Relevant Costs | Relevant Costing Principles | Decision Making | CMA | ACCA | Commerce Specialist |

Summary

This video covers the crucial concept of relevant costing in decision-making, explaining how to focus on relevant costs and ignore irrelevant ones to make better financial choices. The host illustrates the concept with practical examples, such as evaluating material costs for a special job, considering sunk costs, replacement costs, and net realizable value. Key points include the importance of distinguishing between relevant and irrelevant costs, as well as the impact of these decisions on pricing strategies for businesses. The video emphasizes applying relevant costing for more accurate financial decisions in real-world scenarios.

Takeaways

• 😀 Relevant costing is a crucial concept that helps in decision-making by focusing on the costs that directly affect the decision, and ignoring those that don't.
• 😀 Irrelevant costs, like sunk costs (past expenses), should never be included in decision-making as they don’t influence future outcomes.
• 😀 A cost that is common across two options (like rent) is not relevant; only additional or differentiating costs should be considered, such as extra charges for parking.
• 😀 Incremental costs (costs that change with the decision) are always relevant when making a choice, and out-of-pocket costs help quantify these.
• 😀 When faced with decisions, consider the opportunity cost and potential benefits—like whether selling a material is more beneficial than using it for the job.
• 😀 Historical cost, or the price paid in the past for materials, is irrelevant. What matters is the current cost to purchase or replace the material.
• 😀 The net realizable value (NRV) of materials that are overstocked or obsolete can serve as the relevant cost when deciding whether to use or sell them.
• 😀 If a material is in regular use across multiple jobs, the relevant cost is its replacement cost, not the amount currently in stock or its historical cost.
• 😀 Fixed costs that are already allocated (such as head office overheads) are typically irrelevant because they won’t change based on the decision to take on a new job.
• 😀 Applying relevant costing principles can significantly impact profitability, as it helps businesses make more informed, cost-effective decisions, reducing unnecessary costs.

Q & A

What is relevant costing, and why is it important for decision-making?

Relevant costing is a concept used in decision-making that focuses on costs that directly impact a specific decision. It helps eliminate irrelevant costs (such as sunk costs) and ensures that only costs that vary with the decision are considered. Understanding relevant costing helps businesses make more informed, cost-effective decisions.

What are sunk costs, and why are they considered irrelevant in decision-making?

Sunk costs are expenses that have already been incurred and cannot be recovered. Since these costs cannot be altered by future decisions, they are considered irrelevant when making decisions. For example, the initial cost of purchasing a car is irrelevant when deciding whether to replace its tires.

Why is it important to distinguish between relevant and irrelevant costs?

Distinguishing between relevant and irrelevant costs is crucial because it ensures that decision-makers focus on factors that will actually influence the outcome. Including irrelevant costs can lead to confusion and suboptimal decisions.

What is the principle behind the use of the current replacement cost as the relevant cost for regularly used materials?

When a material is in regular use for ongoing operations or other jobs, its relevant cost is the current replacement cost, not the historical cost. This reflects the fact that the material will need to be replaced regardless of its use in a specific decision.

What should be considered the relevant cost when materials are already in stock?

For materials already in stock, the relevant cost is determined by their net realizable value (NRV) or the cost to replace them. If the material can be sold or used elsewhere, the NRV is important. If not, the replacement cost becomes the relevant cost.

What is the decision rule when considering whether to use stock materials or sell them?

When deciding whether to use stock materials in a specific project, the relevant cost is the higher of the net realizable value (NRV) of selling the material or the replacement cost of acquiring new material. This ensures that the decision maximizes value.

Why is the concept of incremental costs important in relevant costing?

Incremental costs refer to the additional costs incurred if a decision is made. These costs are important in relevant costing because they directly impact the financial outcomes of a decision. Only costs that change due to the decision are considered relevant.

What is the difference between fixed overheads that are allocated and those that are specifically related to a job?

Allocated fixed overheads are general expenses that are spread across all projects, regardless of specific jobs. These are considered irrelevant in decision-making. On the other hand, fixed overheads that are directly attributable to a specific job are relevant because they will vary based on whether the job is accepted.

How does the relevant costing method affect pricing decisions for a business?

The relevant costing method helps businesses determine a price that covers their specific costs for a job or project. By focusing on relevant costs, a business can set a price that ensures profitability without overpricing or underpricing, improving decision-making and financial outcomes.

How can understanding relevant costing help in reducing costs or improving profitability?

By understanding relevant costing, businesses can focus on reducing or eliminating unnecessary costs, such as sunk costs and irrelevant fixed overheads. This ensures that only the costs that directly impact the decision are considered, leading to more efficient use of resources and improved profitability.