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Cost and Management Accounting

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Cost & Management Accounting (MGT-402)
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LESSON # 43
DECISION MAKING
Relevant Costs
Relevant costs are future cash flows arising as a direct consequence of a decision.
 Relevant costs are future costs
 Relevant costs are cash flows
 Relevant costs are incremental costs
Decision making should be based on relevant costs.
a. Relevant Costs are future costs. A decision is about the future and it cannot alter what has
been done already. Costs that have been incurred in the past are totally irrelevant to any
decision that is being made `now'. Such costs are past costs or sunk costs. Costs that have
been incurred include not only costs that have already been paid, but also costs that have
been committed. A committed cost is a future cash flow that will be incurred anyway,
regardless of the decision taken now.
b. Relevant costs are cash flows. Only cash flow information is required. This means that
costs or charges which do not reflect additional cash spending (such as deprecation and
national costs) should be ignored for the purpose of decision making.
c. Relevant costs are incremental costs. For example, if an employee is expected to have no
other work to do during the next week, but will be paid his basic wage (of, say, Rs. 100 per
week)( for attending work and doing nothing, his manager might decide to give him a job
which earns the organization Rs. 40. The net gain is Rs. 40 and the Rs. 100 is irrelevant to
the decision because although it is a future cash flow, it will be incurred anyway whether
the employee is given work or not.
Avoidable Costs
One of the situations in which it is necessary to identify the avoidable costs is in deciding
whether or not to discontinue a product. The only costs which would be saved are the
avoidable costs which are usually the variable costs and sometimes some specific costs. Costs
which would be incurred whether or not he product is discontinued are known as
unavoidable costs.
Differential Costs and Opportunity Costs
Relevant costs are also differential costs and opportunity costs.
 Differential cost is the difference in total cost between alternatives.
 An opportunity cost is the value of the benefit sacrificed when one course of action
is chosen in preference to an alternative.
For example, if decision option A costs Rs. 300 and decision option B costs Rs. 360, the
differential costs is Rs. 60.
Example: Differential Costs and Opportunity Costs
Suppose for example that there are three options, A, B and C, only one of which can be
chosen. The net profit from each would be Rs. 80, Rs. 100 and Rs. 70 respectively.
Since only one option can be selected option B would be chosen because it offers the biggest
benefit.
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Rs.
Profit from option B
100
Less opportunity cost (i.e. the benefit from the most profitable alternative, A)
80
Differential benefit of option B
20
The decision to choose option B would not be taken simply because it offers a profit of Rs.
100, but because it offers a differential profit of Rs. 20 in excess of the next best alternative.
Controllable and Uncontrollable Costs
We came across the term controllable costs at the beginning of this study text. Controllable
costs are items of expenditure which can be directly influenced by a given manger within a
given time span.
As a general rule, committed fixed costs such as those costs arising form the possession of
plant, equipment and buildings (giving rise to deprecation and rent) are largely uncontrollable
in the short term because they have been committed by longer-term decisions.
Discretionary fixed costs, for example, advertising and research and development costs can
be thought of as being controllable because they are incurred as a result of decision made by
management and can be raised or lowered at fairly short notice.
Sunk Costs
A sunk cost is a past cost which is not directly relevant in decision making. The principle
underlying decision accounting is the management decisions can only affect the future. In
decision making, managers therefore required information about future cots and revenues
which would be affected by the decision under review. They must not be misled by events,
costs and revenues in the past, about which they can do nothing.
Sunk costs, which have been charged already as a cost of sales in a previous accounting
period or will be charged in a future accounting period although the expenditure had already
been incurred, are irrelevant to decision making.
Example: Sunk Costs
An example of a sunk cost is development costs which have already been incurred. Suppose
that a company has spent Rs. 250,000 in developing a new service for customers, but the
marketing department's most recent findings are that the service might not gain customer
acceptance and could be a commercial failure. The decision whether or not to abandon the
development of the new service would have to be taken, but the Rs. 250,000 spent so far
should be ignored by the decision makers because it is a sunk cost.
Fixed and Variable Costs
Unless you are given an indication to the contrary, you should assume the following:
 Variable costs will be relevant costs.
 Fixed costs are irrelevant to a decision.
This need not be the case, however, and you should analyze variable and fixed cost data
carefully. Do not forget that `fixed' costs may only be fixed in the short term.
Non-Relevant Variable Costs
There might be occasions when a variable cost is in fact a sunk cost (and therefore a non-
relevant variable cost). For example, suppose that a company has some units of raw material
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in stock. They have been paid for already, and originally cost Rs. 2,000. They are now
obsolete and are no longer used in regular production, and they have no scrap value.
However, they could be used in a special job which the company is trying to decide whether
to undertake. The special job is a `non-off' customer order, and would use up all these
materials in stock.
a. In deciding whether the job should be undertaken, the relevant cost of the materials
to the special job is nil. Their original cost of Rs. 2,000 is a sunk cost, and should be
ignored in the decision.
b. However, if the materials did have scrap value of, say, Rs. 300, then their relevant
cost to the job would be the opportunity cost of being unable to sell them for scrap,
i.e. Rs. 300.
Attributable Fixed Costs
There might be occasions when a fixed cost is a relevant cost, and you must be aware of the
distinction `specific' or `directly attributable' fixed costs, and general fixed overheads.
Directly attributable fixed costs are those costs which, although fixed within a relevant range
of activity level are relevant to a decision for either of the following reasons.
a. They could increase if certain extra activities were undertaken. For example, it may be
necessary to employ an extra supervisor if a particular order is accepted. The extra salary
would be an attributable fixed cost.
b. They would decrease or be eliminated entirely if a decision were taken either to reduce
the scale of operations or shut down entirely.
General fixed overheads are those fixed overheads which will be unaffected by decisions to
increase or decreased the scale of operations, perhaps because they are an apportioned share
of the fixed costs of items which would be completely unaffected by the decision. General
fixed overheads are not relevant in decision making.
Absorbed Overhead
Absorbed overhead is a national accounting cost and hence should be ignored for decision
making purposes. It is overhead incurred which may be relevant to a decision.
The 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. In this case the
relevant cost of using them is the higher of the following:
Their current resale value
The value they would obtain if they were put to an alternative use.
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.
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Question
Majeed Ltd. has been approached by customer who would like a special job to be done for him,
and who is willing to pay Rs. 22,000 for it. The job would require the following materials:
Total  units Units
Book  value
Realizable
Replacement
Material
required
already
in of units in
value
cost
stock
stock
Rs./unit
Rs./unit
Rs./unit
A
1,000
0
-
-
6
B
1,000
600
2
2.50
5
C
1,000
700
3
2.50
4
D
200
200
4
6.00
9
Material B is used regularly by Majeed Ltd, and if units of B are required for this job, they would
need to be replaced to meet other production demand.
Materials C and D are in stock as the result of previous over-buying, and they have a restricted use.
No other use could be found for material C, but the units of material D could be used in another
job as substitute for 300 units of material E, which currently costs Rs. 5 per unit (of which the
company has no units in stock at the moment).
Required: Calculate the relevant costs of material for deciding whether or not to accept the
contract.
Answer
a. Material A is not yet owned. It would have to be bought in full at the replacement cost of
Rs. 6 per unit.
b. Material B is used regularly by the company. There are existing stocks (600 units) but if
these are used on the contract under review a further 600 units would be bought to
replace them. Relevant costs are therefore 1,000 units at the replacement cost of Rs. 5
per unit.
c. 1,000 units of material C are needed and 700 are already in stock. If used for the contract,
a further 300 units must be bought at Rs. 4 each. The existing stocks of 700 will not be
replaced. If they are used for the contract, they could not be sold at Rs. 2.50 each. The
realizable value of these 700 units is an opportunity cost of sales revenue forgone.
d. The required units of material D are already in stock and will not be replaced. There is an
opportunity cost of using D in the contract because there are alternative opportunities
either to sell the existing stocks for Rs. 6 per unit (Rs. 1,200 in total) or avoid other
purchases (of material E), which would cost 300 x Rs. 5 = Rs. 1,500. Since substitution
for E is more beneficial, Rs. 1,500 is the opportunity cost.
e. Summary of relevant costs:
Rs.
Material A (1,000 x Rs. 6)
6,000
Material B (1,000 x Rs. 5)
5,000
Material C (300 x Rs. 4) plus (700 x Rs. 2.50)
2,950
Material D
1,500
Total
15,450
The Relevant Cost of Labor
The relevant cost of labor, in different situation, is best explained by an example:
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Example: Relevant Cost of Labor
LW plc is currently deciding whether to undertake a new contract. 15 hours of labor will be
required for the contract. LW plc currently products product L, the standard cost details of which
are shown below.
STANDARD COST CARD
PRODUCT L
Rs./Unit
Direct Materials (10kg @ Rs. 2)
20
Direct Labor (5 hrs @ Rs. 6)
30
50
Selling price
72
Contribution
22
c.
What is the relevant cost of labor if the labor must be hired form outside the
organization?
d.
What is the relevant cost of labor if LW plc expects to have 5 hours spare capacity?
e.
What is the relevant cost of labor if labor is in short supply?
Solution
a.
Where labor must be hired from outside the organization, the relevant cost of labor will
be the variable costs incurred.
Relevant cost of labor on new contract = 15 hours @ Rs. 6 = Rs. 90.
b.
It is assumed that the 5 hours spare capacity will be paid anyway, and so if these 5 hours
are used on another contract, there is no additional cost to LW plc.
Rs.
Direct labor (10 hours @ Rs. 6)
60
Spare capacity (5 hours @ Rs. 0)
0
60
c.
Contribution earned per unit of Product L produced = Rs. 22
If it requires 5 hours of labor to make one unit of product L, the contribution earned per labor
hour = Rs. 22/5 = Rs. 4.40.
Rs.
Direct labor (15 hours @ Rs. 6)
90
Contribution lost by not making product L (Rs. 4.40 x 15 hours)
66
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It is important that you should be able to identify the relevant cost which are appropriate to a
decision. In many cases, this is a fairly straightforward problem, but there are cases where great
care should be taken. Attempt the following question:
Question:
A company has been making a machine to order for a customer, but the customer has since gone
into liquidation, and there is no prospect that nay money will be obtained from the winding up of
the company. Costs incurred to date in manufacturing the machine are Rs. 50,000 and progress
payments of Rs. 15,000 had been received from the customer prior to the liquidation.
The sales department has found another company willing to buy the machine for Rs. 34,000 once
it has been completed.
To complete the work, the following costs would be incurred.
a.
Materials: These have been bought at a cost of Rs. 6,000. They have no other use, and if
the machine is not finished, they would be sold for scrape for Rs. 2,000.
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b.
Further labor costs would be Rs. 8,000. Labor is in short supply, and if the machine is
not finished, the work force would be switched to another job, which would earn Rs. 30,000 in
revenue, and incur direct costs of Rs. 12,000 and absorbed (fixed) overhead of Rs. 8,000.
c.
Consultancy fees Rs. 4,000. If the work is not completed, the consultant's contract would
be cancelled at a cost at Rs. 1,500.
d.
General overheads of Rs. 8,000 would be added to the cost of the additional work.
Required:
Assess whether the new customer's offer should be accepted.
Answer:
a.
Costs incurred in the past, or revenue received in the past are not relevant because they
cannot affect a decision about what is best for the future. Costs incurred to date of Rs. 50,000 and
revenue received of Rs. 15,000 are `water under the bridge' and should be ignored.
b.
Similarly, the price paid in the past for the materials is irrelevant. The only relevant cost
of materials affecting the decision is the opportunity cost of the revenue from scrap which would
be forgone ­ Rs. 2,000.
c.
Labor costs Rs Labor costs required to complete work 8,000 opportunity costs:
Contribution forgone by losing other work Rs. (30,000 ­ 12,000)
18,000
Relevant cot of labor
26,000
d.
The incremental cost of consultancy from completing the work is Rs. 2,500.
Rs.
Cost of completing work
4,000
Cost of canceling contract
1,500
Incremental cost of completing work
2,500
e.
Absorbed overhead is a national accounting cost and should be ignored. Actual overhead
incurred is the only overhead cost to consider. General overhead costs (and the absorbed overhead
of the alternative work for the labor force) should be ignored.
f.
Relevant costs may be summarized as follows:
Rs.
Rs.
Revenue from completing work
34,000
Relevant Costs:
Materials:
Opportunity cost
2,000
Labor:
Basic pay
8,000
Opportunity Cost
18,000
Incremental cost of consultant
2,500
30,500
Extra profit to be earned by accepting the order
3,500
The Deprival Value of an Asset
The deprival value of an asset represents the amount of money that a company would have to
receive if it were deprived of an asset in order to be no worse off than it already is.
The deprival value of an asset is best demonstrated by means of an example.
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Example: Deprival Value of an Asset
A machine cost Rs. 14,000 ten years ago. It is expected that the machine will generate future
revenues of Rs. 10,000. Alternatively, the machine could be scrapped for Rs. 8,000. An equivalent
machine in the same condition would cost Rs. 9,000 to buy now. What is the deprival value of the
machine?
Solution
Firstly, let us think about the relevance of the costs given to us in the question.
Cost of machine = Rs. 14,000 = past/sunk cost
Future revenues = Rs. 10,000 = revenue expected to be generated
Net realizable value = Rs. 8,000 = scrap proceeds
Replacement cost = Rs. 9,000
When calculating the deprival value of an asset, use the following diagram.
Lower of
Replacement
Revenue
Cost
Expected
(Rs. 9,000)
(Rs. 10,000)
Higher of
NRV
(Rs. 10,000)
(Rs. 8,000)
Therefore, the deprival value of the machine is the lower of the replacement cost and Rs. 10,000.
The deprival value is therefore Rs. 9,000.
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Table of Contents:
  1. COST CLASSIFICATION AND COST BEHAVIOR INTRODUCTION:COST CLASSIFICATION,
  2. IMPORTANT TERMINOLOGIES:Cost Center, Profit Centre, Differential Cost or Incremental cost
  3. FINANCIAL STATEMENTS:Inventory, Direct Material Consumed, Total Factory Cost
  4. FINANCIAL STATEMENTS:Adjustment in the Entire Production, Adjustment in the Income Statement
  5. PROBLEMS IN PREPARATION OF FINANCIAL STATEMENTS:Gross Profit Margin Rate, Net Profit Ratio
  6. MORE ABOUT PREPARATION OF FINANCIAL STATEMENTS:Conversion Cost
  7. MATERIAL:Inventory, Perpetual Inventory System, Weighted Average Method (W.Avg)
  8. CONTROL OVER MATERIAL:Order Level, Maximum Stock Level, Danger Level
  9. ECONOMIC ORDERING QUANTITY:EOQ Graph, PROBLEMS
  10. ACCOUNTING FOR LOSSES:Spoiled output, Accounting treatment, Inventory Turnover Ratio
  11. LABOR:Direct Labor Cost, Mechanical Methods, MAKING PAYMENTS TO EMPLOYEES
  12. PAYROLL AND INCENTIVES:Systems of Wages, Premium Plans
  13. PIECE RATE BASE PREMIUM PLANS:Suitability of Piece Rate System, GROUP BONUS SYSTEMS
  14. LABOR TURNOVER AND LABOR EFFICIENCY RATIOS & FACTORY OVERHEAD COST
  15. ALLOCATION AND APPORTIONMENT OF FOH COST
  16. FACTORY OVERHEAD COST:Marketing, Research and development
  17. FACTORY OVERHEAD COST:Spending Variance, Capacity/Volume Variance
  18. JOB ORDER COSTING SYSTEM:Direct Materials, Direct Labor, Factory Overhead
  19. PROCESS COSTING SYSTEM:Data Collection, Cost of Completed Output
  20. PROCESS COSTING SYSTEM:Cost of Production Report, Quantity Schedule
  21. PROCESS COSTING SYSTEM:Normal Loss at the End of Process
  22. PROCESS COSTING SYSTEM:PRACTICE QUESTION
  23. PROCESS COSTING SYSTEM:Partially-processed units, Equivalent units
  24. PROCESS COSTING SYSTEM:Weighted average method, Cost of Production Report
  25. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Accounting for joint products
  26. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Problems of common costs
  27. MARGINAL AND ABSORPTION COSTING:Contribution Margin, Marginal cost per unit
  28. MARGINAL AND ABSORPTION COSTING:Contribution and profit
  29. COST VOLUME PROFIT ANALYSIS:Contribution Margin Approach & CVP Analysis
  30. COST VOLUME PROFIT ANALYSIS:Target Contribution Margin
  31. BREAK EVEN ANALYSIS MARGIN OF SAFETY:Margin of Safety (MOS), Using Budget profit
  32. BREAKEVEN ANALYSIS CHARTS AND GRAPHS:Usefulness of charts
  33. WHAT IS A BUDGET?:Budgetary control, Making a Forecast, Preparing budgets
  34. Production & Sales Budget:Rolling budget, Sales budget
  35. Production & Sales Budget:Illustration 1, Production budget
  36. FLEXIBLE BUDGET:Capacity and volume, Theoretical Capacity
  37. FLEXIBLE BUDGET:ANALYSIS OF COST BEHAVIOR, Fixed Expenses
  38. TYPES OF BUDGET:Format of Cash Budget,
  39. Complex Cash Budget & Flexible Budget:Comparing actual with original budget
  40. FLEXIBLE & ZERO BASE BUDGETING:Efficiency Ratio, Performance budgeting
  41. DECISION MAKING IN MANAGEMENT ACCOUNTING:Spare capacity costs, Sunk cost
  42. DECISION MAKING:Size of fund, Income statement
  43. DECISION MAKING:Avoidable Costs, Non-Relevant Variable Costs, Absorbed Overhead
  44. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS
  45. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS:MAKE OR BUY DECISIONS