Relevant costing - TONTUF Money

1. Concept of Relevant Costing

Relevant Costing:

• Definition: Relevant costing is a decision-making approach that focuses on costs that will be directly affected by a specific decision. These are costs that will be incurred or avoided as a result of making the decision.
• Purpose: To provide a clear basis for decision-making by considering only the costs that will change as a result of the decision, ignoring sunk costs and other non-relevant costs.

2. Identifying and Calculating Relevant Costs

Relevant Costs:

• Definition: Costs that will be directly impacted by a specific decision. These typically include:
  • Variable Costs: Costs that vary directly with the level of production or activity (e.g., raw materials, direct labor).
  • Avoidable Fixed Costs: Fixed costs that can be eliminated if a particular decision is made (e.g., rent for a specific production facility that would be closed).

Calculation Example:

• Suppose a company needs to decide whether to accept a special order. Relevant costs might include:
  • Additional direct materials and labor required for the special order.
  • Additional overheads directly associated with the special order.
  • Exclude fixed costs that will remain unchanged regardless of the decision.

3. Concept of Opportunity Costs

Opportunity Costs:

• Definition: The benefit that is foregone by choosing one alternative over another. It represents the value of the next best alternative that is not chosen.
• Application: Consider the opportunity cost when evaluating different decision options. For example, if a company chooses to use a resource for one project, the opportunity cost is the benefit that could have been gained from using that resource for another project.

4. Issues Surrounding Make-or-Buy and Outsourcing Decisions

Make-or-Buy Decision:

• Definition: A decision to either produce a product in-house or purchase it from an external supplier.
• Issues:
  • Cost Comparison: Evaluate the total cost of producing in-house versus buying, including direct and indirect costs.
  • Quality Control: Assess the quality of the product from external suppliers compared to in-house production.
  • Capacity and Expertise: Consider whether the company has the capacity and expertise to produce the product effectively.
  • Flexibility and Reliability: Evaluate the flexibility and reliability of suppliers versus in-house production capabilities.

5. Calculating and Comparing “Make” Costs with “Buy-In” Costs

Make Costs:

• Definition: Costs incurred to produce the product internally, including direct materials, direct labor, and allocated overheads.
• Calculation: Sum all these costs to determine the total cost of making the product.

Buy-In Costs:

• Definition: Costs to purchase the product from an external supplier, including the purchase price and any additional costs such as shipping, handling, and potential quality inspection costs.
• Calculation: Sum all these costs to determine the total cost of buying the product.

Comparison:

• Compare the total make costs with the total buy-in costs to determine which option is more cost-effective.

6. Comparing In-House Costs and Outsource Costs

In-House Costs:

• Include all direct and indirect costs related to producing the product or performing the task internally.

Outsource Costs:

• Include all costs associated with outsourcing, such as the price charged by the external provider, along with any additional costs like transition, oversight, or quality control.

Other Issues:

• Strategic Fit: Whether outsourcing aligns with the company's strategic goals.
• Control and Confidentiality: The level of control and confidentiality over the process and product.
• Long-Term Implications: Potential long-term impacts on business operations, supplier relationships, and employee morale.

7. Applying Relevant Costing Principles

Shutdown Decisions:

• Relevant Costs: Include avoidable fixed costs and any additional costs or savings from shutting down a part of the operation. Exclude sunk costs.

One-Off Contracts:

• Relevant Costs: Include additional costs directly attributable to the one-off contract. Compare these with the revenue from the contract to assess profitability.

Further Processing of Joint Products:

• Relevant Costs: Evaluate the additional costs required to further process joint products and compare these with the additional revenue generated to determine if further processing is worthwhile.

By applying relevant costing principles, you can make informed decisions that focus on costs directly impacted by your choices, ensuring that you address the most pertinent financial aspects of each decision. If you need more specific examples or calculations, just let me know!