Dr. Varadraj Bapat, IIT Mumbai1 Module 13. Relevant Costs in Decision Making.

Dr. Varadraj Bapat, IIT MumbaiDr. Varadraj Bapat, IIT Mumbai 11

Module 13.Module 13.

Relevant Costs Relevant Costs in Decision in Decision

MakingMaking


Decision MakingDecision Making

IntroductionIntroduction Relevant Vs. Sunk costRelevant Vs. Sunk cost Make or Buy decision makingMake or Buy decision making Shutdown CostShutdown Cost Joint ProductJoint Product Joint Product Cost AllocationJoint Product Cost Allocation Introduction of new productIntroduction of new product


RelevantRelevant CostCost

Cost which are relevant for a Cost which are relevant for a particular business decision. They particular business decision. They are not historical cost but future are not historical cost but future costs to be associated with different costs to be associated with different inputs and activities related a inputs and activities related a particular business decision.particular business decision.


Relevant cost is expected future cost Relevant cost is expected future cost which differs for alternative course. which differs for alternative course. Usually variable costs are relevant Usually variable costs are relevant while fixed cost are non-relevant. while fixed cost are non-relevant.

Ex. Make or Buy, Special PricingEx. Make or Buy, Special Pricing



However, It is not essential that all However, It is not essential that all variable cost are relevant and all variable cost are relevant and all fixed cost are irrelevant. Fixed or fixed cost are irrelevant. Fixed or variable costs that differ for various variable costs that differ for various alternatives are relevant costs. alternatives are relevant costs.



Relevant costs draw our alternation Relevant costs draw our alternation to those elements of cost which are to those elements of cost which are relevant for decision.relevant for decision.e.g. 1)e.g. 1) Fixed Cost for project X is Rs. Fixed Cost for project X is Rs. 5 lakhs and for alternative project Y 5 lakhs and for alternative project Y it is 7 lakhs.it is 7 lakhs.therefore fixed cost is relevant in therefore fixed cost is relevant in this example. this example.


EE.g. 2).g. 2) Direct material under Direct material under alternative I- Rs. 150 per Kg.alternative I- Rs. 150 per Kg.

Direct material under alternative II- Direct material under alternative II- Rs. 150 per Kg.Rs. 150 per Kg.

therefore variable cost is not therefore variable cost is not relevant in this example.relevant in this example.


SUNK COSTS

Sunk costs are all costs incurred or committed in the past that cannot be changed by any decision made now or in the future. Sunk costs should not be considered in decisions.


SUNK COSTS

E.g. cost incurred on research of a product will be irrelevant while making decision whether to undertake production or not.


Sunk CostSunk Cost

Sunk costs have been incurred and Sunk costs have been incurred and

cannot be reversed. Historical costs cannot be reversed. Historical costs are sunk costs. They play no role in are sunk costs. They play no role in decision making in the current decision making in the current period.period.


Sunk Cost do not affect future costs Sunk Cost do not affect future costs and cannot be changed by any and cannot be changed by any current or future action, hence these current or future action, hence these costs are irrelevant in decision costs are irrelevant in decision making.making.

Ex. Spending on advertising during Ex. Spending on advertising during

product launching is sunk for taking product launching is sunk for taking a decision on continuance of producta decision on continuance of product


Make / BuyMake / Buy

Very often make-or-buy Very often make-or-buy decision is the act of making a decision is the act of making a tactical choice between tactical choice between producing an item internally producing an item internally and buying it from an outside and buying it from an outside supplier. supplier.


Make / BuyMake / Buy

Under such circumstances Under such circumstances two factors are to be two factors are to be considered:considered:

whether surplus capacity is whether surplus capacity is available andavailable and

the marginal cost.the marginal cost.


Elements of the Elements of the "make“ analysis analysis includeinclude::

Incremental inventory-carrying costsIncremental inventory-carrying costs Direct labor costsDirect labor costs Incremental factory overhead costsIncremental factory overhead costs Delivered purchased material costsDelivered purchased material costs


Incremental managerial costsIncremental managerial costs Any follow-on costs stemming from Any follow-on costs stemming from

quality and related problemsquality and related problems Incremental purchasing costsIncremental purchasing costs Incremental capital costsIncremental capital costs Ms. KeshavMs. Keshav (Case)


Cost considerations for the "buy" Cost considerations for the "buy" analysis includeanalysis include::

Purchase price of the partPurchase price of the part Transportation costsTransportation costs Receiving and inspection costsReceiving and inspection costs Incremental purchasing costsIncremental purchasing costs Any follow-on costs related to quality Any follow-on costs related to quality

or serviceor service


ShutdownShutdown CostCost

Some times it becomes necessary for Some times it becomes necessary for a company to temporarily close down a company to temporarily close down the factory or unit because of trade the factory or unit because of trade downturn with view to reopening it in downturn with view to reopening it in the future. In this situation decisions the future. In this situation decisions are based on the variable cost are based on the variable cost analysisanalysis. .


If selling price is above the variable If selling price is above the variable cost then it better to continue cost then it better to continue because the losses are minimized. because the losses are minimized. By closing the manufacturing By closing the manufacturing activity, some extra fixed expenses activity, some extra fixed expenses (e.g. Security) may be incurred and (e.g. Security) may be incurred and certain fixed expenses can be certain fixed expenses can be avoided (e.g. maintenance cost of avoided (e.g. maintenance cost of plant). Such costs are also relevant.plant). Such costs are also relevant.

Shutdown CostShutdown Cost


TThe decision is based on as to he decision is based on as to whether the contribution is more whether the contribution is more than the difference between than the difference between fixed expenses incurred in fixed expenses incurred in normal operation and the fixed normal operation and the fixed expenses incurred when the expenses incurred when the plant is shut down.plant is shut down.


Introducing Introducing new Productnew Product

There are two reasons why a There are two reasons why a commercial enterprise should commercial enterprise should undertake the time, effort, and undertake the time, effort, and expense of introducing a new product expense of introducing a new product or service: or service:

(1) customers have shown interest(1) customers have shown interest


(2) demand is sufficient and (2) demand is sufficient and sustainable enough for the proposed sustainable enough for the proposed product to make a profit. product to make a profit.

In other words, successful In other words, successful enterprises sell what customers want enterprises sell what customers want to buy rather than what the to buy rather than what the entrepreneur wants to sell.entrepreneur wants to sell.


All relevant costs should be All relevant costs should be recovered over a period of product recovered over a period of product life.life.

Introducing Introducing new Productnew Product


Joint ProductJoint Product

When two or more products of When two or more products of equivalent importance are equivalent importance are produced simultaneously, they produced simultaneously, they are termed as joint products. are termed as joint products.


Joint ProductJoint Product

In other words two or more In other words two or more products separated in course of products separated in course of the same processing operation, the same processing operation, each product being in such each product being in such proportion that no single product proportion that no single product can be designated as a major can be designated as a major product.product.


Joint Products usually Joint Products usually require further processing.require further processing.


Joint Products. Joint Products.

in Coke production, Coal is in Coke production, Coal is raw material with Coke, raw material with Coke, Sulfate of ammonia, light oil Sulfate of ammonia, light oil asjoint products.asjoint products.


E.g. Refining Process, where E.g. Refining Process, where crude oil is crude oil is raw materialraw material gives Petrol, Diesel, Gas as gives Petrol, Diesel, Gas as Joint Products.Joint Products.


SeparateProcessing Costs

FinalSale

SeparateProcessing

FinalSale

SeparateProcessing


Crude Oil

JointProductionProcess

Split-OffPoint

JointCosts Petrol

Diesel

Joint Product Cost Allocation




By ProductBy Product

By Product is product of relatively By Product is product of relatively small total value that is produced small total value that is produced simultaneously with a product of with a product of greater total value. The product with greater total value. The product with the greater value (Main product), is the greater value (Main product), is usually produced in greater usually produced in greater quantities than the By Product.quantities than the By Product.



In other words, when two or more In other words, when two or more products are separated in course of products are separated in course of the same processing operation, the same processing operation, where one of the products being in where one of the products being in such proportion/ value that it can be such proportion/ value that it can be designated as a Main product, while designated as a Main product, while others are considered as By others are considered as By Products.Products.



ex. ofex. of By-products

in coke manufacture - gas and tar

in lumber mills - sawdust.

cotton cleaning process - cotton seed

coconut oil industry - coca shells


TerminologyTerminology

Joint Product ProcessJoint Product Process: A : A process that results in process that results in production of two or more production of two or more products, which are termed products, which are termed as joint products.as joint products.


TerminologyTerminology

Joint product costJoint product cost: The cost : The cost of the raw materials/input of the raw materials/input and the joint production and the joint production process.process.


Split Off PointSplit Off Point: : The point in The point in the production process the production process where the individual where the individual products become separately products become separately identifiable.identifiable.


Joint Cost Joint Cost Allocation: : MethodsMethods•Physical units methodPhysical units method•Relative Sales Value MethodRelative Sales Value Method•Sale value at split off pointSale value at split off point•Net Realisable value methodNet Realisable value method


Allocating Allocating Joint CostsJoint Costs

Allocation based on the sales values /relative sales values of theproducts at the split-off point.

Allocation based on a physical measure of the product produced eg Weight

Sales Value/ Relative Sales Value Method

Physical Units Method


Allocation is based on estimated sales value at split off point

Net-Realizable-Value Method

Constant Gross Margin method

Allocation based onsales value less post-separation processing costs

Dr. Varadraj Bapat, IIT Mumbai1 Module 13. Relevant Costs in Decision Making.

Documents

cost sunk costs

sunk cost relevant

iit mumbai3 relevant

fixed cost

elements of cost

iit mumbai4 relevant

varadraj bapat

marginal cost