TW8 Lecture Notes PDF

STRATEGIC MANAGEMENT ACCOUNTING AND PERFORMANCE MEASUREMENT FINANCE DEPARTMENT SMAPM 2023-2024  LECTURE 8 FINANCE DEPARTMENT SMAPM 2023-2024  WHAT IS A RELEVANT COST? Relevant costs can be defined as any cost relevant to a de...

STRATEGIC MANAGEMENT ACCOUNTING AND PERFORMANCE MEASUREMENT FINANCE DEPARTMENT SMAPM 2023-2024  LECTURE 8 FINANCE DEPARTMENT SMAPM 2023-2024  WHAT IS A RELEVANT COST? Relevant costs can be defined as any cost relevant to a decision. A matter is relevant if there is a change in cash flow that is caused by the decision. Relevant costs and revenues are: In the FUTURE INCREMENTAL only CASH only FINANCE DEPARTMENT SMAPM 2023-2024  FUTURE Only future cash flows that occur as a result of the decision should be considered, e.g. any future costs or revenue. Sunk costs (i.e. costs that have already been incurred in the past) are not relevant to the decision and should therefore be ignored – we cannot change the past. FINANCE DEPARTMENT SMAPM 2023-2024  INCREMENTAL Only extra cash flows that result from the decision should be considered, e.g., extra costs or revenues. Opportunity costs should be included – look at the next best alternative resource use. Fixed costs should be ignored unless there is an incremental fixed cost resulting from the decision. Committed costs (i.e. costs that are unavoidable in the future) are not affected by the decision and should therefore be ignored. FINANCE DEPARTMENT SMAPM 2023-2024  CASH Only cash items are relevant to the decision. Depreciation is not relevant since it is not a cash flow. A change in the cash flow can be identified by asking if the amounts that would appear on the company’s bank statement are affected by the decision, whether increased or decreased. FINANCE DEPARTMENT SMAPM 2023-2024  IRRELEVANT COSTS: WHAT TO IGNORE? FINANCE DEPARTMENT SMAPM 2023-2024  IRRELEVANT COSTS FINANCE DEPARTMENT SMAPM 2023-2024  IRRELEVANT COSTS: SUNK COSTS Sunk costs are NOT relevant Sunk, or past, costs are already spent. A decision on whether or not a new endeavour is started will have no effect on this cash flow, so sunk costs cannot be relevant. FINANCE DEPARTMENT SMAPM 2023-2024  IRRELEVANT COSTS: COMMITTED COSTS Committed costs are NOT relevant Committed costs are money that is already contracted to be spent. Committed costs are costs that would be incurred in the future but they cannot be avoided because the company has already committed to them through another decision which has been made. FINANCE DEPARTMENT SMAPM 2023-2024  IRRELEVANT COSTS: NON-CASH COSTS Notional (non-cash) costs are NOT relevant Depreciation is not a cash flow and is dependent on past purchases and somewhat arbitrary depreciation rates. Book values are not relevant as these are simply the result of historical costs and depreciation. FINANCE DEPARTMENT SMAPM 2023-2024  IRRELEVANT COSTS: FIXED COSTS Fixed costs are NOT relevant Irrespective of what treatment is used in the company’s management accounts to split up costs, if the total costs remain the same, there is no cash flow effect caused by the decision. Note that additional fixed costs caused by a decision are relevant. So, if you were evaluating the viability of a new production facility, then the rent of a building specially leased for the new facility is relevant. FINANCE DEPARTMENT SMAPM 2023-2024  FIXED COSTS FINANCE DEPARTMENT SMAPM 2023-2024  OPPORTUNITY COST It is the value of the best alternative that is foregone when a particular course of action is undertaken. It emphasises that decisions are concerned with choices and that by choosing one plan, there may be sacrifices elsewhere in the business. FINANCE DEPARTMENT SMAPM 2023-2024  OPPORTUNITY COST: EXAMPLE A new project requires the use of an existing machine that would otherwise be sold. Information concerning the machine is as follows: Original purchase price = $20,000 Current net book value = $5,000 Estimated current sales value = $4,000 What is the relevant cost if the machine if used in the project? FINANCE DEPARTMENT SMAPM 2023-2024  RELEVANT COST: EXAMPLE 1 The salary to be paid to a market researcher who will oversee the development of a new product. This is a new post to be created especially for the new product but the $12,000 salary will be a fixed cost. Is this cost relevant to the decision to proceed with the development of the product? FINANCE DEPARTMENT SMAPM 2023-2024  RELEVANT COST: EXAMPLE 2 The $2,500 additional monthly running costs of a new machine to be purchased to manufacture an established product. Since the new machine will save on labour time, the fixed overhead to be absorbed by the product will reduce by $100 per month. Are these costs relevant to the decision to purchase the new machine? FINANCE DEPARTMENT SMAPM 2023-2024  RELEVANT COST: EXAMPLE 3 The Office cleaning expenses of $125 for next month. The office is cleaned by contractors and the contract can be cancelled by giving one month’s notice. Is this cost relevant to a decision to close the office? FINANCE DEPARTMENT SMAPM 2023-2024  RELEVANT COST: EXAMPLE 4 Expenses of $75 paid to the marketing manager. This was to reimburse the manager for the cost of travelling to meet a client with whom the company is currently negotiating a major contract. Is this cost relevant to the decision to continue negotiations? FINANCE DEPARTMENT SMAPM 2023-2024  RELEVANT COST OF MATERIAL FINANCE DEPARTMENT SMAPM 2023-2024  EXAMPLE 1 FINANCE DEPARTMENT SMAPM 2023-2024  EXAMPLE 2 FINANCE DEPARTMENT SMAPM 2023-2024  EXAMPLE 3 FINANCE DEPARTMENT SMAPM 2023-2024  RELEVANT COST OF LABOUR FINANCE DEPARTMENT SMAPM 2023-2024  EXAMPLE 1 FINANCE DEPARTMENT SMAPM 2023-2024  EXAMPLE 2 FINANCE DEPARTMENT SMAPM 2023-2024  EXAMPLE 3 FINANCE DEPARTMENT SMAPM 2023-2024  RELEVANT COST OF NON-CURRENT ASSETS FINANCE DEPARTMENT SMAPM 2023-2024  RELEVANT COST OF MACHINERY FINANCE DEPARTMENT SMAPM 2023-2024  SHORT-TERM DECISIONS IN RELEVANT COSTING Make vs Buy decision - Make vs Buy with no limiting factor - Make vs Buy with limiting factor Shut-Down decision One-off contracts Further processing decision FINANCE DEPARTMENT SMAPM 2023-2024  MAKE OR BUY DECISIONS Businesses may be faced with the decision whether to make components for their own products themselves or to concentrate their resources on assembling the products, obtaining the components from outside suppliers instead of making them 'in-house’. There are TWO types of make vs. buy decisions: Make or buy decisions with no limiting factors Make or buy decisions with limiting factors FINANCE DEPARTMENT SMAPM 2023-2024  MAKE OR BUY DECISIONS WITH NO LIMITING FACTOR In a make-or-buy decision with no limiting factors, the relevant costs are the differential costs between the two options. If the resources are bought in, their purchase cost is wholly marginal. However, if manufacturing the components internally, the comparative costs of doing so will be the direct materials and labour costs, plus the variable overhead. If the total variable costs of internally manufactured components are seen to be greater than the cost of obtaining similar components elsewhere, it is obviously uneconomic to produce these items internally, and better to outsource. FINANCE DEPARTMENT SMAPM 2023-2024  MAKE OR BUY DECISIONS WITH LIMITING FACTOR 1. Calculate the saving per unit of each product. Saving = Buy price – VC to make. 2. Divide this by the amount of limiting factor each product uses. This gives the saving per unit of the limiting factor. 3. Rank products. The higher the saving per unit of limiting factor, the greater the priority to make that product. 4. Allocate the scarce resource to the products in the order of the priorities, until it is fully used up. 5. Buy from an external source any product with unsatisfied demand FINANCE DEPARTMENT SMAPM 2023-2024  MAKE OR BUY DECISIONS: OTHER ISSUES Reliability of external supplier Specialist skills Alternative use of resource Social Legal Confidentiality Customer reaction FINANCE DEPARTMENT SMAPM 2023-2024  SHUT DOWN DECISIONS Part of a business, a department or a product, may appear to be unprofitable. The business may have to make a decision as to whether or not this area should be shut down. There are TWO types of costs when making shut down decisions: Quantifiable costs and benefits Non-quantifiable costs and benefits FINANCE DEPARTMENT SMAPM 2023-2024  QUANTIFIABLE COSTS AND BENEFITS Lost contribution from the area that is being closed (= relevant cost of closure) Savings in specific fixed costs from closure (= relevant benefit of closure) Known penalties and other costs resulting from the closure, e.g., compensation to customers (= relevant cost of closure) Known reorganisation costs (= relevant cost of closure) Known additional contribution from the alternative use for resources released (= relevant benefit of closure). FINANCE DEPARTMENT SMAPM 2023-2024  NON-QUANTIFIABLE COSTS AND BENEFITS Some of the costs and benefits discussed above may be non-quantifiable at the point of making the shut-down decision: Penalties and other costs resulting from the closure (e.g., compensation to customers) may not be known with certainty Reorganisation costs may not be known with certainty Additional contribution from the alternative use for resources released may not be known with certainty. FINANCE DEPARTMENT SMAPM 2023-2024  ONE-OFF CONTRACTS When a business is presented with a one-off contract, it should apply relevant costing principles to establish the cash flows associated with the project in order to help set a price. The minimum contract price = the total net relevant cash flow associated with the contract. FINANCE DEPARTMENT SMAPM 2023-2024  ONE-OFF CONTRACTS The minimum price is effectively a break-even price, so will give the firm no gain or loss. If the contract price does not cover these cash flows then it should be rejected as the company will have less cash if it accepts the contract. Any price higher than the minimum will mean that the company is better- off accepting the contract than rejecting it. FINANCE DEPARTMENT SMAPM 2023-2024  FURTHER PROCESSING DECISIONS Joint products arise where the manufacture of one product inevitably results in the manufacture of other products. The specific point at which individual products become identifiable is known as the split-off point. Costs incurred before the split-off point are called joint costs and must be shared between joint products produced. After separation products may be sold immediately or may be processed further. Any further processing costs are allocated directly to the product on which they are incurred. FINANCE DEPARTMENT SMAPM 2023-2024  FURTHER PROCESSING DECISIONS When deciding whether to process a particular product further or to sell after split-off only future incremental cash flows should be considered: Any difference in revenue and any extra costs. Joint costs are sunk at this stage and thus not relevant to the decision. (Note: if we are considering the viability of the whole process, then the joint costs would be relevant). FINANCE DEPARTMENT SMAPM 2023-2024  THANK YOU! FINANCE DEPARTMENT SMAPM 2023-2024