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15/03/2018 11:07:30 PM

Relevant-Cost Analysis

Relevant costs are expected future costs, and relevant revenues are expected future revenues that differ among the alternative courses of action being considered. Revenues and costs that are not relevantare said to be irrelevant. It is important to recognize that to be relevant costs and relevant revenues they must:

  • Occur in the future—every decision deals with selecting a course of action based on its expected future results.
  • Differ among the alternative courses of action—costs and revenues that do not differ will not matter and, hence, will have no bearing on the decision being made.

Managers should avoid two potential problems in relevant-cost analysis. First, they must watch for incorrect general assumptions, such as all variable costs are relevant and all fixed costs are irrelevant. In the Surf Gear example, the variable marketing cost of $5 per unit is irrelevant because Surf Gear will incur no extra marketing costs by accepting the special order. But fixed manufacturing costs could be relevant. The extra production of 5,000 towels per month does not affect fixed manufacturing costs because we assumed that the relevant range is from 30,000 to 48,000 towels per month. In some cases, however, producing the extra 5,000 towels might increase fixed manufacturing costs. Suppose Surf Gear would need to run three shifts of 16,000 towels per shift to achieve full capacity of 48,000 towels per month. Increasing the monthly production from 30,000 to 35,000 would require a partial third shift because two shifts could produce only 32,000 towels. The extra shift would increase fixed manufacturing costs, thereby making these additional fixed manufacturing costs relevant for this decision.

Second, unit-cost data can potentially mislead decision makers in two ways:

1.When irrelevant costs are included. Consider the $4.50 of fixed manufacturing cost per unit (direct manufacturing labor, $1.50 per unit, plus manufacturing overhead, $3.00 per unit) included in the $12-per-unit manufacturing cost in the one-time-only special-order decision (see Exhibits 11-4 and 11-5). This $4.50-per-unit cost is irrelevant, given the assumptions in our example, so it should be excluded.

2.When the same unit costs are used at different output levels. Generally, managers use total costs rather than unit costs because total costs are easier to work with and reduce the chance for erroneous conclusions. Then, if desired, the total costs can be unitized. In the Surf Gear example, total fixed manufacturing costs remain at $135,000 even if Surf Gear accepts the special order and produces 35,000 towels.

Including the fixed manufacturing cost per unit of $4.50 as a cost of the special order would lead to the erroneous conclusion that total fixed manufacturing costs would increase to $157,500 ($4.50 per towel 35,000 towels). The best way for managers to avoid these two potential problems is to keep focusing on (1) total revenues and total costs (rather than unit revenue and unit cost) and (2) the relevance concept. Managers should always require all items included in an analysis to be expected total future revenues and expected total future costs that differ among the alternatives.