Relevant Costs For Decision Making

Mark Fielding-Pritchard

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The concept of Relevance

A. What is Relevance?

Relevant Information - the predicted future costs and revenues that will differ among alternatives. Although past data may be helpful in predicting future costs and revenues, past data is irrelevant in making future decisions.

The expected future costs that differ between alternatives are the relevant costs to be used in selecting from the competing alternatives.

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The Sales Order

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The Sales Order (cont’d)

Misuse of Unit Cost:

Misinterpreting fixed unit costs may cause a manager to decide that a special order results in a bad decision due to a mistreatment of the fixed manufacturing costs (i.e., treating them as variable).

Avoid Confusing Variable and Fixed Costs!

Activity-Based Costing, Special Orders, and Relevant Costs:

Businesses that have identified all their significant cost drivers can predict the effects of special orders more accurately.

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Deletion or Addition of Products, Services, or Departments

Avoidable Costs - will not continue if an ongoing operation is

changed or deleted. These costs are relevant in making the decision.

Unavoidable Costs - will continue even if an operation is halted.

These are not relevant because they will not differ between

alternatives. Unavoidable costs may include Common Costs – costs

of facilities and services that are shared by users (e.g., building

depreciation, heating, air conditioning, and general management

expenses).

The same principles regarding relevance applied to special orders

apply to decisions concerning adding or deleting products or

departments.

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Opportunity Costs, outlay costs, differential costs Opportunity Cost - maximum available contribution to profit forgone

(i.e., rejected) by using limited resources for a particular purpose.

Outlay Cost - requires a cash disbursement sooner or later and is the typical cost recorded by accountants.

Presenting revenues, costs, and income of two alternatives and the differences in those revenues, costs, and incomes is referred to as differential analysis.

Differential Costs (or Incremental Costs) – the difference in costs between two alternatives. Examples provided include an employee quitting her job to go into business for herself and changing the production level of automobiles.

It is important to consider opportunity costs when evaluating alternative courses of action.

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Make-or-Buy Decisions

Basic Make or Buy and Idle Facilities

Manufacturers have to decide whether to make or buy parts and subassemblies that go into their final products. Some companies make all their own parts and subassemblies in order to assure product quality, while others buy most of theirs to protect mutually advantageous long-run relationships with suppliers. Many companies only make parts if their facilities cannot be used to better advantage.

When idle facilities exist, quantitative factors bearing on the decision typically include the direct material, direct labour, variable overhead, fixed overhead that may be avoided if the part is purchased, and the purchase cost of buying the parts.

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Make-or-Buy Decisions (cont’d)

Basic Make or Buy and Idle Facilities

(cont’d) (The key to make-or-buy decisions is identifying the additional costs for making (or the costs avoided by buying) a part or component. Using activity analysis can help in identifying these costs.)

The alternative uses for the facilities that would be occupied if the part was made should be considered. The basic example can be expanded to include the possible renting out of the space used to make the parts, and the possibility of producing other products in that space. In all cases, companies should relate these decisions to the long-run policies for the use of capacity.

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Optimal Use of Limited Resources If a plant that makes more than one product is being

operated at capacity, the orders to accept are those that make the biggest total profit contribution per unit of the limiting factor.

Limiting Factor or Scarce Resource - an item that restricts or constrains the production or sale of a product or service. For example, in retail sales, the limiting resource is often floor space. Thus, retail stores must either focus on products using less space or using the space for shorter periods of time (i.e., greater Inventory Turnover - number of times the average inventory is sold per year). Do not emphasize those products that give the largest contribution per sales Peso or per unit of product.

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