Lecture 3 Relevant Cost Analysis

Introductory
Management Accounting
Lecture 3
Relevant costs
Learning objectives
The identification and use of costs
and benefits information in
making managerial decisions.
ChunLei Yang
Lecture outline
 Relevant costs for decision-making-what
does it mean?
 General applications/ rules
 Illustrations
 Problems in estimating relevant flows
More in Lecture 8
ChunLei Yang 3
Managerial Decisions
Key point: To make a decision is to choose
between alternatives:
• What price to charge for a particular contract?

• Whether or not to accept a special order at a particular
price?
• Whether to make or buy a particular car component?
…
ChunLei Yang 4
The concept of relevant costs
What is “Cost”?
The amount of resources, usually measured
in monetary terms, sacrificed to achieve a
particular objective.
But, “cost” has multiple meanings…
ChunLei Yang 5
The concept of relevant costs
What is “Relevant”?
– What is relevant?
– Relevant for what?
Only those costs and benefits that differ between

alternatives are relevant in a decision.
ChunLei Yang 6
Principles of relevance
Key point:
Relevant costs are differential future cash flows
(DFC).
1. Only cash flows are relevant
2. Only future cash flows are relevant
3. Only changes in future cash flows are relevant

ChunLei Yang 7
Working out DFC
It is very important to distinguish between:
– Past (historical/sunk) costs- irrelevant
– Future costs:
• Opportunity costs relevant
• Outlay costs relevant
• Future costs that do not differ irrelevant
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Working out DFC:
DFC=cash outlay + opportunity costs
• Cash outlay: incremental cash flow

Deduce cash outlay by considering costs and benefits of
alternatives under any decision (e.g. doing sth/ not doing
it; make/buy)
• Opportunity costs: the future cash flow that is forgone by not
taking up the opportunity
Include opportunity cost by considering the benefits of
opportunities forgone (foregone benefits from the best
alternative use of the resources) and avoidable costs (the
cost thereby avoided).
ChunLei Yang 9
Working out DFC:
Relevant costs depend on resource availability (owned/supply
available/restricted supply) and on possible resource use
(alternative opportunities).
What would be the relevant cost in the following situations?

– Resources required are not already owned, but supplies
are freely available.
– Resources required are already owned/ controlled
• No alternative use. eg Materials in stock
• Alternative use available. eg, Labour working on
other projects
ChunLei Yang 10
Illustrations-1
New product "Q" will use an existing machine.
Machine cost £50,000; age 3 years
Annual depreciation £10,000
Is depreciation relevant to the decision on

production?
NO - THERE IS NO CASH FLOW

(Relevant cost = benefit lost from the best alternative
use of the machine)
ChunLei Yang 11
Illustrations-2
The company has spent £60,000 on research
and development of Q.
Is this £60,000 relevant to the production

decision?
NO - THE CASH FLOW IS PAST. It is a

sunk cost, unaffected by the decision
ChunLei Yang 12
Illustrations-3
Fixed annual production costs of the company total £500,000.
Q will use 20% of production line capacity.
Current operations run at 70% Capacity
Is a proportion of the fixed costs (20% of £500,000)

relevant to the decision on production?
NO - THE FIXED COSTS WILL BE INCURRED WITH OR

WITHOUT THE NEW PRODUCT
ChunLei Yang 13
Illustrations-4
Q will use skilled labour currently working on product L*.
L SALES 30,000
SKILLED LABOUR 10,000
*OTHER COSTS 13,000
23,000
Annual Cash Surplus 7,000
*In order to produce Q, the production of L has to cease.
*‘Other costs’ are cash based, and can be avoided if the production of L ceases.
What is the relevant labour cost for production of Q?

Differential cash flow:
10,000 Labour+7,000 Surplus lost = 17,000
Sales lost 30,000- Other costs avoided 13,000 = 17,000
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Relevant costs for decision making
Decision rule:
Accept, if relevant costs < relevant benefits
Reject, if relevant costs > relevant benefits
Applicable to a variety of managerial decisions:

– Whether to keep or replace old equipment;
– Adding and dropping product lines/ segments;
– Whether to make or buy a key component;
– Whether a special order should be accepted;
– How to solve a bottleneck problem.
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Question 1 pricing decision-charging a special order
A garage bought an old car a year ago
for £3,000. The car needs a replacement
engine which costs £300. This requires
7 hours to fit by a mechanic who is paid
£8 an hour. At the present the garage is
short of work. However the owners
A. 3000
have decided to keep the mechanics B. 3800
because skilled labour is difficult to
find and an upturn in repair work is
C. 3500
expected soon. Without an engine the D. 3856
car could be sold for £3500.
What is the minimum price at which

the garage would have to sell the car,
with a reconditioned engine fitted, to
justify doing the work?
ChunLei Yang
Question 2-How much does the flood cost our business?
Kane Company produces a single model of engine for a car manufacturer. Due to the
recent floods, Kane has suffered a production break-down which lasted for 10 days.
During that time no engines were produced.
(1) Depreciation of the machinery is based on the conventional straight-line method of
calculation. The plant manager estimates that the machinery will fall in value by
£600,000 each week regardless of the level of production. In addition, it is felt that
its value will fall by £450,000 for every 100 engines that are produced.
(2) Overhead expenses are recovered at the rate of 200% on production labour. Most of
the overhead expenses are unaffected by the level of production (e.g. rent, rates,
maintenance, staff wages), but some, such as power and lighting, vary directly with
production. The general manager estimates that the latter type of overhead expense,
varying directly with the level of production, amounts to £30,000 for every 100
engines produced.
(3) During the period of the break-down the maintenance staff, whose wages are
included in the fixed overhead expense, carried out a major overhaul on one of the
company’s machines using materials costing £30,000. This overhaul would
normally have been performed by an outside contractor at a price, including
materials, of £300,000.
(4) Information relating to the loss in sales volume/rev., direct materials and labour
costs can be found in the sales director and managing director’s estimations (see the
next two slides.
The sales manager’s perspective:
He estimated the cost of the floods was £15 million.

His reasoning is:
production lost was 1,000 engines, each of which could
have been sold for £15,000, giving a total loss of turnover
of £15 million.
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The Managing Director’s Perspective:

The company’s managing director feels that the sales manager was overstating
the cost of floods and provides the following statement instead:
£’000
Expenses avoided:
Materials (£3000/engine) 3,000
Production labour (£1500/engine) 1,500
Depreciation of machinery 5,250
Overheads: 200% on labour 3,000
12,750
Loss of sales revenue: 15,000
Cost of floods 2,250
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Cost of floods
£ £
Contribution lost:
Sales revenue (1000 engines) 15,000,000
Less:
materials (1) 3,000,000
Production labour(2) 1,500,000
Fall in machine value(3) 4,500,000
Variable overheads (4) 300,000 9,300,000
Loss of contribution 5,700,000
Less: savings on overhaul (5) 270,000
Cost of floods 5,430,000

20
Assumptions:
1. It is assumed that materials are freely available at a market price of £3,000

per engine.
2. It is assumed that no payment is made to production labour during the
floods
3. Depreciation based on book value is not relevant as it merely represents an
arbitrary writing off of historical cost. Assuming that the machinery is not
sold at the beginning of the floods, the fall in value of £600,000 per week
will occur whether or not production continues. It is therefore not relevant
in assessing the cost of the floods. However, the fall in value due to use is
avoided and must be included as a saving, i.e. 10*£450,000=4,500,000
4. Those overheads which are fixed regardless of the level of production may
be ignored as they are payable with or without the floods. The overheads
which are avoided as a result of the floods must be included in the
statement as a saving, i.e. 10*30,000=300,000
5. By utilising the maintenance staff to carry out the major overhaul, the
company pays only for materials (£30,000). An outside contractor would
have charged £300,000. A saving of £270,000 is effected which would not
have been possible without the floods.
21
Difficulties in estimating relevant CFs
 The future is uncertain and prediction is difficult;
 Inflation can make prediction unreliable;
 Recognizing all cash flow impacts and interdependencies can
be difficult.
 More importantly…Relevant costs consider only financial
consequences of managerial decisions. Need to include non-
financial issues
Feel free to critique—What other factors can you think of

which could limit the relevant costs analysis?
ChunLei Yang 22
Study checklist
 Make managerial decisions based on their relevant costs and
benefits (Atrill and McLaney, Chapter 2; Atrill and McLaney,
Exercise 2.2)
 Understand the strength and weakness of relevant costs

analysis.
 Prepare for Demonstration 1: Hawaii plc

The question and guidance notes can be found in the
Welcome Pack. The question is not as daunting as it looks!
 Prepare for CVP analysis
ChunLei Yang

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Introductory

• What price to charge for a particular contract?

But, “cost” has multiple meanings…

Only those costs and benefits that differ between

1. Only cash flows are relevant

2. Only future cash flows are relevant

3. Only changes in future cash flows are relevant

• Cash outlay: incremental cash flow

What would be the relevant cost in the following situations?

Is depreciation relevant to the decision on

NO - THERE IS NO CASH FLOW

Is this £60,000 relevant to the production

NO - THE CASH FLOW IS PAST. It is a

Is a proportion of the fixed costs (20% of £500,000)

NO - THE FIXED COSTS WILL BE INCURRED WITH OR

What is the relevant labour cost for production of Q?

Applicable to a variety of managerial decisions:

What is the minimum price at which

The sales manager’s perspective:

He estimated the cost of the floods was £15 million.

The Managing Director’s Perspective:

Loss of contribution 5,700,000

Less: savings on overhaul (5) 270,000

Cost of floods 5,430,000

1. It is assumed that materials are freely available at a market price of £3,000

Feel free to critique—What other factors can you think of

 Understand the strength and weakness of relevant costs

 Prepare for Demonstration 1: Hawaii plc

 Prepare for CVP analysis

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