Transcript Chapter 5 - Blackhall Publishing

Chapter 5
Relevant Costs and Revenues for
Decision-making
Relevant costs and revenues
for decision-making
Each decision point is a unique opportunity, which
often requires relevant specialist information to back
the decision.
The primary role of the accountant in the decisionmaking process is to provide this information which
may be constructed or revised to fit a specific
problem.
Relevant costs and revenues
‘Costs and revenues appropriate to a specific
management decision’
Relevant costs and revenues as defined by CIMA Official Terminology
Historic and sunk costs
Incremental costs
Opportunity costs
Replacement costs
Historic / Sunk costs
‘Cost that has been irreversibly incurred or
committed and cannot therefore be
considered relevant to a decision’
Sunk cost as defined by CIMA Official Terminology
Example 5.1: Historic / sunk costs
Sunk costs (machinery) should be ignored.
Food Land Limited
is €5,000 better off
by altering rather
than selling
immediately.
Incremental costs
‘Incremental costs are the changes in future
costs and revenues that occur, as a result of
decisions’
Example 5.2: Incremental costs
and revenues
Example 5.2: Incremental costs
and revenues
At first it would seem foolish to accept the deal offered by Duncan Tours.
However by accepting the tour company’s offer, the fixed costs will not
change in total. Only sales and variable cost will change. Sales will
increase by €20 per bed-night taken up and variable costs will increase by
€15 per bed-night taken up. These are the incremental costs and benefits.
As the benefits outweigh the costs, the offer should be accepted. The
business would lose out on extra profit of €9,750 (1,950 rooms x €5 (€20 €15)) if all the spare capacity (rooms) were not taken up by the tour
company.
Opportunity cost
‘The value of the benefit sacrificed when one
course of action is chosen in preference to
an alternative’
Opportunity cost as defined by CIMA Official Terminology
Example 5.3: Opportunity costs
Replacement cost
‘Cost of replacing an asset’
Replacement cost as defined by CIMA Official Terminology
Example 5.4: Replacement cost
Accounting for business decisions
Decision to outsource
Decision to discontinue a department
Decision for partial closure
Special pricing decisions
Decision-making with Limiting Factors
Example 5.5: Outsourcing decision
Fixed overhead will not change irrespective of the decision and is irrelevant. The
relevant costs are materials, labour and supervision amounting to €157,000.
Comparing this to the cost of outsourcing at €175,000, the hotel should retain its
cleaning department.
Example 5.6: Closing an
unprofitable department
Example 5.6: Closing an
unprofitable department
As the department
has a positive
contribution it
should remain
open
By closing the
baby department,
overall profit fall by
€30,000 the lost
contribution from
the Baby
department
Example 5.7: Close in the off-season decision
Example 5.7: Close in the off-season decision
The analysis shows
that the business
should stay open
based on financial
criteria alone. The
cost of closing would
be the loss in
revenue of €25,000
with the benefits of
closing (the cost
savings) only coming
to €23,800.
Example 5.8: Special pricing
decisions
Example 5.8: Special pricing
decisions
At first it would seem that Monaghan Clothing should reject the order as the
offer price of €20 is 43 per cent below their normal supply price and does not
exceed the full cost price of producing the tracksuits. However focusing on the
cost estimates, the fixed overhead of €280,000 will not change and the variable
overhead will not change as a result of the order. Also direct labour is not
expected to change as the company is presently working at 70 per cent of
capacity. As these are the non-incremental costs for this order, they should be
ignored in the decision process. The only costs that are incremental are the
materials cost of €5.00 and the extra adjustment costs of €1.00, thus the company
should accept the order. The relevant costs and benefits relating to the decision
are as follows:
Limiting factors
‘Anything which limits the activity of an
entity’
Limiting factor as defined by CIMA Official Terminology
Sales demand.
Operating capacity.
Shortage of labour.
Shortage of materials.
Lack of available finance.
Limited distribution channels.
Limiting factors
Step 1 - Establish if a constraint actually exists.
Step 2 - Establish the contribution per unit.
Step 3 - Establish the contribution per limiting
factor and rank in order of the highest
contribution per limiting factor.
Step 4 - Establish the optimum plan.
Step 5 - Calculate the profit based on this plan.
Example 5.9: Limiting factors
Example 5.9: Limiting factors
Example 5.9: Limiting factors
Example 5.9: Limiting factors
Qualitative factors
Customers
Employees
Competitors
Legal constraints
Creditors / suppliers:
Atkinson, Berry and Jarvis (1995)