RELEVANT COSTING

1. Introduction A key part of business is decision making. This involves selecting a course
of action NOW that will affect the future. Relevant costing is a method that is used for long term
and short term decisions. Short-term decisions concern how to make the best use of resources in the
short term- they are operational or tactical in nature. Short-term decisions are usually concern
relatively low values, are likely to be repeatable/ reversible and individually are not expected to have
much impact on the business long term. For short term decisions we can ignore the time value of
money. Typical examples involve make-or-buy, contract pricing, acceptance of one-off orders and
shut down decisions.

2. Relevant Costing Relevant costs refer to costs which are directly incurred (or saved)
by the decision being made. As a rule they should be Future, Incremental and cash based. An
exception to this is Opportunity costs which is the value of the next best alternative, that must be
sacrificed in order to pursue the current course of action. Opportunity costs can only apply to limited
or finite resources- otherwise no sacrifice results from using them.
Example: The cost of contribution lost from transferring key workers to focus on a new project
would be a relevant cost for the new project.

3. Non –relevant costs Non-relevant costs are those that will not change as a result of
the decision. Always read the particulars of the question – but in general the following costs are not
relevant for decision making.
Sunk costs – These are costs, which have already been paid. Therefore they will not change as a
result of a decision and therefore are not relevant when evaluating the costs of a decision. An
example may be costs of research relating to a new product – these should not be allowed to
influence the decision to go ahead with the product because those costs have been already paid and
not change
Committed Costs – these type of costs must be paid regardless of the decision. They are usually
ongoing commitments – possibly lease or rental agreements that must be honoured by the business in
the short term.
Book Values or historic costs these costs are usually irrelevant to a decision because they are out of
date and are not a consequence of a decision being taken now.
Non- monetary costs – these are accounting valuations and estimates such as depreciation and
amortisation – these are not cash flows, so are seen as irrelevant for decision making.

Example 1 Identify the relevant costs from scenarios below: Your research team have spent
$50,000 researching project Q during 2X14? ( Relevant / Non relevant) The production manager
currently earns a salary of $20,000p.a. Your new project will incur approximately $5000 p.a of
overtime from him which means his salary is expected to be $25,000 for the duration of the project.
(Which is relevant cost for project here? $20,000 or $5000 or $25,000) A decision to manufacture a
new product is expected to increase fixed costs by $3000 per month. ( Relevant / Non-relevant)

Solution
$ 50000 – Irrelevant because sunk cost
$ 20000 – Irrelevant Committed cost because it is salary paid to him
$ 5000 - Relevant because it is incremental cost ( overtime paid to him)

Example 2 The availability of Material B is limited to 8,000 kg

Product X Y Z
Demand (units) 2,000 2,500 4,000
Variable cost to make ($ per unit) 10 12 14
Selling price ($ per unit) 13 17 16
Kg of B required per unit 3 2 1
(included in variable cost)
Which products should the company make and which should it buy?

Example 2 Russell Tutorial College Ltd provides day courses for businesses. During 20X8
the courses are being offered at £80 each, the variable cost being £50. It is estimated that the
profit for the year will be £300,000, after allowing fixed costs of £240,000.

In 20X9, it is anticipated that the variable cost per course will increase by £4, due to an increase
in lecturers' remuneration. Fixed costs are also expected to increase, by £20,000.

The management has heard that its main competitor, Kevin Tutors Ltd, is likely to increase the
price of its courses in 20X9. As demand for these business courses is always very high, the
management believe that 20X9 would be a good time to increase Russell Tutorial College 's
selling prices too.

The following alternatives are being considered:

i. increase the selling price to £90 - demand is expected to rise by 5%

ii. keep the price increase to £6 - increased demand of 20% anticipated

Required

a. How many courses in 20X8 ? and Prepare a marginal costing statement for each
proposal.

b. Calculate the break-even point (in units) for each alternative

c. Using alternative ii), calculate how many courses the college would need to book
to earn a profit of £450,000

d. What course of action would you recommend to the management of Russell

Tutorial College? Are there any qualitative factors that should be considered?

Solution

Note re 19x8 : Sales Price pu = £80 – Var Cost pu of £50 gives Cont. pu of £30
Total Profit of £300,000 + Total Fixed Costs of £240,000 = Total Cont. of £540,000
Thus the number of courses to give this total cont. = £540,000/£30 = 18,000 courses

a) Marginal Costing Statement

£
Proposal i) Sales Revenue 18,900 @ £90 1,701,000

Less Variable Costs 18,900 @ £54 (1,020,600)

Total Contribution 18,900 @ £36 680,400

Less Fixed Costs (260,000)

Profit 420,400

£
Proposal ii) Sales Revenue 21,600 @ £86 1,857,600

Less Variable Costs 21,600 @ £54 (1,166,400)

Total Contribution 21,600 @ £32 691,200

Less Fixed Costs (260,000)

Profit 431,200

b) BEP in units = Fixed Costs

Contribution per unit

i) 260,000 / 36 = 7,223 courses

ii) 260,000 / 32 = 8,125 courses

c) Target Profit

= Fixed Costs + Target Profit

Contribution per unit

= 260,000 + 450,000
32
= 22,188 courses

d) Higher Contribution = Higher Profit (If Fixed Costs remain the same)
Alternative ii) therefore looks best

However, management should monitor actual sales carefully, as this alternative gives the
higher BEP (8,125 courses) and a lower contribution per unit (£32 per course).
Management should also consider qualitative factors when making the decision such as
capacity restrictions, classroom sizes, student facilities adequate for increased levels of
demand etc.