Relevant Costs

and
Areas of Decision Making
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On the basis of relevance to decision-
making
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Relevant costs
Marginal cost
Differential cost
Opportunity cost
Irrelevant costs
Absorbed fixed cost
Sunk cost
Committed cost
Relevant Cost
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Expected future costs that are essential but differ
for alternative courses of action. Hence it is a cost
that would arise as a direct consequence of the
decision under review.
Exp: One is faced with a choice of making a
journey by car or by public transport, the car tax
and insurance costs are irrelevant since they will
remain the same whatever alternative is chosen.
However, the petrol costs for the car will differ
depending on which alternative is chosen, and
this cost will be relevant for decision-making.
Marginal Cost
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Total variable cost i.e. Prime Cost + Variable
Overheads. This cost is relevant for decision
making as this will be incurred in future for
additional units of production.
It will be a relevant cost for decision making as
this will be incurred in future for additional
units of production.

Differential Cost
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It is the increase or decrease in total cost or
change in specific elements of cost that result
from any variation in operations. It represents an
increase or decrease in total cost resulting out of:
Producing or distributing a few more or few less of the
products
A change in the method of production or of
distribution
An addition or deletion of a product or a territory and
Selection of an additional sales channel
Opportunity Costs
The value of sacrifice made or benefit
of opportunity foregone by
selecting one particular alternative
in preference to other alternatives.

Example: If you were
not attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college for
one year is $15,000.
Cont
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Example: A firm operates at full capacity. If a
new order is to be undertaken, contribution
foregone on the existing sales (i.e. due to full
capacity) constitutes opportunity cost for the
new order.
It is relevant cost where alternatives are
available. However, opportunity cost does not
find any place in formal accounts and is
computed only for comparison purposes.
Sunk Costs
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Sunk costs cannot be changed by any decision. They are not
differential costs and should be ignored when making
decisions.

Example: You bought an automobile that cost
$10,000 two years ago. The $10,000 cost is sunk
because whether you drive it, park it, trade it, or sell
it, you cannot change the $10,000 cost.
Committed Cost
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A cost, which has been committed by the
management, is not relevant for decision
making.
Exp: costs arising from the possession of plant,
building and equipment (e.g. depreciation,
rent, taxes, insurance premium, etc).
These are un-avoidable cost.
Adding / Dropping Product Lines
Decisions related to dropping old products (or
segments) and adding new products (or
segments) are among the most difficult that a
manager makes.
Two basic approaches can be used to analyze
data in this type of decision.
Compare contribution margins and fixed costs
Compare net operating incomes

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Cont
Compare contribution margins and fixed costs. A
segment should be added only if the increase in total
contribution margin is greater than the increase in
fixed cost. A segment should be dropped only if the
decrease in total contribution margin is less than the
decrease in fixed cost.
Compare net operating incomes. A second approach is
to calculate the total net operating income under each
alternative. The alternative with the highest net
operating income is preferred. This approach requires
more information than the first approach since costs
and revenues that dont differ between the
alternatives must be included in the analysis in order to
compute net operating incomes.
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Discontinuance & Diversification
If any products performance is not
impressive, then such product should be
discontinued only if there is no contribution
margin from that product.
Similarly, when a firm intends to introduce a
new product into the market, it will be
ensured whether that particular product is
able to recover at least its variable cost.
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Beware of Allocated Common Costs
Allocated common costs can make a profitable
segment look unprofitable. Allocated common
costs that would not be affected by a decision
are irrelevant and should be ignored.

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Non-Cost Considerations
Loss of market share to competition
Loss of goodwill and market Image
Strain in labour -Management relations
Availability of skilled labour on re-opening
Needs to maintain machine in operating
condition
Arrangement of finance for compensation
payable on retrechment (if any)
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Key / Limiting Factor
It represents a resource whose availability is less than
its requirement. It denotes a resource constraint
situation.
It is a factor which at a particular time or over a period
limits the activities of a Firm.
It is also called as Critical factor or Budget factor.
Examples are:
Shortage of raw materials
Labour shortage
Restrictions in plant capacity
Demand or sales expectancy
Cash availability
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Procedure for Decision-making
Step I: Identify the key factor
Step II: Compute Total Contribution or
Contribution per unit of product
Step III: Compute Contribution per unit of the
key factor
Step IV: Rank the products based on
Contribution per unit of key factor
Step V: Allocate the key resources based on
the ranks given in Step IV.
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Optimising the Product Mix
In case of multi products and multi lines of
activity, the problem arises as to which
product or sale mix will yield maximum profit.
It helps in discontinuance of non-profitable
products and lines of activity which will not
even cover its variable costs.
The alternative yielding the highest
contribution will be selected.
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Make or Buy decisions

These decisions can affect the firms production
methods and capacities, available working capital, cost
of borrowing funds and competitive position.
Costs that will incur for both the options are not
relevant to the analysis.
The firm should make an analysis of the cost, quality
and quantity considerations of the individual make or
buy decisions.
Differential Cost Analysis is especially useful if the
company has idle capacity and idle workers that can be
used to make the tools or parts.
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Make or Buy decisions


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Outside price compared
with marginal cost

Outside if mc>op

Inside if mc<op


Other factors

Plant capacity
Mc + loss of contribution
of displaced works
Non cost factors

Assurance of quality
Assurance of continuity
Assurance of maintaining price
Considerations:
When the company is working at full capacity
Contribution lost will be calculated
If want to manufacture, then what to do?
If want to buy, availability of outside suppliers who can
deliver the item in the quantities, quality and time
required.
When the company is not working at its full capacity
Simple decision on the basis contribution
But need to check the capacity (people, plant and space)
available and ability to achieve required quality standards


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Accept or Reject New (Export) Order
The contribution analysis is to be made as to see
whether it is profitable to accept or reject new order.
If the company has excess or idle production capacity,
the management can consider the possibility of selling
the additional products at less than normal selling
price.
Only the relevant variable costs should be used in the
decision analysis to arrive at an appropriate price.
Fixed costs are relevant only if incurred to facilitate the
special order.
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Sell or Process Further
Joint Product: Represents two or more products
separated in the course of same processing
operations, usually requiring further processing
each product being in such proportion that no
single product can be designated as a major
product. Exp: In oil refining: Petrol, Diesel, Liquid
Petroleum Gas, Kerosene, Paraffin, etc are joint
products.
By Product: A secondary product which
incidentally results from the manufacture of main
product and also from the same process.
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Point of Separation

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Raw
Material
Joint Process Cost
(RM, Labour & OHs
Split-off
Point
Waste/Scrap
Product C
BP (Linoleum)
Product B
JP (Benzol, Sulphate
of Ammonia)
Product A
JP (Coke, Tar)
Further/Additional
Process Cost
Decision Considerations
Depends upon whether the increase in total revenues
exceeds the additional cost incurred for processing
beyond split-off. There may be two situations:
The company is evaluating the possibility of processing
beyond split off and must incur certain equipment costs
and other fixed costs if additional processing is to incur.
The company already processes a product beyond split off
and has invested in the equipment and required
manpower.
Compare the contribution from the sale of partially
processed product with contribution from sale of the
completely processed product.

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