Hansanod case

1. MANAGERIALACCOUNTING
RELEVANT COSTING AND DECISION MAKING

2. DECISIONS
Under managerial accounting we can simply define decisions as choosing a
course of action from among alternatives.

3. INFORMATION FOR DECISION MAKING
Information required for decision making differs considerably from that used for profit
reporting and inventory valuation.
We can now try and examines the differences between the provision of different types of
information.

4. COSTACCOUNTING VS INFORMATION FOR DECISIONMAKING
Information derived from cost accounting data accumulation systems is misleading for
decision making purposes. Absorption costing is used for profit reporting and inventory
valuation purposes but as it does not separate fixed and variable costs, it does not provide
relevant information for decision making
For one-off decisions or decisions affecting the use of marginal spare capacity, absorption
costing information about unit profits is irrelevant and misleading. On the other hand,
since total contribution must be sufficient to cover the fixed costs of the business,
marginal costing would be unsuitable as a basis for establishing long-term sales prices for
all output.

5. MARGINAL COSTING FOR DECISION MAKING
 As mentioned above, absorption costing is not useful for decision making as it produces misleading
information. Marginal costing is used for decision making purposes as it splits costs clearly into fixed and
variable elements. This distinction is important as fixed costs are not relevant for short-term decision
making.
 Typically, in the short run, fixed costs remain unchanged, which means that the marginal cost, revenue
and contribution of each decision option are relevant.
 When marginal costing is used for short-term decision making, the best option is always the one that
maximises contribution.
 Even if fixed costs do change, the division of costs into their fixed and variable components is still needed
to allow you to identify contribution.

6. COSTS THATVARY WITHACTIVITY LEVELS
 A large proportion of short-term decisions require information about how costs and revenues vary with
activity so that the alternative options of each decision can be evaluated. Here are some examples.
(a) At what level should budgeted output be set?
(b) Should component X be manufactured internally or purchased from a supplier?
(c) Should a one-off special order be accepted?
 For each of these decisions, management require estimates of costs at different levels of activity of the
alternative courses of action. An organization might decide to accept a one-off order without
understanding that the extra work will mean taking on new staff. Fulfilling the order at the agreed price
might therefore result in an overall loss for the organization.

7. RULES
 The relevant cost of material shall include opportunity cost if any. When the availability of raw material is
so limited that it restricts production volume, the opportunity cost is the contribution from next best
alternative production. If the material has no alternative production use, the opportunity cost is its net
disposal value. Other rules for determination of relevant cost are given below:
 lets Consider the material is currently held in stock. The relevant cost of material which is not currently
held in inventory is its purchase cost plus opportunity cost.
If the material required is available in inventory, the next thing we need to look at is whether or not the
material is actively being used for some other purpose.
If yes, the relevant cost is its replacement cost plus opportunity cost. The raw material stock must be restored
to fulfil regular usage needs. Replacement cost is the actual cost to restore the stock level.
If no, the relevant cost of the material is its opportunity cost i.e. the estimated net disposal value.

8. The above rules may be presented in a chart as shown below:
Relevant Cost of Material Flow Chart
Example
Company XD has received an offer to purchase 700 units of Product A at $75 per unit.
Details about material required are as follows:
Material X Y Z
Quantity required per unit 1.0 kg 1.5 kg 0.4 kg
Total quantity available in stock 800 kg 400 kg 100 kg
Limit on market availability None None 500 kg
Total price per unit $14.25 $9.80 $30.00
Total disposal value per unit $7.00 $4.00 N/A
Regularly used? Yes No Yes
Quantity required for alternative use N/A N/A 400 kg
Contribution per kg from second best alternative use. N/A N/A $25.00
Total relevant costs other than material are $5,000.

9. • However the total material required is 1,050 kg [=700×1.5kg] hence the company needs to
purchase 650kg of material Y, the relevant cost of this second portion is its purchase price i.e.
$6,370 [=650×$9.80]. The opportunity cost of this second portion is zero because the material
X has not alternative use and also because there is no limit on availability. Total relevant cost
of material Y is $7,970 [=$1,600+$6,370]
• Material Z is tricky because there is a limit on availability which restricts production options.
Material Z required for the offer is $180kg [=700×0.4kg]. First, since material Z is in regular
use, its relevant cost shall include the replacement cost of $5,400 [=180kg×$30/kg]. Further,
the company has to sacrifice alternative production based on material Z partially. Therefore the
contribution lost as a result shall also be considered a relevant opportunity cost. Material Z
shortage for alternative production caused if the company choses to fulfil the offer is 80kg
[=400kg–(500kg+100kg–280kg)]. The opportunity cost is the contribution lost i.e. $2,000
[=80kg×$25/kg]. Total relevant cost of material Z is thus $7,400 [=$5,400+$2,000]

10.  Total relevant cost of material
= $9,975 + $7,970 + $7,400
= $25,345
 Total relevant cost
= $25,345 + $5,000
= $30,345
 Increase in income on accepting the offer
= 700 × $75 = $52,500 – $30,345
= $22,155

11. • Required: Determine total relevant cost and decide whether or not XD should accept the offer
assuming the decision won't affect regular sales.
Solution
Material X required to complete the offer is 700 kg [=700×1.0kg], all of which is already
available in stock. However material X is in regular use, therefore the relevant cost is its
replacement cost which is $9,975 [=700kg×$14.25/kg]. Since the material is in regular use, the
company has to incur an incremental cash flow in order to restore stock levels. There is no limit
on availability so the opportunity cost is zero.
The company has 400 kg of material Y in stock which has no alternative use so the relevant cost
of that portion is just its opportunity cost i.e. disposal value which $1,600 [=400kg×$4/kg].

12. SHORT-TERM DECISION MAKING
Costs should therefore be divided into
(a) Purely variable costs, such as direct materials, which can be easily attributed to products,
services, customers and so on.
(b) Variable costs that are fixed in the short term and which cannot be directly attributed to cost
objects, but which are avoidable if the product is not produced, the service not provided and so
on.
(c) Fixed costs, which become variable in the longer term, or if activity levels change
significantly. They are not relevant to short-term decision making based on marginal costing
principles as they do not change in the short term.
By classifying costs in this way, it is then possible to predict total costs at different levels of
output.
There is a conflict between cost accounting for profit reporting and inventory valuation and the
convenient availability of information for decision making.
The division of costs into their variable and fixed components is useful in the context of short-
term decision making.

13. RELEVANT COSTS AND REVENUES
Relevant costs and revenues are simply cash flows that arise as the result of a decision. If
a cash flow if unaffected by a decision then it is not relevant.
So, what are the features of relevant costs?
The first feature is that it they are future oriented. That means that a relevant cost is one
that we will incur in the future as a direct result of a management decision.
The next feature relates to cash. Relevant costs are cash transactions rather than
accounting or paper transactions. This means that a relevant cost is not going to be
depreciation or notional rent, for example.

14. The next feature is that relevant costs are incremental in nature. This means that the cost will
increase or maybe the revenue will increase in direct relation to a particular decision. If
management decide to manufacture a certain number of units of a specific product in a factory,
and if the cost of that unit is factored in (e.g. we decide to make 20 units at a certain price), that
is an incremental cost because we incur those costs in direct response to that particular decision
to produce those products.
There are two other types of relevant cost that we need to be aware of. The first is opportunity
cost. An opportunity cost represents the benefit forgone as a result of choosing a particular
option. So, what does that mean? Let's take a simple example to explain. Suppose I get paid
every week to do a certain job. If I decided to go on holidays any particular week, the
opportunity cost of me

15. Relevant cash flows are future cash flows
In the example of the pump development costs for the product are not taken into account.
They are sunk (historical costs) that will not be changed as a result of a decision.
Relevant cash flows are incremental cash flows
The quarterly bill for materials used to make pumps could be £50,000. Increasing the
number of pumps produced by one unit increases the bill to £50,500. The relevant cost of
the extra pump is neither £50,000 nor £50,500. It is the change in total material costs
triggered by the decision to make one more pump – £500.

16. Make-or-Buy
As with most decisions financial information plays an important part, make or buy
decisions are no exception. Make-or-buy decisions extend to:
Manufacture or buy from a supplier
Doing something ourselves or hiring another company to do it
The comparison of the cost of each alternative can be based on its marginal costs, plus any
additionally incurred fixed costs. We should ignore any costs which are unaffected by our
decisions (current fixed costs), since they are not really relevant.

17. Discontinuance
• Faced with a loss making product/service or business unit, senior management are often tempted to take
the decision to close the unit and reduce losses. However, care needs to be taken when making this kind of
decision as under certain circumstances closing a loss making product or service can increase company
losses!
Product-mix decisions & Limiting Factor
• Some businesses may face situations in which sales demand is in excess of current productive capacity.
For example, the output may be restricted due to a shortage of labour, materials or equipment.
Special pricing decisions
• Relates to pricing decisions made outside the main market of a business. Typically they involve one-time
only orders or orders at a price below the prevailing market price.

18. NON- RELEVANT COSTS AND REVENUES
we could describe it as costs and revenues that we would not consider in short-term decision
making. There are four main non-relevant costs that we're going to run through - sunk costs,
committed costs, notional costs, and fixed costs.
The first we're going to look at are sunk costs. So, what are sunk costs? Sunk costs are costs that we
have already incurred. They're never relevant in short-term decision making. A good example of a
sunk cost would be as follows; suppose we're producing a new product and we've paid for customer
surveys to see how good this product is or what our customers’ reaction is to this proposed idea. If
we decide to produce the product, we will have incurred that cost anyway

19.  The next non-relevant cost is a committed cost. A committed cost is one that we've committed to and so,
regardless of whichever decision we intend to make or whichever decision we decided to choose, we will incur
this cost regardless. Therefore, it is a non-relevant cost because we will incur this regardless of whether we
decide to pursue a particular course of action or not.
 The next is a notional cost. Very simply, these are non-cash items. As you'll recall from earlier on in this article,
in order to be considered a relevant cost, it has to be a cash transaction. So, a non-cash transaction or a non-cash
item would be depreciation or notional rent, or maybe a translation gain or loss on foreign exchange. Those
would be examples of non-cash items.
 Finally, we have fixed costs. Fixed costs are a little tricky because some fixed costs we do include as being
relevant, and some we would say are non-relevant. Relevant fixed costs would be fixed costs that are specific to
that particular decision. So, what do I mean by that? Let's say we have a shutdown decision. If we avoid certain
fixed costs, maybe rental payments or salaries for supervisors, as a result of shutting down a particular division,
then fixed costs would be considered a relevant cost. .

20. THE ASSUMPTIONS IN RELEVANT
COSTING
• Relevant costs are future costs. Whenever anyone tries to predict what will happen in the
future, the predictions are often incorrect. Cost accountants have to make the best
predictions of relevant income and costs that they can and at the same time recognize the
assumptions on which their estimates are based.
There are a number of assumptions in relevant costing including the following;

21. ACCOUNTING CONCEPT
Accruals
Relevant costs and revenues are calculated on a cash basis rather than an accruals basis
and do not include such items as depreciation and allocated fixed costs. Decision making
focuses on future costs - past costs are never relevant.
Reliability
As relevant costs and revenues are based in the future, they can never be 100% reliable.

22. Relevance
By their very nature, relevant costs and revenues should always be relevant to the decision
being made. However detailed knowledge of the decision is necessary in order to determine
what is relevant and what is not.
Completeness
Relevant costs and revenues should be complete for the decision being made but will not
include any items that do not affect that decision

23. Comparability
If companies are trying to make a choice between alternatives, the potential outcomes of
these alternatives must be comparable – that is, all relevant costs and revenues relating to
each alternative must be included. Sunk costs, non-cash costs and costs that are not
affected by the decision must always be excluded
Going concern
Not all decisions are based on the assumption that the company will continue in profitable
business for the foreseeable future – for example, shutdown decisions.

24. REFERENCES
• Mitchell Franklin et al, 2019, Principles of accounting, volume 2, 12th Media services.
• Khan & Jain, 2006, Management accounting, Tata McGraw-Hill Education.
• Jawahar Lal, 2009, Cost accounting 4E, Tata McGraw-Hill Education.
• Peter Clarke, 2010, Costing, decision - making and control, edition 2, Institute of Chartered
Accountants in England & Wales.
• Ray Proctor et al, 2012, Management accounting: Decision making and performance
management, FT press.
• Greg N Gregoriou et al, 2012, best practices in management accounting, Palgrave Macmillan.