Analysing which costs are most relevant to decision making

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Jessup ltd is advertising and public relations Company. The company specializes in outdoor advertising, production, printing, events, promotions services, road signs and banners. On the other hand Jessup ltd gives the best service to clients and helps expand, promote and develop their customer business. The company is run by four directors who are all advertising experts. While the company is doing very well they feel it has reached a stage where they need better management of the accounting function.


The chartered institute of management accounting has been define Strategic Management Accounting as "a form of management accounting in which emphasis is placed on information which relates to factors external to the firm, as well as non-financial information and internally generated information."(CIMA 2000)

On the other hand, management accounting is internal trading building role accounting and finance professionals that work in organizations. However management accounting is concern on provisions and accounting utilization of information for managers in organizations, it provide the inform business results that will be allow manager better prepare in their management and control functions. on overall strategic management accounting is a type of management accounting.

2.1 Role of Strategic Management Accountants

A management accountant is valued business partners and directly support to an organization strategic gold. (Startups, 2010) The role of strategic management accountant is


One of the basic propose of a manager is making decision. (Garrison and Noreen, 2000) Therefore, relevant costs understanding are importance once realize that there are many areas where relevant costs concept is used namely as to continue or discontinue or shut down decisions; pricing; accept or reject special order; limiting factor due to scarce resources and make or buy decision. In all state above, management needs enough relevant information and makes correct decision. So that manager need to understand what really is relevant cost. (Blogspot, 2009)

In decision making, cost and revenues can be classified according to whether they are relevant depend on the decision context. (Colin drury, 2005) The cost that meets the requirement of good management accounting information is 'Relevant costs'. (Docstoc, 2010) Relevant cost and revenue are future costs and revenues will be change by decision. (Colin drury, 2005) However, to affect a decision a cost must be future cost and cash costs.

3.1 Two Main Principle of Relevant Cost

Future costs are relevant, past or committed costs do not affect the decision. (UOS, 2008) However cash costs are to be included and non cash cost should be ignore in the decision making process. For example, like depreciation which it is follows the rule of book-keeping. (Fao, 2010) Therefore relevant cost can be incremental cost, avoidable cost and opportunity cost.

3.1.1 Incremental Cost

Incremental cost also can refer to difference cost it can change and it difference in total cost among alternatives which is calculated to aid decision making. (Robert Scarlett, Bob Scarlett, 2007) Incremental cost must be compared with incremental revenues because it is to arrive at a decision. (Hubpages, 2010) For example, variable cost. (Robert Scarlett, Bob Scarlett, 2007)

3.1.2 Avoidable Cost

Deciding whether or not to discontinue a product is one of the situations which are necessary to identify the avoidable costs. Avoidable costs which are usually variable costs and sometimes may be a few specific costs that is the only cost which would be saved. For example, shutdown, divestment decisions and etc. (Freebookonline, 2010)

3.1.3 Opportunity Costs

Opportunity costs are the benefits of that sacrifice when one action is chosen, in preference to alternatives. The opportunity cost is the potential benefit foregone. (Accaglobal, 2010) For example, Zen has a full time job that cost him £80 per day while attending the job. He has to spend two days on house to take care of the sick father and the employer has agreed to give him the leave but without the pay. So the £160 in lost wages would be opportunity costs of taking the two days leave for take care of the sick father.


Irrelevant costs and revenues are cost that should be ignoring it when making decision because they are not future cost. (Smccd, 2010) For example I sell an advertising board to A with the cost of £10000 and B also with the cost of £10000. So there is no irrelevant revenue, because get the same cost. There are some types of irrelevant cost which are sunk cost; committed cost; notional cost; historical cost and other assumption.

3.2.1 Sunk Cost

Sunk cost is something happen in the past that is not directly relevant in decision making.(Garrison and Noreen, 2000) On the other hand, sunk cost may result risk aversion.(Marcel Zeelenberg, 2007) Beside that according to Robert Kee say that "economic theory state that it is no longer relating for decision making when fixed cost of capacity once achieved is sunk cost". (Robert Kee, 2008)

3.2.2 Committed Cost

Whatever decision is making now there will be a future cash outflow that will be incurred. For example, sign a legally binding contract. (scribd, 2010)

3.2.4 Notional Cost

Notional cost also can refer as imagining costs like create a cost that the company didn't have. For example notional rent. (Accaglobal, 2010)

3.2.5 Historical Cost

Historical cost is costs that happen in the past which is irrelevant for decision making but for prediction future cost this is the best available basis. (Csus, 2010)

3.2.6 Other Assumption

Other assumption has variable cost and fixed cost. All variable cost is usually will be relevant costs and all fixed cost is irrelevant for decision making. By the way fixed costs may only be fixed in the short term. (Freebookonline, 2010)


Relevant cost for material will become current replacement cost unless material was bought but will not be replaced. On the other hand, the relevant cost will be higher of the following of their current resale value and the value they obtain if they were put to alternative use. Whereas in the event the materials have no resale value, they the opportunity cost will be nil. (Freebookonline, 2010) In table 1.0 below is show that use the following decision tree to determine the relevant costs for material. An example has show in appendix 2.0. As a result in appendix 1.0, Jeremy Plc would accept the order because the additional income of £5750 exceeds the relevant cost of materials.

Table 1.0 Relevant cost of material

Sources taken from:


Determine direct labor costs which relevant to short-term decision depends on circumstances. The labor force is to be maintained in the short-term when a company has temporary spare capacity, so that the direct labor cost will be irrelevant for short-term decision making purposes. (Colin drury, 2006) However, if labor force could be placed to a utility alternative, hence the relevant costs are the variable costs of labor and associated variable overheads + contribution forgone from unable put it to alternative use. (Scribd, 2010)

In table 2.0 below show to determine the relevant costs for labor and the existence of spare capacity is a factor however it is same to material. An example has show in appendix 2.0. As a result in appendix 2.0 Jeremy Plc can accept the new customer's offer because the revenue from completing work is £ 28,000. The relevant Costs of Materials: Opportunity cost is £1,500, labor of basic pay is £8,000. Opportunity Cost of losing other job is £18,000 and incremental cost of consultant is £2,200, so total up is £29,700. There has an extra profit to be earned by accepting the order is £1,700. So lastly, manager has a huge responsibility on making a correct decision on whether to discontinuing a product line, segment or division, acceptance of a special order, limiting factor decision and make or buy decision.


Cost system classified as direct costing system, traditional absorption costing systems and activity based costing system (ABC). In here will discuss a little bit of traditional absorption costing and activity based costing, but more concentrate on ABC. (Colin Drury, 2006) ABC is one accounting theory which involves determines all business costs to every individual good or service provided. (Wisegeek, 2010) In order to determine the selling price of a good or service, Jess up must include direct cost and indirect cost. Direct cost and indirect cost are similar as overhead cost. Direct cost is cost that involve in the process. However indirect cost is cost that can not involve in process. (UOS, 2008)

4.1 Traditional Costing

Traditional cost accounting methods designed around 1870 to 1920 and those day industry do not have automation is labor intensive and have low level of overhead costs compared to today. However, this altered quickly from 1960s and especially in 1980s. On other hand, traditional costing also can refer as absorption costing. (Emblemsvag, 2010) However, the traditional cost accounting method refer to allocates overheads cost to production departments. (AccountingCoach, 2010) The cost are allocated randomly base on the direct labor hours, or the production machine hours and other.(Differencebetween, 2010) In appendix 3.0 will show the example. As a result in appendix 3.0 the total production cost per unit of product S is £48, product T £85 and lastly product U is £104.

4.2 Activity Based Costing (ABC)

Activity based Costing is a kind of costing system that could be used to determine costs more exactly. (Tiffany Bradford, 2008 Nowadays ABC systems are being taken by many manufacturing and service organizations. (Tzvi Raz and Dan Elnathan, 1999) ABC is a costing method that is designed to provide managers with information on fees for making strategic decisions and others that could affect the ability and hence "fixed" costs. (Garrison and Noreen, 2000) It is a new approach to determine overhead costs to product. (Pauline Weetman, 1996) Therefore ABC method refers to allocates overheads costs are based on activity not department anymore. By the way ABC system also used many cost drivers as absorption bases. (Colin Drury, 2006) Cost driver is a factor which causes of the cost of an activity performed in the value chain. (12manage, 2010) Below the table 3.0 is showed the steps in an ABC system.

An example will show in appendix 3.0. As a result in appendix 3.0 the total production cost of product S is £363.42, product T £146.59 and product U £72.75.

4.2.1 Reason for development ABC

The direct labor and material costs accounting were the largest proportion of the costs because traditional cost accumulation system had only a narrow range of product and when overheads costs were only a very small fraction of the total costs. Recently activity based costing grew in popularity due to some factors specific. One of the reasons is increase in the number of support services. For examples: production scheduling, inspection hours and etc. Another one is increase in the overhead proportion of total costs. (CAT-ACCA resources, 2010) Beside that there is increase diversity products generated by a company and diversity customer requests. Lastly this method tends to be more complicated while in a company, some products are being produced in large groups other is being only in small groups (Activity Based Costing). Activity based costing would be continue to grow in usage as long as years due to this work scholars. (Articlesbase, 2008)

4.2.2 Benefits of ABC

During the late 1980s ABC appeared first in the academic literature. In 1990s it had reached the professional accountancy journals and at that time has already being use by a lot of company with progressive attitudes. (Pauline Weetman, 1996) The main benefit if introduce ABC into Jessup is the company will have greater understanding of product or customer profitability. (Valuebasedmanagement, 2010) With ABC, Jessup ltd might be control or manage costs with manages activities which become their basis by monitoring a sum key performance measure. (CAT-ACCA resources, 2010) Beside that ABC also can help the Jessup manager to analyze the cost. (Valuebasedmanagement, 2010) On other hand, ABC also can help the company to identification things that not giving extra value then forgone it. Whereas the system is also particularly with the performance management of departments employ the majority of human resources in the contemporary enterprise system. However this process also will allow Jessup ltd to implement priced strategies across another firm diagonal as business processes, channels supply networks and appreciation efficiently and optimum analyzed in this process. (Scribd, 2010) Lastly through ABC, accountants can now promote the future of the organization, not just in the last report.(UOS, 2008)

4.2.3 Problem of ABC

On above have showed the benefit of ABC but there are also have some problem of ABC. If Jessup ltd introduces ABC into company they will face the identifying of cost driver. The cost driver is not an easy task. Beside that overhead usual to a few cost pools which still need arbitrary method to apportion the costs. For example rent, rates and building depreciation. (CAT-ACCA resources, 2010) Although that, the implementation cost and time involved in data collection and obtain relevant apportion the costs. (UOS, 2008) On the other hand ongoing ABC system can be expensive when maintaining it. (Qfinance, 2010) Some manager will not approve to use the system because the system is very transparent and they want to keep several things out of the view of the owners of the company. (Scribd, 2010)

According to Al -Omiri (2007) survey conducted in UK show that has 50% of organizations are using ABC system however another 50% of organizations are using traditional absorption costing system and other system. Based on the above survey, we can conclude that Jessup ltd is good to apply on ABC system because 50% of UK Company is applied.

5.0 Conclusion

Lastly this report will give board of directors much recognition in source of finance and investment appraisal. In sources of finance company if want to invest in debt, company have to consider the impact of gearing and other factors such as duration of borrowings and any restrictive covenants. However in investment appraisal all technique can be precious because all of it explains difference uses. In additional, a company pay too much of debt the dividend will decrease. So Lakes plc not just wants to consider on investment and financing decision, it also need to consider on dividend policy. Finally my advice is negotiating for Lakes plc financial needs remember that self-confidence and realisms will play an important part.