Study unit

6: Relevant
Costing
Minimum Price & Special
Orders
 • Distinguish between relevant and non-relevant
information.
• Define the following cost terms and to identify each of
them in different situations:
• Relevant cost / income (and therefore non-relevant cost /
income);
• Opportunity cost;
Learning • Differential cost / income;
• Sunk cost;
Outcomes • Avoidable cost;
• Incremental cost / income / cash flow; and
• Decremental cost / income / cash flow.
• Identify and qualify the qualitative factors regarding
decision-making.
• Make decisions regarding buying or making of
products.
• Make decisions regarding special orders.
Definitions
• Relevant costs – Future costs and revenues that will be changed by a particular decision,
whereas irrelevant costs and decisions will not be affected by that decision.
• Opportunity costs – Costs that measure the opportunity that is sacrificed when the choice
of one course of action requires that an alternative be given.
• Differential cash flows – The cash flows that will be affected by a decision that is to be
taken, also known as incremental cash flows.
• Sunk costs – Costs that have been incurred by a decision made in the past that cannot be
changed by any decision made in the future.
• Avoidable costs – Costs that may be saved by not adopting a given alternative
• Incremental costs/ cash flows - The cash flow that will be affected by a decision that is to
be affected by a decision that is to be taken, also known as differential cash flows.
• Decremental costs – Decrease in total cost as a result of choice of alternative.
Relevant
Costs

GOLDEN RULE OF
RELEVANT COST :
TEST EVERY ITEM
AGAINST THESE
 Costs that are irrelevant for management
decision making purposes

Examples
Non- • Sunk costs
relevant • Allocated fixed costs
Costs • Normal depreciation
• Any future cost that does not differ between
the alternatives.
Class
Example
Class Sell Keep

Example Original purchase price Sunk cost = irrelevant

Market value 65 000
•Should Mrs A sell or keep her Expected selling costs (5 000)
car?
Maintenance costs (18 000)
Repairs (20 000)
Insurance Does not differ between
alternatives = irrelevant.

Cost of new car (250 000)

Total cash flow (190 000) (38 000)

 Decisions made using relevant costing:
1. Special selling price decisions (Special
Relevant Orders)
Costing – 2. Product mix decisions when capacity
constraints exist
A decision 3. Decisions on replacement of equipment
making (Not applicable to 2nd year)
tool 4. Outsourcing (Make or Buy) decisions
5. Discontinuation decisions (Not applicable
to 2nd year)
Pricing Decisions

Assumptions:
- Future selling price for normal sales will not be affected by special price
- No better opportunities will present itself during the period
- Unused resources that has no alternatives uses will yield a greater contribution
- Fixed costs are unavoidable for the period under consideration
Special orders - Pricing
Capacity constraints:
• No capacity constraints exist -> Any price higher than variable cost is acceptable as it makes a
contribution towards covering the fixed costs.
• Capacity constraints exist –> Price must include variable cost + cost of capacity (additional costs
incurred) or lost contribution when production needs to be sacrificed.

If the additional order affects normal sales – include opportunity costs.

Types of questions:
- Calculate minimum price
- What would the effect be on profit when accepting the offer
- Accept or reject the offer with explanations
Qualitative Factors to consider
XXX
Factors that cannot be expressed in monetary terms

• Reliability of suppliers –> Will they be able to provide enough material for the special order and on time?
• Deadlines –> Will this affect the timelines for our normal orders
• Customer loyalty if we charge a lesser price for a special order
• What if they insist on a lower price ?

• Limited capacity
• Will you need to sacrifice normal sales?
• What will the affect be on existing customers? (customer relationships/ possible reputational damage/loss of clients)
• Opportunity costs – what if better opportunities pop up
• Can your machinery operate at the maximum level?
• Staff morale on working at maximum capacity

• Forex gains/losses – this is a qualitative factors because at times we cannot always quantify the impact of forex if payment of the good/service is
at a later stage
• Inflation
• Employees
• Is there a shortage of qualified/ knowledgeable staff?
• Do staff require training
• Possible increase in wages or new employment opportunities
Qualitative Factors to consider
XXX
Factors that cannot be expressed in monetary terms

• New Customer
• Reputational damage for being associated with this client
• Creditworthiness
• Possible future orders from this customer
• Possible new market/ contracts
• Longer term contract
• NPV analysis, especially if investment in assets
• How financed?
• Info beyond the short term?
• Renegotiation of future sales price Apply your
• Good – guaranteed business mind!!
• Legal
• Legal implications if party does not keep to contract
• Cancellation clause / Penalties to get out of contract
 Long term orders
This should be calculated on a full cost basis

There is a possibility that fixed costs could be reduced over a longer period of time – Need to include fixed
costs and variable costs in the consideration.
Pricing Decisions

Maximum Price – Highest price that we can ask

for the product
Minimum price + Mark – Up

Minimum Price – Lowest price that we can ask

where we are no better or worse off than before
the order (amount where no profit or loss is
made)
Variable cost + opportunity cost +
incremental fixed cost

Cheat sheet – rules for relevant costing

 Class
Example
• Company manufactures towels. Total Per unit
Revenue 600,000 20.00
• Plant has capacity for 48 000 units per Cost of sales 360,000 12.00
month, but monthly production is Marketing 210,000 7.00 R5 is variable
currently 30 000. Full cost of product 570,000 19.00
Profit 30,000 1.00
• As a result of a strike at another supplier
a hotel is interested in buying 5 000 VC FC TC
towels at R11 per towel. Direct materials 6.00 - 6.00
Direct labour 0.50 1.50 2.00
• Fixed overheads are based on the
Overheads 1.00 3.00 4.00
production of 48 000 units. Manufacturing cost 7.50 4.50 12.00
• No additional fixed costs as a result of
the order and no marketing is necessary
for the order.
 Relevant
amounts

Revenue 55,000 11.00

Variable costs:
Class Manufacturing
Marketing
37,500
0
7.50

Example Contribution 17,500 3.50

Fixed costs:
Manufacturing 0
Marketing 0
Profit 17,500
Class Question