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Summary LU5: Relevant costs
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- BCOM FINANCIAL MANAGEMENT
- Institution
- University Of South Africa (Unisa)
A summary of LU5: Relevant costs
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Luthando Zulu: 17599770Finance 2B – FINM6212
LU5: Relevant costs
Introduction:
Relevant costs refer to future expected cost that change when faced with different alternatives. Relevant
costing is used in businesses to analyze alternatives and make decisions. They include:
Avoidable costs Variable costs that can be avoided if a particular alternative is not taken.
Differential costs Costs that change for each available alternative, or the difference in costs between
two or more alternatives.
Opportunity costs The benefit or value that must be forfeited in order to acquire a particular
alternative.
When analysing costs, it is imperative that we categorize them as either relevant or irrelevant. Irrelevant
costs will not influence a decision and remains unchanged regardless of the alternative. They include:
Non-cash items These have no impact on cash flows (e. g. depreciation)
Sunk costs Costs which have already been incurred and will never be recovered
When can relevant costing be applied in decision-making?
It can be used in deciding:
On a product mix when limiting factors (scarce resources) exist
Make or buy decisions
Whether to add a new product line
Whether to accept or reject a special order
Whether to replace property, plant and equipment
Whether to continue or discontinue shut down a division, dept. or subsidiary
On the pricing of products
Example 5.1:
We will now consider three interrelated examples and explain which have relevant and/or irrelevant costs.
Part A
Assume that you are a young adult who has recently matriculated. Upon matriculation, you are faced with
the decision of whether to enrol in a higher education institution or to begin working. Your uncle, who
owns several fast-food restaurants, has already offered you a job with a salary of R10 000 per month.
However, you decide to rather pursue your studies, and forfeit the salary of R10 000 per month.
By choosing to study, you forgo the salary that could have been earned by working for your uncle. The
opportunity cost of R10 000 per month is the relevant cost, as this is the best alternative that has been
forgone.
Part B
Your uncle informs you that he is considering upgrading the menu of one of his fast-food restaurants, in
order to increase demand. He has tried this before, but customers did not respond well to the new menu.
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, He was therefore forced to return to the old menu. He incurred a once-off fee of R20 000 to pay the chef
who created the new menu, and R10 000 for the food the spoiled due to customers not purchasing the
new meals that were introduced. He further informs you that the new chef will first perform market
research in order to determine the preferences of the target market, before drawing up the new menu.
This new chef will charge a once-off fee of R25 000 for the creation of this menu.
If your uncle chooses to upgrade the current menu, a cost of R25 000 will be incurred. This R25 000 is
the relevant cost, as it is a differential cost. Costs incurred in the past have no bearing on the future. The
sunk cost of R30 000 (R20 000 + R10 000) is an irrelevant cost, as it is a cost that has already been
incurred.
Part C
In the process of creating the new menu, the new chef informs your uncle that instead of oven baking
potato chips in house, the restaurant could purchase potato chips which are already oven baked in order
to speed up the production process. This will result in an additional cost of R7 per meal.
By choosing to purchase oven baked chips, your uncle will incur an extra R7 per meal. This is a relevant
cost, as it is a variable cost that can be avoided, if the choice to continue oven baking chips in house is
chosen.
Importance of qualitative factors:
Qualitative factors cannot be expressed in monetary terms but can have a bearing on the decision. For
instance, when faced with a make or buy decision, the following qualitative factors may arise and should
be considered before making the decision:
A “buy” decision may result in the closure of a division, resulting in potential redundancies and
impacting employee morale in other divisions
Dependence on the external supplier to deliver in a timely manner
Impact on product quality
Impact on relationships with customers and long-term suppliers
Customer requirements might not be met. This will result in a loss of customer goodwill and the
potential decline in future sales.
Technological changes, which may make future (internal) production cheaper
If the decision is to make, it impacts on future expansion by tying up available capacity
Results in competitor economies of scale
Application of relevant costing in decision making:
Product mix decisions when limiting factors exist:
Product mix decisions are necessary when the demand for sales exceeds a company’s productive
capacity. A company needs to first identify which resources are the limiting factors that restrict output in
the short run. To determine the optimal production level, it is necessary to calculate the contribution per
limiting factor for each component/ product, and then proceed to rank the components/ products in order
of profitability.
The aim is to find the products that have a high contribution margin, which identifies the products that are
most profitable given the limiting factor. This then tells us which products should be sold first (through
ranking the products), in order to maximize profits.
For instance, suppose your limiting factor is labor. Product A takes 2 labor hours to produce, and Product
B takes 3 hours. They both have a contribution margin of R6. It would be best to produce more of Product
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