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Cost Accounting for Decision-making. Lesson 1. Part I. Describe and Identify Relevant and Irrelevant Costs for Making Business Decisions. Question. In our daily life, we usually ask: ‘How much does “ it” cost?’. So how can we recognize and classify costs?.
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Cost Accounting for Decision-making Lesson 1
Part I Describe and Identify Relevant and Irrelevant Costs for Making Business Decisions
Question In our daily life, we usually ask: ‘How much does “it” cost?’ So how can we recognize and classify costs?
Activity 1 – Group Discussion 1. How many types of classification of costs have we learned? 2. What are they?
Classification of Costs 1. For reporting purposes (Inventory valuation and profit measurement) • Direct cost and indirect cost • Prime cost and overhead • Product cost and period cost • Expired cost and unexpired cost Can you provide examples for each type?
Classification of costs 2. Based on cost behaviour • Fixed • Variable • Mixed • Step Can you provide examples for each type?
Classification of costs 3. For decision-making purpose • Relevant cost • Irrelevant cost What are they?
Activity 2 – Class Discussion You are considering to trade in your old printer for a new model of printer that consumes less electricity. The new and old printers use the same printing papers but with different toner cartridges. Are the following items relevant costs or irrelevant costs in your decision-making process: • The price for new printer. • The price for old printer. • The price of the printing papers. • The price of toner cartridges. • The amount of electricity consumed.
Activity 2 – Solution • The price for new printer: Relevant • The price for old printer: Irrelevant • The price of the printing papers: Irrelevant • The price of toner cartridges: Relevant • The amount of electricity consumed: Relevant
Relevant Costs: Definition Relevant costs are those future costs that will differ across options. You may ask ‘Will the cost be different if we choose another option?’
Relevant Costs: Example A company is considering to buy a new photocopy machine and has to choose between Model A and Model B. The purchase price of Model A is more expensive than Model B. Do the purchase prices of both machines are relevant costs? In this case, the purchases prices of both machines are relevant costs. They are future costs that will differ depending on which machine the company has chosen.
Types of Relevant Costs: Opportunity Costs Opportunity costs are the benefits that lost when one option is chosen over another. A company has $300,000 for investment in a non-current asset. It can either purchase a new welding machine or a delivery van with the same price. If the company finally chooses to purchase the new welding machine, the opportunity cost of this decision would be the investment in the delivery van.
Types of Relevant Costs: Incremental Costs Incremental costs are the additional costs resulting from a chosen option. A company’s direct material cost increases from $300,000 to $360,000 as the result of increasing its production units from 6,000 to 7,200, the incremental direct material cost of this 1,200 units is $60,000.
Types of Relevant Costs: Avoidable Costs Avoidable costs are costs that can be saved by adopting a given option. If a company stops producing a product, it will no longer have to pay for the direct material cost of that product, then this cost is an avoidable cost.
Irrelevant Costs: Definition Irrelevant costs are those future costs that will not be affected by a business decision. You may ask ‘Will the cost be indifferent if we choose another option?’
Irrelevant Costs: Example Let’s consider the depreciation cost of a machine in which the company used in its operation. Is this depreciation cost a relevant cost or an irrelevant cost? In this case, the depreciation cost is an irrelevant cost because the cost incurred is not affected by future actions; cannot be avoided; and does not differ across options.
Types of Irrelevant Costs: Sunk Costs Sunk costs are costs that have been incurred by a decision made in the past and that cannot be changed by any decision that will be made in the future. A company spends $150,000 on a marketing study for a new product to see whether it will succeed in the marketplace. This $150,000 becomes a sunk cost no matter the company decides to launch or not to launch the product at the end.
Types of Irrelevant Costs: Unavoidable Costs Unavoidable costs are costs that will be incurred irrespective of the business decisions the company makes. A company produces 2 types of products, X and Y, in the same factory. Rent expense for the factory is $50,000 per month. Due to a sudden decrease in demand, the company decide to stop the production for Y. Irrespective of this decision, the company still has to pay the rent of $50,000. Therefore this $50,000 is an unavoidable cost.
