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Module 1: Breakeven Point and Sensitivity Analyses in Cost Accounting

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Relevant Costs in Decison Making

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Namaste. In our earlier sessions we have been discussing CVP BEP analysis, different types of decision-making scenarios, we have seen how it can be used for profit planning, we have seen product mix, key factor base decision making and so on.Now let us learn and discuss a few more concepts and then we again go back to further cases.So, now, we are going to talk about the relevant cost in decision making.So, we will see the difference between relevant versus sunk costs, make or buy decision, shutdown decision, joint product, allocation of joint product cost and so on.Now, what is a relevant cost?Now when it comes to decision making a manager needs to be able to identify the relevant cost.In financial accounting, we look at the historical cost, but here are the relevant cost is nota historical cost, but it is a future cost which is associated with different inputs and activities for a particular decision.So, the relevant cost depends on the decision which we want to take, because as per decision what cost is relevant needs to be considered.Now, this is the expected future cost which defers with an alternative course.Normally variable costs are relevant and fixed costs are not - relevant.Of course, I have said normally or usually, it may not be every time.Now, let us take an example of make or buy or special pricing decision.In making or buy scenario what cost will be relevant?Suppose we are producing it ourselves fixed costs are anyway not going to change.So, what matters is a variable cost of manufacture versus the purchase cost if there is any change in the transport cost, we will add the transport cost to purchase cost.So, we compare the variable cost of making versus the variable cost of buying, do not involve fixed cost into it because it is a short term decision and it is not going to change by make or buy, that is why in a make or buy scenario variable cost of manufacture is an important relevant cost.Similarly, in case of special pricing by special pricing what we mean is, if this pricing is not going to disturb our normal market prices or it is not going to affect our normal customers we can afford to sell at the much lower prices, we can just sell at costs enough to cover our variable cost.If you remember one of the cases we had discussed pricing for government contract which was not to affect the normal market.So, the variable cost was 72, normal selling price was around 152, we had sold they taken a decision to sell it at just at 92.So, that we can cover variable cost any incremental fixed cost, not total fixed cost just the incremental fixed cost and a small profit maybe, this is how special pricing can be done and itis very important for us to identify the relevant cost and just charge the relevant cost.Though as a general rule we say that variable costs are most relevant and fixed costs are not it is not that it is always true.So, it is not necessary that every variable cost is relevant similarly to every fixed cost may not be irrelevant.Again if you remember the earlier case of government contract there was going to become an increase in the production fixed cost, then that incremental part of the fixed cost was considered as relevant.Suppose you are doing a make or buy decision normally as we discussed the variable cost of manufacture is relevant versus the variable cost of buying is relevant.But suppose some of the raw materials are lying idle with us and they are close to expiry day and they will have to be thrown out if we do not use, in such scenario this is the raw material is lying idle we may not consider the cost of raw material as relevant, because anyway it is going wasted.So, there is no point in including it in the variable cost of manufacture, are you getting it?One more of a day to day example not a business kind of example, let us say in summers water is in sharp short supply people pay for buying water, the cost of water increases substantially.If the season changes and rainy season starts and a lot of water are pouring through rains perhaps the cost of water will become 0.Though it is a variable cost it is irrelevant now because now we do not have to pay for it of course, from the environmental angle the water remains very very important, but this from cost perspective what I am trying to say is, depending on the availability and depending on change in the course as per the decision we will have to be very much particular about what is relevant and what is irrelevant cost.Now, relevant costs draw our alternative to those elements of costs which are important for decision. For example, the fixed cost of project X is 5,00,000 and for the alternate project, it is 7,00,000.Now, since the 2 projects are involving a change in the fixed costs, we, in this case, we cannot say that the fixed costs are irrelevant, fixed cost at least to the extent of change will be considered as a relevant cost.Now, the other type of cost is called a sunk cost, now all those costs which are not relevant are called as sunk, they have been already incurred or they have been committed in the past and they cannot be changed by the decision, then there is no point in considering those costs in decision making those costs are called as sunk costs.For example, the cost of research for the product, when we are making a decision on launching or not launching of that product the research cause becomes irrelevant, that does not mean research is not important, but let us say we have already spent 1 crore rupees on research.The product is ready now technically sound, but we have to just take a decision from an economic and managerial angle should we float the product or no.Now if the sales of the product are likely to be 2 crores and the cost of manufacturers 1.5 crores, should the product be launched?Now if you go by total costing you will feel that the sale is 2 lakh 2 crores, cost of manufacture is 1.5 plus the cost of research is 1; that means, the cost is 2.5 versus sale of2 so, the answer may be no for the launching of the product.But actually, this is not a correct decision because the cost of research has already been taken it is completely incurred and it is no way to reduce that costs now, it makes sense to ignore that cost and just look at the cost of operations or cost of manufacture which is 1.5 and the revenue is 2.So, by launching the product we will be able to make a positive contribution of 0.5 crores, although considering the total research cost of 1 crore will be still in a loss, but by not launching a product will be incurring a loss of 1 crore which is our research cost, it will make a better sense to launch the product and at least recover 50 lakhs.Are you getting me? So, it is necessary that we identify sunk costs and ignore them for decision making.Now, sunk costs have already been incurred and they cannot be reversed and that is why they play no role in the decision making.They do not affect any future cost, one more example is spending on advertising.Now when the product is launched a lot of money spent on advertising that money cannot be recovered, we spent it with the hope that it will improve the demand for the product.In the case in future, the product demand has not increased or whether it has increased either way the cost of advertising once incurred becomes sunk ok.When we are taking the decision of going for advertising or no at that time it is relevant, but once we have taken a decision and once we have incurred the cost, later on for calculating the profitability of the product the advertising cost becomes sunk, are you getting?So, as per scenario, it is very important for us to identify relevant costs and sunk costs.Giving one more example suppose you are doing portfolio management or you are doing buying and selling of shares and you have purchased a particular share for 1000, later on, the price of share come downs to comes down to say 800.Should you buy should you sell or not sell that share, you may feel that since the purchase cost is 1000 and the current price is 800 you will incur a loss of 200.So, better not sell, but in case the future price is likely to be 700 it makes sense to sell it because the current losses are 200 they are going to increase to 300.So, it is better to come out at 800 and not wait till prices to go down to 700 the purchase cost of 1000 is irrelevant now.What is relevant is the current price of 800 and what is likely to be the future price your decision of either selling or not selling or buying or not buying, essentially depends on future cost on future prices not dependent on the past costs, got it.Now let us look at one or two more scenarios that are made or buy.Now, make or buy is often a tactical choice, a particular product can be made internally or we can outsource it get it from the outside supplier.Now two factors become very important whether surplus capacity is available.In case we already have enough capacity to make that, instead of considering the total cost.We will just consider the marginal cost of manufacture versus the cost of the suppliers.Now, the elements of make analysis include there are some other factors which you should consider like, incremental inventory carrying costs.That by making it our self do you have to keep more inventory or weather when you get from outside you have to keep more inventory if the supplies are not regular from outside you may have to buy it in bulk quantities so, though that factor becomes important.Then direct labour cost becomes important because it being a direct cost it is variable, then is there any incremental factory overheads, then what about the delivered purchase material cost, does it require any transportation cost, these factors will be considered for make or buy decision.Few more factors like incremental managerial cost, any follow-up action particularly because of quality considerations, incremental purchasing costs, incremental capital cost like indeed for some new equipment.All these factors will be important to make decisions.Now when it comes to buying decision, that is we have got an offer from some supplier we can buy it from outside please look into the cost aspects, one is, of course, the purchase price, but apart from purchase price transportation, receiving and inspection costs, incremental purchasing costs, any follow up cost because of quality or service issues, these factors will be considered.So, we will take a total of buy related costs and we will take a total of make related costs and then comparing the two, the make or buy decision will be taken getting it?Now, let us look at shut down; sometimes it becomes necessary to make a temporary shutdown because if the demand for the product goes down or if there is lack of availability of raw material or labour or some of the inputs, instead of paying FT variable cost or instead of not being able to sell our products it might be advisable to temporarily closed down the product.Especially, if the selling price is below variable costs it is better to close, but if the selling price can recover at least the variable costs it makes sense to continue the production.When you close a manufacturing facility there may be some extra fixed costs like security.Similarly, some of the fixed costs may be reduced like maintenance.So, we will have to consider those relevant costs only to the extent they are going to change.So, the decision should be based on whether the contribution is more than the difference between fixed overhead expenses in the normal course and fixed overheads when the plant is closed.Normally the fixed cost will reduce when the plant is shut down so, there will be some savings in the fixed costs will compare it with the contribution generated by being able to operate it, based on the comparison of the two shutdown decision can be taken.Now, the next one is introducing a new product.Now there are certain reasons why while launching a commercial new venture, what are the important aspects be considered.One is the demand or the interest from the customers, we will also look at whether there is a sustainable enough demand for starting to make a new product or for the launching of a new product.So, for any successful enterprise, we would look at the customer demand and take that call, but at the same time, we have to ensure that all relevant costs are being recovered over the period of product life.Sometimes it may not be possible to recover the cost in the first year or the first month or even in the one and a half years or 2 years.But over the whole life of the product, we do have to consider whether it is able to recover the costs and make enough surplus then there will be a point in launching a new product.Now let us look at one more aspect that is known as joint products.Now, when there are two or more products being produced together they are called joint products.In other words, these two products up to a point of time are made from the same process then they separate and you have two different products which may or may not require further processing.For example, in coke production, coal becomes raw material and you just do not get coke you also get other products like for example, sulfate of ammonia, light oil so, all these three are considered as join products.Similarly, in a refinery crude oil is a raw material.Normally we get petrol, diesel and gas as joint products.This is how the graph looks like.So, crude oil is an input, we need to pass it through the refining process which is a joint production process.So, the costs which are incurred in the process are joined costs.At a split of point the two products for example, here petrol and diesel separate and you may have to incur some extra cost, post-separation they are called as separate processing costs and then you will be able to finally, sale the product.Now, there are also scenarios of by-product.By product is a product of relatively insignificant or a very small value.So, water coming out as joint products are the main products along with that we may get some product with just evolves and having a relatively smaller economic value that will be considered as a byproduct.Now the value which would generate from by product is normally credited to the main product.Example of by product is in case of coke manufacture you may give some gas and tar, or in lumbermills, you may get some sawdust or in cotton cleaning processes some cotton seeds, or coconut oil industry you get coca shells all these are examples of by products they have a very small value.So, they are not charged with any costs rather their sale value or their realizable value is credited to the main product.Some of the small terminologies now a joint product process is a process which results in two or more products.The costs which are incurred up to a split-off point are considered joint product cost. At the split-off point the two products separate.Now, the cost issue involved is whatever is a cost which is incurred up to the split-off needs to be carefully separated and charged to two products.There are some of the methods which are popularly used if two products have reasonably same economic value you may go for the physical unit method.So, for example, if petrol and diesel they have similar value sale value it can be based on the number of litters produced.If the values are different you can go for relative sale value method, sometimes at split-off, you know their market value then you can go for market or sale value of split off or sometimes it will be based on net realizable value.Now, each of the methods is just explained again, in the physical unit method it is an allocation based on some physical measurements like weight or based on the number of litters and so on.Similarly, it can be done by other methods there is one more method known as constant gross margin method, where are they assume that the gross margin is constant and reducing that much of gross profit the cost is estimated.And in case of net realizable value first, we know the value of the sale price value or the sale price after separation we reduce the post-separation costs to get the net realizable value and allocation will be based on net realizable value.So, I hope you have got this with these will stop here.Namaste Thank you.