Relevant cost analysis

Introduction to Relevant Cost Analysis

Hello there! Welcome to one of the most practical and exciting parts of the Performance Management (PM) syllabus. In this chapter, we are looking at how managers make decisions. Should we take on a special contract? Should we close a department? Should we make a component or buy it from someone else?

To answer these questions, we don't look at every single cost in the accounts. Instead, we only look at the costs that actually change because of our decision. This is called Relevant Costing. Don't worry if this seems a bit abstract at first; by the end of these notes, you'll be thinking like a pro manager!

The Golden Rule: The FIC Test

For a cost to be considered "relevant" to a decision, it must pass three simple tests. If it doesn't pass all three, we ignore it! You can remember this using the mnemonic FIC.

1. Future: The cost must occur in the future. We cannot change the past, so anything that has already happened is irrelevant.
2. Incremental: The cost must be an extra cost that arises specifically because of the decision. If we would pay the cost anyway (regardless of our choice), it is not relevant.
3. Cash Flow: The cost must be an actual movement of cash. Non-cash items like depreciation are just accounting entries and don't count here.

Quick Review: A relevant cost is a Future, Incremental, Cash flow.

The "Ignore List": Common Irrelevant Costs

In your exam, the examiner will try to distract you with "red herring" costs. Here are the ones you should usually ignore:

• Sunk Costs: These are costs already spent. Example: You spent \$5,000 on a market research report last month. Whether you launch the product now or not, that \$5,000 is gone. It’s "sunk."
• Committed Costs: Costs we are legally bound to pay in the future, regardless of our decision. Example: A non-cancellable lease agreement.
• Depreciation: This is an accounting allocation of cost, not a cash flow.
• Notional Costs: These are "pretend" costs like internal rent charged between departments.
• General Overheads: Unless the overheads increase specifically because of the project, we ignore fixed overheads that are simply "absorbed" or "allocated."

Did you know? The concept of "Sunk Costs" is why people sometimes finish a terrible meal at a restaurant just because they paid for it. In Relevant Costing, we'd say: "The money is gone whether you eat it or not; so only eat it if it brings you future utility!"

Relevant Cost of Materials

Deciding the cost of materials isn't always as simple as looking at the price tag. We use a logical "decision tree" approach:

Step 1: Is the material already in stock?

If NO: The relevant cost is the current purchase price (the cost to go out and buy it now).

Step 2: If it IS in stock, is it used regularly by the business?

If YES: The relevant cost is the replacement cost (because if we use it for this project, we have to buy more for our regular work).

Step 3: If it's in stock but NOT used regularly (it's surplus):

The relevant cost is the higher of:
1. The Net Realisable Value (NRV): What we could sell it for right now.
2. The Value from an alternative use: What we save by using it elsewhere.

Note: If the material is useless and has no scrap value, the relevant cost is Zero.

Relevant Cost of Labour

When calculating the cost of staff time, ask yourself: "What happens if we take them off their normal job?"

• Scenario A: Idle Time. If we have spare staff sitting around being paid anyway, the incremental cost of using them for a new project is Nil.
• Scenario B: Hiring more staff. If we hire new casual workers for the project, the relevant cost is their hourly wage.
• Scenario C: Full Capacity (The trickiest one!). If staff are busy and we move them to a new project, we lose the "Contribution" they were making on their old job.
  \( \text{Relevant Cost} = \text{Variable Cost of Labour} + \text{Opportunity Cost (Contribution Lost)} \)

Analogy: Imagine you have a personal assistant you pay \$20/hour. If they are currently doing nothing, asking them to file papers costs you \$0 extra. If they are currently selling products that make you \$50/hour in profit, and you ask them to file papers instead, that filing just cost you \$50 in lost profit!

The Concept of Opportunity Cost

Opportunity Cost is a vital term in PM. It is the benefit foregone by choosing one alternative over the next best alternative.

For example, if you spend 2 hours studying Performance Management, the opportunity cost is the 2 hours of sleep (or Netflix!) you gave up. In business, if we use a machine for "Project A," the opportunity cost is the profit we could have made using that machine for "Project B."

Relevant Cost of Non-Current Assets

If a project requires the use of an existing machine:

• The original cost is a sunk cost (Irrelevant).
• The depreciation is a non-cash item (Irrelevant).
• The Relevant Cost is usually the deprival value. This is the amount of money the company would lose if it were suddenly deprived of that asset.

Quick Tip: If a question mentions "carrying value" or "book value," ignore it! These are accounting figures, not cash flows.

Common Mistakes to Avoid

1. Including Interest: Usually, interest is handled at the corporate level, not the project level. In PM Relevant Costing, we typically ignore interest unless specifically told otherwise.
2. Forgetting "Avoidable" Costs: If closing a department saves \$1,000 in rent, that \$1,000 is a relevant saving (an inflow).
3. Confusion with Fixed Costs: Remember, "Fixed" doesn't always mean "Irrelevant." If a project requires us to rent a new machine for a fixed fee of \$500, that \$500 is incremental and therefore relevant.

Summary Table

Cost Type | Status | Why?
Sunk Cost | Irrelevant | Already spent in the past.
Committed Cost | Irrelevant | Must pay regardless of decision.
Incremental Cash Flow | Relevant | Extra cash leaving the business.
Opportunity Cost | Relevant | Benefit lost from the next best option.
Depreciation | Irrelevant | Not a cash flow.
Net Realisable Value | Relevant | Potential cash inflow if sold.

Final Encouragement

Relevant costing is all about being logical. Always ask yourself: "If I say 'Yes' to this project, will my bank balance be different tomorrow compared to if I say 'No'?" If the answer is yes, that difference is your relevant cost! Keep practicing the material and labour decision trees, as they are very popular with examiners. You've got this!