AHMAD IZZAT BIN MOHD IDRIS

AP150154
SECTION 2
FOC: INTRODUCTION TO RELEVANT COSTS

Define:
1) Relevant Cost
A relevant cost is a cost that only relates to a specific management decision, and which
will change in the future as a result of that decision. The relevant cost concept is
extremely useful for eliminating extraneous information from a particular decision -
making process. Also, by eliminating irrelevant costs from a decision, management is
prevented from focusing on information that might otherwise incorrectly affect its
decision. This concept is only applicable to management accounting activities; it is is not
used in financial accounting, since no spending decisions are involved in the preparation
of financial statements. For example, the Archaic Book Company (ABC) is considering
purchasing a printing press for its medieval book division. If ABC buys the press, it will
eliminate 10 scribes who have been copying the books by hand. The wages of these
scribes are relevant costs, since they will be eliminated in the future if management buys
the printing press. However, the cost of corporate overhead is not a relevant cost, since it
will not change as a result of this decision.

2) Irrelevant Cost
An irrelevant cost is a cost that will not change as the result of a management decision.
However, the same cost may be relevant to a different management decision.
Consequently, it is important to formally define and document those costs that should be
excluded from consideration when reaching a decision. For example, the salary of
an investor relations officer may be an irrelevant cost if a management decision relates to
issuing a new product, since dealing with investors has nothing to do with that particular
decision. However, if the board of directors is considering taking the company private,
then it may no longer need an investor relations officer; in the latter case, the salary of
the investor relations officer is highly relevant to the decision. As another example, the
rent for a production building is irrelevant to the decision to automate a production line,
as long as the automated equipment is still housed within the same facility.
3) Incremental Cost
Incremental cost are defined as the difference in cost between two alternatives.
Incremental costs are relevant in decision making. In other words, incremental cost is the
extra cost associated with manufacturing one additional unit of production. It can be
useful when formulating the price to charge a customer as part of a one-time deal to sell
additional units. For example, if a company has room for 10 additional units in its
production schedule and the variable cost of those units (that is, their incremental cost) is
a total of $100, then any price charged that exceeds $100 will generate a profit f or the
company.

4) Opportunity Cost
Opportunity cost is profit forgone as a result of taking a given course of action.
Opportunity costs are relevant in decision making. For example, Jane currently earns
$20k per annum (Cost of the Opportunity) and is considering leaving her job to attend a
course to qualify as an accountant. As an accountant she will earn $50k per annum
(Opportunity).
Suggest types of decision making can be made by firm related to relevant cost

Firm can use the make or buy decisions, accepting or declining special contract, setting prices
of products, accept or reject special order, and adding or eliminating products, segments, or
customers.

Make Buy
Per Unit Total Cost for Per Unit Total Cost for
(RM) 15,000 units (RM) 15,000 units
(RM) (RM)
Purchase - - 20 300,000
Direct Material 6 90,000 0 0
Direct Labour 8 120,000 0 0
Variable 1 15,000 0 0
Manufacturing
Overhead
Supervisory salaries *5 30,000 0
(40%) (75,000x40%)
Fixed Manufacturing 0 0 0
Overhead, common
but allocated
Total 17 255,000 20 300,000

To conclude, XYZ company should reject the outside’s offer because the total cost making by
own is lower if compared to the total cost if purchase from outside.