Operating decisions imply an understanding of costs. Among cost distinctions, “relevant costs” is broadly used for operating decision. Relevant costs are the future, incremental cash flows that result from a decision. Relevant costs specifically do not include sunk costs, i.e. costs that have been incurred in the past, as nothing we can do can change those earlier decisions. Relevant costs are avoidable costs because, by taking a particular decision, we can avoid the cost. Unavoidable costs are not relevant because, irrespective of what our decision is, we will still incur the cost. Relevant costs may, however, be opportunity costs. An opportunity cost is not a cost that is paid out in cash. It is the loss of a future cash flow that takes place as a result of making a particular decision.
Through this post, I am going to demonstrate how to implement relevant costs into a three strategic operating decision: Make vs Buy, Equipment replacement, and material requirement with simplified case example. Enjoy!
Relevant Costs – Make Versus Buy Decision
A concern with subcontracting or outsourcing has dominated business in recent years as the cost of providing goods and services in-house is increasingly compared to the cost of purchasing goods on the open market. The make versus buy decision should be based on which alternative is less costly on a relevant cost basis that is taking into account only future, incremental cash flows.
The costs of in-house production of a computer processing service that averages 10,000 transactions per month are calculated as $25,000 per month. This comprises $0.50 per transaction for stationery and $2 per transaction for labor. In addition, there is a $10,000 charge from head office as the share of the depreciation charge for equipment. An independent computer bureau has tendered a fixed price of $20,000 per month.
Based on this information, stationery and labor costs are variable costs that are both avoidable if processing is outsourced. The depreciation charge is likely to be a fixed cost to the business irrespective of the outsourcing decision. It is therefore unavoidable. The fixed outsourcing cost will only be incurred if outsourcing takes place.
The relevant costs for each alternative can be compared as shown in below table:
Note: The $10,000 share of depreciation costs is not relevant as it is unavoidable.
The relevant costs for this decision are therefore those shown in the next table:
Note: Based on relevant costs, there would be a $5,000 per month saving by outsourcing the computer processing service.
Relevant Costs – Equipment Replacement
A further example of the use of relevant costs is in the decision to replace plant and equipment. Once again, the concern is with future incremental cash flows, not with historical or sunk costs or with non-cash expenses such as depreciation.
Lie Hotel Company replaced its kitchen one year ago at a cost of $120,000. The kitchen was to be depreciated over five years, although it will still be operational after that time. The hotel manager wishes to expand the dining facility and needs a larger kitchen with additional capacity. A new kitchen will cost $150,000, but the kitchen equipment supplier is prepared to offer $25,000 as a trade-in for the old kitchen. The new kitchen will ensure that the dining facility earns additional income of $25,000 for each of the next five years.
The existing kitchen incurs operating costs of $40,000 per year. Due to labor saving technology, operating costs, even with additional dining, will fall to $30,000 per year if the new kitchen is bought. These figures are shown below:
On a relevant cost basis, the difference between retaining the old kitchen and buying the new kitchen is a saving of $50,000 cash flow over five years. On this basis, it makes sense to buy the new kitchen.
The original kitchen cost has been written down to $96,000 (cost of $120,000 less one year’s depreciation at 20% or $24,000). The original capital cost is a sunk cost and is therefore irrelevant to a future decision. The loss on sale of $71,000 ($96,000 written down value [minus] $25,000 trade-in) will affect the hotel’s reported profit, but it is not a future incremental cash flow and is therefore irrelevant to the decision.
However, there is a tension between a decision based on future incremental cash flows and the reported financial position that will show a significant (non-cash) financial loss in the year in which the old kitchen is written off.
Relevant Costs of Materials Requirements
As the definition of relevant cost is the future incremental cash flow, it follows that the relevant cost of direct materials is not the historical (or sunk) cost but the replacement price of the materials. Therefore it is irrelevant whether or not those materials are held in inventory, unless such materials have only scrap value or an alternative use, in which case the relevant cost is the opportunity cost of the forgone alternative. The cost of using materials can be summarized as follows:
- If the material is purchased specifically the relevant cost is the purchase price.
- If the material is already in stock and is used regularly, the relevant cost is the purchase price (i.e. the replacement price).
- If the material is already in stock but is surplus as a result of previous overbuying, the relevant cost is the opportunity cost, which may be its scrap value or its value in any alternative use.
Lie Dharma Putra Ltd has been approached by a customer who wants to place a special order and is willing to pay $16,000. The order requires the materials shown below:
- Material A would have to be purchased specifically for this order
- Material B is used regularly and any inventory used for this order would have to be replaced.
- Material C is surplus to requirements and has no alternative use. Material D is also surplus to requirements but can be used as a substitute for material E.
- Material E, although not required for this order, is in regular use and currently costs $8.00 per kg, but is not in stock.
The relevant material costs are shown below:
As a result of the above, Lie Dharma Putra would accept the special order because the additional income exceeds the relevant cost of materials.
- In the case of A, the material is purchased at the current purchase price.
- For B, even though some inventory is held at a lower cost price, it is used regularly and has to be replaced at the current purchase price.
- For C, the 400 kg in inventory have no other value than scrap, which is the opportunity cost of using it in this order. The 100 kg of C not in inventory have to be purchased at the current replacement price.
- For D, the opportunity cost is either the scrap value or the saving made by using material D as a substitute for material E.
As the substitution value is higher, this is what Lie Dharma would do in the absence of this particular order. Therefore, the opportunity cost of D is the loss of the ability to substitute for material E. Relevant costs are a useful tool in helping to make operational decisions. However, there are other approaches to costing that are also valuable.