Relevant Costs & Revenues - Chapter 10

• Topic 3 focuses on relevant costs and revenues for decision-making, referencing Chapter 10 of the Rohde and Seal textbook.

Learning Objectives

• Differentiate between relevant and irrelevant costs and revenues in decision-making, noting that these can also be known as avoidable and unavoidable costs.
• Establish relevant cash flows for decision-making and apply these principles in different situations.
• Define and understand key cost terms, including differential costs, opportunity costs, sunk costs, and incremental cash flows.

Decision Making: Types

• Pricing.
• Make or buy.
• Further processing.
• Launching/withdrawing products/services.
• Accepting one-off proposals.
• Extra shift proposals.
• Closedown proposals.
• Utilizing limiting factors.

Decision Making: Process

• An accountant performs a quantitative analysis using relevant costing principles.
• The accountant presents the quantitative analysis, which focuses on future incremental cash flows.
• The accountant contributes to broader discussions, considering qualitative factors like the decision's impact on various stakeholder groups.
• The ultimate decision is made and then implemented.

Quantitative Analysis: Relevant Costing Rules

• Sunk costs are always irrelevant.
• Committed costs are also irrelevant.
• Fixed costs are generally irrelevant unless the decision directly changes fixed costs.
• Variable costs are typically relevant because they are incremental.
• Limiting factors: the relevant cost is the income that is given up by not pursuing the next best option (opportunity cost).

Cost Concepts

• A relevant cost is one that differs between the available alternatives.
• Criteria for overall cost (benefit) being examined: must be a future item, must differ between alternatives, and must be a cash flow (all 3 criteria must be met).
• Costs avoidable if choosing one alternative over another are relevant.
• Unavoidable costs, including sunk costs and future costs that stay the same across options, are never relevant.
• Different costs can be relevant for different purposes, and qualitative factors are important.

Stock Specific Rules

• If stock needs replacing, the relevant cost is the replacement cost.
• If stock doesn't need replacing, the relevant cost is the higher of the net realisable value or the value of the next best use.

Qualitative Analysis

• Stakeholder groups to consider include:
  • Customers
  • Suppliers
  • Employees
  • Local community
  • Government
  • Public relations
  • Corporate social responsibility.

Example: Replacing Old Equipment

• Problem: White Co. is considering replacing an old machine with a new, more efficient one. The sales are £200,000 p.a., and fixed expenses are £70,000 per year excluding depreciation. The new machine costs €90,000; annual variable costs are €80,000; expected life 5 years. The old machine has an original cost of €72,000, a remaining book value of €60,000, a current disposal value of €15,000, annual variable costs of €100,000, and a remaining life of 5 years.
• Incorrect Analysis: The manager incorrectly suggests not buying the new machine due to a £45,000 loss on disposal of the old machine (Remaining book value £60,000 - Disposal value £15,000).
• Correct Analysis: requires comparing costs and revenues over the five years for both options. Consider the variable expenses.

Special Pricing

• Special pricing decisions involve one-time orders not considered a part of the company's regular business.
• Jet plc: they receive a one-time order not part of normal business. The single product has a variable cost of £8; the normal selling price is £20. A foreign distributor wants to buy 3,000 units for £10 each. Annual capacity is 10,000 units, while annual fixed costs are £48,000. Jet plc is currently producing and selling only 5,000 units.
• Profit increases by £6,000 if Jet accepts the offer. A contribution margin for a special order is £10 - £8 = £2, with a change in profit of £2 * 3,000 units = £6,000.

Opportunity Cost

• Opportunity cost constitutes the economic benefits that are given up because of choosing a particular course of action. They are not actual monetary outlays and typically aren't in the accounts of an organization.

Product Mix Decisions

• Constrained resources are the 'limiting factors' such as low sales demand, shortage of suitably qualified workers, shortage of appropriate materials, lack of available funding, or insufficient space within premises.
• Need to "make the best of a bad situation"- Use limited resources to meet demand and maximise profit (or minimize costs).
• Steps:
  • Identify the contribution per unit.
  • Calculate the amount of scarce resource each unit requires.
  • Calculate the contribution per limiting factor for each unit.
  • Rank the products relative to their contribution per limiting factor
• Example of Ensign Company: Machine A1 is used at 100% capacity (2,400 minutes per week), has product 1 (40% contribution margin, 1 min processing time), and product 2 (30% contribution margin, 0.5 min processing time). For product 1, limiting factor is £24 per minute. For product 2, limiting factor is £30 per minute. Product 2 should be given precedence in production over product 1, given products relative contribution margin.

Discontinuation Decisions

• This is relevant to a segment that has not reported a profit for several years due to a certain issue.
• Comparing contribution margins and fixed costs.
• Lovell should drop the digital watch segment if costs savings will exceed lost contribution margin.
• If the digital watch line is dropped, fixed general factory overhead and administrative expenses are reallocated across product lines. Depreciation is not relevant since it's booked as a sunk cost and isn't avoidable.
• The alternative with the highest profit is the best.

Determining Relevant Costs

• Determining the relevant costs of direct materials entails considering sunk costs, replacement costs and opportunity costs.
• Determining the relevant costs of direct labour entails considering if there is spare capacity.