MODUL PERKULIAHAN

Relevant cost for

Decision Making

Fakultas Program Studi Tatap Muka Kode MK Disusun Oleh

12
Economic & Business Accountancy Kode MK Alfiandri, MAcc

Abstract Kompetensi
Diisi dengan abstract 1. Understand cost and benefit in
making decision
2. Understand avoidable cost
Pembahasan
1. Introduction

In the organization managers face tough decision in the business like what product
should sell, whether to make or buy components parts, what price should be charged,
what channel of distribution is going to be used, whether to accept special orders with
special price or vice versa. Making as such decision often difficult which a bit
complicated by numerous alternatives and massive amount of the data, only some might
be relevant.

Each decision has always two alternatives neither decides about cost and benefit
and comparability between cost and benefit. The key to make such comparisons is
differential analysis focusing on the costs and benefits that differ between the
alternatives. Costs that differ between alternatives are called relevant costs. Benefits
that differ between alternatives are called relevant benefits. Distinguishing between
relevant and irrelevant costs and benefits is critical for two reasons. First, irrelevant data
can be ignored—saving decision makers tremendous amounts of time and effort.
Second, bad decisions can easily result from erroneously including irrelevant costs and
benefits when analyzing alternatives. To be successful in decision making, managers
must be able to tell the difference between relevant and irrelevant data and must be able
to correctly use the relevant data in analyzing alternatives

Before go further about relevant cost and benefit, it should understand its concept.

2. Identifying Relevant Cost and Benefit

Only those costs and benefits that differ in total between alternatives are relevant in a
decision. If the total amount of a cost will be the same regardless of the alternative selected,
then the decision has no effect on the cost, so the cost can be ignored. For example, if you
are trying to decide whether to go to a movie or rent a DVD for the evening, the rent on your
apartment is irrelevant. Whether you go to a movie or rent a DVD, the rent on your apartment
will be exactly the same and is therefore irrelevant to the decision. On the other hand, the

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 cost of the movie ticket and the cost of renting the DVD would be relevant in the decision
because they are avoidable costs.

An avoidable cost is a cost that can be eliminated by choosing one alternative over
another. By choosing the alternative of going to the movie, the cost of renting the DVD
can be avoided. By choosing the alternative of renting the DVD, the cost of the movie
ticket can be avoided. Therefore, the cost of the movie ticket and the cost of renting the
DVD are both avoidable costs. On the other hand, the rent on your apartment is not an
avoidable cost of either alternative. You would continue to rent your apartment under
either alternative. Avoidable costs are relevant costs. Unavoidable costs are irrelevant
costs

To refine the notion of relevant costs a little further, two broad categories of costs are
never relevant in decisions—sunk costs and future costs that do not differ between the
alternatives. Sunk cost is a cost that has already been incurred and cannot be avoided
regardless of what a manager decides to do. For example, suppose a used car dealer
purchased a five-year-old Toyota Camry for $12,000. The amount paid for the Camry is
a sunk cost because it has already been incurred and the transaction cannot be undone.

On the other hand, Future costs that do not differ between alternatives should also be
ignored. Continuing with the example discussed earlier, suppose you plan to order a
pizza after you go to the movie theater or you rent a DVD. If you are going to buy the
same pizza regardless of your choice of entertainment, the cost of the pizza is irrelevant
to the choice of whether you go to the movie theater or rent a DVD. Notice, the cost of
the pizza is not a sunk cost because it has not yet been incurred. Nonetheless, the cost
of the pizza is irrelevant to the entertainment decision because it is a future cost that
does not differ between the alternatives

3. Different cost for different purposes

Costs that are relevant in one decision situation are not necessarily relevant in another.
This means that managers need different costs for different purposes. For one purpose,
a particular group of costs may be relevant; for another purpose, an entirely different
group of costs may be relevant. Thus, each decision situation must be carefully analyzed

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 to isolate the relevant costs. Otherwise, irrelevant data may cloud the situation and lead
to a bad decision. For example, Cynthia currently stays in Boston, Texas and she would
like to visit her friend in New York in this weekend. She has on tight budget and therefore
tries to decide whether to take the train or drive the car and the question is which cost
and benefit are relevant in this decision? Here is the list of information

Item (a) the original cost of the car is a sunk cost. This cost has already been incurred and
therefore can never differ between alternatives. Consequently, it is irrelevant and should be
ignored

Item (b), the cost of gasoline consumed by driving to New York City, is a relevant cost. If
Cynthia takes the train, this cost would not be incurred. Hence, the cost differs between
alternatives and is therefore relevant

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Item (c), the annual cost of auto insurance and license, is not relevant. Whether Cynthia
takes the train or drives on this particular trip, her annual auto insurance premium and her
auto license fee will remain the same

Item (d), the cost of maintenance and repairs, is relevant. While maintenance and repair
costs have a large random component, over the long run they should be more or less
proportional to the number of miles the car is driven. Thus, the average cost of $0.065 per
mile is a reasonable estimate to use

Item (e), the monthly fee that Cynthia pays to park at her school during the academic year is
not relevant, regardless of which alternative she selects—driving or taking the train—she will
still need to pay for parking at school

Item (f) is the total average cost of $0.619 per mile is not relevant cost because this does not
relate with drive the car or catch the train. No such cost incurred and that is not relevant to
decision

Item (g), the decline in the resale value of the car that occurs as a consequence of driving
more miles, is relevant in the decision. Because she uses the car, its resale value declines,
which is a real cost of using the car that should be taken into account

Item (h), the $104 cost of a round-trip ticket on the train, is relevant in this decision. If she
drives, she would not have to buy the ticket

Item (i) is relevant to the decision, even if it is difficult to put a dollar value on relaxing and
being able to study while on the train. It is relevant because it is a benefit that is available
under one alternative but not under the other

Item (j), the cost of putting Cynthia’s dog in the kennel while she is gone, is irrelevant in this
decision. Whether she takes the train or drives to New York City, she will still need to put her
dog in a kennel

Item (k), is not relevant to decision Item (m), the cost of parking in New York City, is relevant
to the decision

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Finally list relevant cost shows below:

From a purely financial standpoint, it would be cheaper by $33.86 ($137.86 − $104.00) to

take the train than to drive

4. Adding and Dropping Product line and other segments

Decisions relating to whether product lines or other segments of a company should be

dropped and new ones added are among the most difficult that a manager has to make.
In such decisions, many qualitative and quantitative factors must be considered.
Ultimately, however, any final decision to drop a business segment or to add a new one
hinges primarily on the impact the decision will have on net operating income. To assess
this impact, costs must be carefully analyzed. To understand this, we are going to take
example Drug company has three product line drug, cosmetic and housewares. Figure
below shows the income statement of the company

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From the information above, the manager can quick make decision which product should be
dropped and remained i.e., Housewares (dropped), Drugs and Cosmetic (remained). Making
quick decision based on the information is a bit flawed conclusion due to that information do
not distinguish between fixed expenses that can be avoided if a product line is dropped and
common fixed expenses that cannot be avoided by dropping any particular product line.

If the housewares line is dropped, then the company will lose $20,000 per month in
contribution margin, but by dropping the line it may be possible to avoid some fixed costs
such as salaries or advertising costs. If dropping the housewares line enables the company
to avoid more in fixed costs than it loses in contribution margin, then its overall net operating
income will improve by eliminating the product line. On the other hand, if the company is not
able to avoid as much in fixed costs as it loses in contribution margin, then the housewares
line should be kept. In short, the manager should ask, “What costs can I avoid if I drop this
product line?”

To answer that question, the manager should analyze the fixed cost

1. The salaries expense represents salaries paid to employees working directly on the
product. All of the employees working in housewares would be discharged if the product
line is dropped.

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2. The advertising expense represents advertisements that are specific to each product line
and are avoidable if the line is dropped.

3. The utilities expense represents utilities costs for the entire company. The amount
charged to each product line is an allocation based on space occupied and is not
avoidable if the product line is dropped.

4. The depreciation expense represents depreciation on fixtures used to display the

various product lines. Although the fixtures are nearly new, they are custom-built and will
have no resale value if the housewares line is dropped.

5. The rent expense represents rent on the entire building housing the company; it is
allocated to the product lines on the basis of sales dollars. The monthly rent of $20,000
is fixed under a long-term lease agreement.

6. The insurance expense is for insurance carried on inventories within each of the three
product lines. If housewares is dropped, the related inventories will be liquidated and the
insurance premiums will decrease proportionately.

7. The general administrative expense represents the costs of accounting, purchasing, and
general management, which are allocated to the product lines on the basis of sales
dollars. These costs will not change if the housewares line is dropped.

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Based on analyze then the management can determine that $15,000 of the fixed expenses
associated with the housewares product line are avoidable and $13,000 are not.

As stated earlier if the housewares product line were dropped, the company would lose the
product’s contribution margin of $20,000, but would save its associated avoidable fixed
expenses. We now know that those avoidable fixed expenses total $15,000. Therefore,
dropping the housewares product line would result in a $5,000 reduction in net operating
income as shown below

The fixed costs that can be avoided by dropping the housewares product line ($15,000) are less
than the contribution margin that will be lost ($20,000). Therefore, based on the data given, the
housewares line should not be discontinued unless a more profitable use can be found for the
floor and counter space that it is occupying.

Figure below shows comparative analysis:

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Further reading about “To make and Buy Decision “, please read “Relevant Cost for Decision
Making” Garrison & Noreen, or another Managerial Accounting resources

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Daftar Pustaka

Garrison, R.H. 2006. Managerial Accounting. Edisi 11. Penerbit Salemba Empat. Jakarta

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