Relevant Costing and Short-term Decisions
Decision Making
Relevant Costing and Short-term Decisions
Syllabus tag: KASNEB CPA | Intermediate Level | CA25 Management Accounting | Topic 7 Relevant Costing and Short-term Decisions
Lesson objectives
By the end of this topic, you will be able to:
- Apply the three tests that make a cost relevant
- Value materials and labour correctly under different circumstances
- Evaluate a special order, a make-or-buy decision and a shutdown decision
- Rank products by contribution per unit of the limiting factor
- Identify the qualitative factors a numerical answer leaves out
Why this matters
Absorption costing gives a full cost per unit. That full cost is the wrong number for almost every short-term decision, because it contains costs that will not change whatever is decided. This topic supplies the right number.
The three tests
A cost is relevant only if it is:
- Future — past costs are gone whatever is decided
- Incremental — it changes as a result of the decision
- Cash — depreciation and apportioned overhead are not cash flows
Fail any one and the cost is ignored. Two consequences follow immediately:
Sunk costs are irrelevant. KES 400,000 already spent on market research does not appear in the decision, however painful that feels.
Committed costs are irrelevant. A signed lease that cannot be cancelled costs the same under every option.
Opportunity cost is relevant, even though no invoice exists for it. What is given up by choosing one course over another is a real cost of that choice.
Valuing materials
The right value depends on what would otherwise happen to the material.
| Circumstance | Relevant cost |
|---|---|
| Not in stock | Purchase price |
| In stock, in regular use | Replacement cost |
| In stock, no other use, could be sold | Resale value |
| In stock, no other use, no resale value | Nil |
Material held with no alternative use and a resale value of KES 180,000 is valued at 180,000, not at what it originally cost. If the same material were in regular use, the relevant figure would be its replacement cost of 260,000, because using it here means buying more.
Valuing labour
| Circumstance | Relevant cost |
|---|---|
| Spare capacity, staff already paid | Nil |
| Extra staff hired | The wage paid |
| Full capacity, work diverted | Wage plus contribution forgone |
Take 900 hours diverted from other work that earns KES 340 of contribution per hour, with a wage of KES 400:
Relevant cost = (900 × 400) + (900 × 340) = 360,000 + 306,000 = KES 666,000
The contribution forgone is the opportunity cost, and leaving it out is the commonest error in this topic.
:::checkpoint A manager says labour is free for this order because the staff are on salary and idle this month. Under what circumstance is that correct, and under what circumstance is it badly wrong? :::
Special orders
A customer offers to buy 2,000 units at KES 620 against a normal price of 900. Variable cost is KES 500 and there is spare capacity.
Contribution per unit = 620 − 500 = KES 120 Total contribution = 2,000 × 120 = KES 240,000
Accept. Fixed costs do not change, so the whole 240,000 is extra profit.
The absorption cost of 620 would have suggested the order merely breaks even. That comparison is wrong, because it charges the order with fixed costs that would be incurred anyway.
Three cautions the arithmetic does not show: whether existing customers will learn of the lower price, whether the capacity is genuinely spare, and whether the customer will expect 620 next time.
Make or buy
A component costs KES 480 to make in variable cost and can be bought for 560. Making it also requires KES 300,000 of fixed costs that would be avoided if bought in.
Saving per unit = 560 − 480 = KES 80 On 9,000 units = KES 720,000 Less avoidable fixed costs = (300,000) Net benefit of making = KES 420,000
Only the avoidable fixed costs enter. Apportioned head office overhead continues whichever way the decision goes and is therefore irrelevant.
Limiting factors
When one resource is scarce, rank by contribution per unit of that resource, not per unit of product.
| Product A | Product B | |
|---|---|---|
| Contribution per unit | KES 300 | KES 420 |
| Machine hours per unit | 3 | 6 |
| Contribution per machine hour | KES 100 | KES 70 |
B earns more per unit and A earns more per scarce hour. With machine time the constraint, make A first. Ranking by contribution per unit would give exactly the wrong answer.
Shutdown decisions
A division earns contribution of KES 1,800,000 against avoidable fixed costs of KES 1,200,000.
Net benefit of continuing = KES 600,000
Keep it open. Apportioned central overhead does not disappear if the division closes — it is simply reallocated to the divisions that remain, which is why a division can look unprofitable on a full-cost statement and still be worth keeping.
:::checkpoint A division shows a loss of KES 400,000 after being charged KES 900,000 of apportioned head office costs. Should it close? Show the calculation and state the assumption you are making. :::