Welcome to Relevance in Short-Term Decision Making!
Hello there! Welcome to one of the most practical and "real-world" chapters in your CIMA P1 journey. Have you ever had to decide whether to fix an old car or buy a new one? Or maybe you’ve wondered if you should accept a last-minute freelance job? If so, you’ve already practiced the basics of Relevant Costing!
In this chapter, we are going to learn how management accountants filter through piles of data to find only the information that actually matters for a specific decision. This is part of the Short-term commercial decision making section of your syllabus. By the end of these notes, you’ll be able to spot a relevant cost from a mile away!
1. What Exactly is a "Relevant" Cost?
In management accounting, we don't care about every single number. We only care about costs and revenues that will change as a direct result of our decision. Don’t worry if this seems tricky at first; just remember the F.I.C. rule!
For a cost to be relevant, it must meet these three criteria:
• F - Future: It must be a cost that will occur in the future. Past costs don't matter because we can't change the past!
• I - Incremental: It must be an "extra" cost. If you would pay the cost regardless of your decision, it isn't relevant.
• C - Cash Flow: It must be an actual cash movement. Accounting entries like depreciation are not relevant because no physical cash leaves the bank.
Quick Review: If a cost is not Future, Incremental, AND a Cash Flow, you should ignore it when making your decision.
2. The "Ignore List": Irrelevant Costs
To succeed in your exams, you need to be a "cost detective." You must identify and ignore Irrelevant Costs. These are "red herrings" designed to distract you.
Sunk Costs
A Sunk Cost is money that has already been spent. It’s gone! Whether you choose Option A or Option B, you can't get that money back.
Example: You spent \( \$5,000 \) on a marketing study last month to see if a new product would sell. Whether you launch the product or not, that \( \$5,000 \) is gone. It is irrelevant.
Committed Costs
These are costs that we are legally bound to pay in the future, regardless of the decision we make today.
Example: You signed a 5-year lease for a warehouse. Even if you decide to stop production today, you still have to pay the rent. The rent is a committed cost and is irrelevant to the decision of whether to stop production.
Non-Cash Items
The most common one is Depreciation. Depreciation is just an accounting way of spreading the cost of an asset over time. It isn't a cash payment, so we always ignore it in relevant costing.
3. Opportunity Costs: The "Road Not Taken"
This is a concept that often trips students up, but it’s actually very simple. An Opportunity Cost is the benefit you give up by choosing one option over another.
Analogy: Imagine you have one free hour tonight. You can either work a part-time shift for \( \$20 \) or go to the cinema. If you choose to go to the cinema, the Opportunity Cost is the \( \$20 \) you didn't earn. Even though you didn't "pay" \( \$20 \) to the cinema, you are still "down" by \( \$20 \) compared to your other option.
Key Formula:
\( \text{Relevant Cost} = \text{Specific Out-of-Pocket Cash Costs} + \text{Opportunity Costs} \)
4. Relevant Cost of Materials
When a project needs materials, how do we price them? We use a "logical path" to decide. Ask yourself these questions in order:
Step 1: Do we already have the materials in stock?
• No: Then the relevant cost is the current purchase price (the cost to buy them now).
• Yes: Go to Step 2.
Step 2: Are the materials used regularly by the business?
• Yes: If we use them for this project, we will have to buy more to replace them for our regular work. So, the relevant cost is the replacement cost.
• No: Go to Step 3.
Step 3: If we don't use them for this project, what would we do with them?
• Option A: Sell them as scrap? Then the relevant cost is the scrap value (what we lose by not selling them).
• Option B: Use them for something else? Then the relevant cost is the value they would have created elsewhere.
Takeaway: We always pick the highest benefit we are giving up!
5. Relevant Cost of Labour
Labor is similar to materials. We need to see if the business has "spare capacity" (people sitting around with nothing to do) or if they are "at full capacity" (busy working on other things).
Case 1: Spare Capacity
If you have employees who are already being paid but have no work to do, the relevant cost of using them on a new project is Zero (\( \$0 \)). Why? Because you are paying them anyway! No incremental cash is leaving the business.
Case 2: No Spare Capacity (Full Capacity)
If your workers are busy, you have two choices:
1. Hire new temporary staff: The relevant cost is the incremental cost of the new staff.
2. Move workers from an existing project: This is where it gets interesting! The relevant cost is:
\( \text{Direct Labour Cost} + \text{Lost Contribution from the other project} \)
Did you know? This "Lost Contribution" is an opportunity cost. You are losing the profit that the worker would have made on their original job.
6. Common Mistakes to Avoid
• Including Interest: Usually, interest is handled at a higher level of finance. In P1 short-term decisions, we generally treat interest as irrelevant unless specifically told otherwise.
• Using Book Value: The "Book Value" (the value in the accounts) of an old machine is irrelevant. Only the current resale value (what you could sell it for today) matters.
• Forgetting "Avoidable" Costs: If a cost disappears because you stop a project, that saving is relevant!
Summary: The Golden Rules
1. Only look forward (Future).
2. Only look at what changes (Incremental).
3. Only look at the bank account (Cash Flow).
4. Always include the "benefit foregone" (Opportunity Cost).
5. Ignore sunk costs, depreciation, and general fixed overheads that don't change.
Don't worry if you find the labor and material logic paths a bit fast—try drawing them out as a flowchart! Once you see the "logic" of why we use replacement cost or scrap value, it becomes much easier to remember.