FBS FINAL STUDY NTS SMT1 RELEVANT COSTS

Part 1: The Foundation of Relevant Costs

Effective decision-making relies on understanding which costs matter and which do not.

1.1 What is a Relevant Cost?

• Definition: A cost is relevant only if it meets two criteria:

  1. It is a future cost.

  2. It differs between the decision alternatives.

• These costs are also known as avoidable costs, differential costs, or incremental costs.

1.2 Identifying Irrelevant Costs (What to Ignore)

To find relevant costs, eliminate two categories of irrelevant costs:

1. Sunk Costs:

   • Definition: Costs that have already been incurred and cannot be changed by any future decision.

   • Examples:

     • Purchase price of old equipment.

     • Depreciation on a past purchase.

2. Future Costs that Do Not Differ:

   • Definition: Costs that will be identical regardless of the chosen alternative.

   • Example: General rent that must be paid under all scenarios.

1.3 Why Isolate Relevant Costs?

• Efficiency: Saves time by focusing only on pertinent data.

• Accuracy: Prevents confusion and the risk of making a bad decision based on misleading, irrelevant information.

• Key Principle: Different Costs for Different Purposes - A cost that is relevant in one decision may be completely irrelevant in another. Managers must analyze each situation on its own merits.

Part 2: Applying Relevant Costs to Specific Business Decisions

This section applies the foundational concepts to common managerial problems.

LO2: Keep or Replace Old Equipment

• The Trap: Managers often focus on the "loss" on disposal (Book Value - Salvage Value) of the old equipment.

• The Truth: The book value of old equipment is a sunk cost and is completely irrelevant.

• The Correct Analysis:

  • Relevant costs include:

  • Cost of the new machine.

  • Salvage value of the old machine.

  • Any changes in operating expenses (e.g., reduction in labour or materials).

  • Irrelevant costs include:

  • Original cost of the old machine.

  • Its book value.

  • Its depreciation.

LO3: Dropping or Retaining a Product Line/Segment

• The Trap: Traditional income statements allocate common fixed costs (like company-wide rent) to segments, which can make a profitable segment look unprofitable.

• The Rule: A segment should be dropped only if the lost contribution margin is greater than the avoidable fixed costs saved:

  • If Contribution Margin Lost > Avoidable Costs Saved → Do NOT drop (profit will decrease).

  • If Contribution Margin Lost < Avoidable Costs Saved → Drop (profit will increase).

• The Correct Analysis:

  1. Calculate the segment's Contribution Margin (CM): Sales - Variable Costs.

  2. Identify the traceable fixed costs that would be avoided if the segment were eliminated (e.g., segment manager's salary, direct advertising).

  3. Compare the two.

  • The difference is the Segment Margin: CM - Traceable Fixed Costs. This is the true measure of a segment's contribution to covering common company costs.

  1. Always beware of allocated common costs. These costs will not disappear if a segment is dropped and are therefore irrelevant.

LO4: Make or Buy Decisions (Vertical Integration)

• The Rule: A company should buy a part externally only if the purchase price is less than the avoidable costs of making it internally.

• Identifying Relevant (Avoidable) Costs:

  • Relevant costs include:

  • Direct materials.

  • Direct labour.

  • Variable overhead.

  • Any specific fixed costs that would be eliminated (e.g., a supervisor's salary for that part's production line).

  • Irrelevant costs include:

  • Depreciation on existing equipment (a sunk cost).

  • Allocated general overhead (a common cost that won't change).

• The Role of Opportunity Cost:

  • If the facilities used to make the part have an alternative use (e.g., renting out the space or making a new product), that foregone profit becomes an opportunity cost.

  • This opportunity cost must be added to the "Make" column to ensure a fair comparison.

LO5: Accepting or Rejecting Special Orders

• Definition: A one-time order that is not part of normal business, often placed when there is idle capacity.

• The Rule: Accept the order if the incremental revenue exceeds the incremental costs.

• Critical Assumptions:

  1. Idle capacity exists (the order does not affect normal sales).

  2. Fixed costs are not affected by the order.

• The Analysis:

  1. Relevant costs include:

  • The special order price.

  • Direct materials.

  • Direct labour.

  • Variable overhead.

  • Any order-specific fixed costs (e.g., a special mould).

  1. Irrelevant costs include:

  • Existing fixed manufacturing overhead (will be incurred regardless).

  • The normal full-product cost.

LO6: Utilization of Constrained Resources (The Bottleneck)

• Definition: A constraint (or bottleneck) is any resource that limits the company's ability to meet demand (e.g., limited machine hours, labour hours, or materials).

• The Key Insight: To maximize profit, focus on the product with the highest contribution margin per unit of the constrained resource, not per unit of product.

• Formula:
  $ext{Contribution Margin per unit} / ext{Amount of constrained resource required per unit}.$

• Managing Constraints:

  1. Emphasize products with the highest CM per constraint.

  2. Relax (or Elevate) the Constraint: Find ways to increase capacity at the bottleneck (overtime, subcontracting, new equipment).

  3. Value Bottleneck Time: The CM per hour generated at the bottleneck shows how much a company should be willing to pay to keep it running.

Part 3: Advanced Decision-Making Topics

When decisions become more complex, additional tools are required.

LO6 (Extended): The Problem of Multiple Constraints (Linear Programming)

• The Scenario: When a company faces more than one constraining resource, simply calculating the CM per unit of a single constraint is insufficient.

• The Solution: Linear Programming: A quantitative method used to find the optimal combination of products that maximizes total contribution margin subject to multiple constraints.

• Key Terms:

  • Objective Function: The formula to be maximized (e.g., Maximize £35P + £30F).

  • Constraints: The mathematical expressions of resource limits (e.g., $10P + 15F \leq 4,000$ kg).

  • Feasible Region: The set of all possible production combinations that satisfy all constraints.

  • Optimal Solution: Always found at a "corner point" of the feasible region.

LO7: Joint Product Costs and the Contribution Approach

• Definitions:

  • Joint Products: Two or more products produced from a common input.

  • Split-off Point: The point where the joint products become separately identifiable.

  • Joint Costs: All costs incurred up to the split-off point.

• The Critical Rule: Joint costs are irrelevant for "Sell or Process Further" decisions. By the time products reach the split-off point, the joint costs are sunk costs.

• The Pitfall of Allocating Joint Costs: Allocating joint costs for individual product profitability analysis is dangerous and can lead to incorrect decisions, as it makes profitable products look unprofitable.

• The "Sell or Process Further" Decision Rule: A product should be processed further after the split-off point only if the incremental revenue from further processing exceeds the incremental processing costs:
  $ext{Profit from further processing} = ( ext{Final Sales Value} - ext{Sales Value at Split-Off}) - ext{Cost of Further Processing}.$

Activity-Based Costing (ABC) and Relevant Costs

• The Link: ABC improves the traceability of costs to products or segments.

• A Critical Caveat: Just because a cost is traceable does not automatically mean it is avoidable.

• The Manager's Task: Managers must still determine whether a traceable cost would actually disappear if a decision were implemented. A sunk cost (like depreciation on special fixtures with no resale value) remains a sunk cost, regardless of how precisely it is traced.

Summary of Key Points: A Quick Reference