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RELEVANT COSTING Relevant Cost: a Cost That Differs Between

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RELEVANT COSTING Relevant Cost: a Cost That Differs Between RELEVANT COSTING Relevant cost: A cost that differs between alternatives in a particular decision. This term as synonymous with avoidable cost & differential cost. That is used to describe costs that are specific to management's decisions. The concept of relevant costs eliminates unnecessary data that could complicate the decision- making process. Criteria: 1. Cost or expense attributable or chargeable to one or more activities on the basis of benefits received or some other logical relationship. 2. Differential or quantifiable future cost that must be considered in making a particular decision. 3. Relevant cost is a cost that will be incurred in the future. Historical costs are sunk costs which has no relevancy in the decision making. The costs must differ between alternatives. Identifying relevant cost & benefits: only those costs & benefits that differ in total between alternatives are relevant in a decision. If a cost will be the same regardless of the alternative selected, then the decision has no effect on the cost & it can be ignored. Sunk cost: a sunk cost is a cost that has already been incurred & that can not be change by any decision made now or in the future. Since sunk cost cannot be changed by any decision there not differential cost. Therefore they can & should be ignored when making a decision. Sunk costs are always the same, no matter what alternatives are being considered, and they are therefore always irrelevant & should be ignored. Split off point: that point in the manufacturing process where some or all of the joint products can be recognized as individual products. Avoidable cost: a cost that can be eliminated (in whole or in part) by choosing one alternative over another in a decision making situation. This Term is synonymous with relevant cost & differential cost. Opportunity cost: it s the potential benefit that is given up when one alternative is selected over another. It is not usually entered in the accounting records of an organization, but it is a cost that must be explicitly considered in every decision a managers make. Differential cost: Any cost that differs between alternatives in a decision-making situation. This term is synonymous with avoidable cost and relevant cost. TRANSFER PRICING: the price charged when one division or segment provides goods or services to another division or segment of an organization. When the division s are evaluated based on their profit ,return on investment or residual income, a price must be established for such a transfer otherwise , the division that produces the good or services will receive no credit. The price in such a situation is called a transfer price. Negotiated transfer price: a transfer price agreed on between buying & selling division. Negotiated several price have several importance advantages. First, this approach the autonomy of the divisions & is consistent with the spirit of decentralization. Second, the managers of the division are likely to have much better information about the potential cost & benefits of the transfer than others in the company. Range of acceptable transfer prices : the range of transfer prices within which the profits of both the selling division would increase as a result of a transfer. Sub-optimization: an overall level of profitability that is less than a segment or a company is capable of earning. In contrast, sub optimization occurs when managers do not act in the best interest of the overall company or even in the best interest of their own segment. VARIABLE COSTS: Variable costs are costs that vary in total directly and proportionately with changes in the activity level but remain the same per unit at every level of activity. e.g., direct materials and direct labor for a manufacturer, cost of goods sold, sales commission, and freight-out for a merchandiser, and gasoline in airline and trucking companies. FIXED COSTS: Fixed costs are costs that remain the same in total regardless of changes in the activity level. Fixed costs per unit vary inversely with activity: as volume increases, unit cost declines, and vice versa. e.g., depreciation, executive salary, factory rent, utilities expenses. The lowest acceptable transfer price for the selling division: Clearly, the selling division would like for the transfer price to be as high as possible, but how low would the manager of the selling division be willing to go? The answer is that a manager will not agree to a transfer price that is less than his or her “cost.” But what cost? If the manager is rational and fixed costs are unaffected by the decision, then the manager should realize that any transfer price that covers variable cost plus opportunity cost will result in an increase in segment profits. The opportunity cost is the contribution margin that is lost on units that cannot be produced and sold as a result of the transfer. Therefore, the lowest acceptable transfer price as far as the selling division is concerned is: Transfer price ≥ Variable cost per unit+ (Total contribution margin on lost sales/Number of units transferred). When there is idle capacity, there are no lost sales and so the total contribution margin of lost sales is zero. If the selling division has no idle capacity, then the transfer price would have to cover at least the division’s variable cost plus the contribution margin on lost sales .
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