Relevant Costing Theory Top1 Notes

• Relevant costing is important for the short-term, it can aid in decisions such as: make or buy, adding or dropping a business segment, competitive pricing and other processing decisions.

• A relevant cost for decision making needs to contain three elements:

1. Future (hasn’t occurred yet)

2. Differ between the alternatives (so if the alternatives are the same then this cost is not relevant as the decision has no effect on the cost)

3. Future cash flow (depreciation, bad debts are not relevant to cash flow).

• Opportunity Costs: A potential sacrifice in choosing one alternative over the other.

  • Special orders are not considered to be opportunity costs because there is no giving up of any external sales to fulfil an order etc.

• Incremental Cost/ Revenue: The amount with which the costs change if one decision is made over another.

• Avoidable Costs: Costs which are in general avoidable and are relevant for the decision-making process, discontinuing a product, product line or business segment.

• Sunk Cost: This is money already spent which cannot be recovered and these costs are irrelevant for the decision-making process.

• Special Orders: will only be relevant if they incur incremental costs and benefits, if they do not affect the fixed costs then they are not incremental and thus, not relevant.

LIMITING FACTORS:

• A limiting factor is something which constrains the company, and in term the company cannot fulfil its demand.

• Sales demand will always be a limited factor.

• Shortage or lack of skilled workers.

• Shortage of materials.

• Lack of SNE’s Funding.

• Insufficient space.

• Machine Hours- bottleneck.

  • Generally, where the constraint cannot be overcome in the short-term period, it is relevant to make the most out of what the company has considering its constraint.

  • Here it is advised to use the Contribution per limiting factor method, which ranks the products from highest to lowest unit contribution margin per limiting factor, producing products with the higher the unit contribution margin, will in term maximise the profits, however, if this product is not on demand it might be problematic.

  • Optimal combination of products which yield maximum total contribution, which is the ranking of products.

• To meet demand and maximise profits the above should be done and depending on the limiting factor more can be done also such as; overtime to produce more, automation, train workers to become more skilled, if it’s the machine maybe subcontract someone to take on some work. Invest.

• Outsource.

• Redesign product, thus substitute material.

• Stock-pile material if cheaper now.

• Will the customer be satisfied with the lower standard if redesigning and substituting materials.

• Maybe automate If skilled labour is the constraint.

• Pay more to increase morale and productivity.

• Hire skilled staff.

NON-FINANCIAL FACTORS TO CONSIDER BEFORE SUBMITTING A QUOTE:

1. Time

2. Risk

3. Capacity

4. ...

Buy the full version of these notes or essay plans and more in our Irish Management Accounting Theory Notes.