1

Relevant costs and irrelevant costs

• For decision making costs and revenues can be classified according to whether they are relevant to a particular decision.

2

Decision making, planning and controlling process

Identify the objective

Searching for alternative course of action

Gather the data

Select the course of action

Implement the decision

Compare the planned and actual output

Respond to divergences from plan

ThesisAnti thesisSynthesis

ProfitWealth

3

Relevant costs and irrelevant costs

• For decision making costs and revenues can be classified according to whether they are relevant to a particular decision.

4

Relevant Cost

Meaning:Relevant costs represent those future costs that will be changed by a particular decision, while irrelevant costs are those that will not be affected by that decision.

5

Relevant Costs

There are two aspects of these costs:• They must be expected Future costs• They must be different among alternatives

course of action.

6

Example

• Past costs are not relevant costs. Historical costs or sunk costs are not relevant.

• Generally variable costs are relevant costs but variable costs which do not differ by a decision are not relevant.

• Generally fixed costs are not relevant but fixed costs which differ by decision becomes relevant

• Book value of equipment is not relevant but disposal value of an equipment is relevant.

7

Avoidable and unavoidable Costs

• Avoidable costs are those costs that may be saved by not adopting a given alternative, where as unavoidable costs can not be saved. Therefore, only avoidable costs are relevant for decision making.

8

Sunk Costs

• Costs which do not change under given circumstances and do not play any role in decision making process are known as sunk costs. They are historical costs incurred in the past.

• Sunk costs are irrelevant for decision making but they are distinguished from irrelevant costs because not all irrelevant costs are sunk costs.

9

Opportunity Costs

• An opportunity cost is a cost that measures the opportunity that is lost or sacrificed when the choice of one course of action requires that an alternative course of action be given up. It is important to note that opportunity costs only apply to the use of scarce resources. This concept is used for decision making and cost control.

10

Incremental Costs

• Incremental costs and revenues are the difference between costs and revenues for the corresponding items under each alternative being considered. Incremental costs may or may not include fixed costs. If fixed costs change as a result of decision, the increase in costs represents an incremental costs. If fixed costs do not change as a result, the incremental cost will be zero.

11

Factors affecting Decision

Decision will be affected by two factors:1 Quantitative Factors2 Qualitative FactorsNote: While taking decision qualitative factors

should also be considered.

12

• Relevant costs and irrelevant costs are always defined with reference to the particular situation.

13

Determining the relevant costs of direct material

• Determining the direct material costs that are relevant to short term decisions depends on the circumstances:

• That any materials required would not be taken from existing stock but would be purchased so the estimated purchase price would be the relevant material cost.

14

• Where materials are taken from existing stock do remember that original purchase price represents a past or sunk costs and is therefore irrelevant for decision making.

15

• If materials are to be replaced then using the material for a particular activity will necessitate their replacement. Thus, the decision to use the materials on an activity will result in additional acquisition costs compared with the situation if the materials were not used on that particular activity. Therefore, the future replacement cost represents the relevant cost of the material.

16

• Where the materials have no further use apart from being used on a particular activity and that materials have some realizable value then realizable value will be the relevant cost. If the materials have no realizable value the relevant cost of material will be zero.

17

Determining the relevant cost of direct labor

• Determining the direct labor costs that are relevant to short term decisions depends on the circumstances.

• Where a company has temporary spare capacity and the labor force is to be maintained in the short term, the direct labor cost incurred will remain the same for all alternative decisions. The direct labor cost will therefore be irrelevant for short term decision.

18

• Where Casual labor is used and where workers can be hired on a daily basis to adjust the output level in such case labor cost will be a relevant costs for decision making purpose.

19

• In a situation where full capacity exists and additional labor supplies are unavailable in the short term and where no further overtime is possible, the only way that labor resources could then be obtained for a specific order would be to reduce existing production. In such a case labor costs will be hourly labor rate plus an opportunity cost consisting of the contribution per hour that is lost by accepting the order.

20

Important points to remember

1- While preparing relevant cost sheet you should ask yourself what difference it will make if the alternative is selected. Never allocate common fixed costs to the alternatives.

21

2- You should focus on how each alternative will affect future cash flows of the organization. changes in the apportionment of fixed costs will not alter future cash flows of the company.

22

3- You should also consider the opportunity cost if resources are scarce. Your analysis should recommend the alternative that yields the largest contribution per limiting factor.

23

• Remember that our aim should always be to maximize long term net cash inflows.

24

• Remember that while determining relevant costs always consider whether the cost is incremental to the company level and not at lower levels with in the company.