Week 8

• Relevant costs are those costs/revenues that are relevant to a particular decision

  From the standpoint in time that the decision is being taken relevant costs/revenues must be

  FUTURE

  INCREMENTAL

  CASH FLOWS

  All three conditions must be satisfiedüInclude opportunity costs and opportunity income
• Opportunity costs and income can be difficult to identify, but should be included.
• Opportunity income: benefit gained when one course of action is chosen in preference to another
• Opportunity cost: benefit sacrificed when one course of action is chosen in preference to another
• Most resources will have an alternative use and this must be valued as part of the cost of pursuing a course of action
• Irrelevant costs

  •Past costs – SUNK costs – (Fails the FUTURE rule)
• •Committed costs (which will be paid anyway - Fails the INCREMENTAL rule )
• Allocated costs (e.g. through overhead absorption – Fails the INCREMENTAL rule )
• Costs which do not involve cash – (e.g depreciation – Fails the CASH FLOW rule)
• Future Incremental Cash Flows

  •The rental income

  •The fee charged by the agency for the booking

  •The cleaning and laundry required

  •The extra cost of electricity used

  •The cost of any breakages etc
• Situations requiring relevant costing

  Here are some examples of situations where we should use relevant costing principles…

  Make/buy and Outsourcing decisions

  Discontinuation decisions- continue with or terminate a contract/product etc

  Special pricing
• Situations requiring relevant costing

  Equipment replacement

  Product mix where there are capacity constraints
• Make-or-buy and outsourcing decisions

  Also consider qualitative factors before making a decision

  These are VERY important

  Will price be maintained?

  Will quality be guaranteed?

  Reliability of supplier?

  Redundancy cost?

  Effect on morale?

  Impact on customers?
• Sometimes a company is offered a one off order that is not part of normal operations

  Normal overheads are expected to be covered by all the other work

  We would consider accepting if the incremental revenue was greater than the incremental costs

  Incremental costs may include additional fixed costs as well as variable costs- the key question is what changes if we accept this order ?
• Analysis should also be undertaken to assess the impact of the decision on stakeholders and other parties:

  Customers (existing and future)

  Suppliers

  Competitors

  Employees

  Local community

  Environment

  Business partners etc.
• The past purchase price is NEVER relevant – it’s SUNK!
• Analysis of costs and revenues for decision making must be rigorous and focus on future, incremental cash flows only
• This will indicate a decision based on the financial data, but other, qualitative information must also be considered, particularly the impact on stakeholders