Management Accounting-

Decision Making
Stage-5

Rizwan Ahmad Malik

FCMA, LLB, CFE
 Relevant Costing
Definition
Relevant costs are future cash flows arising as
direct consequence of a decision.
• Relevant Costs are future Costs (includes committed costs)
• Relevant Costs are cash flows (ignore non-cash depreciation)
• Relevant Costs are Incremental Costs

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 Relevant Costing
Relevant Costs:
A relevant cost for the decision has following characteristics,
• Relevant cost is a future cost. The cost which has been
incurred in the past are called sunk costs and are not relevant
for the decision.
• Relevant costs are incremental costs. Relevant cost arises as a
direct consequence of a decision.
• Relevant costs are cash flows. These are always settled in
cash. Non-cash expenses are never relevant.
• Different terminologies are used for different types of relevant
and irrelevant costs. These are summarized as follows.

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 Relevant Costing
Certain Kinds of Costs

Differentia Avoidable
l Costs Costs

Opportuni
Sunk Costs
ty Costs
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 Relevant Costing
Differential Cost
Difference between the two cost alternatives
Avoidable Costs
Specific costs of an activity or sector of a business which would
be avoided if that activity did not exist.
Opportunity Costs
The value of the benefit sacrificed when one course of action is
chosen in preference to an alternative.
Sunk Cost
A sunk cost is a past cost which is not directly relevant in
decision making.

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 Relevant Costing
Irrelevant Costs Relevant Costs
Sunk costs: Avoidable costs:
Costs which have been incurred in the past Costs which can be avoided by not accepting a
prior to making any decision are called sunk project or by not making a decision are called
costs. E.g. If the raw materials have been avoidable costs. Avoidable costs are relevant
purchased prior making a decision about the for the project decisions.
new product, raw material cost is not irrelevant Examples:
for this decision. oMaterial, labor and variable overheads are
Committed cost: considered avoidable and relevant cost for
The costs which have been committed to be project decisions.
incurred in future are called committed costs. oDirectly attributable fixed costs i.e. fixed costs
Committed costs are sunk costs and irrelevant which arise as a direct consequence of a project,
for the decisions. are considered relevant cost.
Unavoidable costs: Opportunity cost:
Costs which can’t be avoided by not taking a The benefit of the best alternative forgone by
decision or project are called unavoidable costs. preferring one alternative over the other is
These costs do not arise a direct consequence of called ‘opportunity cost’. Opportunity costs
a decision hence irrelevant for a project become relevant if the resources are scarce.
decision. Examples:
Examples: oIf a project uses a building which can
oGeneral overheads or absorbed overheads are otherwise be rented or sold, the rent or the sale
considered unavoidable hence irrelevant for proceeds forgone is opportunity cost of using
project decisions. the building and is relevant for the decisions.
oOther fixed costs which do not arise or change oIf the raw material being used in the project
as a direct consequence of a project are can be sold or has an alternative use, its use
considered unavoidable and irrelevant. value or scrape value will be its relevant costs.
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 Relevant Costing
Relevant Cost of Materials- Important to Note
Relevant Cost of Material is their current replacement
cost, unless the materials have already been purchased
and would not be replaced once used. In such case the
relevant cost of using them is higher of the following-
I. Their current sale value
II. The value they may obtain, if put to an alternative
use.
Further, If the materials have no resale value and no
other possible use, then the relevant costs of using
them would be nil.

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 Relevant Costing
Relevant Costing- Basic Tips
• General Rule: items of income or expense are only relevant to the decision if they
make the business richer or poorer when the business goes ahead with the decision.
• For example, non-cash items are non relevant (such as depreciation of fixed assets),
since to become richer the business must receive cash as a result of their decision and
to become poorer the business must spend cash.
• This would also help to explain the concept of opportunity cost- where another
opportunity is foregone if the business goes ahead with the decision under
consideration. The amount by which they would be poorer is relevant and is called
the opportunity cost.
• It is important that you know which revenues and costs are relevant and which are
non-relevant.
Relevant Non-Relevant
Cash Sunk costs
Opportunity costs Committed costs
Incremental cash flows Non-cash items
Share of group-wide fixed overheads

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 Relevant Costing
Exercise-1 The output of a process consists of two joint
products A and B and a by-product. Product B can be further
processed to in order to increase its sales price. To assist the
management in making decision whether to carry out
further processing which one of the following is relevant.
(The option which may affect the decision to further process
or not).
A. The share of the total processing cost which has been allocated to
Product B.
B. The sales value of Product A.
C. The physical quantities of each product produced from common
process.
D. The cost of further processing and increase in sales value of B.
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 Relevant Costing
Exercise-2 RC Ltd is tendering for a six months
contract which would require the use of a specialist
machine. The machine was purchased four years ago
for Rs. 9,000 and now has book value of Rs. 3,500. RC
Ltd was about to sell the machine for Rs. 4,000 but if
they used it on this contract , it can be sold at Rs.
2,500 after six months. The variable cost of operating
the machine for six months would be Rs 6,000/-
The relevant cost of operating machine for six
months is
A- Rs. 7,500 B- Rs. 10,000 C- Rs. 12,500 D. Rs 15,000
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 Relevant Costing
Application of Relevant Costing Concepts
• Special Selling Price Decisions
• Product Mix Decision- Capacity Constraint
• Equipment Replacement Decisions
• Outsourcing (Make or Buy Decision)
• Business Discontinuation Decisions

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Accountants- Management Accounting & 11
Decision Making
 Relevant Costing
Special Selling Price Decisions
Special Pricing Decisions involve one time orders only or orders at
below market price. At 1st instance it looks like that order should be
rejected since the proposed selling price is less than the actual total
cost.
Some Conditions
• Future Price must not be affected by the order
• Company has unused capacity available which has no alternative
usage.
• Short Term Horizon
• Relevancy and irrelevancy of any cost is subject to a particular
situation.

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 Relevant Costing
Special Selling Price Example

Current Cost Cost after Additional Order

Units in
Product A 38,000 total

Units 35,000 3,000 units at Rs. 20 Differential

Sales 40 1,400,000 1,460,000 60,000

Direct Labor 12 420,000 420,000 -

Direct Materials 8 280,000 304,000 24,000
V Ohs 2 70,000 76,000 6,000
22 770,000 800,000 30,000
Fixed Ohs 8 280,000 280,000 -
Marketing Ohs 3 105,000 105,000 -
11 385,000 385,000 -
Profit 7 245,000 275,000 30,000

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 Relevant Costing
Equipment Replacement Decision
Relevant cost principles is also applicable in case of Equipment
Replacement Decisions. The note able point is that past or
sunk cost is irrelevant in such cases. While doing calculations
at this stage, we need to ignore the time value of money at
this stage.

Example

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 Relevant Costing
Equipment Replacement Decisions-
Example Question
Old Equipment Rs
Rs. 3 per
Purchase Price 180,000 Variable Cost per Unit unit
Life 6 years
3 years old machine Capacity 20,000 units
zero salvage value
straight line depreciation method
present WDV Rs 90,000
Disposal Value Rs 40,000 and zero in three years time

New Equipment
Rs. 2 per
Cost 70,000 Variable Cost per Unit unit
Life 3 years
Zero scrap value Capacity 20,000 units

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 Relevant Costing
Solution
New
Old Machine Machine Difference
cost/
Variable Cost revenue Status
20,000 units for 3 yrs 180,000 120,000 (60,000) Relevant

Old Machine Book Value 90,000 (90,000) Irrelevant

For Depreciation Charge

Old Machine W/O 90,000 90,000 Irrelevant

Old Machine Disposal (40,000) (40,000) Relevant

Purchase of New Machine 70,000 70,000 Relevant

270,000 240,000 (30,000) Saving

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 Relevant Costing
Alternate Method- The Correct Method of Presentation

Saving on Variable Cost 60,000 Relevant

Rs 3 - Rs 2

Old Machine Disposal 40,000 Relevant

Purchase of New Machine (70,000) Relevant

Savings 30,000

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 Relevant Costing
Outsourcing- Make or Buy Decision
Outsourcing is the process of obtaining goods or services from
outside suppliers instead of producing the same goods or
providing the same services within the organization. We have
to choose from the two options.

Example 1

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 Relevant Costing
Example- Outsourcing Make Buy Decision
Cost of 10,000 components Cost in Rs per unit

Direct Materials 120,000 12

Direct Labor 100,000 10
Variable Overheads 10,000 1
Fixed Manufacturing Overheads 80,000 8
Share of Non-Manufacturing Ohs 50,000 5
360,000 36

Option-Supplier Offer Rs. 30 for 3 years

Situation A
if opted,
labor shall be free at zero cost
Fixed cost of Rs. 10,000 can be saved
Capacity has no other use

Situation B
if opted,
Capacity can be used for Product B 10,000 units
Variable Cost shall be same
Additional Raw Material of Rs. 13 per unit required
Fixed cost of Rs. 10,000 shall not be saved as in A
Capacity has no other use

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Situation A
Relevant Costing
Own Production Outsource for A

Direct Materials 120,000 12 - - Relevant

Direct Labor 100,000 10 - - Relevant
Variable Overheads 10,000 1 - - Relevant
Only Rs.
Fixed Manufacturing 10,000
Overheads 80,000 8 70,000 7 Irrelevant relevant
Share of Non-Manufact OHS 50,000 5 50,000 5 Irrelevant
360,000 36 120,000 12

Outsourcing Cost - - 300,000 30 Relevant

Total
Cost 360,000 36 420,000 42
Additional Cost 60,000
Alternate Method
Outsourcing Cost 300,000 30 Relevant
300,000
Direct Materials 120,000 12 Relevant
Direct Labor 100,000 10 Relevant
Variable Overheads 10,000 1 Relevant
Fixed Manufacturing
Overheads 10,000 1 Relevant
240,000
Additional Cost 60,000

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 Relevant Costing Produce
  Outsource A
Situation B Component B

Direct Materials - - 130,000 13 Relevant

Direct Labor - - 100,000 10 Relevant
Variable Overheads - - 10,000 1 Relevant
Only Rs.
Fixed Manufacturing 10,000
Overheads - - 80,000 8 Irrelevant relevant
Share of Non-Manufacturing
Ohs - - 50,000 5 Irrelevant
- - 370,000 37

Outsourcing Cost 300,000 -

Total Cost 670,000

Sales of Part-B 340,000

Net Costs of Option- B 330,000

Current Cost of
Option- A 360,000

Saving 30,000

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 Relevant Costing
Alternative Solution
Product B
Direct Materials 130,000
Direct Labor 100,000
Variable Overheads 10,000
Fixed Manufacturing Overheads 10,000
250,000

Sale 340,000
Savings from B 90,000

Loss from A (60,000)

Net Saving by opting B 30,000

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