RELEVANT COSTING

RELEVANT COSTING

Introduction

In accounting and management, cost, as a word is often defined differently depending on the setting and the cost approach under the subject as well as the circumstance. Financial accountants record the actual cost. Other types of cost include;

Fixed and variable cost; fixed cost, as the name suggests does not increase or decrease, for instance, rent. Variable cost is the type of cost that changes with a change in the production level, for instance, labor cost. The types of costs that are proportional to the production rate called mixed costs.

By product cost; this is the cost of a product produced incidentally in the production of the main product. An example is the cost of rice jam produced while milling rice.

Allocated cost; this is the overhead incurred in the process of manufacturing a product. This type of cost is not used in the decision-making process.

Discretion cost; these are costs that do not cause any effect on an organization when dropped, example is the cost of training employees.

The above types of costs are categorized according to their effects, but for the decision-making process of the management, costs are categorized based on their effective relevance on the decision and management items. For the purpose of decision making, cost relevant costs are taken into consideration. Relevant costing tries to measure the cost purpose of an entity decision.  Relevant costing concentrates on the business decision thus ignoring the rest of the costs that have no effect on the business decision. Some costs do not make any change but others do. Relevant revenue and cost will always have an effect on the profitability of an entity. Managers use decision models to do a thorough analysis of the relevant costs and revenue. An amount does not necessarily have to be in material form for it to be relevant.

Examples of irrelevant costs include;

• Sunk cost; this is an expense that was incurred in the past. This cost is irrelevant since it has zero effects on the future flow of cash in the entity.
• Committed cost; these are the future costs that cannot be foregone. Committed costs are irrelevant because, regardless of the nature of the considered entity decision, these costs will have to be incurred.
• Non-cash expenses; these are the intangible expenses like depreciation, these costs are not relevant since they do not alter the cash flows of the entity.
• General overheads; the overheads are irrelevant because they are not altered by the considered decision.

Relevant cost and revenue.

Features of relevant cost and revenue.

Relevant costs have two main features;

1. Differ between options; in a case where both options incur a similar cost, then we say that the costs are not relevant.
2. Expected cost in the future; not every future cost is considered relevant in the decision making the role of management, but again a cost is only relevant if it carries a future cost. Historical costs can also be considered relevant only if they are yet to repeat in the future, otherwise, history cost or past costs are irrelevant.

Types of relevant costs and revenue

The following are the various types of relevant costs;

• Differential costs; this is the change between two accounting items various conditions in terms of decisions, situations, and projects. In case there is no significant change in the value then the item is irrelevant. Differential cost is contrasted against differential revenue in the process of making a decision.
• Marginal cost; this is the additional cost of producing an additional unit of a product. When the quantity of production is increased by one unit, the cost of production also increases. In case the cost remains constant then the item is considered irrelevant. The marginal cost has to be compared with marginal revenue before arriving at the final decision.
• Opportunity cost; this is the cost of a foregone opportunity. Cash inflows have to be sacrificed in case of a management decision that does not favor its production. Managers should not overlook other projects after making a decision to invest in some other projects. The management should analyze the opportunities in all the available options and choose the alternative with the best rewards.

Uses of relevant cost and revenue in decision making.

Even though relevant costing is a vital technique in decision making, it is not advisable to use it alone in all the financial decision-making processes since for an entity to survive the long term challenges, a profit margin must be determined, this profit margin has to be determined using the total cost and not relevant cost.

Applications of relevant costing and revenue include the following;

1. It is used in the determination of a competitive price.
2. The management uses relevant cost to make a decision on whether to buy or produce an item.

Decision-Making Techniques

Types of Decisions to be made using relevant cost and revenue

• The details and approaches of relevant cost and revenue are used to make both long term decisions and short term decisions.
• In both cases, the factor of the time value of money must be taken into consideration.

Types of the decisions include the following;

• 1. Limiting factor decision.

Limiting factors are factors that hinder the operational efforts, one of the limiting factors is consumer demands, the demand will dictate the production level.  other determinant factors of production include available raw material, machine capacity, and availability of Labour.

In a case where an entity specializes in one line of products, the available resources become the limiting factor in profit maximization process

However, when an entity is involved in the production of several types of products using the same limited resources, a budgeting crisis occurs due to difficulty in coming up with appropriate production mix formula that will ensure profit maximization. The out per unit will be used to determine what is produced at what volume to maximize profit. The management follows the following steps;

1. calculation of unit output of each product
2. Mention the limiting factor of production e.g. direct material.

• Determine the arithmetic volume of the limited resource to be consumed in each line of production. E.g. X units of direct material.

1. Calculate the contribution per unit of the identified limited resource.
2. Arrange the produced goods according to their respective contribution per unit of the limited resource.
3. Use the ranking to come up with a production plan.

assumptions of limiting factors:

• Maximization of contribution results into the maximization of returns
• Use of variable costs as the relevant cost.
• We assume that considered decisions will not change the fixed cost. Hence we consider it irrelevant.

• 1. one-off contractual decision

• The project once done, is not repeated again in the coming days.
• This decision is considered when extra returns supersede relevant costs.
• Using the relevant costs, the management makes a decision on either to do the project using the cost offered by the client or come up with a selling price.
•  Profit is the difference between returns minus relevant costs.
• This type of decision may be experienced in a situation whereby an entity has the surplus capacity and it gets an opportunity to get marginal profit.

• 1. Make-or-Buy decisions

• This is a decision by the management on either to purchase or produce an item. The decision is arrived at with respect to the relevant costs. The option with the lowest relevant cost is preferred.
• The evaluation of this decision involves an analysis of;

• • Cost of production that the company is going to save; and
  • Extra cost incurred in purchasing the item.
• So as to surpass some obstacles, an entity may decide to give contracts to other entities in a situation where the load is too much and the option is viewed cheaper.
• To get maximum profit, the management makes a decision on what to purchase and what to produce.  The management chooses to get items from an entity with the lowest price.
• In order to verify the lowest cost of an item, the management must compare;

• • Extra cost on purchasing price; with
  • the cost of internal production

• 1. Make-or-buy decision non-financial considerations

Non-financial considerations will often be relevant to make-or-buy decision:

• When work is outsourced, the entity loses some control over the work. It will rely on the external supplier. There may be some risk that the external supplier will:

• • provide a lower quality.
  • fail to meet delivery on said dates.
• The entity will lose some flexibility. If it needs to increase or reduce the supply of the outsourced item at short notice.
• The redundancy of employees may occur as a consequence of outsourcing affecting relations between management and other employees.

• 1.  Decisions to shut down

• This is a decision to shut down a section of the operations of an entity.
•  This decision is based on the fact that when the effects of shut down are better than the relevant costs.

Managerial importance of relevant cost and revenue

• Relevant costing is vital in getting rid of unnecessary details and items from a given decision-making process. In the process of doing this, the decision-makers are shielded from concentrating on unnecessary details that may alter the effectiveness of the decision. This ensures an accurate decision is made by the management.
• Profit maximization. The management makes a decision based on the details provided on the relevant costing approach, the decision is toward profit maximization. This improves the performance of the company. When the maximum profit is achieved, it translates to an efficient performance by the managers.
• Quick and accurate decision making. the management is able to use the predetermined relevant costing guidelines to guide them in making the current decisions. This aids in a fast and accurate decision-making process.

Limitation of relevant costing:

• There are many limitations of relevant costing:
• For the management to arrive at the accurate outcome, then a thorough analysis has to be done on the items. Every item has its distinct characteristics hence should not be treated generally.
• Relevant costing does not take care of the future time of money.
• Another limitation of relevant costing is the challenge in determining opportunity costs. Opportunity cost is not easy to calculate and prove

Conclusion

Decision making is a very vital role in the management of a business. Most often, stakeholders overlook the process of decision making and make rush choices based on greed and anxiety to get quick cash. Management is advised to use relevant costing alongside other decision-making techniques to arrive at the best possible decision to ensure the success of the business. The strongest function of relevant costing is its ability to eliminate unnecessary items in the decision-making list. Therefore, this approach should be embraced by all managers.