#17128 - Relevant Costing Theory Top1 - Irish Management Accounting Theory

• 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. Reliability of the financial projections

5. Reaction of competitors/customers

6. Skills of the workforce.

POTENTIAL PROBLEMS WITH USE OF RELEVANT COSTING:

• It tends to only be successful in the short-term, it could not be successful in the long term as the limiting factor may not last forever.

• As result, there may be temptation to include items which are irrelevant such as fixed costs and if this is done then an overall understatement of costs occur, which provides misleading information to the company.

• Qualitative factors may include issues such as the effect that a decision may have on product or service quality; on the morale of the workforce; the reliability of the supplier to deliver goods/services on time; the effect on any existing customers; and the effect of the decision on the reputation of the business.

• Obtaining financial data, dealing with opportunity costs may be difficult in identifying the quantitative benefits or non-benefits, as well as the fact it can be hard to be reasonably informed about different courses of action.

“Joint product costs are irrelevant in decisions regarding what to do with a product from the spilt-off point forward”

• Joint-products concern two or more products produced from a common input and these products spilt-off in the manufacturing process at the time they become their own separate product.

• It concerns the costs which are incurred up to the spilt-off point and thus, are sunk costs and irrelevant...