The organizations strive to earn short-run profits. In making short-run decisions, not all cost and revenue data is relevant. The cost data relevant for decision-making is referred to as relevant costs and that which is not useful for decision-making is non-relevant costs. On the revenue side, the only relevant revenue is the incremental & differential revenue.
Relevant and Non-Relevant Costs:
1.Future Costs and Sunk Costs (IR):
A future cost is that cost yet to be incurred and since the decision is in the future, future costs are relevant.
A sunk cost is a historical cost which has already been incurred and cannot be reversed hence irrelevant for decision-making.
2.Incremental Costs and Deferential Costs:
An incremental cost is that which increases or decreases due to the change in the operating level in a particular decision made.
A differential cost is that which differs between alternatives. All these costs are relevant.
3.Out of Pocket Costs and Imputed Costs (Notional Costs):
Out of pocket cost is an actual cash outflow and is relevant for decision-making. Imputed costs are book costs e.g. depreciation & notional rent, and are irrelevant for decision-making.
4. Committed Costs and Directly Attributable Fixed Costs: A committed cost is a contractual cost to be incurred in the future, it is irrelevant for decision-making. Directly attributable fixed costs are those fixed costs which arise because of directly engaging in a particular production line. They are relevant for decision-making.
NB: It is clear that not all future costs are relevant and also not all fixed costs are irrelevant.
This is a value of second best alternative or it is the value of the best alternative foregone, it’s relevant.
6.Controllable and Avoidable Costs:
A controllable cost is that which can be influenced by management decision. Avoidable cost (escapable cost) is that which can be eliminated when the decision is left out. These are relevant for decision-making.
NB. 1 Uncontrollable, unavoidable, fixed costs that can’t be eliminated, and sunk costs are irrelevant. 2. Relevant costs are future incremental cash flows.
THE RELEVANT COSTS OF MATERIALS
a) Where the materials are in continuous use, the relevant cost is the future replacement cost. b) Where the materials are not in continuous use, the relevant cost is the higher of the salvage value and the value for the alternative use.
Relevant Cost of Labour:
The relevant cost of labour is the replacement cost or the incremental cost or the hiring cost or all the above.
Relevant Overhead Costs:
Only directly attributable overheads are relevant for decision-making, any non-cash overheads, fixed overheads and general overheads are irrelevant. General overheads refer to head quarters overheads charged to jobs.
NB: The above provides a guide to make informed quantitative decisions. However, qualitative factors have to also be taken into account as they can impact on the decision.
Assumptions in shot term decision making
▪ In decision-making, we assume the information given is complete and reliable. ▪ Fixed costs, variable costs per unit, and selling price are known with certainty and fixed. ▪ Cost behavior is known with certainty.
▪ The objective of the firm is to maximize short-run profits.
The short-run decisions include:-
• Make or buy decision
• Drop or maintain production line (shut down decision)
• Lease or operate decision
• Product mix under limiting factor decision
• Special order decision
• Process further decision.
Example Identification of Relevant Costs:
A company has been making a machine to order for a customer, but the customer has since gone into liquidation and there is no prospect that any money will be obtained from the winding up of...