Relevant Costs as different from accounting Costs (OM)

The effort in this article has been to emphasize the need for a proper consideration of the relevant cost concept i.e. costs which should enter into analysis for an optimal management decision. It has also been stressed that since the major function of accounting is reporting the accounting costs will not be very useful when the objective before the manager is to choose between various alternative lines of action open to him. According costs are usually past oriented and report the status of the income or profit and loss during a given period whereas cost data needed to help the manager in his choice of a future course of action.

Historical cost data cannot reflect the cotemporary cost of inputs. The input raw materials might have cost Rs 1 lakh during the last quarter but it may be worth Rs 150,000 today. The bank loan secured the pervious month may have been secured at an interest of 11% and may have been invested in a project fetching 15% returns. But there is no information as to how the same capital could possibly have been better utilized in other ventures fetching over 20% returns. Such cost figures of the lost opportunities, do not exist in any of the historical accounting cost data. We have also seen how the allocation of overheads to different products or departments is erroneous. If the overheads, for instance were to be allotted based on the total sales of the product or on the direct labor used in the product then any variation in the direct labor used or in the product will produce corresponding variation in the allocation of the overhead of the product. Actually, the variation in the direct labor used or in the sales may not have any relation at all with the management decision regarding the output level of the product. The production process may be made more labor intensive and therefore may invite more allocation of the total factory overhead. Thus allocation of overheads is meaningful as far as any decision regarding that product is concerned. The accounting cost does not properly make a distinction between the fixed and the variable cost, the sunk or the incremental cost. This is so because accounting costs are neither decision oriented nor future oriented. The cost analysis for decision making should take only the relevant cost into consideration and therefore, the cost analysis is tailor-made for a particular decision.

What is necessary is that managers should take the help of the accounting cost data, screen it, modify it or make use of it or interpret it to suit their particular decision making need.

Example Illustrating Relevant Cost Analysis:

Kartik & Co

Kartik & Co is a manufacture of motorized cycles popularly known as mopeds. Many components in the mopeds are bought out parts. Due to a sudden spurt in demand in the years 1999 and 2000, the company underwent considerable expansion. The year 2001 marked a lower demand for mopeds than anticipated. The situation it appears now to the company, may not improve in the near future. Due to this reason the equipment capacities in the forging and machining sections are being utilized to the extent of 65% only, at present.

The Company’s Deputy General manager (Operations) feels that the excess capacity in the plant can be utilized by manufacturing an important forged (and machined) component which is presently being bought from an outside supplier Suman Enterprises, within Kartik’s plant itself.

Roughly 10,000 pieces of this forged component are being annually from Suman at the average rate of Rs 20 per piece. The delivery charges are extra and amount to Rs 700/- per lot of 1,000 pieces. The forged piece sent by the supplier in lots pieces each. The cost of receiving and inspection is figured to be around Rs 14,000 per annum attributable to this bought-out part.

About twice during the past year Suman failed to deliver the components on time and Sathya estimates that the loss in revenues to the company amounted to Rs 50,000 due to such uncertainty.

In spite of the vagaries of the supplier, Suman Enterprises provides good quality material. In fact, the average figure for the defectives can be put at 2% which is quite good compared to the performance of many other vendors in the area. If Kartik & Company were to make the same components, the rejects could be higher by almost 5%.

The cost accountants of Kartik estimate that, if Kartik were to make the component internally, the direct materials costs would be Rs 9.55 per piece and the tools and supplies may cost around Rs 500 per per 1000 pieces of component. The direct labor involved comprises two elements: (1) Forging, and (2) Machining. The costs of direct labor are estimated at Rs 1.05 and Rs 4.40 per piece for the two elements respectively. The plant overheads are generally taken at 250% of the direct labor; the fixed overheads are Rs 100,000.

The DGM (operations) wants to know whether his hunch “that making the component internally is better” is right.


This is a typical make or buy decision and the relevant cost for the two options need to be considered.

Presently the component is being bought and the relevant costs are:

(1) Purchase price @ Rs 20.00 per pieces : Rs 2,00,000
(2) Costs of delivery @ Rs 700 per 1000 pieces : Rs 7,000
(3) Cost of receiving and inspection : Rs 14,000
(4) Cost of bad quality (@ 2% rejects)
0.02 X (purchase price + delivery cost) Rs 4,140
(5) Costs due to uncertainty of supplies : Rs 50,000
Total cost: Rs 2,75,140

If Kartik & Co were to make the components internally the relevant costs would be:

(a) Direct material @ Rs 9.55 per piece :Rs 95, 500
(b) Direct labor @ Rs (1.05 + 4.40) per piece : Rs 54,500
( c ) Tools and supplies @ Rs 5.00 per 1000 pieces Rs 5,000
(d)* Plant overheads which vary with the output
(250/100 x 54,400) – (1,00,000) : Rs 36,250

*Note the fixed overheads are sunk costs which continue to accumulate whether the component is produced in the shop or not.

Total: 1,91,250

The rejects are expected to be 5%
Therefore Total Costs will be: Rs 2,01,300
Obviously in the present circumstances, the manager’s hunch is correct. The company is justified in making the product internally.