FIN -311

INFORMATION FOR DECISION

MAKING
BAC/ BAU 3
CHARPTER 1

RELEVANT COST AND REVENUE FOR SHORT-TERM DECISION MAKING

How many decisions have you made today?

May be you have made a big one such as accepting a job offer or may be your decision was as
simple as settling your plans for the weekend or choosing a restaurant for dinner. Regardless of
whether decisions are significant or routine, most people follow a simple logical when making
them. This process involves gathering information, making predictions, making a choice, acting
on a choice and evaluating results. It also includes deciding what costs and benefits each choice
affords. Some costs are relevant while others are not relevant to what decision we make. So the
question is what are relevant costs and relevant revenues?

Relevant costs are expected future costs and relevant revenues are expected future revenues that
differ among the alternative courses of action being considered.

Decision making in volves making a choice between two or more alternatives. The decision will
be‘rational’profit maximizing. All decisions will be made using relevant costs and revenues

When a business is making one of the shortest decisions mentioned, it should only consider
relevant cash flows that arise as a result of this decision

Cash position if accepted A

Cash position if reject proposal B

Relevant cash flow = A-B

It is important to recognise that to be relevant costs and relevant revenues, they must;

 Occur in the future- every decision deals with selecting a course of action based on its
expected future results
 Differ among the alternative courses of action - Costs and revenues that do not differ
will not matter and hence will have no bearing on the decision being made.

A relevant cash flow is a “future incremental cash flow”

 Future
Only future cash flows that occur as a result of the decision should be considered, e.g.
any future costs or revenue. Sunk costs (i.e. costs that have already been incurred in the
past) are not relevant to the decision and should therefore be ignored – we cannot change
the past.
 Incremental
Only extra cash flows that occur as a result of the decision should be considered, e.g. extra costs
or revenues. Fixed costs should be ignored unless there is an incremental fixed cost as a result of
the decision. Committed costs (i.e. costs that are unavoidable in the future) are not affected by
the decision and should therefore be ignored. Opportunity costs should be included – look at
the next best alternative use of a resource.
 Cash flow
Only cash items are relevant to the decision. For example, depreciation is not relevant since it is
not a cash flow
Identify which of the following costs are relevant to the decisions specified:
(a) The salary to be paid to a market researcher who will oversee the development of a new
product. This is a new post to be created especially for the new product but the K12,000
salary will be a fixed cost. Is this cost relevant to the decision to proceed with the
development of the product?
The salary is a relevant cost of K12,000. Do not be fooled by the mention of the fact that it
is a fixed cost, it is a cost that is relevant to the decision to proceed with the future
development of the new product. This is an example of a directly attributable fixed cost. A
directly attributable fixed cost may also be called a product-specific fixed cos
(b) The K12,500 additional monthly running costs of a new machine to be purchased to
manufacture an established product. Since the new machine will save on labour time, the
fixed overhead to be absorbed by the product will reduce by K500 per month. Are these
costs relevant to the decision to purchase the new machine?
The K12,500 additional running costs are relevant to the decision to purchase the new
machine. The saving in overhead absorption is not relevant since we are not told that the
total overhead expenditure will be altered. The saving in labour cost would be relevant
but we shall assume that this has been accounted for in determining the additional
monthly running costs
 (c) Office cleaning expenses of K12,500 for next month. The office is cleaned by contractors and
the contract can be cancelled by giving one month’s notice. Is this cost relevant to a decision
to close the office?
This is not a relevant cost for next month since it will be incurred even if the contract is
cancelled today. If a decision is being made to close the office, this cost cannot be included
as a saving to be made next month. However, it will be saved in the months after that so it
will become a relevant cost saving from month 2 onwards.
(d) Expenses of K7,500 paid to the marketing manager. This was to reimburse the manager for
the cost of travelling to meet a client with whom the company is currently negotiating a
major contract. Is this cost relevant to the decision to continue negotiations?
This is not a relevant cost of the decision to continue with the contract. The K7,500 is sunk
and cannot be recovered even if the company does not proceed with the negotiations
Since decision making is concerned with choosing between future alternative courses of action ,
and nothing can be done to alter the past, then past costs are not relevant for decision –making.

Consider a situation where an individual is uncertain as to whether he should purchase a monthly

rail ticket to travel to work or use his car. Assuming that the individual will keep the car, whether
or not he travels to work by train, the cost of the road fund licence and insurance will be
irrelevant, since there costs remain the same irrespective of the mode of travel. The cost of fuel
will, however, be relevant, since this cost will vary depending on which method of transport is
chosen

When are relevant costs used?

The business considers relevant costs in its decision making. So relevant costs are used when a
decision has to be taken and the concern is whether the decision will increase profits or not, or
which decision will increase the profits most. Some of the decision could be;

1. Deciding whether to agree to accept a job or undertake some work at a stated

price that the customer will pay.
2. Whether to sell joint products from a common process at the point they are output
from the common process, or whether they should be processed further before
selling them at a higher price.
 3. Whether to make products “in house” or whether to subcontract or outsource the
work to an external supplier.
4. Shut-down decisions
5. One-off contract decisions

There are two basic types of decision where relevant costs are used.

I. Decisions about whether to do something or whether not to do it

II. Decisions that involve selecting between two or more different options about what to do.

To identify the relevant costs and benefits that will be affected by a decision, the approach
should be to look at each item of costs or benefits in turn. Benefits may be additional revenue or
savings in costs as a result of the decision. For each item of costs or benefits, it is necessary to
specify the relevant costs or benefits. This is the costs or benefits that should be taken into
account when reaching the decision.

So for cost to qualify as a relevant cost, it has to be a future cash flow arising as a direct
consequence of a decision. It should have the followings;

I. It must be a cost that will occur in the future. Any cost that has already been incurred in
the past cannot be a relevant costs.
II. It must be a cost (benefit) that results in cash flow. Depreciation charges and overhead
absorption costs cannot be relevant costs.
III. It must arise as a direct consequence of the decision. Any costs or benefits that will
happen anyway, regardless of the decision, cannot be a relevant cost.

It can finally be concluded that;

1. Sunk costs cannot be relevant costs. Sunk costs are costs that have been already been
incurred.
2. Committed costs cannot be relevant costs. These are costs that will be incurred in the
future, they cannot be avoided because they have already been committed.

SOME EXAMPLES ON HOW WE CAN IDENTIFY RELEVANT COTS FOR

DIFFERENT TYPES OF COST
Relevant costs associated with non-current assets
The relevant costs associated with non-current assets as follows:
Typical relevant cash flows
 The purchase price of any new machinery that needs to be bought.
 If an existing machine is to be used in the project that would otherwise have been sold, then
there is an opportunity cost equal to the proceeds foregone.
 Scrap/disposal proceeds on new assets bought
.  If we need to take an existing machine from another department and it is not replaced (either
by choice or because a replacement is not available), then there is an opportunity cost equal to
the lost contribution from the other department would need to be included.
Items that are not relevant
 Depreciation is not a cash flow so is never relevant.
 Profit or loss on disposal incorporates accumulated depreciation so is not relevant – instead
look at the cash element only – i.e. the scrap proceeds.
 The original purchase price of existing machinery is a sunk cost.
 The NBV of existing machinery is a combination of the original price (sunk) and accumulated
depreciation (not a cash flow)
A. CRANE USER COSTS
A decision may involve having to use a crane to some additional work
Once the Crane has been bought its purchase cost is a sunk cost. Depreciation is not
a relevant cost, because it is not a cash flow.
However, using the Crane may involve some incremental costs. These costs may be
referred to as user costs. They include hire charges where the Crane will have to be
hired or rented as a result of the decision. They also include any fall in the resale
value of the Crane or other assets that the organization owns, where the fall in value
will be caused by using the asset as a consequence of the decision.

EXAMPLE ON USER COSTS

Zakale Co is considering whether to undertake some contract work for a customer.

The machinery required for the contract would be as follows.
 a. A special glass cutting machine will have to be hired for five months for the work
(the length of the contract). Hire charges for the machine are K 75,000 per month,
with a minimum hire charge of K400,000.
b. All other machinery required in the production for the contract has already been
purchased by the organization on hire purchase. The monthly hire purchase
payments for this machinery are K 150,000. This consists of K100,000 for capital
repayment and K50,000 as an interest charge. The last hire purchase is to be made
in three months’ time. The cash price of this machinery was K1,200,000 two
years ago. It is still being depreciated on a straight line basis at the rate of K
50,000 per month. It still has a useful life which will enable it to be operated for
another 48 months.
The machinery is highly specialized and is unlikely to be required for other, more
profitable jobs over the period during which the contract work would be carried
out. Although there is no immediate market by selling this machine, it is expected
that a customer might be found in the future. It is estimated that the machine
would lose K 50,000 in its eventual sale if it is used for the contract.

What is the relevant cost for the machinery for the contract?

SOLUTION
K
Incremental Hire Costs 400,000
User costs 50,000
450,000

RELEVANT COST OF LABOUR

Often the labour force will be paid irrespective of the decision made and the costs are
therefore not incremental. Take care, however, if the labour force could be put to an
alternative use, in which case the relevant costs are the variable costs of the labour and
associated variable overheads plus contribution forgone from not being able to put it to its
alternative use.
 Example
Suppose that a special job would require 45 hours of labour time. Employees are paid K 7
per hour. There is sufficient idle capacity among the workforce for 32 hours of the work.
The extra 13 hours would be worked in overtime. For which the additional pay is K 14.05
per hour.
For the above example, the relevant cost of labour is the incremental cost. Of the 45
hours required for the work, 32 hours would be paid anyway, so the cost is a committed
cost that will be incurred anyway and it is not relevant. However, there will be additional
costs of K182.65 (13 hours at K14.05 per hour) for the overtime working, which will be
an additional ‘cash’ cost.
Suppose that another job will require 40 hours of skilled labour. The skilled workforce is
paid K25 per hour and is working at full capacity. If the special job is undertaken, the
skilled would be taken off other work that earns a contribution of K18 per hour, after
deducting the costs of the labour and variable overheads of K7.50 per hour. In this
example the relevant costs of labour must include the variable costs of labour plus any
associated variable overhead, and the contribution that would be lost by taking the skilled
workers off the other work.

We can conclude that where a company has a temporary spare capacity and the labour force is to
be maintained in the short term, the direct labour costs incurred will remain the same for all
alternative decisions. The direct labour cost will be irrelevant for short term decision making
purposes. If in a situation where casual labour is used and where workers can be hired on a daily
basis, a company may then adjust the employment of labour exactly the amount required to meet
the production requirements. The labour cost will increase if the company accepts additional
work, and will decrease if the production is reduced. In this situation the labour cost will be a
relevant cost for decision –making purposes.

In a situation where full capacity exists and additional labour supplies are unavailable in the
short term, and where no further overtime working is possible, the only way that labour
resources could then be obtained specific order woyuld be to reduce existing production. This
would release labour for the order, but the reduced production would result in a lost contribution,
and this lost contribution must be taken into account when ascertaining the relevant cost for the
specific order. The relevant labour cost per hour where full capacity exists is therefore the hourly
labour rate plus an opportunity cost of the contribution per hour that is lost by accepting the
order.

In summary we can say

-When the is spare capacity of labour, relevant cost is K nill

-When there is full capacity and the company can hire more labour i.e take an extra staff or pay
overtime, the relevant cost is thye extra cost of labour.

-When there is full capacity and the business can’t hire more labour, the relevant cost is the
opportunity cost of diverting labour i.e lost contribution and extra labour cost.

RELEVANT COST OF MATERIALS

The relevant cost of raw materials is generally their current replacement cost, unless the
materials have already been purchased and would not be replaced once used.

Any materials required that would not be taken from existing inventories but would be purchased
at a later date, and so the estimated purchase price would be the relevant material cost. Where
material are taken from the existing inventory do remember that the original purchase price
represents a past or sunk cost and is therefore irrelevant for decision making. If the materials are
to be replaced then using the materials for a particular activity will necessitate their replacement.
Thus, the decision to use the materials on an activity will result in additional acquisition costs
compared with the situation if the materials were not used on that particular activity. Therefore
the future replacement cost represents the relevant cost of the materials.

If materials have already been purchased but will not be replaced, then the relevant cost of using
them is either

a. Their current resale value or

b. The value they would obtain if they were put to an alternative use, if this is greater
than their current resale value.

The higher of (a) or (b) is then the opportunity cost of the materials. If the materials have no
resale value and no other possible use, then the relevant cost of using them for the opportunity
under consideration would be nil.
Consider now the situation where the materials have no further use apart from being used on a
particular activity. If the materials have realizable value, the use of the materials will result in
lost sales revenue, and this lost sales revenue will represent an opportunity cost that must be
assigned to the activity.

In summary we can say

-If material is in sock and in regular use and will be replaced, the relevant cost is the replacement
cost
-If material is in stock and will not be replaced, the relevant cost is the opportunity cost i.e lost
scarp value or lost contribution if use here instead of elsewhere. Is there an alternative use of the
materials?
If the answer is NO, the relevant cost is the scrap /disposal value
If the answer is YES, the relevant cost is the higher of:
Value in the other use or
-Scrap value
EXAMPLE

OPPORTUNITY COSTS

Other potential relevant costs include opportunity costs.

Opportunity cost is the value of a benefit sacrificed when one course of action is chosen, in
preference to an alternative. The opportunity is represented by the forgone potential benefit from
the best rejected course of action. You will often encounter opportunity costs when there are
several possible uses for scare resource.

For example, if material is in short supply, it may be transferred from the production of one
production to that of another product. The opportunity cost is contribution lost from ceasing the
production of the original product.

Example 1.

A new project requires the use of an existing machine that would otherwise be sold. Information
concerning the machine is as follows:

 Original purchase price = K20,000

 Current net book value (NBV) = K5,000

 Estimated current sales value = K4,000

Required:

What is the relevant cost (if any) if using the machine in the project?

Solution
 The original purchase price is sunk so is not relevant.

 The NBV is a combination of the purchase price (sunk) and depreciation (not a cash flow) so
is not relevant.

 By undertaking the project we miss out on the opportunity of selling the asset and thus have an
opportunity cost of (K4,000).

Cash position if accept proposal NIL

Relevant cash flow = (K4,000)

Cash position if reject proposal Receive K 4,000

(and do next best alternative instead)

MAKE OR BUY DECISIONS

There are different types of decision were relevant costs are required to evaluate the decision
choices. In a make or buy decision, the choice is between making items in-house or purchasing
them from an external supplier. In this situation, the relevant costs for the make or buy decision
are the differential costs between the two options.

However the ‘make’ option should give management more direct control over the work but they
‘buy’ option has the benefit that the external organization has a specialist skill and expertise in
the work. Make or buy should not be based exclusively on considerations. Issues such as control,
quality, flexibility, reliability of delivery and speed of delivery may all affect the decision to
make or buy.

There are two types of make vs. buy decisions:

 Make or buy decisions with no limiting factors
 Make or buy decisions with limiting factors.
Make or buy decisions with no limiting factors

In a make or buy decision with no limiting factors, the relevant costs are the differential costs between
the two options.
EXAMPLE
Make or buy with a limiting factor In the presence of a limiting factor
, the following step-by-step approach could be adopted with a make vs. buy question:
(1) The saving per unit of each product is calculated. Saving = Purchases price – VC to make. (
2) Divide this by the amount of scarce resource (a.k.a. limiting factor) each product uses. This gives the
saving per unit of the limiting factor (LF).
(3) Rank products. The higher the saving per unit of LF, the greater the priority to make that should be
given to the product.
(4) Once the priorities have been decided, the scarce resource is allocated to the products in the order
of the priorities, until it is fully used up.
(5) Any products with unsatisfied demand can be satisfied by buying from the external source
EXAMPLE

Make vs. buy: other issues to consider

In addition to the relative cost of buying externally compared to making inhouse, management must
consider a number of other issues before a final decision is made.
 Reliability of external supplier: can the outside company be relied upon to meet the requirements in
terms of:
-quantity required
– quality required
– delivering on time
– price stability.
 Specialist skills: the external supplier may possess some specialist skills that are not available in-
house.  Alternative use of resource: outsourcing will free up resources which may be used in another
part of the business.
 Social: will outsourcing result in a reduction of the workforce? Redundancy costs should be
considered.  Legal: will outsourcing affect contractual obligations with suppliers or employees?
 Confidentiality: is there a risk of loss of confidentiality, especially if the external supplier performs
similar work for rival companies.
 Customer reaction: do customers attach importance to the products being made in-house?
OUTSOURCING

Outsourcing is the process of obtaining goods and services from outside suppliers instead of
producing the same goods or providing the same services within the organization. Decisions on
whether to produce components or provide services within the organization or to acquire them
from outside suppliers are called outsourcing or make or buy decisions. Many organisations
outsource some of their activities such as payroll and purchasing functions or the purchase of
speciality components.

Reasons for the trend towards outsourcing activities include the following.

a. Frequently the decision is made on the grounds that specialist contractors can offer
superior quality and efficiency. If a contractor’s main business is making a specific
component it can invest in the specialist machinery and labour and knowledge skills
needed to make that component. However, the component may be only one of many
needed by the contractor’s customer and the complexity of components is now such
attempting to keep internal facilities up to the standard of specialist detracts from the
main business of the customer.
b. Contracting out manufacturing frees capital that can be invested in core activities, such as
market research, product definition, product planning, marketing and sales.
c. Contractors may have capacity and flexibility to start production very quickly to meet
sudden variations demand. In- house facilities may not be able to respond as quickly,
because of the redirect resources from elsewhere.
d. There is not enough work to keep internal staff fully occupied, so it is cheaper to
outsource the work. For example, many organisations outsource payroll administration
because it is not worthwhile employing staff with knowledge of payroll work.

The costs relevant to decisions about whether or not to outsource activities are little different (if
at all) to those that are taken into account in a conventional make or buy situation. The relevant
costs are the differential costs between performing the service internally or using an external
provider.
PERFORMANCE OF OUTSOURCERS

Once a decision has been made to outsource, it is essential that the performance of the outsourcer
is monitored and measured.

Measure could include cost savings, service improvement and employee satisfaction.

However, this is not the final word: other non-financial decisions have to be considered.

1. The in-house option should give management more direct control over the work, but the
outsource option often has the benefit that the external organization has a specialist skill
and expertise at work
2. Will the outsourcing create spare capacity? How should that spare capacity be profitably
used?
3. Are there hidden benefits to be obtained from subcontracting?
4. Would the company’s workforce resent the loss work to an outside subcontractor, and
might such a decision cause an industrial dispute?
5. Would the subcontractor be reliable with delivery times and quality?
6. Does the company wish to be flexible and maintain better control over operations by
doing everything itself?

Advantages
-Greater flexibility
- Lower investment risk
-Improved cash flow
-Concentrates on core competence
-Enables more advanced technologies to be used without making investment

Disadvantages
Possibility of choosing wrong supplier
Loss of visibility and control over process
Possibility of increased lead times
DISCONTINUATION DECISIONS (SHUTDOWN DECISIONS)

Most organisations periodically analyse profits by one or more cost objects, such as products, or
services, customers and locations. Periodic profitability analysis provides attention-directing
information that highlights those unprofitable activities that require more detailed appraisal to
ascertain whether or not they should be discontinued.

A shutdown should result in savings in annual operating costs for a number years into the future

Closure will probably release unwanted non-current assets for sale

Employees affected by the closure must be made redundant or relocated, perhaps after retraining
or else offered early retirement.

EXAMPLE

One of a leading IT company manufactures three Cards, Credit Card, Debit Card and Fuel Card.
The present net annual income from these is as follows

Credit Card Debit Card Fuel Card

Total

K K K
K

Sales 80,000 40,000 90,000

210,000

Variable costs 50,000 25,000 55,000

130,000

Contribution 30,000 15,000 35,000

80,000

Fixed costs 14,000 18,000 20,000

52,000

Profit/loss 16,000 (3,000) 15,000

28,000
The company is concerned about its profit performance, and is considering whether or not to
cease selling Debit card. It is felt that selling prices cannot be raised or lowered without
adversely affecting net income. K 5,000 of the fixed costs of Debit Card are direct fixed cost
which would be saved if production ceased (attributable costs). All other fixed costs, it is
considered, would remain the same.

By stopping production of Debit card, the consequence would be a K10,000 fall in profits

Loss of contribution (15,000)

Saving in fixed costs 5,000

Incremental loss (10,000)

Suppose , however, it were possible to use the resources realized by stopping production of Debit
Card and switch to producing a new item, DSTV Card, which would sell for K50,000 and incur
variable costs of K30,000 and extra direct costs of K6,000. A new decision is now required

Debit Card DSTV Card

K K

Sales 40,000 50,000

Variable costs 25,000 30,000

15,000 20,000

Less direct fixed costs 5,000 6,000

Contribution to share fixed and profit 10,000 14,000

It would be more profitable to shut down production of Debit Card and switch resources to
making DSTV Card in order to boost profits by K4,000 to K32,000.

Further considerations:
 The price may be acceptable for a one-off contract but not for pricing all contracts and products – for
example, when viewing a one-off contract fixed costs will probably be ignored as unavoidable. However,
if every manager ignores fixed costs, then the company will end up making a loss.

 The minimum price obtained using relevant costing may be much lower than typical market prices. A
firm may thus be reluctant to accept this price if it might affect the prices of other contracts in the future
– for example, other customers may hear about the low prices offered and demand similar lower prices
on their contracts.

 On the other hand a company may be willing to accept a loss on this contract if it increases the
chances of winning subsequent contracts (albeit at what price?)

Further processing decisions

A further processing decision will be tested in the context of joint products in the exam. Joint product
costing was introduced in ‘Management Accounting’ (MA):
 Joint products arise where the manufacture of one product inevitably results in the manufacture of
other products..
 The specific point at which individual products become identifiable is known as the split-off point.
 Costs incurred before the split-off point are called joint costs and must be shared between joint
products produced.
 After separation products may be sold immediately or may be processed further. Any further
processing costs are allocated directly to the product on which they are incurred.