Dr. Varadraj Bapat, IIT Mumbai1 Module 13. Relevant Costs in Decision Making

Dr. Varadraj Bapat, IIT Mumbai2 Decision Making Introduction Introduction Relevant Vs. Sunk cost Relevant Vs. Sunk cost Make or Buy decision making Make or Buy decision making Shutdown Cost Shutdown Cost Joint Product Joint Product Joint Product Cost Allocation Joint Product Cost Allocation Introduction of new product Introduction of new product

Dr. Varadraj Bapat, IIT Mumbai3 Relevant Cost Cost which are relevant for a particular business decision. They are not historical cost but future costs to be associated with different inputs and activities related a particular business decision.

Dr. Varadraj Bapat, IIT Mumbai4 Relevant cost is expected future cost which differs for alternative course. Usually variable costs are relevant while fixed cost are non-relevant. Ex. Make or Buy, Special Pricing Relevant Cost

Dr. Varadraj Bapat, IIT Mumbai5 However, It is not essential that all variable cost are relevant and all fixed cost are irrelevant. Fixed or variable costs that differ for various alternatives are relevant costs. Relevant Cost

Dr. Varadraj Bapat, IIT Mumbai6 Relevant costs draw our alternation to those elements of cost which are relevant for decision. e.g. 1) Fixed Cost for project X is Rs. 5 lakhs and for alternative project Y it is 7 lakhs. therefore fixed cost is relevant in this example.

Dr. Varadraj Bapat, IIT Mumbai7 E.g. 2) Direct material under alternative I- Rs. 150 per Kg. Direct material under alternative II- Rs. 150 per Kg. therefore variable cost is not relevant in this example.

Dr. Varadraj Bapat, IIT Mumbai8 SUNK COSTS Sunk costs are all costs incurred or committed in the past that cannot be changed by any decision made now or in the future. Sunk costs should not be considered in decisions.

Dr. Varadraj Bapat, IIT Mumbai9 SUNK COSTS E.g. cost incurred on research of a product will be irrelevant while making decision whether to undertake production or not.

Dr. Varadraj Bapat, IIT Mumbai10 Sunk Cost Sunk costs have been incurred and cannot be reversed. Historical costs are sunk costs. They play no role in decision making in the current period.

Dr. Varadraj Bapat, IIT Mumbai11 Sunk Cost do not affect future costs and cannot be changed by any current or future action, hence these costs are irrelevant in decision making. Ex. Spending on advertising during product launching is sunk for taking a decision on continuance of product

Dr. Varadraj Bapat, IIT Mumbai 12 Make / Buy Very often make-or-buy decision is the act of making a tactical choice between producing an item internally and buying it from an outside supplier.

Dr. Varadraj Bapat, IIT Mumbai 13 Make / Buy Under such circumstances two factors are to be considered: whether surplus capacity is available and whether surplus capacity is available and the marginal cost. the marginal cost.

Dr. Varadraj Bapat, IIT Mumbai 14 Elements of the analysis include: Elements of the "make“ analysis include:  Incremental inventory-carrying costs  Direct labor costs  Incremental factory overhead costs  Delivered purchased material costs

Dr. Varadraj Bapat, IIT Mumbai 15  Incremental managerial costs  Any follow-on costs stemming from quality and related problems  Incremental purchasing costs  Incremental capital costs  Ms. Keshav  Ms. Keshav (Case)

Dr. Varadraj Bapat, IIT Mumbai 16 Cost considerations for the "buy" analysis include: Purchase price of the part Purchase price of the part Transportation costs Transportation costs Receiving and inspection costs Receiving and inspection costs Incremental purchasing costs Incremental purchasing costs Any follow-on costs related to quality or service Any follow-on costs related to quality or service

Dr. Varadraj Bapat, IIT Mumbai17 Shutdown Cost Some times it becomes necessary for a company to temporarily close down the factory or unit because of trade downturn with view to reopening it in the future. In this situation decisions are based on the variable cost analysis.

Dr. Varadraj Bapat, IIT Mumbai18 If selling price is above the variable cost then it better to continue because the losses are minimized. By closing the manufacturing activity, some extra fixed expenses (e.g. Security) may be incurred and certain fixed expenses can be avoided (e.g. maintenance cost of plant). Such costs are also relevant. Shutdown Cost

Dr. Varadraj Bapat, IIT Mumbai19 T he decision is based on as to whether the contribution is more than the difference between fixed expenses incurred in normal operation and the fixed expenses incurred when the plant is shut down.

Dr. Varadraj Bapat, IIT Mumbai 20 Introducing new Product There are two reasons why a commercial enterprise should undertake the time, effort, and expense of introducing a new product or service: (1) customers have shown interest

Dr. Varadraj Bapat, IIT Mumbai 21 (2) demand is sufficient and sustainable enough for the proposed product to make a profit. In other words, successful enterprises sell what customers want to buy rather than what the entrepreneur wants to sell.

Dr. Varadraj Bapat, IIT Mumbai 22 All relevant costs should be recovered over a period of product life. Introducing new Product

Dr. Varadraj Bapat, IIT Mumbai23 Joint Product When two or more products of equivalent importance are produced simultaneously, they are termed as joint products.

Dr. Varadraj Bapat, IIT Mumbai24 Joint Product In other words two or more products separated in course of the same processing operation, each product being in such proportion that no single product can be designated as a major product.

Dr. Varadraj Bapat, IIT Mumbai25 Joint Products usually require further processing.

Dr. Varadraj Bapat, IIT Mumbai26 Joint Products. in Coke production, Coal is raw material with Coke, Sulfate of ammonia, light oil asjoint products. in Coke production, Coal is raw material with Coke, Sulfate of ammonia, light oil asjoint products.

Dr. Varadraj Bapat, IIT Mumbai 27 E.g. Refining Process, where crude oil is raw material gives Petrol, Diesel, Gas as Joint Products.

Dr. Varadraj Bapat, IIT Mumbai 28 Separate Processing Costs Final Sale Separate Processing Final Sale Separate Processing Separate Processing Costs Crude Oil Joint Production Process Split-Off Point Joint Costs Petrol Diesel Joint Product Cost Allocation Separate Processing Costs

Dr. Varadraj Bapat, IIT Mumbai29 By Product By Product is product of relatively small total value that is produced with a product of greater total value. The product with the greater value (Main product), is usually produced in greater quantities than the By Product. By Product is product of relatively small total value that is produced simultaneously with a product of greater total value. The product with the greater value (Main product), is usually produced in greater quantities than the By Product.

Dr. Varadraj Bapat, IIT Mumbai30 By Product In other words, when two or more products are separated in course of the same processing operation, where one of the products being in such proportion/ value that it can be designated as a Main product, while others are considered as By Products. In other words, when two or more products are separated in course of the same processing operation, where one of the products being in such proportion/ value that it can be designated as a Main product, while others are considered as By Products.

Dr. Varadraj Bapat, IIT Mumbai31 By Product ex. of ex. of By-products in coke manufacture - gas and tar in lumber mills - sawdust. cotton cleaning process - cotton seed coconut oil industry - coca shells

Dr. Varadraj Bapat, IIT Mumbai32 Terminology Joint Product Process: A process that results in production of two or more products, which are termed as joint products.

Dr. Varadraj Bapat, IIT Mumbai33 Terminology Joint product cost: The cost of the raw materials/input and the joint production process.

Dr. Varadraj Bapat, IIT Mumbai34 Split Off Point: The point in the production process where the individual products become separately identifiable.

Dr. Varadraj Bapat, IIT Mumbai35 Joint Cost : Methods Joint Cost Allocation: Methods Physical units method Physical units method Relative Sales Value Method Relative Sales Value Method Sale value at split off point Sale value at split off point Net Realisable value method Net Realisable value method

Dr. Varadraj Bapat, IIT Mumbai36 Allocating Joint Costs Allocation based on the sales values /relative sales values of the products at the split-off point. Allocation based on a physical measure of the product produced eg Weight Sales Value/ Relative Sales Value Method Physical Units Method

Dr. Varadraj Bapat, IIT Mumbai37 Allocation is based on estimated sales value at split off point Net- Realizable- Value Method Constant Gross Margin method Allocation based on sales value less post-separation processing costs