Chapter 3:

Measuring relevant costs and revenues for decision-making

1)Difference between relevant & irrelevant costs & revenues

2)Qualitative factors
3)Relevant & irrelevant costs for 5 decision-making problems:
(a)Special pricing decisions
(b) Product-mix decisions with capacity constraints
(c) Replacement of equipment: irrelevance of past costs
(d) Outsourcing & make or buy decisions
(e) Discontinuation decisions
4)Relevant costs for direct material & direct labour
1) Difference between relevant & irrelevant costs & revenues
• In making non-routine decisions, only relevant costs and revenues (benefits)
must be considered

the approach used here is decision-relevant approach

objective: maximise PV of all future net cash inflows (i.e. long-term not short-term)
where future costs and revenues are certain (no risk)

• Relevant costs and revenues are required for non-routine decision-making such as:
1. Special selling price decisions.
2. Product-mix decisions when capacity constraints exist
3. Decisions on replacement of equipment.
4. Outsourcing (Make or buy) decisions.
5. Discontinuation decisions.
Difference between relevant & irrelevant costs & revenues
• Relevant costs & revenues are:-
: costs & revenues that will be affected by the decision
: hence costs & revenues that are independent of decision is irrelevant
: relevant future cash flows (since decisions are about future alternatives,
not past)
: hence, past costs (sunk costs) are irrelevant
: relevant future cash flows must be different between alternatives
considered (i.e. differential / incremental cash flows)
: hence common future cash flows between alternatives considered are
irrelevant
E.g.: Depreciation is irrelevant
Sunk cost as it is the allocation of past costs to future periods; original cost
(cost of fixed assets) is unavoidable and common to alternatives being
considered.
E.g.: Common fixed cost is irrelevant
It is common to alternatives being considered (central fixed costs); it is also
sunk cost as it is the original cost of fixed asset being distributed to different
parts / products of the co.)

Practice: You already have a car, however you are deciding whether to
travel by train or by car. What is the relevant costs involved?
2) Relevant costs: Qualitative factors
• Qualitative factors

In applying relevant costs and revenues for decision making

Decisions based only on quantitative terms do not tell whole story

Qualitative factors must also be considered.

E.g.: A company is considering to buy a component from supplier instead of
manufacturing it. However, if supplier does not deliver on time or increases prices
later co. cannot meet customer demand or requirement on time and may lose
customer goodwill and future sales
And because of buying outside, component division may close down and result in
redundancies employee morale reduces and future output reduces

These qualitative factors must be taken into account when making decision and
expressed in non-financial quantitative terms

e.g.: % increase in ‘on-time-deliveries’; % reduction of defective products to

customers; % reduction in customer waiting time

if qualitative factors are not expressed in non-financial quantitative terms & not taken into
account, wrong decision may be made – RISKS from decision may outweigh cost savings.
3) Relevant & Irrelevant Costs for 5 decision-making problems
(a)Special pricing decisions
• Pricing decisions outside the main market
• (i)Typically one-time only orders (ii) orders at a price below the prevailing market price.

Example 1: (A short-term order)

Capacity for a department within a clothes company = 50 000 units p/month
Due to liquidation of 1 of its customers, co. has excess capacity
Hence, expected monthly production and sales for next quarter at
normal selling price of £40 = 35 000 units p/month

Estimated costs and revenues (for 35 000 units):

The excess capacity is temporary. As the excess capacity is temporary, direct labour; fixed man. o/h and the
non-man. costs remain unchanged (i.e. based on 50,000 uts. p/mth). A company has offered to buy 3,000
sweaters each month for the next three months at a price of £20 per unit. The customer wants the its logo to
be inserted & this would cost £1 p/unit. No subsequent sales to this customer anticipated. The customer will
collect the goods & hence no marketing & distribution costs incurred. Should this offer be accepted?
Relevant & Irrelevant Costs for 5 decision-making problems
• Evaluation of the order (£’s monthly costs and revenues)
Relevant & Irrelevant Costs for 5 decision-making problems
• Only variable costs, the extra selling costs and sales revenues differ between
alternatives and are relevant costs/revenues.

• Since relevant revenues exceed relevant costs the order is acceptable subject
to the following assumptions:

1. Normal selling price of £40 will not be affected in future

(If co. is planning to sell product below this price again in the future, this will affect
future market price through competition. In the long run profits will be affected – short
term gain but long term losses)
2. No better opportunities will be available during the short term period.
3. The unused resources have no alternative uses that will yield a
contribution to profits in excess of £27,000 per month.
4. The fixed costs are unavoidable for the period under consideration.
E.g. these costs (labour etc.) need to be retained for future upsurge in demand

• Note that the identification of relevant costs depends on the circumstances.

- I.e. some costs (such as labour) are relevant in certain situations but irrelevant in
others. For e.g., casual labour may not be needed in the short term (relevant cost)
Relevant & Irrelevant Costs for 5 decision-making problems

Example 2 (A longer-term order)

• In the short-term, capacity cannot be easily altered and hence some costs
remain unchanged and are irrelevant (e.g. direct labour and fixed costs).

•However, in the long-term, capacity can be altered (e.g. reduced) and hence
short term irrelevant costs can become relevant now.

 Assume now that demand in the foreseeable future will remain at 35,000 units.
Given that productive capacity is 50,000 units, co. has to look for long-term market
for unutilised capacity of 15,000 units
 Assume that there are potential customers willing to enter into contractual
agreement with co. for 3 years for the supply of 15,000 sweaters a month at £25
p/unit; costs of inserting logo remains unchanged (£1 p/unit) and no non-
manufacturing costs incurred
 No other better opportunities exist so if the contract is not accepted direct labour
will be reduced by 30%, manufacturing non-variable costs reduced by £70 000 per
month and marketing reduced by £20 000.Unutilised facilities can be rented out at
£25 000 per month. Variable costs (direct material & variable man.o/h) changes
with volume and hence if contract not accepted, it will reduce by 30%.
Should the co. enter into this contractual agreement?
Relevant & Irrelevant Costs for 5 decision-making problems

• Evaluation of the order (£’s monthly costs and revenues):

(1) (2) (3)

Do not accept Accept the Difference
orders orders (Relevant costs)
Units sold 35 000 50 000 15 000
£ £ £
Direct labour 294 000 420 000 126 000
Variable costs 350 000 500 000 150 000
Manufacturing non-
variable overheads 210 000 280 000 70 000
Extra selling costs 15 000
15 000
Marketing/dist.costs 85 000 105 000 20 000
Total costs 939 000 1 320 000 381 000
Revenues-facilities rental 25 000 25 000
OC
Sales revenues 1 400 000 1 775 000 (375 000)
Profit 486 000 455 000 31 000
Relevant & Irrelevant Costs for 5 decision-making problems

• Company will be better off by £31 000 per month if it reduces capacity
(assuming there are no qualitative factors to be considered).

• In the short term only some costs are relevant

•However, in the longer-term all of the above costs and revenues are
relevant.

•Hence two factors affecting the relevance of costs / revenues are

- type of cost
- time horizon
Relevant & Irrelevant Costs for 5 decision-making problems
(b) Product-mix decisions when there is capacity constraints
•In the short-term, capacity / production constraints cannot be removed
easily
•I.e. it is difficult to reduce resources / acquire additional resources
•Hence, when there is a production constraint in the short term, output is
restricted
•Important to identify the scarce resources (limiting factors) that restrict the
output (e.g. shortage of skilled labour; raw materials; equipment; space)

Method
• When there is a limiting factor, co. needs to determine the product-mix /
optimum production plan that will maximise profits

•Calculate contribution per limiting factor, & not contribution per unit sold

•The objective is to concentrate on those products/services that yield the

largest contribution per limiting factor.
Relevant & Irrelevant Costs for 5 decision-making problems
• Example
ABZ Ltd. manufactures and sell component parts to the automobile industry & below are the
expected figures for the next quarter. Because of the breakdown of 1 machine, machine
capacity is limited to 12,000 machine hours for the period & insufficient to meet sales demand
What is the limiting factor and advise on the product mix plan to maximise profits.

Components X Y Z
Contribution per unit £12 £10 £6
Machine hours per unit 6 2 1
Estimated sales demand (units) 2 000 2 000 2 000
Required machine hours 12 000 4 000 2 000

1)Calculate contribution per limiting factor (machine hours)

Contribution per machine hour £12 / 6 hr £10 / 2 hr £6 / 1 hr
[contribution per ut. / machine hours per ut.] =£2 =£5 =£6

Ranking per machine hr 3 2 1

Relevant & Irrelevant Costs for 5 decision-making problems
2) Profits are maximized by allocating scarce capacity according to ranking
per machine hour as follows:

Production Machine hours Balance of machine

(12 000 hrs. available) used hours available
2 000 units of Z 2 000 10 000
2 000 units of Y 4 000 6 000
1 000 units of X 6 000 –

(6,000 hrs. / 6 hrs.)

3)The optimum production plan will result in the following:

2 000 units of Z at £6 per unit contribution 12 000
2 000 units of Y at £10 per unit contribution 20 000
1 000 units of X at £12 per unit contribution 12 000
Total contribution (max. profits in short term with capacity constraints) 44 000
Relevant & Irrelevant Costs for 5 decision-making problems
Qualitative factors
•In determining the product mix (optimum production plan) when there is
capacity constraints, qualitative factors must be considered

•E.g.: loss of customer goodwill that will lead to shortfall in sales in future
as company is unable to satisfy normal demands of regular customers

• Hence co. may need to acquire extra machines (extra machine hours) to
meet this demand in the long term.

•When there is more than 1 limiting factor, this method of determining

optimum production plan is difficult to achieve

•Hence, need to resort to other methods such as linear programming

Relevant & Irrelevant Costs for 5 decision-making problems

(c)Decisions on replacement of equipment

• In replacement of old equipment decision, objective is to show that the old
equipment’s book value (WDV) is irrelevant (past cost).
• The original purchase cost of the old machine, its WDV and depreciation are
irrelevant for decision-making.
• Assumption here is that £1 today = £1 tomorrow (but in reality incorrect)

Example
ABZ Ltd purchased machine 3 years ago £180,000 (depreciation is straight line) for 6
yrs. with no salvage value. ABZ is thinking of replacing this machine with a new one
that will reduce variable costs. Should ABZ retain old machine or buy new machine?

•Present WDV of existing machine (remaining life of 3 years) £90 000

•Cost of new machine (expected life of 3 years and 0 scrap value) £70 000
•Variable operating costs (£3 per unit old machine)
• (£2 per unit new machine)
•Output of both machines is 20 000 units per annum
•Disposal value of old machine now £40 000
•Disposal value of new and old machines in 3 years time £0
•Selling price identical regardless of which machine used
Relevant & Irrelevant Costs for 5 decision-making problems
• Total relevant costs over a 3 year period are as follows:
(1) (2) (3)
Retain Buy Difference
old mach. New mach. (relevant)
£ £ £
•Variable operating costs:
20 000 units at £3
per unit (3 yrs) 180 000
20 000 units at £2
per unit (3 yrs) 120 000 (60 000)
•Old machine book value:
3-year annual
depreciation charge 90 000
Lump sum write-off 90 000
•Old machine disposal value (40 000) (40 000)
Initial purchase price
of new machine _______ 70 000 70 000
Total cost 270 000 240 000 (30 000)
Relevant & Irrelevant Costs for 5 decision-making problems

• Note that the depreciation charge of the old machine for 3 years (book value) is
not a relevant cost i.e. it is sunk cost and is same for either alternative

(i)if old machine retained: £90k written off over 3 years

(ii)if new machine retained:£90k written of as lump sum

•Depreciation charges of new machine not included as it identical to the cost price of
the new machine (no need for double counting!)
Relevant & Irrelevant Costs for 5 decision-making problems
(d) Outsourcing (make or buy decisions)
• Involves obtaining goods or services from outside suppliers instead of from
within the organization. E.g. includes outsourcing payroll; speciality components

Example 1
A division currently manufactures10 000 components type A p.a.
The costs are as follows & remain unchanged in the foreseeable future:
Total (£) Per unit (£)
Direct materials 120 000 12
Direct labour 100 000 10
Variable manufacturing o/h 10 000 1
Fixed man. o/h 80 000 8
Share of non-manufacturing o/h 50 000 5
Total costs 360 000 36

There are negotiations to outsource 10,000 uts. component A at £30 p/ut. & this will remain
unchanged.
If outsourced, DL will be redundant, with no redundancy costs incurred
DM & variable o/h is avoidable; fixed o/h will reduce by £10,000 p.a.; & non-man. Costs
will remain unchanged
No alternative uses of released capacity
Relevant & Irrelevant Costs for 5 decision-making problems
• Assuming there is no alternative use of the released internal capacity arising from
outsourcing, annual costs for making or buying Comp. A will be as follows:
(1) (2) (3)
Make Buy Difference (relevant)
(£) (£) (£)
Direct materials 120 000 120 000
Direct labour 100 000 100 000
Variable man. o/h 10 000 10 000
Fixed man. o/h 80 000 70 000 10 000
Non-man. costs 50 000 50 000
Outside purchase cost
incurred / (saved) _______ 300 000 (300 000)
Total costs incurred/
(saved) 360 000 420 000 (60 000)

• By making component A, relevant cost savings are £60,000 as compared to

outsourcing, when released capacity has no alternative uses & hence this is
the better alternative
Relevant & Irrelevant Costs for 5 decision-making problems
Example 2
Assume that by outsourcing, released capacity can be used to make 10,000 units of
Component B at a selling price of £34 per unit. DL; variable manufacturing o/h; fixed
o/h & non-manufacturing costs for Component B is the same if Component A is
manufactured. Material for Component A is not required, however, materials for
Component B is £13 per unit. What should the co. do?
(1) (2) (3) (3) vs. (2)
Make A only Buy A only Buy A; Make B Relevant costs
(£) (£) (£) (£)
Direct materials 120 000 130 000 130 000
Direct labour 100 000 100 000 100 000
Variable man. o/h 10 000 10 000 10 000
Fixed man. o/h 80 000 70 000 80 000 10 000
Non-man. costs 50 000 50 000 50 000
Outside purchase
cost incurred 300 000 300 000
Revenues from B (340 000) (340 000)
Total net costs/ 360 000 420 000 330 000 (90 000)
relevant cost.

Hence, the best alternative here would be to outsource Comp.A & make Comp.B as it
contributes relevant profits of £90,000 as compared to just outsourcing Comp.A.
Relevant & Irrelevant Costs for 5 decision-making problems

(e)Discontinuation decisions

• Routine periodic profitability analysis highlights potential unprofitable

activities that require more detailed appraisal to ascertain whether or
not cost object (i.e. product / service / customer / location) should
be discontinued.

E.g.:The Euro Company is a wholesaler who sells its products to retailers

throughout Europe. Euro’s headquarters in is in Brussels. The company
has adopted a regional structure with each region consisting 3-5 sales
territories. Each region has its own regional office and a warehouse which
distributes the goods directly to the customers. Each sales territory also
has an office where the marketing staff are located. The Scandinavian
region consists of 3 sales territories with offices located in Stockholm,
Oslo and Helsinki. The budgeted results for the next quarter are as
follows: -
Relevant & Irrelevant Costs for 5 decision-making problems

Stockholm Oslo Helsinki Total

(£000s) (£000s) (£000s) (£000s)
COGS 800 850 1000 2650
Salespersons’ salaries 160 200 240 600
Sales office rent 60 90 120 270
Dep. sales off. equip. 20 30 40 90
Apport. warehouse rent 24 24 24 72
Dep. Warehouse equip. 20 16 22 58
Regional & HQ costs
:cause & effect alloc. 120 152 186 458
:arbitrary apport. 360 400 340 1100
Total costs assigned
to each location 1564 1762 1972 5298
Reported profit / (loss) 236 238 (272) 202
Sales 1800 2000 1700 5500
Relevant & Irrelevant Costs for 5 decision-making problems

Discontinue Helsinki: COGS; salespersons’ salaries; sales office rent & regional
HQ from cause & effect allocation can be eliminated.
Assuming performance results are the same in the future, should Helsinki be
discontinued?
Keep Helsinki Discontinue Difference
open Helsinki (relevant cost)
£000 £000 £000
COGS 2650 1650 1000
Salespersons’ salaries 600 360 240
Sales office rent 270 150 120
Dep. sales off. equip. 90 90
Apport. warehouse rent 72 72
Dep. Warehouse equip. 58 58
Regional & HQ costs
:cause & effect alloc. 458 272 186
:arbitrary apport. 1100 1100
Total costs to be assigned 5298 3752 1546
Reported profit 202 48 154
Sales 5500 3800 1700
Relevant & Irrelevant Costs for 5 decision-making problems

Direct Material :Relevant Cost

Type of cost Relevance
1)Stock purchased at later date - Relevant

2)Materials taken from existing stock purchased earlier - Not relevant as this
is sunk cost

3)If materials taken from existing stock and must be replaced - Replacement cost
is relevant

4)If materials can only be used on a particular activity and - Lost NRV from
have no further use and has some NRV using materials is
opportunity cost
(relevant)

5)If materials as in (4) has no NRV - No opportunity

cost
(not relevant)
Relevant & Irrelevant Costs for 5 decision-making problems

Direct Labour :Relevant Cost

Type of cost Relevance
1)Short term, with temporary excess capacity - Not relevant as
labour would be
maintained

2)Casual labour where workers hired on daily basis - Relevant (hired

according to
production needs)

3)Where co. operates at full capacity (no available labour) - Relevant cost is
and no further overtime working. Only way to secure hourly labour rate
additional labour for specific order is to reduce current + opportunity cost
production to release labour. Reduced production will result in (ie.loss contribution)
loss of contribution from current production
 Reference
Colin Drury, Management and Cost Accounting,
9th Edition, Cengage Learning EMEA.
ISBN 978-1-4080-9393-1