Relevant Costing
1 Introduction
A key part of running a business is decision-making: choosing a course of action now that will affect the future. This chapter carries most of syllabus section P1C, short-term commercial decision-making — what the main types of short-term decision are, the concepts that underpin them, and the techniques used to support them.
Short-term decisions concern how to make the best use of resources in the short term. They are operational or tactical rather than strategic: they usually involve relatively low values, are often repeatable or reversible, and individually are not expected to change the shape of the business. Because the periods involved are short, the time value of money is ignored — discounting belongs to the long-term decisions of P2.
Typical examples are accepting or refusing a one-off order, pricing a contract, deciding whether to make a component or buy it in, and deciding whether to discontinue a product or close a department. All of them are worked in this chapter.
Section | What it deals with |
§2–§5 | The underlying concepts: what the decision is trying to achieve, what makes a cost or a revenue relevant, and why the answer differs from the profit statement. |
§6–§8 | The three classic techniques: a full relevant-cost schedule, a discontinuation decision and a make-or-buy decision under a constraint. |
§9 | Pricing and revenue-maximising decisions. |
§10 | Weighted benefit scoring and cost/benefit analysis — for decisions that do not reduce to a single money figure. |
§11–§12 | Data and technology, and the ethical dimension. |
1.1 The implications of deciding on a short-term basis
Deciding in the short term is not simply deciding over a shorter period. Taking the capacity as given, and the fixed costs of holding it as already committed, has four consequences that run through the whole of this chapter.
The measure of success becomes contribution, not profit. Because the fixed costs are unaffected by the decision, the option that earns the most contribution is the option that earns the most profit. That is why every technique in §6 to §8 works in contribution and why the answer never carries an apportioned overhead.
The answer will not agree with the profit statement, and it is not meant to. Financial reporting measures a period; a short-term decision measures a difference between two futures. §5 sets the two side by side.
A short-term decision taken often enough becomes a long-term position. A price that recovers marginal cost is defensible for one order and ruinous as a policy: accept enough of them and the marginal price becomes the market price, and the fixed costs are never recovered. §9.4 makes the same point about pricing, and it is the commonest reason a technically correct relevant-cost answer is the wrong business answer.
The consequences outlast the decision. Discontinuing a product loses the customers who bought the rest of the range with it; buying a component in loses the skill to make it; a rushed order damages the quality of everything else on the line that week. These are not measured in the schedule, and §10 gives a structured way to bring them into the comparison rather than mentioning them at the end.
The first of this chapter’s three recordings: thirty-seven minutes on relevant costing — future incremental cash costs, opportunity cost and the costs that are not relevant (sections 3 and 4), Example 1, then Example 2 note by note to a total relevant cost of $88,200 (section 6). The shutdown and make-or-buy recordings are at sections 7 and 8. Three points before you play it.
Two figures to write down: the subcontractors cost $31,300, and the opportunity cost of the materials is $31,500 (7,500 kg × $4.20). They are notes 1 and 6 of Answer 2, and the $88,200 total needs both.
Section numbers: where it says “section two” and “section three”, read sections 3 and 4 of these notes.
Coverage: sections 2, 3.2 and 5, and sections 9 to 12 — pricing, weighted benefit scoring, data and technology, and ethics — are taught only in these notes.
2 The objectives of short-term decision-making
Before any technique is applied it is worth being clear what a short-term decision is trying to achieve, because that is what makes one cost relevant and another irrelevant.
Maximise the contribution earned from resources that are already committed. In the short term the capacity exists and the fixed costs of holding it are going to be paid whatever is decided. What is genuinely at stake is the contribution — the extra revenue less the extra cost — that each option would generate.
Take only decisions that leave the organisation better off than the next best alternative. A decision is worth taking if the incremental benefit exceeds the incremental cost, where the incremental cost includes what has to be given up.
Serve the organisation's wider objectives as well. Value is not created by cash alone. Quality, delivery reliability, customer relationships, staff morale, reputation and sustainability all bear on a short-term decision, and §10 gives a structured way of bringing them into the comparison instead of listing them as an afterthought.
These objectives explain the whole of the relevant-costing rule that follows. A cost that will be incurred whatever is decided cannot make one option better than another, so it is excluded — not because it is unimportant, but because it is not part of what is being decided.
3 Relevant costs and relevant revenues
Relevant cost
A cost is relevant to a decision if it is directly incurred, or directly saved, as a consequence of the decision being taken. As a rule a relevant cost must be future, incremental and cash-based.
Test | What it means | What it excludes |
Future | The cost must still lie ahead. The decision cannot change the past. | Sunk costs, historic costs, book values |
Incremental | The cost must differ between the options. If the same amount is paid whichever option is chosen, it cannot influence the choice. | Committed costs, apportioned overheads, unavoidable fixed costs |
Cash-based | The cost must be a movement of cash. | Depreciation, amortisation, provisions and other accounting allocations |
3.1 Opportunity cost
There is one important addition to the three tests.
Opportunity cost
The value of the next best alternative that must be sacrificed in order to pursue the chosen course of action. It is a relevant cost even though no cash is paid out, because cash that would otherwise have been received is given up.
Opportunity costs arise only where a resource is limited or finite. If there is as much of something as anyone could want, using some of it on this decision sacrifices nothing. The commonest forms in an examination are:
contribution lost on other work when scarce labour or machine time is diverted to the decision;
the sale proceeds given up when material already in inventory is consumed rather than sold;
the rent or income given up when space or an asset is used rather than let out.
For example, the contribution lost by transferring key workers away from their existing jobs to work on a new project is a relevant cost of that project.
3.2 Relevant revenues
The same three tests apply on the revenue side, and questions test them less often only because students forget they exist. A relevant revenue is a future, incremental cash receipt that arises because the decision is taken. It includes:
the revenue from the new order, contract or product;
revenue the organisation would lose elsewhere — a new product that takes sales from an existing one brings in only the difference, not the whole of its own revenue;
cash inflows that are not sales at all, such as scrap proceeds, the sale of a machine that would otherwise be kept, or a grant that depends on the decision.
A revenue that will be received whatever is decided is as irrelevant as a cost that will be paid whatever is decided.
4 Non-relevant costs
Non-relevant costs are those that will not change as a result of the decision. Always read the particulars of the question, because the same cost can be relevant in one scenario and not in another — but in general the following are not relevant to a decision.
Type | Why it is not relevant |
Sunk costs | Costs that have already been paid. They cannot change as a result of a decision taken now. Research already carried out on a new product is the standard example: the money is gone whether the product goes ahead or not, and the only question left is whether it is worth spending MORE. |
Committed costs | Costs the organisation is already contractually bound to pay whatever it decides — typically an existing lease or rental agreement, or a supply contract that must be honoured in the short term. The distinction from a sunk cost is timing: a committed cost is still in the future, but it is not incremental, so it fails the second test rather than the first. |
Book values and historic costs | The carrying amount of an asset, or the price originally paid for it, is out of date and is not a consequence of a decision being taken now. What matters about an asset already owned is what it could earn or fetch in its next best use. |
Non-monetary costs | Accounting valuations and allocations such as depreciation and amortisation. They are not cash flows, so they are irrelevant to decision-making — although the cash cost of the asset itself, if it has still to be bought, certainly is relevant. |
Apportioned overheads | A share of a general overhead allocated to a product or department. Sharing an existing overhead out differently does not make the organisation spend any more. Only the INCREMENTAL part of an overhead is relevant. |
A committed cost is not the same thing as a sunk cost.
A sunk cost has already been paid; a committed cost has not been paid but must be. Both fail the relevance test, for different reasons, and a question will often include one of each to see whether you can say why each is excluded rather than merely that it is.
Identify the relevant costs from the scenarios below.
(a) Your research team have spent $50,000 researching project Q during 20X4. (Relevant / Non-relevant)
(b) The production manager currently earns a salary of $20,000 p.a. Your new project will incur approximately $5,000 p.a. of overtime from him, which means his salary is expected to be $25,000 for the duration of the project. (Which is the relevant cost for the project here — $20,000, $5,000 or $25,000?)
(c) A decision to manufacture a new product is expected to increase fixed costs by $3,000 per month. (Relevant / Non-relevant)
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5 The difference with profit reporting
A relevant-cost statement and a profit statement are answering different questions, and a student who does not see that will keep importing figures from the wrong one. Profit reporting measures the performance of a whole period after the event, under accounting rules that require every cost of that period to be recognised somewhere. Relevant costing measures the consequences of one decision, before the event, and deliberately ignores everything that will not change.
Profit reporting | Relevant costing | |
Purpose | Report the result of a period | Evaluate one future decision |
Time frame | Backward-looking, a whole period | Forward-looking, the life of the decision |
Fixed overheads | Absorbed into unit costs and charged to the period | Excluded unless the decision changes them |
Depreciation | Charged as an expense | Excluded — it is not a cash flow |
Materials held in inventory | Carried at cost (or net realisable value if lower) | Charged at what is given up by using them — the replacement cost if they are in regular use, the sale proceeds if they are not |
Own employees' wages | An expense of the period | Excluded if they would be paid anyway; included only for overtime, bonuses or replacement staff |
The measure | Profit | Incremental cash flow, or contribution |
The most visible consequence is that a product showing a loss in a profit statement may be well worth keeping, because most of the fixed cost charged against it would simply move elsewhere if it were dropped. That is exactly what Example 3 in §7 demonstrates.
6 Relevant costing in practice
This sort of question is really testing that you can determine what information in the question is relevant to the decision, and what information — for example sunk costs — is irrelevant.
It is not a topic for which you can really learn rules. The main thing is to understand the thought process involved, then to read questions very carefully and to state the assumptions you have made where relevant. A useful discipline is to take each line of a schedule in turn and ask the three questions of §3: is it in the future, does it differ between the options, and is it cash?
The managing director of Parser Ltd, a small business, is considering undertaking a one-off contract and has asked her inexperienced accountant to advise on what costs are likely to be incurred so that she can price at a profit. The following schedule has been prepared:
Costs for special order:
Notes | $ | |
Direct wages | 1 | 28,500 |
Supervisor costs | 2 | 11,500 |
General overheads | 3 | 4,000 |
Machine depreciation | 4 | 2,300 |
Machine overheads | 5 | 18,000 |
Materials | 6 | 34,000 |
98,300 |
Notes:
1. Direct wages comprise the wages of two employees, particularly skilled in the labour process for this job, who could be transferred from another department to undertake work on the special order. They are fully occupied in their usual department and sub-contracting staff would have to be bought in to undertake the work left behind. Subcontracting costs would be $32,000 for the period of the work. Different subcontractors who are skilled in the special order techniques are available to work on the special order and their costs would amount to $31,300.
2. A supervisor would have to work on the special order. The cost of $11,500 is comprised of $8,000 normal payments plus $3,500 additional bonus for working on the special order. Normal payments refer to the fixed salary of the supervisor. In addition, the supervisor would lose incentive payments in his normal work amounting to $2,500. It is not anticipated that any replacement costs relating to the supervisor's work on other jobs would arise.
3. General overheads comprise an apportionment of $3,000 plus an estimate of $1,000 incremental overheads.
4. Machine depreciation represents the normal period cost based on the duration of the contract. It is anticipated that $500 will be incurred in additional machine maintenance costs.
5. Machine overheads (for running costs such as electricity) are charged at $3 per hour. It is estimated that 6,000 hours will be needed for the special order. The machine has 4,000 hours available capacity. The further 2,000 hours required will mean an existing job is taken off the machine, resulting in a lost contribution of $2 per hour.
6. Materials represent the purchase costs of 7,500 kg bought some time ago. The materials are no longer used and are unlikely to be wanted in the future except on the special order. The complete inventory of materials (amounting to 10,000 kg), or part thereof, could be sold for $4.20 per kg. The replacement cost of material used would be $33,375.
Because the business does not have adequate funds to finance the special order, a bank overdraft amounting to $20,000 would be required for the project duration of three months. The overdraft would be repaid at the end of the period. The bank's overdraft rate is 18% per annum.
The managing director has heard that, for special orders such as this, relevant costing should be used that also incorporates opportunity costs. She has approached you to create a revised costing schedule based on relevant costing principles.
Adjust the schedule prepared by the accountant to a relevant cost basis, incorporating appropriate opportunity costs.
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7 Discontinuation (shutdown) decisions
Eleven minutes on the shutdown decision, and both parts are right: a loss of $5,000 where there is currently a profit of $5,000, a deterioration of $10,000 if the division closes, and a net gain of $4,000 in part (b). It earns its place twice over — it gives both routes to the answer and says which is the quicker, and it heads off the commonest misreading by insisting that the $10,000 is a comparison with what you are getting now and not a total loss. One figure to hold on to: the directly attributable fixed costs are $5,000, so if you hear 55,000 at any point, $5,000 is the figure and the recording corrects itself twice within half a minute. The money drifts between £ and $; the question is in dollars.
This sort of question asks for a decision on whether or not to close part of the business — a product, a department, a branch. It is usually prompted by a profit statement showing that the part concerned is making a loss, and the whole point of the technique is that such a statement is the wrong basis for the decision.
The method is the same three tests applied to a closure:
Identify the contribution that would be LOST if the part were closed. That is a relevant cost of closing.
Identify the fixed costs that would genuinely be SAVED — the directly attributable ones. General fixed overheads apportioned to the part are not saved; they are simply reapportioned to whatever remains.
Identify anything the released resources could earn instead, and any extra costs of doing so.
Net them off. Close only if the organisation is better off after closure.
(a) A company manufactures three products, Pawns, Rooks and Bishops. The present net annual income from these is as follows:
Pawns | Rooks | Bishops | Total | |
$ | $ | $ | $ | |
Sales | 50,000 | 40,000 | 60,000 | 150,000 |
Less variable costs | 30,000 | 25,000 | 35,000 | 90,000 |
Contribution | 20,000 | 15,000 | 25,000 | 60,000 |
Less fixed costs | 17,000 | 18,000 | 20,000 | 55,000 |
Profit/(loss) | 3,000 | (3,000) | 5,000 | 5,000 |
The company is considering whether or not to cease selling Rooks. It is felt that selling prices cannot be raised or lowered without adversely affecting net income. $5,000 of the fixed costs of Rooks are direct fixed costs which would be saved if production ceased. All other fixed costs would remain the same.
(b) Suppose, however, that it were possible to use the resources released by stopping production of Rooks to produce a new item, Crowners, which would sell for $50,000 and incur variable costs of $30,000 and extra direct fixed costs of $6,000.
Consider whether the company should cease production and sale of Rooks under each of the scenarios in (a) and (b) above.
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8 Make or buy decisions
Ten minutes on the make-or-buy decision, and entirely correct: savings per kilogram of $1.00, $2.50 and $2.00, a ranking of Y, then Z, then X, and a plan to make 2,500 Y and 3,000 Z with exactly the 8,000 kg available and buy in the rest. It adds two things worth knowing — the shortage test that shows why a ranking is needed at all, and the assumption that every unit is worth supplying whether it is made or bought. Two corrections to carry with you: the demand for Y is 2,500, which is what the question's table says and what the recording works with from the next line onwards, and the limiting-factor chapter it cannot quite remember is chapter 5. This is chapter 14, not the chapter 12 it was numbered under an earlier edition.
In order to overcome problems of limited resources, a firm may buy in a product or component instead of making it itself.
Where the incremental cost of manufacture is less than the cost of buying in, the firm should make — assuming that resources are not limited. Where resources are limited, the firm cannot make everything, and it should concentrate its scarce resource on the products that give the greatest saving over buying in per unit of the scarce resource. This is the limiting-factor rule of Chapter 5, applied to a saving rather than to a contribution.
The method:
Check that the resource really is scarce — compute what would be needed to meet demand in full and compare it with what is available.
For each product, calculate the saving per unit from making rather than buying: the buy-in price less the variable cost to make.
Divide that saving by the quantity of the scarce resource each unit consumes, to get the saving per unit of scarce resource.
Rank on that figure and make in rank order until the resource runs out.
Buy in the balance of demand.
The availability of Material B is limited to 8,000 kg.
Product | X | Y | Z |
Demand (units) | 2,000 | 2,500 | 4,000 |
Variable cost to make ($ per unit) | 10 | 12 | 14 |
Buy-in price ($ per unit) | 13 | 17 | 16 |
Kg of B required per unit | 3 | 2 | 1 |
(Material B is included in the variable cost to make.)
Which products should the company make and which should it buy?
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9 Pricing and revenue-maximising decisions
Pricing is the other half of lead outcome C1. A price is ultimately set by what customers will pay and what competitors charge; the management accountant's contribution is to supply the cost floor below which a price destroys value, the profit consequence of any proposed price, and the volume that would be needed to make it work.
9.1 Full cost-plus pricing (full cost recovery)
The price is set at the full cost of the product plus a mark-up:
Price = Full cost per unit × (1 + mark-up %)
The full cost is the variable cost plus a share of fixed production overhead absorbed on a budgeted volume, and often a share of non-production overhead as well.
Advantages | Disadvantages |
Simple, quick and applicable to a large range of products. | It is circular: the absorbed overhead per unit depends on the volume, and the volume depends on the price being set. |
Ensures that at the budgeted volume all costs are recovered and the mark-up is profit. | If actual volume falls short of budget the overhead is under-recovered, so the “full cost” used to set the price was wrong. |
Defensible to a customer or a regulator where the price has to be justified — cost-plus contracts and regulated prices work this way. | The mark-up percentage is essentially arbitrary. |
Provides a stable reference price around which discounts can be negotiated. | It ignores demand, competitors and what the customer is actually willing to pay. |
9.2 Marginal cost-plus pricing (marginal cost recovery)
The price is set at the marginal — that is, the relevant — cost of the order plus a mark-up, which is then the contribution the order earns:
Price = Marginal cost per unit × (1 + mark-up %)
This is the natural approach in exactly the circumstances this chapter has been dealing with: a one-off order, spare capacity, a competitive tender, a short-life or perishable capacity that will be wasted if it is not sold. The relevant cost of the order is the price floor — the point below which the organisation is worse off for taking the work. In Example 2 that floor is $88,200, not the accountant's $98,300.
Advantages | Disadvantages |
It reflects the real, incremental cost of taking the order. | Used habitually rather than occasionally, it never recovers the fixed costs and the business makes a loss however busy it is. |
It allows spare capacity to be sold at any price above the floor, which is better than leaving it idle. | It anchors the customer at a low price that is hard to raise later. |
It is flexible, so a price can be tailored to a particular customer or tender. | Existing customers who discover the price may demand the same terms. |
It makes the decision explicit: accept above the floor, refuse below it. | Pricing below cost to drive out competitors may breach competition law in some jurisdictions, and pricing below cost is a decision that needs a stated commercial reason. |
9.3 Full and marginal cost recovery compared
Full cost recovery | Marginal cost recovery | |
Base of the price | Variable cost plus absorbed fixed overhead | Relevant (incremental) cost only |
What the mark-up must cover | Profit only — the fixed costs are already in the base | Fixed costs AND profit |
Price floor it implies | Full cost — usually too high, and can lose profitable work | Relevant cost — the true walk-away point |
When it is appropriate | Long-run pricing of a continuing product; cost-plus contracts; regulated prices | One-off orders, spare capacity, tenders, market entry |
Main risk | Turning away work that would have added contribution | Never recovering the fixed costs |
9.4 Revenue maximisation and profit maximisation
Maximising revenue and maximising profit are different objectives with different answers, and the syllabus asks you to be able to describe the difference.
Where demand slopes downwards — the lower the price, the more units are sold — the relationship between price and quantity can be written as a straight line:
P = a − bQ
in which a is the price at which demand would be nil and b is the amount by which the price must fall to sell one more unit. Total revenue is PQ, so marginal revenue — the revenue from one more unit — falls twice as fast as price:
MR = a − 2bQ
Revenue is maximised where MR = 0. Beyond that point an extra unit brings in less than the price cut costs on all the other units, so total revenue falls.
Profit is maximised where MR = MC, marginal revenue equals marginal cost. Since marginal cost is positive, MR = MC happens at a lower quantity and a higher price than MR = 0.
So a business that maximises revenue sells more, at a lower price, and earns less profit than one that maximises profit. That is a real choice, not a mistake — but it should be a deliberate one.
What the outcome asks for. P1C1a says “describe pricing and revenue maximising decisions”. The algebra above is here so that the description means something, and so that you can see why the two objectives diverge; the calculation itself is developed further at P2. What you must be able to do at P1 is describe the decisions, apply cost-based pricing, and explain the difference between maximising revenue and maximising profit.
9.5 Pricing in the short term and in the long term
Short term | Long term | |
Which costs are avoidable | Capacity and fixed costs are already committed, so only the incremental costs are avoidable | Every cost is avoidable, including capacity itself |
The price floor | The relevant cost of the order | Full cost, plus a return on the capital employed |
What the price must achieve | Add contribution from capacity that already exists | Recover all costs and earn the cost of capital |
When revenue maximisation is rational | For a period, and for a reason: launching a product, entering a market, buying market share, clearing capacity that perishes if unsold | Rarely. Maximising revenue without a profit constraint destroys value, and a business cannot do it indefinitely and stay solvent |
The main danger | Anchoring customers at a price that cannot be raised; cross-subsidy hiding a loss-making product | A price level the market has learned to expect that never covers the cost of capital |
Deltra makes a single product. Budgeted production and sales for next year are 20,000 units; the factory has capacity for 30,000 units.
The variable cost is $12 per unit. Fixed production overhead is $180,000 per year and fixed selling and administration overhead is $60,000 per year. Fixed overheads are absorbed on budgeted volume.
(a) Calculate the selling price under full cost-plus pricing, using a mark-up of 25% on full cost.
(b) Calculate the selling price under marginal cost-plus pricing, using a mark-up of 60% on marginal cost, and comment on the result.
(c) A customer offers a one-off order for 2,000 units at $15 per unit. There is spare capacity and no other cost would change. Advise whether Deltra should accept.
(d) Market research indicates that 20,000 units a year can be sold at $30, and that sales volume rises by 1,000 units for every $1 by which the price is reduced. Calculate the price that maximises revenue and the price that maximises profit, and the annual profit at each.
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10 Weighted benefit scoring and cost/benefit analysis
Every technique so far in this chapter reduces a decision to one money figure. Many real short-term decisions do not reduce that way: the options differ on delivery reliability, quality, flexibility, the effect on employees, environmental impact and risk as well as on cost, and the cheapest option is frequently not the best one. Listing those factors under a heading called “non-financial considerations” at the end of an answer is not a technique. Weighted benefit scoring is.
10.1 The method
Weighted benefit scoring
A structured way of comparing options against several criteria at once. Each criterion is given a weight reflecting its importance, each option is scored against each criterion on a common scale, and the weighted scores are added to give one figure per option.
List the options that are genuinely available.
Agree the criteria on which they should be judged — enough to cover what matters, few enough to be meaningful, and not overlapping with one another.
Agree a weight for each criterion, normally summing to 1 (or to 100). This is where the argument should happen, and having it explicitly is half the value of the technique.
Score each option against each criterion on a common scale — 1 to 5 or 1 to 10, with the higher score always the better outcome, including for cost.
Multiply each score by its weight, add the weighted scores for each option, and rank. Then test the ranking by varying the weights.
Cost can be handled either as one of the criteria, as it is in Example 6, or kept outside the scoring so that the options are compared on benefit per $ of cost. Which is better depends on whether cost is one consideration among several or the constraint the decision has to live within.
Kestrel must choose one of three ways of covering a three-month peak in demand:
Option 1 — work overtime in the existing factory
Option 2 — place a short-term subcontract with an outside manufacturer
Option 3 — hire agency staff and run a second shift
Management has agreed four criteria and the following weights: incremental cost 0.40, delivery reliability 0.25, product quality 0.20, effect on permanent staff 0.15.
Each option has been scored out of 10 against each criterion, with 10 the best outcome:
Criterion (weight) | Overtime | Subcontract | Agency + shift |
Incremental cost (0.40) | 4 | 8 | 6 |
Delivery reliability (0.25) | 8 | 5 | 7 |
Product quality (0.20) | 9 | 6 | 5 |
Effect on permanent staff (0.15) | 5 | 8 | 3 |
(a) Calculate the weighted benefit score of each option and state which should be chosen.
(b) The operations director argues that the weight on cost should be 0.25 and the weight on delivery reliability 0.40. Recalculate the scores on that basis and state the effect.
(c) State two limitations of the technique that your answer to (b) demonstrates.
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10.2 Benefits and limitations of weighted benefit scoring
Benefits | Limitations |
It forces the criteria and their relative importance to be made explicit and agreed before the options are compared. | The weights and the scores are subjective, and a modest change to either can reverse the ranking. |
It lets non-financial factors enter the decision on their own terms, instead of being ignored or crudely converted into money. | It gives a false air of precision: ordinal judgements are added and compared as though they were cardinal measurements. |
It is transparent and auditable — anyone can see why one option beat another and challenge the point at which they disagree. | Overlapping criteria double-count: “quality” and “customer satisfaction” may be the same thing scored twice, which silently doubles its weight. |
It handles several options and several criteria at once, which prose comparison does badly. | It can be engineered. Someone who knows the scores can choose weights that produce the answer they want. |
It supports sensitivity analysis directly, by re-running the totals on different weights. | Unless cost is a criterion or a separate constraint, it ignores the SIZE of the money differences entirely — a $10 saving and a $10m saving can score the same. |
10.3 Cost/benefit analysis
Cost/benefit analysis is the wider idea behind everything in this chapter: identify all the incremental costs of a proposal and all the incremental benefits, express as many of them in money as can honestly be expressed, and proceed only where the benefits exceed the costs.
Relevant costing is cost/benefit analysis with both sides restricted to cash flows that pass the three tests. A full cost/benefit analysis differs in two ways: it takes in benefits and costs that fall on people outside the transaction, and it obliges the analyst to say what has been left out because it could not be valued. In the short term no discounting is applied.
State the proposal and the alternative it is being compared with — usually doing nothing.
Identify every incremental cost, including opportunity costs and costs falling on other parts of the organisation.
Identify every incremental benefit, including cost savings, revenue, and benefits that have to be estimated indirectly — time saved valued at a wage rate, defects avoided valued at their rectification cost, a risk reduced valued at its expected cost.
Compare the two, state the assumptions, and list separately the costs and benefits that could not be quantified so that the decision-maker can weigh them.
Benefits of cost/benefit analysis | Limitations |
It makes the case for a proposal explicit and comparable with other proposals. | Benefits that resist valuation — morale, reputation, safety, environmental impact — are systematically under-weighted, because what cannot be measured tends to be dropped. |
It forces indirect and knock-on effects to be looked for rather than assumed away. | The valuations placed on those benefits are estimates and can be chosen to suit the conclusion. |
It records the assumptions, so a later reviewer can test them. | It can be expensive and slow relative to the size of the decision it supports. |
Where a benefit genuinely cannot be valued, it can be carried into a weighted benefit score instead of being lost. | It says nothing about the DISTRIBUTION of costs and benefits — who bears them and who gains — which is often the real point of contention. |
11 Data and technology in short-term decisions
Short-term decisions are made quickly and often, which is exactly the kind of work that improves most when better data is available faster.
What it contributes | |
Sources of data | Transaction and point-of-sale data showing what actually sells together and at what price; production and sensor data showing real machine capacity, downtime and yield rather than standard assumptions; supplier and market data on prices and lead times; customer data on which relationships a discontinuation would damage. |
Modelling | A spreadsheet or planning model turns a relevant-cost schedule into something that can be re-run: change the material price, the machine hours or the buy-in quote and see the decision change. This is the what-if analysis of Chapter 13 §8.2 applied to a decision rather than a budget. |
Optimisation | Where several products compete for several scarce resources — a product mix decision — the ranking rule of chapter 5 is not enough and a solver or linear-programming routine is needed. That is chapter 8. |
Simulation | Repeated random sampling from the distributions of the uncertain inputs, giving a distribution of outcomes rather than a single figure — the natural extension of Chapter 13's expected values. |
Visualisation | Dashboards that show contribution per unit of the scarce resource by product, in something close to real time, so that a mix decision can be revisited during the period rather than only at the budget. |
Choosing the model, and validating it.
The syllabus asks for the use of data and technology in product mix decisions, and the examinable skill is judgement, not software. Two judgements are made before any output is trusted.
Is this the right model for the constraint? One scarce resource is a ranking problem: contribution per unit of the limiting factor, which is Chapter 5. Two or more scarce resources acting together is an optimisation problem and needs a solver or a linear-programming routine, which is Chapter 8. Putting a two-constraint problem through a single-constraint ranking gives a plausible answer that is not the optimum, and a solver run on a problem that has only one binding constraint is effort spent to reach the answer Chapter 5 would have given in a minute.
Are the inputs the relevant ones, and are they live? An objective function must be built from contribution — selling price less variable cost — not from a profit per unit struck after absorbed fixed overhead, because absorbing a fixed cost into the objective changes the ranking and the optimum. The constraints must be the resource availabilities that actually apply in the period being decided, taken from current production and supplier data rather than from a standard set at the start of the year. Machine capacity that assumes no downtime, a material limit that predates a supplier's new allocation, or a labour hour rate that has been superseded will each produce a confident, precise and wrong plan. Sensitivity analysis on the binding constraints (Chapter 13 §8) is the check that says how much any of this matters.
More data does not make a decision more relevant.
A system will happily supply the absorbed full cost of a product to four decimal places. It is still the wrong number for a make-or-buy decision. Technology speeds up the arithmetic and widens the evidence; it does not decide which costs are relevant, and a model built on absorbed costs will give confident, fast, wrong answers.
12 Ethical considerations in short-term decision-making
Short-term decisions bear on people — employees whose jobs depend on a discontinuation, suppliers whose business depends on a make-or-buy, customers who are quoted different prices for the same thing. The CIMA Code of Ethics requires a management accountant to observe five fundamental principles: integrity, objectivity, professional competence and due care, confidentiality and professional behaviour. Each of them can come under pressure in the decisions in this chapter.
Decision | Where the ethical pressure arises |
Discontinuation | The people affected have no say in the analysis. Objectivity requires that the redundancy and closure costs are stated in full and that the savings are not overstated to make a closure look better than it is. Integrity requires that the decision is not presented to staff as settled while it is still being consulted on. |
Pricing | Quoting one customer far less than another for the same goods, sustaining a below-cost price to drive a competitor out, or exploiting a shortage to charge what a customer cannot refuse. Some of this is a competition-law question as well as an ethical one, and professional behaviour requires compliance with the law of the jurisdiction concerned. |
Make or buy | The cheaper supplier may be cheaper because of labour or environmental standards the organisation would not accept in its own factory. A saving obtained that way is a reputational and ethical exposure, not just a contribution. |
Relevant costing itself | The classification of a cost as relevant or irrelevant is a matter of judgement, and it determines the answer. Pressure to call a sunk cost relevant — or to leave an opportunity cost out — in order to reach the conclusion a manager has already chosen is the commonest ethical threat in this whole chapter. |
Confidentiality | A competitor's quoted prices, a supplier's cost breakdown or a customer's forecast obtained in confidence may not be used for another purpose, however useful it would be to the decision. |
The threats the Code names apply directly. A self-interest threat arises where the decision-maker's bonus depends on the answer — a manager whose target is a cost reduction has an interest in a closure looking better than it is. A self-review threat arises where the person evaluating the decision also prepared the estimates it rests on. An intimidation threat arises where a manager makes it plain what answer is expected.
The safeguards are unglamorous and effective: state the assumptions on the face of the analysis; show the sensitivity of the recommendation to the assumptions that are least certain (Chapter 13 §8); have the analysis reviewed by someone with no interest in the outcome; keep the non-financial factors visible in the recommendation rather than in a footnote; and escalate through the organisation's own procedures where a threat cannot be reduced to an acceptable level.
13 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Relevant Costing
12 questionsAnswer the questions one at a time. Your progress is saved so you can leave and come back.
Open chapter practice