the entire
organization. For example, a manager may be more interested in increasing the size of his or
her department, leading to more power and prestige, than in increasing the department’s
effectiveness.

4. Spreading innovative ideas may be difficult in a decentralized organization. Someone in

one part of the organization may have a terrific idea that would benefit other parts of the

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organization, but without strong central direction the idea may not be shared with, and
adopted by, other parts of the organization.

Self-Review Question

Explain the decentralisation process, and its advantages and disadvantages for an
organisation.

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Responsibility Accounting

 Decentralized organizations need responsibility accounting systems that link lower

level managers’ decision-making authority with accountability for the outcomes of
those decisions.
 The term responsibility center is used for any part of an organization whose
manager has control over and is accountable for cost, profit, or investments.
 The three primary types of responsibility centers are cost centers, profit centers, and
investment centers.

Cost Center

 The manager of a cost center has control over costs, but not over revenue or the use
of investment funds. Service departments such as accounting, finance, general
administration, legal, and personnel are usually classified as cost centers.
 In addition, manufacturing facilities are often considered to be cost centers.
 The managers of cost centers are expected to minimize costs while providing the
level of products and services demanded by other parts of the organization.
 For example, the manager of a manufacturing facility would be evaluated at least in
part by comparing actual costs to how much costs should have been for the actual
level of output during the period.
 Flexible budget variances are often used to evaluate cost center performance.

Profit Center

 The manager of a profit center has control over both costs and revenue, but not
over the use of investment funds.
 For example, the manager in charge of a Six Flags amusement park would be
responsible for both the revenues and costs, and hence the profits, of the
amusement park, but may not have control over major investments in the park.
 Profit center managers are often evaluated by comparing actual profit to targeted or
budgeted profit.

Investment Center

 The manager of an investment center has control over cost, revenue, and
investments in operating assets.
 For example, General Motors ’ vice president of manufacturing in North America
would have a great deal of discretion over investments in manufacturing—such as
investing in equipment to produce more fuel efficient engines. Once General
Motors’ top-level managers and board of directors approve the vice president’s
investment proposals, he is held responsible for making them pay off.

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  Investment center managers are often evaluated using return on investment (ROI) or
residual income measures.

Self-review Questions

Find a few examples of three responsibility centers of any firm of your choice and identify
their responsibilities.

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Residual Income

Residual income is another approach to measuring an investment center’s performance.

Residual income is the net operating income that an investment center earns above the
minimum required return on its operating assets. In equation form, residual income is
calculated as follows:

Net Average
Residual Minimum required
= operating - operating 
income rate of return
income assets

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Residual Income and Motivation

 One of the primary reasons why the controller of Alaskan Marine Services
Corporation would like to switch from ROI to residual income relates to how
managers view new investments under the two performance measurement
methods.
 The residual income approach encourages managers to make investments that are
profitable for the entire company but that would be rejected by managers who are
evaluated using the ROI formula.
 Generally, a manager who is evaluated based on ROI will reject any project whose
rate of return is below the division’s current ROI even if the rate of return on the
project is above the company’s minimum required rate of return. In contrast,
managers who are evaluated using residual income will pursue any project whose
rate of return is above the minimum required rate of return because it will increase
their residual income. Because it is in the best interests of the company as a whole
to accept any project whose rate of return is above the minimum required rate of
return, managers who are evaluated based on residual income will tend to make
better decisions concerning investment projects than managers who are evaluated
based on ROI.

Drawbacks of RI

 The residual income approach has one major disadvantage. It cannot be used to
compare the performance of divisions of different sizes.

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  Larger divisions often have more residual income than smaller divisions, not
necessarily because they are better managed but simply because they are bigger.

Practice Exercise

11-2, 11-6, 11-9, 11-12

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Balanced Scorecard

 A balanced scorecard consists of an integrated set of performance measures that

are derived from and support a company’s strategy. A strategy is essentially a theory
about how to achieve the organization’s goals.
 Under the balanced scorecard approach, top management translates its strategy into
performance measures that employees can understand and influence.
 For example, the amount of time passengers has to wait in line to have their baggage
checked might be a performance measure for the supervisor in charge of the
Southwest Airlines check-in counter at the Burbank airport.
 This performance measure is easily understood by the supervisor and can be
improved by the supervisor’s actions.

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Balanced Scorecard and Compensation

Incentive compensation for employees, such as bonuses, can, and probably should, be tied
to balanced scorecard performance measures.

However, this should be done only after the organization has been successfully managed
with the scorecard for some time— perhaps a year or more.

Managers must be confident that the performance measures are reliable, sensible,
understood by those who are being evaluated, and not easily manipulated.

Self-Review Question

Why does a balanced scorecard is important linking managers’ performance to

compensation?

Must Review

Follow-up the Exhibit 11-5 on book page – 494.

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 Chapter 12 – Lecture 8.2

‘Relevant costs’ can be defined as any cost relevant to a decision. A matter is relevant if
there is a change in cash flow that is caused by the decision.

The change in cash flow can be:

 additional amounts that must be paid

 a decrease in amounts that must be paid
 additional revenue that will be earned
 a decrease in revenue that will be earned.

A change in the cash flow can be identified by asking if the amounts that would appear
on the company’s bank statement are affected by the decision, whether increased or
decreased. Banks record cash so this test is reliable.

1. Sunk costs (past costs) or committed costs are not relevant

Sunk, or past, costs are monies already spent or money that is already contracted to be
spent. A decision on whether or not a new endeavour is started will have no effect on this
cash flow, so sunk costs cannot be relevant.

For example, money that has been spent on market research for a new product or
planning a new factory is already spent and isn’t coming back to the company, irrespective
of whether the product is approved for manufacture or the factory is built.

Committed costs are costs that would be incurred in the future but they cannot be avoided
because the company has already committed to them through another decision which
has been made.

For example, if a company has two year lease for piece of machinery, that cost will not
be relevant to a decision on whether to use that machinery on a new project which will
last for the next month.

2. Re-apportionment of existing fixed costs are not relevant

Irrespective of what treatment is used in the company’s management accounts to split up

costs, if the total costs remain the same, there is no cash flow effect caused by the
decision.

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Note that additional fixed costs caused by a decision are relevant. So, if you were
evaluating the viability of a new production facility, then the rent of a building specially
leased for the new facility is relevant.

3. Depreciation and book values (notional costs) are not relevant

Depreciation is not a cash flow and is dependent on past purchases and somewhat
arbitrary depreciation rates. By the same argument, book values are not relevant as these
are simply the result of historical costs (or historical revaluation) and depreciation.

4. Increases or decreases in cash flows caused by a project are relevant

So, if an old product is discontinued three years early to make room for a new product,
the revenue and cost decreases relating to the old product are relevant, as are the
revenue and cost increases on the new. The cost effects relate to both changes in variable
costs and changes in total fixed costs.

5. Revenues forgone (given up) because of a decision are relevant

If a company decides to keep an asset for use in the manufacture of a new product rather
than selling it, then its cash flow is affected by the decision to keep the asset, as it will
now not benefit from the sale of the asset. This effect is known as an opportunity cost,
which is the value of a benefit foregone when one course of action is chosen in preference
to another. In this case, the company has given up its opportunity to have a cash inflow
from the asset sale.

Types of decision

We will now look at some typical examples where you have to decide which costs are
relevant to decision-making. I suggest that you try each example yourself before you look
at each solution. In all examples we ignore the time value of money.

Always think: what future cash flows are changed by the decision? Changes in future
cash flows reliably indicate which amounts are relevant to the decision.

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Example 1: Relevant cost of materials

A company is considering making a new product which requires several types of raw
material:

Units Units Additional information

in inventory required

Material Nil 40 Current purchase price is $7/unit.

A

Material 100 purchased 150 Current purchase price is $14/unit. The

B for $10/unit material has no use in the company
other than for the project under
consideration. Units in inventory can be
sold for $12/unit.

Material 50 purchased 120 Current purchase price is $22/unit. The

C for $20/unit material is regularly used in current
manufacturing operations.

What is the relevant cost of the materials required for manufacture of the new
product?

Solution:
Taking each material in turn:

Material A – As there is no inventory, all 40 units required will have to be bought in at $7

per unit. This is a clear cash outflow caused by the decision to make the new product.
Therefore, the relevant cost of Material A for the new product is (40 units x $7) = $280.

Material B - The 100 units of the material already in inventory has no other use in the
company, so if it is not used on the new product, then the assumption is that it would be
sold for $12/unit. If the new product is made, this sale won’t happen and the cash flow is
affected. The original purchase price of $10 is a sunk cost and so is not relevant. In
addition, another 50 units are needed for the new product and these will need to be bought
in at a price of $14/unit.

The total relevant cost for Material B is:

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 100 units x $12 (lost sale proceeds) = $1,200

50 units x $14 (current purchase price) = $700

$1,900

Material C – This material is regularly used in the company, so if the 50 units in inventory
are diverted to the new product then this will mean that inventory will need to be
replenished. In order to do this, Material C purchases for existing products will be
accelerated by 50 units. The current purchase price of $22 will be used to determine the
relevant cost of Material C as this will be the value of each unit purchased. The original
purchase price of $20 is a sunk cost and so is not relevant. Therefore the relevant cost of
Material C for the new product is (120 units x $22) = $2,640.

Example 2: Relevant cost of labour

A company has a new project which requires the following three types of labour:

Hours Additional information

required

Unskilled 12,000 Paid at $8 per hour and existing staff are fully utilised. The
company will hire new staff to meet this additional
demand.

Semi- 2,000 Paid at $12 per hour. These employees are difficult to
skilled recruit and the company retains a number of permanently
employed staff, even if there is no work to do. There is
currently 800 hours of idle time available and any
additional hours would be fulfilled by temporary staff that
would be paid at $14/hour.

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 Skilled 8,000 Paid at $15 per hour. There is a severe shortage of
employees with these skills and the only way that this
labour can be provided for the new project would be for
the company to move employees away from making
Product X. A unit of Product X takes 4 hours to make and
makes a contribution of $24/unit.

What is the relevant cost of the labour hours required for the new project?

Solution:
Taking each type of labour in turn:

Unskilled – 12,000 hours are required for the project and the company is prepared to hire
more staff to meet this need. The incremental cash outflow of this decision is (12,000
hours x $8) = $96,000.

Semi-skilled - Of the 2,000 hours needed, 800 are already available and already being
paid. There is no incremental cost of using these spare hours on the new project.
However, the remaining 1,200 hours are still required and will need to be fulfilled by hiring
temporary workers. Therefore, there is an extra wage cost of (1,200 hours x $14) =
$16,800.

Skilled: Determining the relevant cost of labour if it is diverted from existing activities is
tricky and is often done incorrectly. If this is the case, then the relevant cost is the variable
cost of the labour plus the contribution foregone from not being able to use the labour for
its existing purpose.

The temptation is to see that the same number of skilled employees are paid before and
after being moved to the new project and therefore the opportunity cost of contribution
foregone from diverting hours away from the existing production of Product X is
the only relevant cost ($24/4 hours = $6 per hour). This is incorrect.

Say, for example, that 4 hours of labour were simply removed by ‘sacking’ an employee
for four hours, one less unit of Product X could be made. Using the contribution foregone
figure of $24 is the net effect of losing the revenue from that unit and also saving the
material, labour and the variable costs. In this situation however, the labour is simply
being redeployed so $24 understates the effect of this, as the labour costs are not saved.

Therefore, the relevant cost of skilled labour is:

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 8,000 hours x $15 (current labour cost per hour) = $120,000

8,000 hours x $6 (lost contribution per hour diverted from making Product
$48,000
X) =

$168,000

Example 3: Relevant cost of machinery

Some years ago, a company bought a piece of machinery for $300,000. The net book
value of the machine is currently $50,000. The company could spend $100,000 on
updating the machine and the products subsequently made on it could generate a
contribution of $150,000. The machine would be depreciated at $25,000 per annum.
Alternatively, if the machine is not updated, the company could sell it now for $75,000.

On a relevant cost basis, should the company update and use the machine or
sell it now?

Solution:
Immediately we can say that the $300,000 purchase cost is a sunk cost and the $50,000
book value and $25,000 depreciation charge are not cash flows and so are not relevant.

If the investment in the machinery is made, then the following cash flow changes are
triggered:

 Machine update cost: $100,000

 Contribution from products: $150,000
 Opportunity cost: $75,000

Therefore, the relevant cost is:

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 Update cost = $100,000

Add contribution = $150,000

Less sales proceeds foregone = $75,000

Net cash outflow $25,000

As the relevant cost is a net cash outflow, the machine should be sold rather than
retained, updated and used.

Example 4: Relevant cost of machinery

A business rents a factory for $60,000 per annum. Only half of the floor space is currently
used and the company is considering installing a new machine in the unused part. The
machine would cost $2.1m, be depreciated over 10 years at $200,000 per annum and
then be sold for $100,000. The company would insure the new machine against damage
for $5,000 per annum.

What are the relevant costs of the new machine purchase?

Solution:
Rent – this is not a relevant cost. Irrespective of how the company might use the floor
space in the factory to generate a return, there is no change in cash flow relating to the
rent as a result of the new machine.

Cost of machine - this is a relevant cost as $2.1m has to be paid out.

Depreciation – this is not a relevant cost as it is not a cash flow.

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Sale proceeds – this is a relevant cost as it is a cash inflow which will occur in 10 years
as a result of the decision to invest.

Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused
by the decision to invest.

These costs will have to be compared to the contribution that can be earned by the new
machine to determine if the overall investment in the asset is financially viable.

The effects shown in Examples 1 – 4, above, are often found in questions where
you are to determine whether or not a company should go ahead with a new
project/investment/product, or if you are asked to calculate the minimum price a
company should charge a customer for a piece of work.

Example 5: Shut down decision

A company has two production lines and its management accounts show the following:

Production Line Production Line

A B

$m $m $m $m

Revenue 28 30

Variable costs 12 20

Fixed costs 10 14

Total cost 22 34

Profit/loss 6 (4)

The total fixed costs of $24m have been apportioned to each production line on the basis
of the floor space occupied by each line in the factory.

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The company is concerned about the loss that is reported by Production Line B and is
considering closing down that line. Closing down either production line would save 25%
of the total fixed costs.

Should the company close down Production Line B?

Solution:
The incremental cash flows of closing down Production Line B are:

Revenue lost = $30m

Variable costs saved = $20m

$6m
Fixed costs saved ($24m x 25%) =
$26m

Therefore, the closure of Production Line B is not a good idea as the revenue lost is
greater than the value of the costs saved.

What about closing down Production Line A?

The incremental cash flows of this decision would be:

Revenue lost = $28m

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 Variable costs saved = $12m

Fixed costs saved ($24m x 25%) = $6m

The closure of Production Line A would also result in the revenue lost being greater than
the value of the costs saved, so this isn’t a good idea either.

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Definitions

 A difference in cost between any two alternatives is known as a differential cost .

 A difference in revenue between any two alternatives is known as differential
revenue .
 Differential costs and revenues are relevant to decision making, whereas costs and
revenues that do not differ between alternatives are irrelevant to decision making.
 Because differential costs and differential revenues are the only inputs that are
relevant to decision making, they are also often referred to as relevant costs and
relevant benefits.

An avoidable cost is a cost that can be eliminated by choosing one alternative over another.
By choosing the alternative of going to the movie, the cost of renting the DVD can be
avoided. By choosing the alternative of renting the DVD, the cost of the movie ticket can be
avoided. Therefore, the cost of the movie ticket and the cost of renting the DVD are both
avoidable costs. On the other hand, the rent on your apartment is not an avoidable cost of
either alternative. You would continue to rent your apartment under either alternative.
Avoidable costs are relevant costs. Unavoidable costs are irrelevant costs.

A sunk cost is a cost that has already been incurred and cannot be avoided regardless of
what a manager decides to do. For example, suppose a company purchased a five-year-old
truck for $12,000. The amount paid for the truck is a sunk cost because it has already been
incurred and the transaction cannot be undone.

Future costs that do not differ between alternatives should also be ignored. Continuing with
the example discussed earlier, suppose you plan to order a pizza after you go to the movie
theater or you rent a DVD. If you are going to buy the same pizza regardless of your choice
of entertainment, the cost of the pizza is irrelevant to the choice of whether you go to the
movie theater or rent a DVD. Notice, the cost of the pizza is not a sunk cost because it has
not yet been incurred. Nonetheless, the cost of the pizza is irrelevant to the entertainment
decision because it is a future cost that does not differ between the alternatives.

An opportunity cost is the potential benefit that is given up when one alternative is selected over another.
For example, if you were considering giving up a high-paying summer job to travel overseas,
he forgone wages would be an opportunity cost of traveling abroad. Opportunity costs are not usually
found in accounting records, but they are costs that must be explicitly considered in every decision a
manager makes.