ACCA Applied Skills · Performance Management

Relevant cost analysis: formula sheet

Full chapter guide

Key formulas

Relevance test: Relevant = future + incremental + cash flow; If any one of the three is missing, leave the item out (opportunity costs count as cash forgone).
Relevant cost of a resource: Relevant cost = cash paid (extra) + opportunity cost; The opportunity cost is the best benefit lost by using the resource in this decision.
Relevant cost of materials already in stock: Higher of: resale value, or cost saved by using elsewhere (replacement cost if the material is regularly used and would be replaced); If the material has no other use and no resale value, the relevant cost is nil. If disposal would cost money, avoiding it is a saving.
Relevant cost of labour: Spare capacity: nil extra (unless paid extra). Fully used: wage cost + lost contribution; Contribution lost = sales less variable costs, including labour, on the work displaced.
Decision rule: Accept if relevant revenues > relevant costs; Equivalent to a positive incremental cash flow.
Relevant cost of material to be bought: Quantity × current purchase price; Use this when the material is not in stock and must be bought.
Relevant cost of material in stock, regularly used: Quantity × current replacement cost; Using it here means you must buy more for the normal work.
Relevant cost of material in stock, no other use: Higher of (net resale value) and (cost saved by not disposing of it); If no alternative use exists and no sale is possible, the relevant cost is zero unless disposal costs are avoided.
Relevant cost of labour, spare capacity: ₹0 extra (if workers are paid anyway); Include any extra pay, such as overtime premium or hiring cost, if the decision triggers it.
Relevant cost of labour, full capacity: Wages paid + contribution lost elsewhere (measured after deducting the labour cost); This equals the contribution lost before labour cost, with no wages added. Never add wages to a contribution that is already before labour cost, or the wages are counted twice.
Relevant cost of overheads: Incremental cash overhead only; Ignore absorbed or apportioned fixed overheads that do not change.
Relevant cost of making: Relevant cost of making = variable costs avoided + avoidable fixed costs + opportunity costs; Use cash costs only. Leave out sunk costs and fixed overheads that continue anyway.
Basic decision rule: Make if relevant cost of making < relevant cost of buying; With no limiting factor, choose the lower relevant cost, then review qualitative factors.
Extra cost of buying per unit: Extra cost of buying per unit = buying price per unit − relevant variable cost of making per unit; Use this figure when a resource is limited. It is the saving you lose by buying.
Ranking with a limiting factor: Ranking measure = (buying price − variable cost of making) ÷ units of scarce resource per unit; Make the items with the highest measure first. Buy those with the lowest.
Total cost with limiting factor: Total cost = cost of items made + cost of items bought; Check that the total scarce resource used does not exceed the amount available.
Shut-down rule: Close if: segment revenue < avoidable costs (variable plus avoidable fixed), i.e. if the contribution after avoidable fixed costs is negative, other things equal; Use avoidable costs only. Include avoidable fixed costs, such as a manager's salary that would end.
Special order rule: Accept if: order revenue > relevant costs (incl. opportunity costs); Spare capacity: opportunity cost is nil. Full capacity: add the contribution lost elsewhere.
Further processing rule: Process further if: (final sales value − split-off sales value) > extra processing cost; Joint costs are ignored because they are incurred either way.
Net benefit of closure: Change in profit from closing = avoidable costs saved − revenue lost (positive = close; negative = keep); Show this as a clear final line. Avoidable costs include variable costs and avoidable fixed costs.
Relevant cost of materials: Materials to be bought: current purchase price. Materials already in stock: if they would be replaced for normal use, the relevant cost is replacement cost. If they would not be replaced, the relevant cost is the higher of net realisable value (sale value less any costs of sale) and the value in an alternative use. If there is no other use and no sale value, the relevant cost is nil.; This rule is used heavily in special order questions. Compare the alternative-use value with the sale value, and take the higher.

Quick revision

Relevant costs are future, incremental cash flows.
Sunk costs are never relevant, whatever they cost originally.
Committed costs are not relevant because they happen either way.
Depreciation and apportioned fixed overheads are usually not relevant.
Opportunity cost is the benefit lost by choosing one option over another, and it is relevant.
Materials already owned and not replaced: relevant cost is the higher of net resale value and the value in the best alternative use; zero if it has neither.
Materials that must be replaced: use the current replacement cost.
Spare labour has no relevant cost; labour that must be moved costs wage plus lost contribution.
Only extra overhead spend caused by the decision is relevant.
Make or buy: compare avoidable cost of making with the buy-in price, and use contribution per limiting factor unit if resources are scarce.
Shut down if the avoidable costs saved (variable plus avoidable fixed) exceed the revenue lost, that is, if the segment's contribution is less than its avoidable fixed costs; also consider knock-on effects on other segments.
Process further if incremental revenue exceeds incremental cost; joint costs are irrelevant.

Common mistakes

Including sunk costs such as past research or money already spent. Fix: Ask 'can the decision change this?' If the cash has already gone, exclude it.
Including depreciation or absorbed fixed overheads as a cost. Fix: Use only variable costs and fixed costs that actually change because of the decision. Depreciation is non-cash.
Using the original cost of stock already held. Fix: Use replacement cost if the stock would be replaced, or the best of resale value and disposal cost saved if it has no other use.
Charging full labour cost when staff have spare capacity and are paid anyway. Fix: If there is no extra payment, the relevant labour cost is zero. Say so and state the reason.
Including absorbed fixed overhead as a cost of making. Fix: Include fixed costs only if they are avoidable by buying. Use the stated saving, not the absorbed rate.
Ranking by the buying price or by the make cost per hour. Fix: Rank by the extra cost of buying per unit of scarce resource. This shows how much you save by using each hour on making.
Including apportioned head office costs in a shut-down decision. Fix: Check which costs would truly disappear. Only avoidable costs count. A segment with positive contribution toward shared costs may be worth keeping.
Deducting joint costs in a further processing decision. Fix: Joint costs are sunk at split-off. Compare only the extra revenue with the extra processing cost.

Exam tips

Show a one-line reason beside every item you include or exclude. Markers award marks for the treatment, not only the total.
In objective questions the wrong options are often sunk costs, book values or absorbed overheads. Eliminate them first.
For labour, always check whether there is spare capacity. This is the most common trap in written questions.
State your assumptions when the question is unclear, such as whether stock will be replaced.
Finish with a decision and at least one qualitative point, because constructed response questions often ask for it.
Look for wording such as 'already in stock', 'spare capacity', 'paid anyway' and 'fully used'. These tell you which rule applies.
In constructed response answers, set out a table of items with a short reason for each. Marks are given for the reason as well as the figure.
In objective questions, work out the relevant cost quickly and check the options. A wrong answer scores zero, so check whether you used replacement cost instead of book value.