Chapter 12 – Lecture 8.

‘Relevant costs’ can be defined as any cost relevant to a decision. A matter is relevant if
there is a change in cash flow that is caused by the decision.

The change in cash flow can be:

 additional amounts that must be paid

 a decrease in amounts that must be paid
 additional revenue that will be earned
 a decrease in revenue that will be earned.

A change in the cash flow can be identified by asking if the amounts that would appear
on the company’s bank statement are affected by the decision, whether increased or
decreased. Banks record cash so this test is reliable.

1. Sunk costs (past costs) or committed costs are not relevant

Sunk, or past, costs are monies already spent or money that is already contracted to be
spent. A decision on whether or not a new endeavour is started will have no effect on
this cash flow, so sunk costs cannot be relevant.

For example, money that has been spent on market research for a new product or
planning a new factory is already spent and isn’t coming back to the company,
irrespective of whether the product is approved for manufacture or the factory is built.

Committed costs are costs that would be incurred in the future but they cannot be
avoided because the company has already committed to them through another decision
which has been made.

For example, if a company has two year lease for piece of machinery, that cost will not
be relevant to a decision on whether to use that machinery on a new project which will
last for the next month.

2. Re-apportionment of existing fixed costs are not relevant

Irrespective of what treatment is used in the company’s management accounts to split

up costs, if the total costs remain the same, there is no cash flow effect caused by the
decision.

Page 1 of 10
Note that additional fixed costs caused by a decision are relevant. So, if you were
evaluating the viability of a new production facility, then the rent of a building specially
leased for the new facility is relevant.

3. Depreciation and book values (notional costs) are not relevant

Depreciation is not a cash flow and is dependent on past purchases and somewhat
arbitrary depreciation rates. By the same argument, book values are not relevant as
these are simply the result of historical costs (or historical revaluation) and depreciation.

4. Increases or decreases in cash flows caused by a project are relevant

So, if an old product is discontinued three years early to make room for a new product,
the revenue and cost decreases relating to the old product are relevant, as are the
revenue and cost increases on the new. The cost effects relate to both changes in
variable costs and changes in total fixed costs.

5. Revenues forgone (given up) because of a decision are relevant

If a company decides to keep an asset for use in the manufacture of a new product
rather than selling it, then its cash flow is affected by the decision to keep the asset, as
it will now not benefit from the sale of the asset. This effect is known as an opportunity
cost, which is the value of a benefit foregone when one course of action is chosen in
preference to another. In this case, the company has given up its opportunity to have a
cash inflow from the asset sale.

Types of decision

We will now look at some typical examples where you have to decide which costs are
relevant to decision-making. I suggest that you try each example yourself before you
look at each solution. In all examples we ignore the time value of money.

Always think: what future cash flows are changed by the decision? Changes in future
cash flows reliably indicate which amounts are relevant to the decision.

Page 2 of 10
Example 1: Relevant cost of materials

A company is considering making a new product which requires several types of raw
material:

  Units Units Additional information

in inventory required

Material Nil 40 Current purchase price is $7/unit.

A

Material 100 purchased 150 Current purchase price is $14/unit. The

B for $10/unit material has no use in the company
other than for the project under
consideration. Units in inventory can
be sold for $12/unit.

Material 50 purchased 120 Current purchase price is $22/unit. The

C for  $20/unit material is regularly used in current
manufacturing operations.

What is the relevant cost of the materials required for manufacture of the
new product?

Solution:
Taking each material in turn:

Material A – As there is no inventory, all 40 units required will have to be bought in at $7

per unit. This is a clear cash outflow caused by the decision to make the new product.
Therefore, the relevant cost of Material A for the new product is (40 units x $7) = $280.

Material B - The 100 units of the material already in inventory has no other use in the
company, so if it is not used on the new product, then the assumption is that it would be
sold for $12/unit. If the new product is made, this sale won’t happen and the cash flow is
affected. The original purchase price of $10 is a sunk cost and so is not relevant. In
addition, another 50 units are needed for the new product and these will need to be
bought in at a price of $14/unit.

The total relevant cost for Material B is:

Page 3 of 10
 100 units x $12 (lost sale proceeds) = $1,200

50 units x $14 (current purchase price) = $700

  $1,900

Material C – This material is regularly used in the company, so if the 50 units in

inventory are diverted to the new product then this will mean that inventory will need to
be replenished. In order to do this, Material C purchases for existing products will be
accelerated by 50 units. The current purchase price of $22 will be used to determine the
relevant cost of Material C as this will be the value of each unit purchased. The original
purchase price of $20 is a sunk cost and so is not relevant. Therefore the relevant cost
of Material C for the new product is (120 units x $22) = $2,640.

Example 2: Relevant cost of labour

A company has a new project which requires the following three types of labour:

  Hours Additional information

require
d

Unskilled 12,000 Paid at $8 per hour and existing staff are fully utilised.
The company will hire new staff to meet this additional
demand.

Semi- 2,000 Paid at $12 per hour. These employees are difficult to
skilled recruit and the company retains a number of permanently
employed staff, even if there is no work to do. There is
currently 800 hours of idle time available and any
additional hours would be fulfilled by temporary staff that

Page 4 of 10
 would be paid at $14/hour.

Skilled 8,000 Paid at $15 per hour. There is a severe shortage of

employees with these skills and the only way that this
labour can be provided for the new project would be for
the company to move employees away from making
Product X. A unit of Product X takes 4 hours to make and
makes a contribution of $24/unit.

What is the relevant cost of the labour hours required for the new project?

Solution:
Taking each type of labour in turn:

Unskilled – 12,000 hours are required for the project and the company is prepared to
hire more staff to meet this need. The incremental cash outflow of this decision is
(12,000 hours x $8) = $96,000.

Semi-skilled - Of the 2,000 hours needed, 800 are already available and already being
paid. There is no incremental cost of using these spare hours on the new project.
However, the remaining 1,200 hours are still required and will need to be fulfilled by
hiring temporary workers. Therefore, there is an extra wage cost of (1,200 hours x $14)
= $16,800.

Skilled: Determining the relevant cost of labour if it is diverted from existing activities is
tricky and is often done incorrectly. If this is the case, then the relevant cost is the
variable cost of the labour plus the contribution foregone from not being able to use the
labour for its existing purpose.

The temptation is to see that the same number of skilled employees are paid before and
after being moved to the new project and therefore the opportunity cost of contribution
foregone from diverting hours away from the existing production of Product X is
the only relevant cost ($24/4 hours = $6 per hour). This is incorrect.

Say, for example, that 4 hours of labour were simply removed by ‘sacking’ an employee
for four hours, one less unit of Product X could be made. Using the contribution
foregone figure of $24 is the net effect of losing the revenue from that unit and also
saving the material, labour and the variable costs. In this situation however, the labour
is simply being redeployed so $24 understates the effect of this, as the labour costs are
not saved.

Page 5 of 10
 Therefore, the relevant cost of skilled labour is:

8,000 hours x $15 (current labour cost per hour) = $120,000

8,000 hours x $6 (lost contribution per hour diverted from making

$48,000
Product X) =

  $168,000

Example 3: Relevant cost of machinery

Some years ago, a company bought a piece of machinery for $300,000. The net book
value of the machine is currently $50,000. The company could spend $100,000 on
updating the machine and the products subsequently made on it could generate a
contribution of $150,000. The machine would be depreciated at $25,000 per annum.
Alternatively, if the machine is not updated, the company could sell it now for $75,000.

On a relevant cost basis, should the company update and use the machine
or sell it now?

Solution:
Immediately we can say that the $300,000 purchase cost is a sunk cost and the
$50,000 book value and $25,000 depreciation charge are not cash flows and so are not
relevant.

If the investment in the machinery is made, then the following cash flow changes are
triggered:

 Machine update cost: $100,000

 Contribution from products: $150,000
 Opportunity cost: $75,000

Therefore, the relevant cost is:

Page 6 of 10
 Update cost = $100,000

Add contribution = $150,000

Less sales proceeds foregone = $75,000

Net cash outflow $25,000

As the relevant cost is a net cash outflow, the machine should be sold rather than
retained, updated and used.

Example 4: Relevant cost of machinery

A business rents a factory for $60,000 per annum. Only half of the floor space is
currently used and the company is considering installing a new machine in the unused
part. The machine would cost $2.1m, be depreciated over 10 years at $200,000 per
annum and then be sold for $100,000. The company would insure the new machine
against damage for $5,000 per annum.

What are the relevant costs of the new machine purchase?

Solution:
Rent – this is not a relevant cost. Irrespective of how the company might use the floor
space in the factory to generate a return, there is no change in cash flow relating to the
rent as a result of the new machine.

Cost of machine - this is a relevant cost as $2.1m has to be paid out.

Depreciation – this is not a relevant cost as it is not a cash flow.

Page 7 of 10
Sale proceeds – this is a relevant cost as it is a cash inflow which will occur in 10 years
as a result of the decision to invest.

Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused
by the decision to invest.

These costs will have to be compared to the contribution that can be earned by the new
machine to determine if the overall investment in the asset is financially viable.

The effects shown in Examples 1 – 4, above, are often found in questions where
you are to determine whether or not a company should go ahead with a new
project/investment/product, or if you are asked to calculate the minimum price a
company should charge a customer for a piece of work.

Example 5: Shut down decision

A company has two production lines and its management accounts show the following:

  Production Line Production Line

A B

  $m $m $m $m

Revenue   28   30

Variable costs 12   20  

Fixed costs 10   14  

Total cost   22   34

Profit/loss   6   (4)

 
The total fixed costs of $24m have been apportioned to each production line on the
basis of the floor space occupied by each line in the factory.
Page 8 of 10
The company is concerned about the loss that is reported by Production Line B and is
considering closing down that line. Closing down either production line would save 25%
of the total fixed costs.

Should the company close down Production Line B?

Solution:
The incremental cash flows of closing down Production Line B are:

Revenue lost = $30m

Variable costs saved = $20m

$6m
Fixed costs saved ($24m x 25%) =
$26m

Therefore, the closure of Production Line B is not a good idea as the revenue lost is
greater than the value of the costs saved.

What about closing down Production Line A?

The incremental cash flows of this decision would be:

Revenue lost = $28m

Page 9 of 10
 Variable costs saved = $12m

Fixed costs saved ($24m x 25%) = $6m

The closure of Production Line A would also result in the revenue lost being greater
than the value of the costs saved, so this isn’t a good idea either.

Page 10 of 10