Relevant Irrelevent And Sunk Costs Accounting Essay

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Relevant cost:

The relevant costs and benefits required for decision-making are only those that will be affected by the decision. Costs and benefits that are independent of a decision are obviously not relevant and need not be considered when making that decision. The relevant financial inputs for decision-making purposes are therefore future cash lows, which will differ between the various alternatives being considered.

Irrelevent cost:

As with relevant costs, irrelevant costs may be irrelevant for some situations but relevant for others. Examples of irrelevant costs are fixed overheads, notional costs, sunk costs and book values.

Sunk Costs:

Sunk costs are costs that were incurred in the past. Committed costs are costs that will occur in the future, but that cannot be changed. As a practical matter, sunk costs and committed costs are equivalent with respect to their decision-relevance; neither is relevant with respect to any decision, because neither can be changed. Sometimes, accountants use the term "sunk costs" to encompass committed costs as well.

You can see that different approaches can be used for presenting relevant cost and revenue information. Cost information can be presented that includes The Caledonian Company is a manufacturer of clothing that sells its output directly to clothing retailers. One of its departments manufactures jumpers. The department has a production capacity of 50 000 jumpers per month. Because of the liquidation of one of its major customers the company has excess capacity. For the next quarter current monthly production and sales volume is expected to be 35 000 jumpers at a selling price of £40 per jumper. Expected costs and revenues for the next month at an activity level of 35 000 jumpers are as follow:

Caledonian is expecting an upsurge in demand and considers that the excess capacity is temporary. A company in the leisure industry has offered to buy for its staff 3000 jumpers each month for the next three months at a price of £20 per jumper. The company would collect the jumpers from Caledonian's factory and thus no marketing and distribution costs will be incurred. No subsequent sales to this customer are anticipated. The company would require its company logo inserting on the jumper and Caledonian has predicted that this will cost £1 per jumper. Should Caledonian accept the offer from the company?

(£) (£)

Direct labour 420 000 12

Direct materials 280 000 8

Variable manufacturing overheads 70000 2

Manufacturing non-variable overheads 280000 8

Marketing and distribution costs 105 000 _3

Total costs 1 155 000 33

Sales 1400 000 40

Profit 245 000

Both relevant and irrelevant costs and revenues for all alternatives under consideration. If this approach is adopted the same amount for the irrelevant items (i.e. those items that remain unchanged as a result of the decision which are direct labor, manufacturing non-variable overheads and the marketing and distribution costs in our example) are included for all alternatives, thus making them irrelevant to the decision.-This information is presented in columns (1) and (2). Alternatively, you can present cost information in columns (1) and (2) that excludes the irrelevant costs and revenues because they are identical for both alternatives. A third alternative is to present only the relevant (differential) costs. This approach is shown in column (3). Note that column (3) represents the difference between columns (1) and (2). All of the methods show that the company is better of by £27 000 per month if the order is accepted.

Four important factors must be considered before recommending acceptance of the order. Most of these relate to the assumption that there are no long-run implications from accepting the offer at a selling price of £20 per jumper. First, it is assumed that the future selling price will not be affected by selling some of the output at a price below the going market price. If this assumption is incorrect then competitors may engage in similar practices of reducing their selling prices in an attempt to unload spare capacity. This may lead to a fall in the market price, which in turn would lead to a fall in profits from future sales. The loss of future profits may be greater than the short-term gain obtained from accepting special orders at prices below the existing market price. Given that Caledonian Evaluation of three month order from the company in the leisure industry has found a customer in a different market from its normal market it is unlikely that the market price would be affected. However, if the customer had been within Caledonian's normal retail market there would be a real danger that the market price would be affected. Secondly, the decision to accept the order prevents the company from accepting other orders that may be

(1) (2) (3)

Do not Accept order Diference

accept order (relevant costs)

(£ per month) (£ per month) (£ per month)

Direct labour 420 000 420 000

Direct materials 280 000 304 000 24000

Variable manufacturing overheads 70000 76000 6000

Manufacturing non-variable overheads 280 000 280 000

Inserting company logo 3 000 3000

Marketing and distribution costs 105 000 105 000

Total costs 1 155 000 1 188 000 33 000

Sales 1400 000 1460 000 60000

Profit per month 245 000 272 000 27 000

obtained during the period at the going price. In other words, it is assumed that no better opportunities will present themselves during the period. Thirdly, it is assumed that the company has unused resources that have no alternative uses that will yield a contribution to profits in excess of £27 000 per month. Finally, it is assumed that the fixed costs are unavoidable for the period under consideration. In other words, we assume that the direct labour force and the fixed overheads cannot be reduced in the short term, or that they are to be retained for an upsurge in demand, which is expected to occur in the longer term.

It is important that great care is taken in presenting financial information for decision-making. For stock valuation external financial reporting regulations require that the jumpers must be valued at their manufacturing cost of £30. Using this cost would lead to the incorrect decision being taken. For decision-making purposes only future costs that will be relevant to the decision should be included. Costs that have been computed for meeting stock valuation requirements must not therefore be used for decision-making purposes.

When you are trying to establish which costs are relevant to a particular decision you may find that some costs will be relevant in one situation but irrelevant in another. In Example 4.1 we assumed mat direct labour was-not a relevant cost. The company wishes to retain the direct labour for an expected upsurge in demand and therefore the direct labour cost will be same whether or not the offer is accepted. Alternatively, Caledonian may have had an agreement with its workforce that entitled them to at least three months notice in the event of any redundancies. Therefore, even if Caledonian was not expecting an upsurge in demand direct labour would have been a fixed cost within the three month time horizon.

But now let us consider what the relevant cost would be if direct labour consisted of casual labour who are hired on a daily basis. In this situation direct labour will be a relevant cost, since the labour costs will not be incurred if the order is not accepted.

The identification of relevant costs depends on the circumstances. In one situation a cost may be relevant, but in another the same cost may not be relevant. It is not therefore possible to provide a list of costs that would be relevant in particular situations. In each situation you should follow the principle that the relevant costs are future costs that differ among alternatives. The important question to ask when determining the relevant cost is: What difference will it make? The accountant must be aware of all the issues relating to a decision and ascertain full details of the changes that will result, and then proceed to select the relevant financial information to present to management.