Relevant Cost and Short Term Decisions

In Relevant Cost and Short Term Decisions, there are three learning outcomes we can get from this discussion:

• Discuss the principles of decision making including the identification of relevant cash flows and their use alongside non-quantifiable factors in making rounded judgement.
• Explain why joint costs must be allocated to final products for financial reporting purposes, but why this is unhelpful when decisions concerning process and product viability have to be taken.
• Explain the usefulness of dividing costs into variable and fixed components in the context of short-term decision-making. 

1) Relevant Cost and Non Relevant Cost

Relevant Cost - affected by decisions being taken
Non-relevant cost - cost is the SAME regardless of the decisions being taken

• Sunk/Past cost - spent and cannot be recovered (i.e., NPI Cost)
• Fixed Overhead - do not increase/decrease as a result of decision being taken (i.e., Space, Building)
• Committed cost - expenditure that will be incurred in the future, but as a result of decisions taken in the past that cannot be changed (i.e., Special packaging for new product)
• Historical cost depreciation - do not result in any future cash flows/ book entries only
• Notional cost - only relevant if they represent an identified cost opportunity to use the premise (i.e., notional rent/notional interest)

2) Opportunity Cost

Opportunity cost - value of the benefit sacrificed when one course of action is CHOSEN, in preference to an alternative. This is the forgone potential benefit from the best rejected course of action.




3) Avoidable and Differential/Incremental Cost

Avoidable Cost - specific cost of an activity or sector of a business which would be avoided if the activity or sector did not exist (i.e., shutting down a department - cost of labour/rental cost)

Differential/Incremental Cost - difference in total cost between alternative; calculated to assist in decision making. This is Incremental revenue less incremental cost equals Incremental gain/loss. Ultimately, we'll choose an activity that will give us incremental gain.

 

4) Limiting Factor Decision-Making

Limiting Factor - any factor that is in SCARCE supply and that stops the organisation from expanding its activities further, that is, it limits the organisation's activities.

Examples: (All the factors of production)
1) Materials
2) Labour Hours (Supply of Skilled Labour)
3) Machine Hours (Machine capacity)

Aim: Maximise Contribution

Steps in Making Decision when there is a limiting factor:

1. Check if limiting factor exist (i.e., materials required to produce the maximum demand vs available materials.
2. Calculate the contribution per unit of limiting factor (Note: Do not take the contribution per unit alone. It should relate to the limiting factor)
3. Rank the products from highest to lowest contribution per unit of limiting factor
4. Allocate the available materials according to the rank 

           - Product at Maximum production
           - Product at balancing/residual for production



5) Further Decision Making

Make or Buy

Discontinue a product

Deciding when to close a department

Further processing