RELEVANT COST ANALYSIS
The concept of relevant costing
This
concept is interlinked to decision making which is the making of a choice
between two or more alternatives. The objective of which is to maximize
shareholder value. The decision making process will require the use of relevant
costs and revenue. Relevant costs and revenues may be classified as such when
it change as a direct result of a decision taken.
Features
of Relevant Costs include:
1. Future
costs and revenues (looking to the future as the past
cannot be changed)
2. Cash
flows (of future costs and revenues and excludes non-cash
flow items)
3. Incremental
costs and revenues (when it increases as a result of
decisions taken). Differences in total costs or revenues between two
alternatives.
4. Opportunity
cost:
It represents the best alternative foregone in taking a decision
5. Avoidable
costs: Are specific costs associated with an activity
that would be avoided if that activity did not exist.
Non-relevant costs
Costs
which are not relevant to decision making are known as non-relevant costs and
includes:
1. Sunk
costs: Past costs / historical costs which are not
directly relevant in decision making.
2. Committed
costs: Future costs that cannot be avoided whatever
decision is taken.
3. Non-
cash flow costs: Cost which do not involve the flow of
cash, for e.g. depreciation and notional costs.
4. General
fixed overheads: Usually not relevant unless it is a
stepped fixed costs.
5. Net
book value: Costs which are determined by accounting conventions
rather than by future cash flows.
Example 1:
A
decision has to be made whether to use production method A or B. The cost
figures are as follows:
Method A
Method B
Costs last
year Costs next year Costs last year Costs next year
$ $ $ $
Fixed
costs 5,000
7,000 5,000 7,000
Variable
costs per unit
Labor 2 6 4 12
Materials
12 8 15 10
Required
1. Relevant
cost of Method A = $
2.
Relevant cost of Method B = $
Relevant costs for materials, labor
and overheads
Relevant cost for materials
Use the following decision tree to determine:
Example 1
Z
Ltd has 50 kg of materials P in inventory that was bought five years ago for
$70. It is no longer used but could be sold for $3/kg.
Z
is currently pricing a job that could use 40 kg of material P.
Required:
The relevant cost of material P that should be
included in the contract is $ __________
Example 2
A firm is currently considering a job that requires
1,000 kg of raw material. There are two possible situations.
Situation
1
The
material is used regularly within the firm for various products. The present
inventory is 10,000 kg purchased at $1.80 per kg. The current replenishment
price is $2.00 per kg.
Required:
The relevant cost $ _________
Situation
2
The
company has 2,000 kg in inventory bought 2 years ago for $1.50 per kg, but no
longer used for any of the firm's products. The current market price for the
material is $2.00, but the company could sell it for $0.80 per kg.
Required:
The relevant cost is $ _________
Relevant cost for labor
Similar to materials but note that the existence of
spare capacity is a factor.
Example 1
100
hours of unskilled labor are needed for a contract. The company has no surplus
capacity at the moment, but additional temporary staff could be hired at $4.50
per hour.
Required:
The relevant cost of the unskilled labor on the
contract is $ __________
Example 2
100
hours of semi-skilled labor are needed for a contract. There is at the moment
roughly 300 hours worth of spare capacity. There is a union agreement that
there are no lay-offs. the workers are paid $6.50 per hour.
Required:
The relevant cost of the semi-skilled labor on the
contract is $ _________
Example 3:
Z Ltd is pricing a job that involves the use of 20
hours of skilled labor and 50 hours of semi-skilled labor. The four existing
skilled workers are paid $15 per hour with a minimum weekly wage of $450. They
are currently working 24 hours a week.
The
semi-skilled workforce is currently fully utilized. They are each paid $10 per
hour, with overtime payable at time and a half. Additional workers may be hired
for $12 per hour.
Required:
The
relevant labor cost for Z Ltd's job = $ _________
Relevant costs for non-current assets
Non-current
asset relevant cost such as plant and machinery is determined like materials.
If
to be replaced at the end of useful life then relevant cost is the current
replacement cost.
If not to be replaced, relevant cost is the higher
of proceeds (sale) and the net cash flow arising from the use of the asset (if
not sold).
Example 1
A
machine which cost $10,000 four years ago has a written-down value of $6,000
and the depreciation to be charged this year is $1,000. It has no alternative
use, but it could be sold now for $3,000. In one year's time it will be
unsaleable.
Required:
Relevant cost of the machine = $ __________
Example 2
A
machine which originally cost $80,000 has an estimated useful life of 10 years
and is depreciated at the rate of $8,000 p.a. The net book value of the machine
is currently $40,000 and the net sales proceeds if it were to be sold today are
$25,000.
Required:
Identify whether the costs associated with the
machine are relevant or not. If you think they are not relevant, give reasons.
Opportunity costs
It represents the best alternative that is foregone
in taking a decision. It is the equivalent of profit or contribution foregone
by not taking the next best alternative. If resources are scarce, then
consideration must be given to profits or contribution which could have been
earned from alternative uses of the resources.
Example 1
A
new contract requires the use of 50 tons of metal ZX 81. This metal is used
regularly on all the firm's projects. There are 100 tons of ZX 81 in inventory
at the moment, which were bought for $200 per ton. The current purchase price
is $210 per ton, and the metal could be disposed of for net scrap proceeds of
$150 per ton.
Required:
What cost should be charged to the new contract for
metal ZX 81?
Example 2
A
new contract requires the use of 50 tons of metal ZX 81. There are 25 tons of
ZX 81 in inventory at the moment, which were bought for $200 per ton. The
company no longer has any use for metal ZX 81. The current purchase price is
$210 per ton, and the metal could be disposed of for net scrap proceeds of $150
per ton.
Required:
What
cost should be charged to the new contract for metal ZX 81?
where i can find the answers?
ReplyDelete