Relevant Costing

Areas to be covered:

 INTRODUCTION

 RELEVANT AND IRRELEVANT COSTS

 COST BEHAVIOUR

 CASES OF MATERIAL COST

 CASES OF LABOUR COST

Relevant Costing
Decision making should be based on relevant cost. The cost which is
useful for decision making is known as relevant cost. A relevant cost
is a:
• Only cash items
• Future cash flows
• Incremental cash flows

Following are the examples of some important relevant and

irrelevant costs.

Past or Sunk Cost or Historical cost: Costs that have been incurred to
date are Past Costs or Sunk Costs. Irrecoverable costs. These are
irrelevant for decision making because we cannot change the past.

Committed cost: Costs that are already committed to be incurred

regardless of the decision made. Committed Costs are irrelevant to
decision. Mostly fixed costs are committed cost.

Apportioned cost: All costs or charges being allocated but without the
responsible manager’s control or not actual cost are irrelevant for
decision making. For example absorbed overheads, fixed overheads.
Notional cost: A notional cost or imputed cost is a hypothetical
accounting cost to reflect the use of a benefit for which no actual
cash expense is incurred. For example notional rent, notional
interest, depreciation, provisions. These are non cash items and
irrelevant for decision making.

Incremental Cost: Costs which are additional due to only one specific
decision are incremental cost and they are relevant.

Controllable Cost: Costs that can be controlled because of one

particular decision are controllable costs and they are relevant for
decision making.

Uncontrollable Cost: Costs which cannot be controlled because of a

specific decision are uncontrollable cost and they are irrelevant for
decision making.

Avoidable Cost: Costs that can be avoided because of one specific

decision are avoidable costs and they are relevant. Avoidable cost is
cost which would not be incurred if the activity to which they related
did not exist. Any direct cost which can be saved from ceasing to
sell a product or a closure of an outlet is an avoidable cost.
Unavoidable Cost: Costs that cannot be avoided because of one
specific decision are unavoidable costs and they are irrelevant for
decision making.

Fixed cost: Fixed costs are generally irrelevant to decision making

because they do not change but the incremental fixed costs are
always relevant.

Variable cost: Variable costs are normally relevant for decision making.

Opportunity Cost: Opportunity cost is the cost of second best

alternative which we lose because of one particular decision.
Opportunity cost is the benefit which has been given up, by choosing
one option instead of another.

Opportunity costs only apply to the use of scarce resources. Where

resources are not scarce, no sacrifice exists from using these
resources. If no alternative use of resources exists then the
opportunity cost is zero. But if resources have an alternative use, and
are scarce, then opportunity cost does exist.
CASES OF MATERIAL COST
Materials

Not Available Available

Frequent/Regular Substitute Have no use

Purchase/replacement
Cost is the relevant cost
Have scrap
Higher off: value
• Substitute Value
• Scrap Value

Yes No

Lower off:
• Purchase/replacement cost Zero
• Scrap Value
Example 2: Daniel plc has been approached by a customer who would
like a special job to be done for him, and who is willing to pay $12,000
for it. The job requires the following materials:
Material Units Units Book value of Realisable Purchase cost
required in stock stock $/-unit value $/-unit $/-unit
W 1,000 0 - - 6.00
X 1,000 600 2.00 2.50 5.00
Y 1,000 700 3.00 2.50 4.00
Z 200 200 4.00 6.00 9.00
Material X is used regularly by Daniel plc and if units of X are required
for this job, they would need to be replaced to meet other production
demand.

Material Y and Material Z is in stock as the result of previous overbuying,

and they have a restricted use. No other use could be found for
material Y, but the 200 units of material Z in stock could be used in
another job as substitute for 300 units of material V, which currently
costs $5 per unit (and of which the company has no units in stock at
this moment).

Required: Calculate the relevant costs of material for deciding whether

or not to accept the contract.
Solution:
Example 1: Solve
CASES OF Labour COST
Labour

Not Available Available

Frequent/Regular Alternate use Spare Capacity

Hiring/Employing cost
is the relevant cost
Zero

Lower off:
• Current Labour cost + Overtime premium
• Current Labour cost + Contribution lost
• New Hiring
Example 5: A c o m p a n y i s t h i n k i n g a b o u t t o a c c e p t a c o n t r a c t . I f t h e
contract is accepted, the company has the following cost:

Hours needed Current labour cost Employing new labour cost

Skilled labour 100 hours $4/-hour $5/-hour
Semi-skilled labour 200 hours $3/-hour $4/-hour
Management 20 hours $10/-hour $10/-hour

The skilled workers will be hired as required. Semi-skilled labour

will be diverted from the production of another project called
Product A with resulting loss of sales. Product A generates a
contribution of $1 per labour hour. Otherwise, the skilled
workers can be paid $0.5 overtime premium to perform this
extra contract after their normal working hours. The
management team has spare capacity.

Required: What is the relevant cost of labour?

Solution:
Example 4 & 6: Home Assignment
Practice Question: Home Assignment