Identifying Relevant and Irrelevant Costs

Identifying Relevant and Irrelevant CostsContracting with other firms to obtain necessary goods and services-a process called outsourcing-emerged as a key management strategy during the nineties. Managers hope to benefit from outsourcing by taking advantage of specialization, focusing more attention on core activities, decreasing costs, and increasing flexibility. Outsourcing, or the decision to buy products or services from an external source, rather than making them internally, is but one setting where relevant cost analysis is employed. For a specific decision, the key to relevant cost analysis is first to identify the relevant costs (and revenues) and then to organize them in a manner that clearly indicates how they differ under each alternative.

The purpose of this post is to study the distinction between relevant (future costs that differ among competing decision alternatives) and distinguishing relevant costs from irrelevant costs that do not differ among competing decision alternatives. Follow on…

 

To start, consider the following equipment replacement decision:

Lie Dharma, Inc. is a small start-up company that supplies high-quality components to manufacturers of wi-fi and bluetooth devices. One of its components used in wireless headsets is forecasted to sell 10,000 units during the coming year at a price of $20 per unit. Each of Lie Dharma’s components is manufactured with separate machines in a shared plant.

Headset Component Costs:
– Direct materials = $3.00 per unit
– Conversion = 5.00 per unit
– Selling and distribution = 1.00 per unit
– Inspection and adjustment = $500 per batch (1,000 units)
– Depreciation on machines = $15,000 per year
– Machine maintenance = $200 per month
– Advertising = $5,000 per year

Common Costs:
– Administrative salaries = $65,000 per year
– Building operations = 23,000 per year
– Building rent = 24,000 per year

 

The machine used in the manufacture of headset components is two years old and has a remaining useful life of four years. Its purchase price was $90,000 (new), and it has an estimated salvage value of zero dollars at the end of its useful life. Its current book value (original cost less accumulated depreciation) is $60,000, but its current disposal value is only $35,000.

Management is evaluating the desirability of replacing the machine with a new machine. The new machine costs $80,000, has a useful life of four years, and a predicted salvage value of zero dollars at the end of its useful life. Although the new machine has the same production capacity as the old machine, its predicted operating costs are lower because it consumes less electricity.

Further, because of a computer control system, the new machine allows production of twice as many units between inspections and adjustments, and the cost of inspections and adjustments is lower. The new machine requires only annual, rather than monthly, overhauls. Hence, machine maintenance costs are lower.

Costs for the new machine are predicted as follows:

Conversion costs = $4.00 per unit
Inspection and adjustment = $300 per batch (2,000 units)
Machine maintenance = $200 per year

Note: All other costs and all revenues remain unchanged.

The decision alternatives are to keep the old machine or to replace it with a new machine. An analysis of how costs and revenues differ under each alternative assists management in making the best choice.

As mentioned on the preface, the objective of this post is solely to study the distinction between relevant and irrelevant items. After evaluating the relevance of each item, you can develop an analysis of relevant costs. Next, is the distinction between relevant and irrelevant costs. Read on…

 

Relevance of Future Revenue

Revenues, which are inflows of resources from the sale of goods and services, are relevant if they differ between alternatives. In the above example, revenues are not relevant because they are identical under each alternative. They would be relevant if the new machine had greater capacity or if management intended to change the selling price should it acquire the new machine. (The $35,000 disposal value of the old machine is an inflow. However, revenues refer to resources from the sale of goods and services to customers in the normal course of business. I include the sale of the old machine under disposal and salvage values.)

The keep-or-replace decision facing Lie Dharma’s management might be called a “cost reduction proposal” because it is based on the assumption that the organization is committed to an activity and that management desires to minimize the cost of activities. Here, the two alternatives are either to continue operating with the old machine or to replace it with a new machine.

Although this approach is appropriate for many activities, managers of for-profit organizations should remember that they have another alternative—discontinue operations. To simplify the analysis, managers normally do not consider the alternative to discontinue when operations appear to be profitable. However, if there is any doubt about an operation’s profitability, this alternative should be considered. Because revenues change if an operation is discontinued. Revenues are relevant whenever this alternative is considered.

 

Relevance of Outlay Costs

Outlay costs are costs that require future expenditures of cash or other resources. Outlay costs that differ under the decision alternatives are relevant; outlay costs that do not differ are irrelevant. Lie Dharma’s relevant and irrelevant outlay costs for the equipment replacement decision follow:

Relevant Outlay Costs                      Irrelevant Outlay Costs

Conversion Costs                              Direct Materials
Inspection and Adjustment Costs     Selling and Distribution
Cost of New Machine                        Advertising
Machine Maintenance                       Common Outlay Costs

 

Irrelevance of Sunk Costs

Sunk costs result from past decisions that cannot be changed. Suppose you purchased a car for $15,000 five years ago. Today you must decide whether to purchase another car or have major maintenance performed on your current car. In making this decision, the purchase price of your current car is a sunk cost.

Although the relevance of outlay costs is determined by the decision scenario, sunk costs are never relevant. The cost of the old machine is a sunk cost, not a future cost. This cost and the related depreciation result from the past decision to acquire the old machine. Even though all the outlay costs discussed earlier would be relevant to a decision to continue or discontinue operations, the sunk cost of the old machine is not relevant even to this decision.

If management elects to keep the old machine, its book value will be depreciated over its remaining useful life of four years. However, if management elects to replace the old machine, its book value is written off when it is replaced. Even if management elects to discontinue operations, the book value of the old machine must be written off.

 

Sunk Cost Can Cause Ethical Dilemmas

Although the book value of the old machine has no economic significance, the accounting treatment of past costs may make it psychologically difficult for managers to regard them as irrelevant. If management replaces the old machine, a $25,000 accounting loss is recorded in the year of replacement:

Book value             $60,000
Disposal valu e      (35,000)
Loss on disposal   $25,000

 

The possibility of recording an accounting loss can create an ethical dilemma for managers. Although an action may be desirable from the long-run viewpoint of the organization, in the short run, choosing the action may result in an accounting loss.

Fearing the loss will lead superiors to question her judgment, a manager might prefer to use the old machine (with lower total profits over the four-year period) as opposed to replacing it and being forced to record a loss on disposal. Although this action may avoid raising troublesome questions in the near term, the cumulative effect of many decisions of this nature is harmful to the organization’s long-run economic health.

From an economic viewpoint, the analysis should focus on future costs and revenues that differ. The decision should not be influenced by sunk costs. Although there is no easy solution to this behavioral and ethical problem, managers and management accountants should be aware of its potential impact.

 

Relevance of Disposal and Salvage Values

Lie Dharma, Inc.’s revenues (inflows of resources from operations) from the sale of headset components were discussed earlier. The sale of fixed assets is also a source of resources. Because the sale of fixed assets is a non-operating item, cash inflows obtained from these sales are discussed separately.

The disposal value of the old machine is a relevant cash inflow. It is obtained only if the replacement alternative is selected. Any salvage value available at the end of the useful life of either machine is also relevant. A loss on disposal can have a favorable tax impact if the loss can be offset against taxable gains or taxable income. In this case, although the book value of the old asset remains irrelevant, the expected tax reduction is relevant.

 

Relevance of Opportunity Costs

When making a decision between alternative courses of action, accepting one alternative results in rejecting the other alternative(s). Any benefit foregone as a result of rejecting one opportunity in favor of another opportunity is described as an opportunity cost of the accepted alternative.

Example:

Let’s say you are employed at a salary of $40,000 per year and you have the opportunity to continue to work or the opportunity to go back to school full-time for two years to earn a graduate degree, the cost of getting the degree includes not only all the outlay costs for tuition, books, and so forth, it also includes the salary foregone (or opportunity cost) of $40,000 per year. So, if your tuition and other outlay costs are going to be $25,000 per year for two years, the cost of earning the degree will be $50,000 of outlay costs and $80,000 of opportunity costs, for a total cost of earning the degree of $130,000. Opportunity costs are always relevant in making decisions among competing alternatives.

 

 

A Case Example

You recently made the decision to purchase a very expensive machine for your manufacturing plant that used technology that was well established over several years. The purchase of this machine was a major decision supported by the Chief Financial Officer, based solely on your recommendation. Shortly after making the purchase, you were attending a trade convention where you learned of new technology that is now available that essentially renders obsolete the machine you recently purchased. You feel that it may be best for the company to acquire the new technology since most of your competitors will be using it soon; however, you feel that this cannot be done now that you have recently purchased the new machine. What should you do?

This is a decision that has both economic and ethical dimensions:

  • Economically, the cost of the old machine is a sunk cost, since the expenditure for it has already been made. If it can be sold to another company to recover part of the initial cost, that amount would be relevant to the decision regarding the new technology. However, you should ignore the cost of the recently purchased machine and consider only the outlay costs that will differ between keeping the recently purchased machine and purchasing the new technology, plus any opportunity costs that may be involved with disposing of the existing machine and acquiring the new machine.
  • From an ethical standpoint, managers are often hesitant to recommend an action that reflects poorly on their past decisions. The temptation is to try to justify the past decision. If you have evaluated all of the relevant costs and have considered all of the qualitative issues associated with upgrading the machine, these should be the basis for making your recommendation, not what it will do to your reputation with your superiors.