Decision making - relevant costs
| by Ian Herbert
01 Sep 1998
In this article Ian Herbert looks at the use of relevant costs in management decision making. The objective of this article is to help you to understand:
A key feature of management accounting is its focus on the future. Decision making should only consider what will change as a result of implementing a decision, nothing else. In this respect there are a number of ways in which we can view costs.
It seems strange that a cost can be anything other than a charge to the organisation that results in a sum of money leaving the bank account. However, if you think about charges such as, depreciation, or a provision for doubtful debts, then these are examples of non-cash costs which help us to evaluate performance over a particular time period more easily. As we shall see, such costs are irrelevant to decision making. Relevant costs translate into future cash flows.
The difference in total cost between alternatives, calculated to assist in decision making. *
These are also referred to as incremental costs, usually when a choice exists between maintaining the status quo or taking some positive action. For example, introducing a bonus system, will entail additional costs but, through better performance, should eventually result in an incremental cash inflow. The Barkington Hospital illustration below, is a good example of differential costs occurring between two alternatives.
The value of benefit sacrificed when one course of action is chosen, in preference to an alternative. The opportunity cost is represented by the foregone potential benefit from the best rejected course of action.*
Consider the following example:
Note: In scenario (b) the benefit of £10,000 is not shown in the calculation, as rent will now be received in both options: we are only interested in the relative difference between alternatives.
A past cost not directly relevant in decision making. *
The work should now be done in-house as the incremental cash outflow is less than the money that would be paid to the contractor. Of course, when the Hospital prepares its financial accounts, the cost of labour and materials will be stated as £25,000. However, for the purpose of making a decision about the future the £4,000 already incurred for materials is a sunk cost and is therefore not relevant to the decision.
In short term decision making, fixed costs are generally regarded as sunk costs.
The specific costs of an activity or sector of a business which would be avoided if that activity or sector did not exist.*
If a factory decides to save money, say by closing a part of the production facilities, it is necessary to examine each cost element in terms of whether that cost can be avoided or not. In the long term, all costs are ultimately avoidable, but in the short term, many costs are not. For example, closing a part of the factory might avoid the cost of heating, lighting and cleaning, although in the short term rent, property taxes, security and maintenance costs would presumably still be incurred.
These costs are similar to sunk costs in that they exist as a result of previous decisions although the 'charge' has yet to be incurred or the cash released.
The UK government recently changed the specification of the millennium exhibition dome at Greenwich, London. In doing so they had to pay around £500,000 in compensation to the contracted suppliers, as the new material is to come from a different firm. The decision apparently made financial sense, as the new material will make a permanent and not a temporary facility. The national newspapers however, printed many stories on the theme of government incompetence resulting in the wastage of public resources.
Notional costs are intended to make internal decision making more realistic by assuming that the cost of all resources consumed reflects the full economic value - usually by applying market prices. Notional charges are typically used to charge responsibility centres with a 'market rent', where buildings have been purchased on a freehold basis. Such a mechanism helps to focus management attention on making best use of space so that surplus space across the whole organisation might then be sold or rented to another user. Notional interest is often charged for the use of internally generated funds.
So far, our recommendations to management have been made solely on the basis of financial analysis. In practice, there are usually many other factors, of a qualitative nature, that have to be considered. For example, Barkington Hospital needs to consider the following:
* CIMA Terminology of Management Accounting
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