Financial Decision Making 2 Costs for decision making

Costs for decision making

Financial Decision Making 2 Costs for decision making

Costs for decision making

• Relevant costs

• Cost behaviour

• Reading: Drury chapter 2

Financial Decision Making 2 Costs for decision making

What is a cost?

• The amount of resources, usually measured in monetary terms, sacrificed to achieve a particular objective.

• This is not necessarily the same as the amount paid.

Financial Decision Making 2 Costs for decision making

Relevant costs for decisions

• Example:• You paid £3,000 for a car at an auction. You

have just been offered £5,000 for the car. What is the cost to you of keeping the car for your own use?

• By retaining the car you are forgoing cash of £5,000. Any decision should take this into account.

• £5,000 is the ‘opportunity cost’ of the decision.

Financial Decision Making 2 Costs for decision making

Which costs are relevant?

• Costs which relate to the objective

• Costs which vary from one possible outcome to another.

• Opportunity costs

• Future (outlay) costs

Financial Decision Making 2 Costs for decision making

Which costs are not relevant?

• Historic (sunk) costs

• Committed costs

• Future costs which do not vary as a result of the decision

Financial Decision Making 2 Costs for decision making

Relevant costs activity 1

• A garage business has an old car that it bought several months ago. The car needs a replacement engine before it can be driven. It is possible to buy a reconditioned engine for £300. This would take seven hours to fit by a mechanic who is paid £12 an hour. At present the garage is short of work, but the owners are reluctant to lay off any mechanics or even to cut down their basic working week because skilled labour is difficult to find and an upturn in repair work is expected soon.

• The garage paid £3,000 to buy the car. Without the engine it could be sold for an estimated £3,500. What is the minimum price at which the garage should sell the car with a reconditioned engine fitted?

From Accounting – an Introduction, McLaney and Atrill (Pearson Education Ltd, 2008), activity 8.2

Financial Decision Making 2 Costs for decision making

Relevant costs activity 2

• Assume exactly the same circumstances as in activity 1, except that the garage is quite busy at the moment. If a mechanic is to be put on the engine-replacement job, it will mean that other work that the mechanic could have done during the seven hours, all of which could be charged to a customer, will not be undertaken. The garage’s labour charge is £40 an hour, although the mechanic is paid only £12 an hour.

• What is the minimum price at which the garage should sell the car, with a reconditioned engine fitted, under these altered circumstances?

From Accounting – an Introduction, McLaney and Atrill (Pearson Education Ltd, 2008), activity 8.3

Financial Decision Making 2 Costs for decision making

Cost behaviour

• Different items of expenditure behave in different ways

• Looking at the way costs change as the level of activity changes

Financial Decision Making 2 Costs for decision making

Variable costs

• Total costs change with the level of activity

• Variable cost per unit is constant

• When output zero, cost zero

• Example – raw materials

No of units

No of units

Total cost Cost per unit

Financial Decision Making 2 Costs for decision making

Fixed costs

• Stay the same, irrespective of changes in activity

• When output zero, cost still exists

• Example - rent of shop premises

No of units No of units

Total cost Cost per unit

Financial Decision Making 2 Costs for decision making

Stepped fixed costs

• Fixed over a certain activity range• At particular point, step increase in a fixed cost• Example – rent of premises for a hairdressing

business

No of units

Total cost

Financial Decision Making 2 Costs for decision making

Semi-variable costs• Variable rate per unit in addition to a constant fixed

charge

• Example – telephone bill

• Line rental /Standing charge fixed

• Calls / units used variable

No of units No of units

Total cost Cost per unit

Financial Decision Making 2 Costs for decision making

Purpose of cost behaviour analysis

• Predict costs at different levels of activity

• Forecasting and extrapolating

• Budgeting

• Decision-making

Financial Decision Making 2 Costs for decision making

Problems with cost behaviour analysis

• Oversimplification?

• Accuracy of data about past costs

• Assumes only volume changes affect costs

• Assumes costs follow a straight line

• Only applies in the short term

• Need to regularly review cost behaviour