RELEVANT COSTING
CHAPTER 9
Presented by: Nicole Lieman
FNB 135
Relevant Costing: revision of key concepts
Remember the definition:
Future cash flows that differ between 2
options
Other definitions
Irrelevant
costs
Opportunity
costs
The next best
alternative given
up
Constraint
Common
costs
Unique costs
Sunk costs
Committed
costs
Relevant Costing: revision of key concepts
Two methods
Show all the relevant costs for the 2 options (2
columns)
Show only the incremental cash flows (1 column)
Consider only relevant cash flows
Always consider both qualitative and
quantitative factors
Types of decisions:
Special orders
Outsourcing (make or buy decisions)
Replacement of equipment
Discontinuation decisions (products or divisions)
Timing of decision
How should costs be measured for a range of nonroutine short-term and long-term decisions?
What is the difference?
Short-term Decision
Long-term Decision
Once-off orders, make or buy decisions
(outsourcing), discontinuation decisions,
and replacement of equipment. etc
Whether to make a long-term strategic
move ,set a selling price, introduce a new
product or service, discontinuance of a
product, purchase infrastructure, outsourcing
Identify relevant costs, sunk costs,
opportunity costs/incomes, incremental
costs and avoidable costs in a scenario
related to this decision. (Remember the
irrelevance of book values)
Use capital budgeting (NPV), a multi period
approach.
Selling Price decisions (Short-term)
Costs related to the decision may be different
as we view these costs from a long-term
perspective.
Selling Price decisions (Long-term)
Relevant incremental cost + a mark-up.
Full costs + company return (WACC)
Detailed knowledge
of relevant costing
is very important
NPV and capital
budgeting knowledge is
very important
Relevant Labour costs S/T
Capacity constraints
How can we get additional labour:
Overtime?
More expensive?
New staff? Training
Reduce production of something else
Now have an opportunity cost + relevant cost
Remember: will always go with the cheapest
option to source more labour
Salaries/wages
Partial capacity constraint
Cost of available capacity (eg usual labour rate)
Cost of overtime when need more capacity)
Example 1 labour costs
Relevant material costs: S/T
No alternative use
Materials used regularly in production
Sitting idle: no cost
What about the original
purchase price?
Irrespective of how much is on hand, will need to
be replaced: replacement cost
Have an alternative use
Used on another product, thus if use on order
cannot produce other product: opportunity cost
Could have been scrapped for a small income:
opportunity cost
Would have had to be removed at a cost:
opportunity saving
Example 2 materials
Short term vs long term
Variable costs / Fixed costs / Mixed costs
Long term:
more costs can be changed,
thus more costs will be relevant
Approach:
Consider all costs that would be relevant in
each period
NPV discounted at required return
Required return depends on what is being
analysed:
Company
WACC or divisional return
Example 3 S/T vs L/T
Consider
Head office allocated costs
Free space in factory
Lost or increased sales in another product
By-products
Redundancy costs
Book values
Depreciation allocation of past costs
Idle time
Alternative use for materials
Transfer pricing
Materials (historic cost/replacement cost/MV/NRV/opp cost)
Labour (Permanent salaried/Temporary hourly/No capacity,
opp cost
Qualitative factors to
consider
Decline in employee morale
Trade union reaction
Competitor reaction
Price elasticity
Availability of capacity, materials, labour
Better more lucrative alternatives available
Effect on environment / public outcry
Effect of low price on other customers
Price set now, when renegotiate later, bound to this
More qualitative factors to consider:
Repeat order?
Technical expertise
Timing of cash flows, financing
Reliability and reputation of customers
Tax consequences / allowances
Reliability of forecasts, information
