Relevant Costs HO

Kingston Business School Relevant Costs

Learning Outcomes

  • By the end of this unit, you should be able to:

    • Identify which costs are relevant and which are irrelevant.

    • Make certain decisions based on appropriate relevant information.

Management Decisions

Types of Decisions

  • Common managerial decisions often involve:

    • Purchase of new equipment

    • Special orders: determining charge pricing

    • Dropping or adding a product line

    • Dropping or adding a segment

    • Make or buy decisions

Alternatives Comparison

  • Managerial decisions focus on evaluating alternatives:

    • Assessing benefits and costs of each alternative compared to others.

Village Pizza Case Study

  • Context: Owner has a used oven bought for £9,000 (2 years ago), now valued at £3,000, lasting one more year.

  • An option exists to invest in a new oven for £2,000, which also lasts a year and saves £2,600 in electricity costs.

  • Question: Should she buy the new oven?

The Alternatives

Existing Oven

  • Purchase price: £9,000 (2 years ago)

  • Current book value: £3,000

  • Remaining useful life: 1 year

  • No scrap value

New Oven

  • Purchase price: £2,000

  • Remaining useful life: 1 year

  • Estimated savings: £2,600 in electricity costs

Relevant Costs

  • Definition: Costs and benefits that differ between alternatives.

  • Importance: Identifying relevant costs helps in efficient decision-making and minimizes poor choices due to unclear data.

  • Relevance includes any financial implications, whether they are costs or revenues, where revenues can offset costs.

  • Generally, the option with the lower relevant cost is preferred.

Non-Relevant Costs

  • Definition: Costs that will not change regardless of the decision made.

  • Examples include:

    • Sunk costs (irrecoverable past costs)

    • Fixed overheads that remain unchanged

    • Costs incurred due to past decisions

    • Depreciation as a mere accounting entry and not a real cash outflow

Decision Making Example

  • A business evaluates rearranging its assembly line.

    • Alternative 1: No change - Revenue: £6,250,000, Costs: £4,640,000, Profit: £1,610,000

    • Alternative 2: Rearrangement - Revenue: £6,250,000, Costs: £4,570,000, Profits: £1,680,000

  • Relevant Costs Comparison: Focusing on changes in cost and revenue across the alternatives.

Differential and Incremental Costs

  • Differential Costs: The difference in costs between alternatives.

  • Incremental Costs: Change in costs due to a variance in activity level.

Avoidable vs Unavoidable Costs

  • Terminology of avoidable costs (relevant) and unavoidable costs (irrelevant).

  • Avoidable Costs: Costs that could be saved by not selecting a specific alternative.

  • Unavoidable Costs: Costs that will be incurred regardless of the decision made.

Explanation of Costs

  • Favorable to save £500 rather than generate an additional £400 in revenue.

  • Comparing costs for utilization of warehouse space for stock versus alternative use (e.g., parking).

    • Net benefits and cost analyses guide decision-making.

Non-Financial Opportunity Costs

  • Not all costs are monetary. Non-financial factors include:

    • Quality of work

    • Customer satisfaction

    • Staff happiness

Relevant Costs vs Irrelevant Costs

Cost Classification for Decision-Making

  • Relevant Costs: Future costs varying according to decision.

  • Irrelevant Costs: Future outlay costs that don’t change with decisions.

  • Opportunity Costs: Cost of forgoing the next best option.

  • Sunk Costs: Past incurred costs that should not influence current decision-making.

Relevant Cost Applications: Materials

  • If not in stock, relevant cost is purchase price.

  • If available but not used, relevant cost is scrap or alternative use value.

  • If obsolete with no use, relevant cost is zero.

  • If in regular use, relevant costs are determined by replacement costs (current price).

Relevant Cost Applications: Labour

  • Spare Capacity Existence: Relevant labour cost is zero if employees are on fixed salary.

  • No Extra Capacity: Relevant costs arise when hiring additional staff or paying overtime.

  • If no spare capacity and charging is possible, opportunity costs are relevant.

Relevant Costs and Decision Making

  • Decision-making transcends mere financials; other factors are essential.

  • Non-Financial Quantitative Factors: E.g., on-time arrivals for airlines, hospital wait times.

  • Qualitative Factors: Factors that are hard to measure quantitatively; includes employee morale and customer satisfaction.

Summary of Today’s Session

  • Discussed:

    • Definitions: Relevant vs. Non-Relevant costs

    • Summarized relevant costs with a focus on opportunity and future outlay costs

    • Explored non-relevant costs such as sunk costs

    • Covered types of relevant costs: materials and labor

    • Emphasized decision-making incorporating non-financial qualitative factors.