Relevant Cost Concepts

Fixed costs are those costs which remain unchanged in spite of a change in the volume of output or in the level of activity. For instance, the rent to be paid on the office buildings or the allocated depreciation of machinery remains the same irrespective of the volume of the output. Many a time another term called overheads is used in the accounting systems. This leads to confusion with the fixed cost. In fact, “overheads’’ could be either fixed or variable. Fixed costs refer to the non-variability of a certain class of costs with respect to a decision to vary the output from a plant. If a plant were to produce one lakh units instead of 75,000 units per year, the fixed cost would remain the same in both the cases. The decision as to whether a cost is fixed or not fixed is related to the question of whether the output should be increased or not. The distinction between the costs is according to the question to be answered.

As opposed to fixed cost, those costs that vary continuously with respect to change in the production output or the level of activity are termed as variable costs. If one were to increase the production output from 75,000 units to 100,000 units that much more raw material has to be procured. The cost of the raw materials is a variable cost. Similarly, more labor hours are to be spent in making the finished product in more quantity; and therefore the labor hours are also a variable cost.

Opportunity cost is another important concept with respect to relevancy. The opportunity cost for a particular decision is the benefit derived from the best of the alternative opportunities lost due to the decision to choose a particular line of action. If you had Rs. 10,000 which kept at home instead of depositing in a bank, the decision to keep the money at home has an opportunity cost of the 4% bank interest which would have earned interest on the said Rs 10,000. Reversely, the opportunity cost of keeping the money in a bank instead of keeping it at home is zero; because by keeping the money at home, you would have earned no interest. To give another example, the opportunity cost of using a particular machine to produce product X is the benefit that the company would forgo in terms of not using the machine to produce other products. The opportunity cost in such a case, is the benefit that would have been derived for the best of the available alternatives which is foregone. Opportunity cost figures are important in many cases including that of materials management. When a company decides to invest Rupees one crore in the inventory of raw materials, that much of money is locked, which could have been put to alternative uses or projects. If the return on the various other projects had been 10%, 15%, 20%, then the opportunity cost of the decision to invest the money in raw materials is 20%. This is the cost of capital which needs to be charged to the raw materials. A company might have borrowed money from some source at the rate of 15%. But, this is immaterial in terms of the wisdom of decision (provided there is flexibility in using the money borrowed from that source).

This brings us to the distinction between accounting profit and economic profit. The accounting profit is the profit shown on the P&L Account of the company, that is as per statutory requirements and for the information of the shareholders and other public. Although the accounting profit may be high enough, it does not show as to whether the company could have made more profits. The efficiency of the management decision is never reflected in the accounting profits. The economic profit is for the internal use of the management of the company for giving them guidance in investment and other decisions. The opportunity cost of capital is not reflected in the P&L Accounts, whereas there are implicit costs which need to be taken into account while considering the wisdom of one decision over the other. Opportunity cost considers the full economic cost of scarce resource.

The relevant costs which should enter any decision-making are termed many a time as incremental costs. Incremental cost is the change in the total cost resulting from a decision; it is not necessarily the marginal cost which refers to a unit of output. Only the variable costs pertaining to the decision are relevant in any Incremental Cost Analysis.

Sunk Costs:

Another distinction is between the incremental and the sunk costs. The incremental costs are those that result from a particular decision, while sunk cost would be incurred regardless of the decisions. For instance, the obsolescence part of the depreciation is a sunk cost which is irrelevant for a decision once the equipment is bought. Whether we drive a car 500km more or less has no effect on the obsolescence portion of its depreciation; regardless of our decision to put in 500km less or more, this cost will be incurred. Whereas, any extra wear-and-tear incurred would be quite relevant. In effect, costs incurred in the past which are irrelevant to future decisions are called sunk costs.

Direct cost is one of the various terminologies used regarding costs, which needs to be explained. Many accountants confuse direct cost with variable cost. For instance the direct labor cost and the direct material cost are referred to in the context of the variable costs. However, “direct” actually refers to a particular category of cost which could be attributed to a particular product or to a department. The word ‘direct’ refers to the traceability of a cost factor to a product. It does not mean that a traceable-cost is necessarily a variable cost. For instance, the advertising expense incurred for a particular brand of soap can be directly attributed to that particular brand of soap. Now, this advertising cost is not necessarily variable with respect to the volume of output of that soap product. So, it is not variable cost, yet it is a direct cost. The power consumption in a plant producing a number of products cannot be traced or directed to a particular product. But with a significant variation in the volume of output the power consumption would also increase. Therefore, a part of the power consumption is a variable cost, yet it is not a direct cost in fact, it is an indirect cost.

Overheads: Similar confusion exists regarding the overheads. Many a time all the indirect costs are lumped under the category of overheads. This accounting terminology again does not make the distinction between the fixed and the variable components of the overheads. Such a distinction may be extremely crucial for a management decision to either increase or decrease the level of activity in the organization. Such so called overheads are allocated to different products or product lines, on various bases such as the total sales of each o f the product or the total production costs or the value added or the direct labor cost incurred. Although, such allocation to either different product lines or departments may help the financial accounting, it does not help in decision making.

Distinction between controllable and non-controllable costs is very important in monitoring the performance of the various executives on the basis of predetermined budgets or standards. There are various instances when certain departmental or divisional mangers have to explain for cost-variances over which they have little or no control. The executive should be held responsible only for those costs over which he has control. Otherwise, the entire monitoring and performance evaluation procedure becomes spurious and corrupt. Distinction between the controllable and non-controllable cost ensures more effective and responsible accounting.

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