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I’m struggling to understand the concept of working out the relevant cost of an asset. My BPP book simply shows a “higher of, lower of” diagram, without explaining how it works. I’ll give the question I’m stuck on.
A machine cost $14,000 ten years ago. It is expected that the machine will generate future revenues of $10,000. Alternatively, the machine could be scrapped for $8,000. An equivalent machine in the same condition would cost $9,000 to buy now. What is the deprival value of the machine?
I understand that the $14,000 is a sunk cost, and is irrelevant. Therefore, if the machine was kept, would the cost be – $10,000 + $8,000 = – $2000? However, in that case, would it not be possible to still sell it as scrap afterwards?
The alternative would be to buy a new one. In that case, am I right in saying the cost would be $9,000 – $8,000 = $1,000?
The answer given in my book says “the deprival value of the machine is the lower of the replacement cost and £10,000. The deprival value is therefore $9,000. I’m afraid I can’t draw the diagram here, but it is on page 351 of the BPP book if you have it.
I would be very grateful if someone could explain how this works please, and also how the diagram works.
Thanks a lot.
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Let me give you some idea which will help you without the diagram.When approaching relevant cost for non-current asset questions,first thing that you need to know is whether to keep the asset or to sell it,so for this question,if the machine is kept,it will generate $10000 and it can be sold for $8000,key point:relevant cost is the higher of the “sales proceed” and “net cash inflows from the use of machine”,therefore in the moment the relevant cost is $10000.Why do we use the higher cost?Because we want our machine cost to be higher in the statement of financial position,therefore it is important to decide the best relevant cost to value the machine.Secondly you need to decide whether or not to buy a new machine for $9000 to replace the old one.In this situation,it is different than the situation just now,this time is about money going out,so according to common sense,we do not want to choose the way that cost us more.Therefore when you compare $9000 with previous relevant cost $10000,we will take $9000 as our relevant cost because it costs less than using the old machine,remember our relevant cost is an avoidable cost where in this situation,we will try to avoid the way that costs more and we take the lower cost as our relevant cost.Well i may not be explaining clearly,but to approach this kind of question,first compare the income from selling the machine(Net Realisable Value) and keeping the machine,taking the higher one as the relevant cost,secondly compare the first relevant cost with replacement cost and choose the lower one as relevant cost.If there is no replacement cost,the cost is keeping the machine is relevant cost.
Let me give you one example:A company is considering its option with regard to a machine which cost $60000 four years ago,if sold the machine would generate scrap proceeds of $75000.If kept,this machine would generate income of $90000.The current replacement cost for this machine is $105000.What is the relevant cost of the machine?
Answer:$60000 is sunk cost,so it is confirmed not a relevant cost,then follow the steps,compare selling($75000) and keeping($90000),keeping the machine would help us generate more income and also make our statement of financial position looks better by increasing the value of non-current asset,so the relevant cost in the moment is $90000.Next,compare $90000 with the replacement cost($105000),seems like if this machine was replaced,it would cost us more,therefore we don’t choose to replace and finally our relevant cost for machine is $90000.
I hope my explaination and example can help you to understand the relevant cost for non-current asset 🙂Hi ckseah,
Thanks very much for taking the time to expalin it to me, I understand now. My first ever exam is on Thursday, and I’ve just got to try and understand the fifo method before then, and I might have a chance of passing!
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I was going through the same question in my BPP book and the answer which was given through the ‘lower of’ and ‘higher of’ diagram made no sense to me. The explanation given by Seah is very clear however i do have a little problem with my understanding of the relevant cost of non current asset.
In the first situation the machine should be kept because it generates an income of $10000 compared to its scrap value of $8000 if sold. But if i have to compare with keeping the machine or replacing it then isn’t it again better to keep the machine as it is generating an income where cash is coming in but replacing it would mean buying a new machine making $9000 cash flow out.
Would really appreciate if anyone can help me understand this problem.
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Thanks alot seah! Your example cleared all my doubts~ 🙂
relevant cost of an asset is its deprived value.
deprived value is lower of replacement cost and recoverable amount.
recoverable amount is higher of net selling price and value in use.
above example, replacement cost is 9000.
value in use is 10,000.
net selling price is 8000.
recoverable amount is 10000(the higher value)deprival value is lower of 10000 and 9000, that is 9000.
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