Relevant Cash Flows for DCF Relevant Costs (example 1) – ACCA Financial Management (FM)
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This is one of your best explained lectures ! Thankyou.
Just a feedback needed. Although as per the relevant cash flow theory we should continue the project, but looking at the overall sunkcost of 150,00 which should not be counted as you said – but in real life how can you ignore the costs related to the project, and then taking the relevant future costs of 74,000 pending, surely the actual advise to the managing director would be not to continue this project as it would lead to an overall loss (300,000-324,000=-24,000) because we are considering the costs from the starting point of the project (including the sunk costs) upto all upcoming costs to the sale. What benefit does this theory and calculation then give if it does not seem to be practically implemented. Ofcourse with the constraints mentioned, we should advise the managing director to continue, but in real life – would you , because the overall damage is 324,000 ?
It is not theory but is perfectly practical.
Companies do not make decisions simply looking at one contract in isolation but on the effect of doing the contract on the overall profit of the company. Sunk costs will be a charge on the total profit whether or not the contract is accepted.
If I am right , by continuing the project the loss is limited to $24000+60000 = $84000 (incl. the materials costs of $60000 that has just been incurred)
otherwise the loss would have been $150000+$60000 = $210000 , (ignoring the principles of sunk cost).
Hello Mr Moffat,
First of all, Thank you very much for the Free Online Lectures. They have been very helpful. My question is regarding the Research Staff; it states that *it has been decided that when the project ceases, the department will be closed. Does that not mean it is a committed cost and therefore, we should not consider the wages 60,000 and the estimation of the redundancy and severance pay as they are both committed costs? I am confused.
Thanks in advance.
The choice is between closing now or closing in one years time. If we wait one year then there will be wages to pay. If we close now then there will not be wages to pay. Similarly with the redundancy, the amount depends on when we decide to close.
Thank you very much Sir.
Research wages are already $60,000 meaning they have to paid whether or not we take on the project why are we considering them as relevant ?
The question says that when work ceases the research department will be closed. Therefore if we do not proceed with the project we will pay them redundancy and severance pay now and will not pay them the wages for the coming year. If we do proceed with the project then we will pay them redundancy and severance pay in 1 year and will pay them the wages for the coming year.
Do not understand why the labour issue in particular the $60,000 (material costs). should it be treated as part of the opportunity cost that falls under the alternative project? Also why aren’t we including the $40,000 in the opportunity cost here?
Awesome lectures ??
Sir, thanks for the great lecture but I am confused in one bit. We haven’t discounted the revenue which we will be earning after a year. how have we come to this conclusion that we should continue with this project ?
The very last line of this question specifically says to ignore the time value of money!
I could not understand and you also could not respond although previously asked about the labour issue.
The question is if we are saving the materials cost of £ 60,000 by not taking the other project then why we are not saving the labour if the materials cost is saved by not taking the other project because ultimately the labour works on materials. Or in other words if we will pay the labour in any way then is it not implied that we are going to buy the material for the other project on which labour is utilized in any way. This view gets strenthened
The cost so far for the project was £150,000 and the cost of continuing is £174,000. So the total cost of the project would be £324000 and we are only going to gain £300000…surely it is a loss overall? Im confused
The 150,000 already spent is a sunk cost – it has been spent whether or not we decide to continue. So it is therefore irrelevant – we have lost the 150,000 whatever happens. We therefore just need to compare how much extra would need to be spent if we continue with the revenue we get from continuing.
Thank you for your reply sir. I think I get it from theory point of view…your lecturers are always so helpful thank you
Thank you for your comment 🙂
Thanks John for the explanation aspect of each class of expense. Indeed this area of DCF is closely related to relevant costing as in paper F5/FM. The key to questions of this nature is to identify what is relevant to the decision in question taking into account any opportunity cost/revenue.
I know we have to ignore the $150,000 already spent. But if we add that $150,000 and the additional $174,000 we would incur if we continue for 1 more year, it totals to $324,000 which is $24,000 more than the $300,000 we would earn. On that basis, shouldn’t we be discontinuing the project since it’s not going to be making a profit?
Profits are not relevant – we are looking at the discounted cash flow method of appraisal.
The 150,000 has already been spent. If we nothing then the 150,000 is lost. If we continue then all that matters is whether the extra inflows are more than the extra outflows – if they are, then the loss is reduced and that is worthwhile.
That makes sense. Thank you!
criss07: you are welcome 🙂
Thank you sir. I love watching your lectures. They are always very well explained 🙂
Please why is wages and severance cost not in negative. Afterall it is a cost.
We are calculating the total additional cost to the company if the project in continued. So, we add all the costs.
I could not understand and you also could not respond although previously asked about the labour issue.
The question is if we are saving the materials cost of £ 60,000 by not taking the other project then why we are not saving the labour if the materials cost is saved by not taking the other project because ultimately the labour works on materials. Or in other words if we will pay the labour in any way then is it not implied that we are going to buy the material for the other project on which labour is utilized in any way. This view gets strenthened by the fact that the question has not mentioned anywhere that the labour is idle and if the labour is in continuous use don’t you feel that materials must also be in continuous use andfor such materials in continuous use the relevant cost is the current replacement cost or purchase price. Kindly clear the ambiguity by replying sir.
You must ask this sort of question in the Ask the Tutor Forum and not as a comment on a lecture.
Hey! Couldn’t understand why the overhead absorption costs where ignored?
Because the overhead is not for the particular project. It is the overhead for the company as a whole and will incur even if the project is continued or not.
Why you take 5000 as negative ?
Because it is a cost. The question says that it costs 5,000 to dispose of the materials because they are toxic (poisonous).
I am confused about this as well. The question says that if we don’t use the materials in the project (so if we don’t do the project) then the disposal cost is £5000. But we are calculating the cost to the company if the project is continued…therefore, aren’t we saving the £5000 disposal cost if the project is continued? Thank you
I reviewed the video and now I understand. Thank you