Relevant Costing

What’s it all about?

A technique you can use to simplify decision making when setting selling prices/considering alternative options that takes out all the complication of things that are not going to change anyway.

Key to deciding what cost to use in Relevant Costing

Key to deciding what cost to use in Relevant Costing

Further Reading.

Committed costs – a category of sunk cost where you will continue to pay (in the future) even after you make the decision to not continue.

Relevant Costing – Committed Costs

I usually give the example of the sacked football manager whose contract still needs to be paid even after he (its always he) has been replaced as an example of committed costs. That is, costs you pay in the future but that arise from past decisions. These are therefore irrelevant in decision making as they don’t meet the criteria to be relevant – a future cost/income arising from the change in decision.

Here the £5 pay-off arises from the decision to employ Van Gall in the first place. The next 12 months salary was unavoidable as it was part of the original contract and therefore should not have been considered in the decision to replace the manager.

An interesting article anyway for examples of poor management of a once huge football club, but our main management accounting point from this – the committed cost of paying for a contract even if you don’t want the employee (therefore their salary is not a relevant cost).

“Managers keep coming and going, too. Steve Evans, whose first home game against Blackburn Rovers is on Thursday, is the sixth in 18 months and the payouts due to the dismissed keep mounting. Cellino is thought to be the only owner in British professional football to be paying, or paying off, four managers concurrently (Evans, Redfearn, Uwe Rosler – dismissed last week – and Darko Milanic.) “

But four salaries of sacked managers!!

This article discusses the argument over whether it is better (in cost terms) to keep prisoner in jail or parole them (and invest in other ways of stopping them from reoffending).

The issue is what was the true Marginal Cost of keeping someone in prison. The article rightly draws the distinction between the costs that would change and those that wouldn’t. A full discussion would include the costs of alternative treatments other than prison.

The difference between the marginal $12 rate and the $91 fixed cost rate for the Greensboro jail is that, if 10 or 20 people are removed from jail, those fixed costs don’t change.  The jail still has to be heated, the electric bill paid and the facility must be staffed with guards, nurses and janitors.  Also, the same debt has to be paid on the $92-million Greensboro jail whether that jail is full or empty.

But other costs such as food, provisions and medical services do go up or down depending on the number of inmates being held – so Guilford County does save some money each time an inmate is allowed to await trial at home.

According to Kittelson, the marginal cost of housing an inmate in the Greensboro jail is $12.54 a day, while the cost at the High Point jail per inmate per day is $17.23.  That’s still a savings on each inmate out of jail, but it’s much less than the $73 a day the county has generally used for those calculations.

Watch this.

Another introductory video if you need it…

Possible Written Questions.

(No indication of marks – the more marks a question gets, the more you are expected to write – detail that is, not just words!) If you can’t answer these, you need to do some more reading. I do ‘find’ questions elsewhere, so these aren’t all questions I have used myself.

There is a lot of similarity in written qeustions on this topic. That’ll help you focus.

Explain the differences between Relevant and Irrelevant costs (and revenues).

Explain in which circumstances it would be appropriate to use Relevant costing.

Describe the different treatments of costs for materials in Relevant Costing.

Define the term ‘relevant cost’ and give examples of both relevant and non-relevant (irrelevant) costs.

Discuss the limitations of using Relevant Costing in preparing costs to charge customers.

Explain why Relevant Costing should not be used in all pricing decisions.

Explain the terms Relevant Cost and Irrelevant cost.

Explain the concept of Opportunity Cost.

Your manager has been reading about Relevant Costing and how this allows a company to lower its costs. She thinks that the company should adopt Relevant Costing. Write a memo explaining the circumstances in which Relevant Costing would be an appropriate costing method.

Comment on the use of Relevant Costing to prepare quotations for jobs.

Discuss when it would be appropriate for a company to adopt a Relevant Costing approach.

Discuss the limitations of using Relevant costing when calculating unit costs.

What determines the treatment of materials costs under Relevant Costing?

 What determines the treatment of labour costs under Relevant Costing?