Relevan-t- -------

Relevance is one of the key characteristics of good management accounting information. This means
that management accounting information produced for each manager must relate to the decisions which
he/she will have to make.
'Relevant costs' are the costs that meet this requirement of good management accounting information.
The Chartered Institute of Management Accounting defines relevant costs as:
'the costs appropriate to a specific management decision'
This definition could be restated as 'the amount by which costs increase and benefits decrease as a
direct result of a specific management decision'. Relevant benefits are 'the amounts by which costs
decrease and benefits increase as a direct result of a specific management decision'.
Before the management of an enterprise can make an informed decision on any matter, they need to
incorporate all of the relevant costs which apply to the specific decision at hand in their decision making
process. To include any non-relevant costs or to exclude any relevant costs will result in management
basing their decision on misleading information and ultimately to poor decisions being taken.
Identifying relevant and non-relevant costs
The identification of relevant and non-relevant costs in various decision-making situations is based
primarily on common sense and the knowledge of the decision maker of the area in which the decision is
being made. Armed wiJh these two tools you should be able to sift through all the information that is
available in respect of any decision and extract those costs (and benefits) which are appropriate to the
decision at hand.
In identifying relevant costs for various decisions, you may find that some costs not included in the normal
accounting records of an enterprise are relevanl and some costs included in such records are non
relevant. It is important that you realise that there is a substantial difference between recorded
accounting costs and relevant costs for decision making, and while the latter may be recorded in
the former this is not always the case. Accounting records are used to record the incidence of actual
costs and revenues as they arise. Decisions, on the other hand, are based only on the relevant costs and
benefits appropriate to each decision while the decision is being made. This point is particularly
appropriate when you come to examine opportunity costs and sunk costs that are dealt with below.
In practice, you may also find that the information presented in respect of a decision does not include all
the relevant costs appropriate to the decision but the identification of this omission is very difficult unless
you are familiar with the area in which the decision is being made.
Exercise
The more common types of costs which you will meet when evaluating different decisions are incremental,
non-incremental and spare capacity costs. Are these likely to be relevant or non-relevant?
Suggested Solution
Incremental costs: An incremental cost can be defined as a cost which is specifically incurred by
following a course of action and which is avoidable if such action is not taken.. Incremental costs are,
by definition, relevant costs because they are directly affected by the decision (i.e. they will be
incurred if the decision .goes ahead and they will not be incurred if the decision is scrapped). For
example, if an enterprise is deciding whether or not to accept a special order for its product. the extra
variable costs (Le. number of units in special order x variable cost per unit) which would be incurred in
filling the order are an incremental cost because they would not be incurred if the special order were
to be rejected.
Non-incremental costs: These are costs which will not be affected by the decision at hand. Non
incremental costs are non-relevant costs because they are not related to the decision at hand (i.e.
non-incremental costs stay the same no matter what decision is taken). An example of non
incremental costs would be fixed costs which by their very nature should not be affected by decisions
(at least in the short term). If, however, a decision gives rise to a specific increase in fixed costs then
the increase in fixed costs would be an incremental and, hence, relevant cost. For example, in a
decision on whether to extend the factory floor area of an enterprise. the extra rent to be incurred
would be a relevant cost for that decision.
Spare capacity costs: Because of the recent advancements in manufacturing technology most
enterprises have greatly increased their efficiency and as a result are often operating at below full
capacity. Operating with spare capacity can have a significant impact on the relevant costs for any
short-term production decision the management of such an enterprise might have to make.
If spare capacity exists in an enterprise, some costs which are generally considered incremental may
in fact be non-incremental and thus, non-relevant, in the short term. For example. if an enterprise is
operating at less than full capacity then its work force is probably under utilised. If it is the policy of
the enterprise to maintain the level of its work force in the short term, until activity increases, then the
labour cost of this work force would be a non-relevant cost for a decision on whether to accept or
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reject a once-off special order. The labour cost is non-relevant because the wages will have to be
paid whether the order is accepted or not. If the special order involved and element of overtime then
the cost of such overtime would of course be a relevant cost (as it is an incremental cost) for the
decision.
Two further types of costs that have to be considered are opportunity costs and sunk costs.
Opportunity costs: An opportunity cost is a level of profit or benefit foregone by the pursuit of a
particular course of action. In other words, it is the value of an option, which cannot be taken as a
result of following a different option. For example, if an enterprise has a quantity of raw material in
stock which cost $7 per kg and it plans to use this material in the filling of a special order then you
..
would normally incorporate $7 per kg as part of your cost calculations for filling the order. If, however,
this quantity of material could be resold without further processing for $8 per kg, then the opportunity
cost of using this material in the special order is $8 per kg; by filling the order you forego the $8 per
kg which was available for a straight sale of the material. Opportunity costs are. therefore, the 'real'
economic costs of taking one course of action as opposed to another.
In the above decision-making situation it is the opportunity cost which is the relevant cost and, hence,
the cost which should be incorporated into your cost-versus-beneflt analysis. It is because the loss of
the $8 per kg is directly related to the filling of the order and the opportunity cost is greater than the
book cost. Opportunity costs are relevant costs for a decision only when they exceed the costs of the
same item in the option to the decision under consideration.
You may find the idea of opportunity costs difficult to grasp at first because they are notional costs,
which may never be included in the books and records of an enterprise. They are, however, relevant
in certain decision-making situation and you must bear in mind the fact that they exist when
assessing any such situations.
Sunk costs: a sunk cost is a cost that has already been incurred and cannot be altered by any future
decision. If sunk costs are not affected by a decision then they must be non-relevant costs for
decision-making purposes. Common examples of sunk costs are market research costs and
development expenditure incurred by enterprises in getting a product or service ready for sale. The
final decision on whether to launch the product or service would regard these costs as 'sunk' (i.e.
irrecoverable) and thus, not incorporate them into the launch decision.
Sunk costs are the opposite to opportunity costs in that they are not incorporated in the decision
making process even though they have already been recorded in the books and records of the
enterprise..
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Exercise
(a) An enterprise is considering replacing its professional legal advisers with its own newly trained
personnel. The relevant personnel are currently employed in the secretarial department of the
enterprise and will receive no pay increase when taking up their new responsibilities. They will also
be required to. continue to perform their old duties. The current annual salary bill of these
employees amounts to $100,000. Is the $100,000 a relevant cost in the decision on whether to
replace the professional advisers?
(b) An enterprise is considering the upgrading of its computer system. The upgrading would result in
the annual maintenance contract fee charged by the suppliers rising from $30,000 to $40,000.
Is the maintenance fee a relevant cost to the upgrading decision? Briefly explain your reasoning.
Evaluating decisions involving relevant and non-relevant costs
When you are faced with making a decision, you have to perform two tasks before making the final
decision:
1. Evaluate the options in the decision on a monetary basis using cost versus benefit analysis.
2. Take account of the qualitative factors associated with each option in the decision.
The performance of the first task is dealt with in this section. Performance of the second task is
influenced by experience and common sense.
Once the relevant costs are identified for each option you simply perform a cost versus benefit analysis
for each option and select the one that results in the greatest gain or least cost to the enterprise.
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Revised Summer 2010
f Sample True I False Questions
1. The book value of old equipment is not a relevant cost in a decision.
True False
2. One of the dangers of allocating common fixed costs to a product line is that such
allocations can make the line' appear less profitable than it really is.
True False '
3. A differential cost is a variable cost.
True False,
4. All future costs are relevant in decision making.
True False
5. Variable costs are always relevant costs.
True False
6. A sunk cost is a cost that has already been incurred but that can be avoided at
least in part depending on the action a manager takes.
True False
7. A cost that will be incurred regardless of which course of action a manager takes
is relevant to the manager's decision.
True False
8. Opportunity costs are recorded in the accounts of an organization.
True False
9. In a decision to drop a segment, the opportunity cost of the spaceoccupied by
the segment would be the profit that could be derived from the best alternative
use of the space.
True False
10. Only the variable costs identified with a product are relevant in a decision
concerning whether to eHminate the product.
True False
11. Managers should pay little attention to bottleneck operations because they have
limited capacity for producing output.
True False
12. Defective units should be detected and scrapped or reworked after the bottleneck
operation rather than before it.
True False
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Sample Multiple Choice Questions
1. Acost that does not affect a decision is called an
a) opportunity cost
b) incremental cost
c) avoidable cost
d) irrelevant cost
2. Costs that change between alternatives are called
a) fixed costs.
b) opportunity costs.
c) relevant costs.
d) sunk costs.
3. Acost incurred in the past that cannot be changed by any future action is a(n)
a) opportunity cost
b) sunk cost
c) relevant cost
d) avoidable cost
4. Who generates the data used in incremental analysis?
a. Market analysts and engineers
b. .Engineers and accountants
c. Market analysts, engineers, and accountants
d. Only the accountants
S. Which statement is true about relevant costs in incremental analysis?
a) All costs are relevant if they change between alternatives
b) Only fixed costs are relevant
c) Only variable costs are relevant
d) Relevant costs should be ignored
6. Canada Inc. determined that it must expand its capacity to accept a special order.
Which situation is likely?
a) Unit variable costs will increase
b) Fixed costs will not be relevant
c) Both variable and fixed costs will be relevant
d) The company should accept the order
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7. It costs Lannon Fields $14 of variable costs and $6 of allocated fixed costs to
produce an industrial trash can that sells for $30. A buyer in Mexico offers to
purchase 3,000 units at $18 each. Lannon Fields has excess capacity and can
handle the additional production. What effect will acceptance of the offer have on
net income?
a) Decrease $6,000
b) Increase $6,000
c) Increase $54,000
d) Increase $12,000
8. A factory is operating at less than 100% capacity. Potential additional business will
not use up the remainder of the plant capacity. Given the following list of costs,
which one should be ignored in a dedsion to produce additional units of product?
a) Variable selling expenses
b) Fixed factory overhead
c) Direct labor
d) Contribution margin of additional units
9. A company contemplating the acceptance of a special order has the following unit
cost behavior, based on 10,000 units:
a) Direct materials $4
b) Direct labor $10
c) Variable overhead $8
d) Fixed overhead $6
10. A foreign company wants to purchase 1,000 units at a special unit price of $25.
The normal price per unit is $40. In addition, a special stamping machine will
have to be purchased for $2,000 in order to stamp the foreign company's name
on the product. The incremental income (loss) from accepting the order is
a) $3,000
b) $1,000
c) $(3,000)
d) $(1,000)
11. What is the nature of an opportunity cost?
a) It is always variable
b) It is a potential 'benefit
c) It is included as part of cost of goods sold
d) It is a sunk cost
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12. Wishnell Toys can make 1,000 toy robots with the following costs:
a) Direct Materials $70,000
b) Direct Labor $26,000
c) Variable Overhead $15,000
d) Fixed Overhead $15,000
13. The company can purchase the 1,000 robots externally for $120,000. The
avoidable fixed costs are $5,000 if the units are purchased externally. What is the
cost savings if the company makes the robots?
a) $1,000
b) $5,000
c) $10,000
d) $4,000
14. Which one of the folloWing does not affect a make-or-buy decision?
a) Variable manufacturing costs
b) Opportunity costs
c) Incremental revenue
d) Direct labor
15. Which decision will involve no incremental revenues?
a) Make-or-buy
b) Drop a product line
c) Accept a special order
d) Additional processing
16. Abel Company produces three versions of baseball bats: wood, aluminum, and
hard rubber. A condensed segmented income statement for a recent period
follows:
Hard
Wood Aluminum Rubber Total
Sales $500,000 $200,000 $65,000 $765,000
Variable Expenses 325.000 140,000 58,000 523,000
Contribution Margin 175,000 60,000 7,000 242,000
Fixed Expenses 75,000 35,000 22,000 132,000
Operating Income $100,000 ~ 2 5 , O O O ($15,000) $110,000
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17. Assume none of the fixed expenses for the hard rubber - I ~ n e are avoidable. What
will be total net income if the line is dropped?
a) $125,000
b) $103,000
c) $105,000
d) $140,000
18. Assume all of the fixed expenses for the hard rubber line are avoidable. What will
be total net income if that line is dropped?
a) $125,000
b) $103,000
c) $105,000
d) $140,000
19. What would have to occur for total net income to remain unchanged when the
hard rubber line is dropped?
a) Total net income could not remain the same if hard rubber is dropped.
b) The avoidable fixed expenses for hard rubber would have to be $15,000.
c) The unavoidable fixed expenses for hard rubber would have to equal its
contribution margin.
d) The avoidable fixed expenses for hard rubber would have to be $7,000.
20. If the total net income after dropping the hard rubber line is $105,000, hard
rubber's avoidable fixed expenses were
a) $20,000.
b) $2,000.
c) $7,000.
d) $5,000.
21. North Division has the following information:
Sales $900,000
Variable expenses $480,000
Fixed expenses $465,000
If this division is eliminated, the fixed expenses will be allocated to the company's
other divisions. What is the incremental effect on net income if the division is
dropped?
a) $45,000 increase
b) $465,000 decrease
c) $420,000 decrease
d) $435,000 increase
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22. A company decided to replace an old machine with a new machine. Which of the
following is considered a relevant cost?
a) The book value of the old equipment
b) Depreciation expense of the old equipment
c) The loss on disposal of the old equipment
d) The current disposal price of the old equipment
23. A company is deciding whether or not to replace some old equipment with new
equipment. Which of the following is notconsidered in the incremental analysis?
a) Annual operating cost of the newequipment
b) Annual operating cost of the old equipment
c) Net cost of the new equipment
d) Book value of the old equipment
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