Managers are charged with the responsibility of managing organizational resources effectively and efficiently relative to the organization’s goals and objectives. Making decisions about the use of organizational resources is a key process in which managers fulfill this responsibility. Accounting and finance professionals contribute to the decision-making process by providing expertise and information. Many decisions can be made using incremental analysis. This post introduce the topic of relevant costing, which focuses managerial attention on a decision’s relevant (or pertinent) facts.
Relevant costing techniques are applied in virtually all business decisions in both short-term and long-term contexts. In general these decisions require a consideration of costs and benefits that are mismatched in time; that is, the cost is incurred currently but the benefit is derived in future periods.
In making a choice among the alternatives available, managers must consider all relevant costs and revenues associated with each alternative. One of the most important concepts discussed in this post is the relationship between time and relevance. As the decision time horizon becomes shorter, fewer costs and revenues are relevant because only a limited set of them are subject to change by short-term management actions. Over the long term, virtually all costs can be influenced by management actions. Regardless of whether the decision is short or long term, all decision making requires:
relevant information at the point of decision; the knowledge of how to analyze that information at the point of decision; and enough time to do the analysis. In today’s corporations, oceans of data drown most decision makers. Eliminating irrelevant information requires the knowledge of what is relevant, the knowledge of how to access and select appropriate data, and the knowledge of how best to prepare the data by sorting and summarizing it to facilitate analysis. This is the raw material of decision making [Edward G. Mahler, “Perform as Smart as You Are,” Financial Executive (July–August 1991), p. 18.]
The Concept Of Relevance [Of Relevant Costing]
What factors are relevant in making decisions and why? For information to be relevant, it must possess three characteristics. It must (1) be associated with the decision under consideration, (2) be important to the decision maker, and (3) have a connection to or bearing on some future endeavor.
Relevant Cost and Its Association with Decision
Costs or revenues are relevant when they are logically related to a decision and vary from one decision alternative to another. Cost accountants can assist managers in determining which costs and revenues are relevant to decisions at hand.
To be relevant, a cost or revenue item must be differential or incremental. An incremental revenue is the amount of revenue that differs across decision choices and incremental cost (differential cost) is the amount of cost that varies across the decision choices. To the extent possible and practical, relevant costing compares the incremental revenues and incremental costs of alternative choices. Although incremental costs can be variable or fixed, a general guideline is that most variable costs are relevant and most fixed costs are not. The logic of this guideline is that as sales or production volume changes, within the relevant range, variable costs change, but fixed costs do not change. As with most generalizations, some exceptions can occur in the decision-making process.
The difference between the incremental revenue and the incremental cost of a particular alternative is the positive or negative incremental benefit [incremental profit] of that course of action. Management can compare the incremental benefits of alternatives to decide on the most profitable (or least costly) alternative or set of alternatives. Such a comparison may sound simple; it often is not. The concept of relevance is an inherently individual determination and the quantity of information available to make decisions is increasing. The challenge is to get information that identifies relevant costs and benefits:
If executives once imagined they could gather enough information to read the business environment like an open book, they have had to dim their hopes. The flow of information has swollen to such a flood that managers are in danger of drowning; extracting relevant data from the torrent is increasingly a daunting task [Amitai Etzioni, “Humble Decision Making”, Harvard Business Review (July–August 1989), p. 122].
Some relevant factors, such as sales commissions or prime costs of production, are easily identified and quantified because they are integral parts of the accounting system. Other factors may be relevant and quantifiable, but are not part of the accounting system. Such factors cannot be overlooked simply because they may be more difficult to obtain or may require the use of estimates. For instance, opportunity costs represent the benefits foregone because one course of action is chosen over another. These costs are extremely important in decision making, but are not included in the accounting records.
What Opportunity Cost really is: To illustrate the concept of an opportunity cost, assume that on August 1, Jane purchases a ticket for $50 to attend a play to be presented in November. In October, Jane is presented with an opportunity to sell her ticket to a friend who is very eager to attend the play. The friend has offered $100 for the ticket. The $100 price offered by Jane’s friend is an opportunity cost—it is a benefit that Jane will sacrifice if she chooses to attend the play rather than sell the ticket.
Opportunity [Relevant Cost] Importance to Decision Maker
How do opportunity costs affect decision making? The need for specific information depends on how important that information is relative to the objectives that a manager wants to achieve. Moreover, if all other factors are equal, more precise information is given greater weight in the decision making process. However, if the information is extremely important, but less precise, the manager must weigh importance against precision. The News Note on the following page illustrates that in one of the most crucial industries, health care, accurate financial data are virtually nonexistent.
Bearing on the Future
Information can be based on past or present data, but is relevant only if it pertains to a future decision choice. All managerial decisions are made to affect future events, so the information on which decisions are based should reflect future conditions. The future may be the short run [two hours from now or next month] or the long run [three years from now].
Future costs are the only costs that can be avoided, and a longer time horizon equates to more costs that are controllable, avoidable, and relevant. Only information that has a bearing on future events is relevant in decision making. But people too often forget this adage and try to make decisions using inapplicable data. One common error is trying to use a previously purchased asset’s acquisition cost or book value in current decision making. This error reflects the misconception that sunk costs are relevant costs.
Health Care Accounting Systems Are Seriously Sick
Managed care and an increased emphasis on cost management have created an urgent need among healthcare providers for relevant cost information, but organizations lack the necessary tools to gather the information.
That was one of the key findings in a recent survey conducted by IDG Research. The respondents were 200 senior finance, operations, and information services executives from hospitals, integrated delivery networks, and clinics. “The healthcare market has shifted from a revenue focus to a cost focus, but organizations haven’t yet acquired the tools needed for success in this new environment”, Doug Williams, a partner with Arthur Andersen’s healthcare business consulting practice, explained.
Here are other key findings:
Cost management is the dominant force in today’s healthcare environment. It was cited by 95 percent of the respondents and ran far ahead of revenue generation, resource availability, and integration of multiple facilities. There is a lack of actionable information for decision making. Eighty percent of the respondents want to measure costs over the entire episode of care, but only 33 percent are confident about the quality of their cost data, and only 26 percent said their data are timely for decision making. Fewer than a third thought they even had data they could use for decision making.
There is a dramatic lack of tools for bidding, administering, and evaluating managed care contracts. When respondents were asked about their ability to project revenue, costs, volume/utilization, and profit projections when bidding managed care contracts, 84 percent called the information necessary and valuable, yet only 48 percent were confident about their revenue projection abilities, 31 percent about costs, 26 percent about volume/ utilization, and 20 percent about profit projection abilities.
Sunk Costs Are Nor Relevant In Making Decision
What are sunk costs and why are they not relevant in making decisions? Costs incurred in the past for the acquisition of an asset [or a resource] are called sunk costs. They cannot be changed, no matter what future course of action is taken because past expenditures are not recoverable, regardless of current circumstances. After an asset or resource is acquired, managers may find that it is no longer adequate for the intended purposes, does not perform to expectations, is technologically out of date, or is no longer marketable. A decision, typically involving two alternatives, must then be made: keep or dispose of the old asset. In making this decision, a current or future selling price may be obtained for the old asset, but such a price is the result of current or future conditions and does not “recoup” a historical cost. The historical cost is not relevant to the decision.
These decisions provide an excellent introduction to the concept of relevant information. The following illustration makes some simplistic assumptions regarding asset acquisitions, but is used to demonstrate why sunk costs are not relevant costs.
Sunk Cost Application Technique Example
Assume that Lie Dharma Technologies purchases a statistical process control system for $2,000,000 on January 6, 2008. This system [the “original” system] is expected to have a useful life of five years and no salvage value. Five days later, on January 11, Mr. Phillip Morgan, vice president of production, notices an advertisement for a similar system for $1,800,000. This “new” system also has an estimated life of five years and no salvage value; its features will allow it to perform as well as the original system, and in addition, it has analysis tools that will save $50,000 per year in operating costs over the original system. On investigation, Mr. Morgan discovers that the original system can be sold for only $1,300,000. The data on the original and new statistical process control systems are shown below.
Lie Dharma Technologies has two options:
- use the original system; or
- sell the original system and buy the new system.
Below figure presents the costs Mr. Morgan should consider in making his asset replacement decision—that is, the relevant costs.
Original System New System
(Purchased Jan. 6) (Available Jan. 11)
Cost $2,000,000 $1,800,000
Life in years 5 5
Salvage value $0 $0
Current resale value $1,300,000 Not applicable
Annual operating cost $105,000 $55,000
As shown in the computations, the $2,000,000 purchase price of the original system does not affect the decision process. This amount was “gone forever” when the company bought the system. However, if the company sells the original system, it will effectively reduce the net cash outlay for the new system to $500,000 because it will generate $1,300,000 from selling the old system. Using either system, Lie Dharma Technologies will incur operating costs over the next five years, but it will spend $250,000 less using the new system ($50,000 savings per year x 5 years).
The common tendency is to include the $2,000,000 cost of the old system in the analysis. However, this cost is not differential between the decision alternatives. If Lie Dharma Technologies keeps the original system, that $2,000,000 will be deducted as depreciation expense over the system’s life. Alternatively, if the system is sold, the $2,000,000 will be charged against the revenue realized from the sale of the system. Thus, the $2,000,000 loss, or its equivalent in depreciation charges, is the same in magnitude whether the company retains the original or disposes of it and buys the new one. Since the amount is the same under both alternatives, it is not relevant to the decision process.
Mr. Morgan must condition himself to make decisions given his set of future alternatives. The relevant factors in deciding whether to purchase the new system are:
- cost of the new system ($1,800,000),
- current resale value of the original system ($1,300,000); and
- annual savings of the new system ($50,000) and the number of years (5) such savings would be enjoyed.
Alternative (1): Use original system
Operating cost over life of original system
($105,000 x 5 years) $ 525,000
Alternative (2): Sell original system and buy new
Cost of new system $1,800,000
Resale value of original system (1,300,000)
Effective net outlay for new system $ 500,000
Operating cost over life of new system
($55,000 x 5 years) 275,000
Total cost of new system (775,000)
Benefit of keeping the old system $(250,000)
The alternative, incremental calculation follows:
Savings from operating the new system for 5 years $ 250,000
Less: Effective incremental outlay for new system (500,000)
Incremental advantage of keeping the old system (250,000)
This example demonstrates the difference between relevant and irrelevant costs, including sunk costs. The next section shows how the concepts of relevant costing, incremental revenues, and incremental costs are applied in making some common managerial decisions.
Relevant Cost For Specific Decisions
Managers routinely choose a course of action from alternatives that have been identified as feasible solutions to problems. In so doing, managers weigh the costs and benefits of these alternatives and determine which course of action is best. Incremental revenues, costs, and benefits of all courses of action are measured against a baseline alternative. In making decisions, managers must provide for the inclusion of any inherently non-quantifiable considerations. Inclusion can be made by attempting to quantify those items or by simply making instinctive value judgments about nonmonetary benefits and costs.
In evaluating courses of action, managers should select the alternative that provides the highest incremental benefit to the company. One course of action that is often used as the baseline case is the “change nothing” option. While other alternatives have certain incremental revenues and incremental costs associated with them, the “change nothing” alternative has a zero incremental benefit because it represents the current conditions. Some situations occur that involve specific government regulations or mandates in which a “change nothing” alternative does not exist. For example, if a company was polluting river water and a duly licensed governmental regulatory agency issued an injunction against it, the company (assuming it wishes to continue in business) would be forced to correct the pollution problem. The company could delay the installation of pollution control devices at the risk of fines or closure. Such fines would be incremental costs that would need to be considered; closure would create an opportunity cost amounting to the income that would have been generated had sales continued.
Rational decision-making behavior includes a comprehensive evaluation of the monetary effects of all alternative courses of action. The chosen course should be one that will make the business better off. Decision choices can be evaluated using relevant costing techniques.