Relevant Cost Decisions DECISION MAKING IN THE SHORT

Relevant Cost Decisions DECISION MAKING IN THE SHORT TERM

Decisions o A decision model is a formal method of making a choice, often involving both quantitative and qualitative analyses 2

Five-Step Decision-Making Process 3

Relevance o Relevant Information has two characteristics: n It occurs in the future n It differs among the alternative courses of action o Relevant Costs – expected future costs o Relevant Revenues – expected future revenues 4

Types of Relevent cost Types of Relevant Costs Types of Non-Relevant Costs Future Cash Flows Sunk Cost Cash expense that will be incurred in the future as a result of a decision is a relevant cost. Sunk cost is expenditure which has already been incurred in the past. Sunk cost is irrelevant because it does not affect the future cash flows of a business. Avoidable Costs Committed Costs Only those costs are relevant to a decision that can be avoided if the decision is not implemented. Future costs that cannot be avoided are not relevant because they will be incurred irrespective of the business decision bieng considered. Opportunity Costs Non-Cash Expenses Cash inflow that will be sacrificed as a result of a particular management decision is a relevant cost. Non-cash expenses such as depreciation are not relevant because they do not affect the cash flows of a business. Incremental Cost General Overheads Where different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered. General and administrative overheads which are not affected by the decisions under consideration should be ignored. 5

Identifying Relevant Costs that can be eliminated (in whole or in part) by choosing one alternative over another are avoidable costs. Avoidable costs are relevant costs. Unavoidable costs are never relevant and include: Sunk costs. Future costs that do not differ between the alternatives. 6

Identifying Relevant Costs o gather all costs associated with the alternatives o eliminate all sunk costs o Eliminate all future costs that don’t differ between alternatives o left are the avoidable costs 7

Irrelevance o Historical costs are past costs that are irrelevant to decision making n Also called Sunk Costs- cost that has already been incurred and that cannot be avoided regardless of what a manager decides to do 8

Types of Information o Quantitative factors are outcomes that can be measured in numerical terms o Qualitative factors are outcomes that are difficult to measure accurately in numerical terms, such as satisfaction n Are just as important as quantitative factors even though they are difficult to measure 9

Terminology o Incremental Cost – the additional total cost incurred for an activity o Differential Cost – the difference in total cost between two alternatives o Incremental Revenue – the additional total revenue from an activity o Differential Revenue – the difference in total revenue between two alternatives 10

Relevent cost of material 11

Relevent cost of labour 12

Types of Decisions One-Time-Only Special Orders Insourcing vs. Outsourcing Make or Buy Product-Mix Customer Profitability Branch / Segment: Adding or Discontinuing o Equipment Replacement o o o 13

One-Time-Only Special Orders o Accepting or rejecting special orders when there is idle production capacity and the special orders have no longrun implications o Decision Rule: does the special order generate additional operating income? n Yes – accept n No – reject 14

One-Time-Only Special Orders o Compares relevant revenues and relevant costs to determine profitability 15

Special Orders o Acki Company receives a one-time order that is not considered part of its normal ongoing business. o Acki Company only produces one type of silver key chain with a unit variable cost of TL 16. Normal selling price is TL 40 per unit. o A company in KKTC offers to purchase 3, 000 units for TL 20 per unit. o Annual capacity is 10, 000 units, and annual fixed costs total TL 78, 000, but Acki company is currently producing and selling only 5, 000 units. Should Acki accept the offer? 16

Special Orders If Acki accepts the offer, net income will increase by TL 12. 000. Using the incremental approach: Special order contribution margin = TL 20 – TL 16 = TL 4 Change in income = TL 4 × 3, 000 units = TL 12. 000. 17

Potential Problems with Relevant-Cost Analysis o Avoid incorrect general assumptions about information, especially: n “All variable costs are relevant and all fixed costs are irrelevant” n There are notable exceptions for both costs 18

Potential Problems with Relevant-Cost Analysis o Problems with using unit-cost data: n Including irrelevant costs in error n Using the same unit-cost with different output levels o Fixed costs per unit change with different levels of output 19

Qualitative Factors o Nonquantitative factors may be extremely important in an evaluation process, yet do not show up directly in calculations: n n Quality Requirements Reputation of Outsourcer Employee Morale Logistical Considerations – distance from plant, etc. 20