RELEVANT COSTING FOR DECISION MAKING

Cost Accounting �

In earlier concept, costing was defined as the technique and process of ascertaining costs of a given thing. In sixties, the definition of cost accounting was modified as the � application of costing and cost accounting principles, methods and techniques to the science, art and practice of cost control and ascertainment of profitability of goods or services.� It includes the presentation of information derived there from for the purposes of managerial decision making. It clearly emphasizes the importance of cost accountancy achieved during the period by using cost concepts in ore and more areas and helping management to arrive at good business decisions. To day the scope of cost accounting has enlarged to such an extent that it now refers to the collection and providing all sorts of information that assists the executives in fulfilling the organization goals. Modern cost accounting is being termed as management accounting, since managers being the primary user of accounting information are increasingly using the data provided by the accounts, setting objectives and controlling the operation of the business.
Cost accounting deals with the ascertainment of the cost of product or service. It is a tool of management that provides detailed records and reports on the costs and expenses associated with the operations, mainly for internal control and decision making. Cost accounting basically relates to utilization of resources, such as material , labour, machines,etc and provides information like product cost, process cost, service or utility cost, inventory value etc, so as to enable the management taking important decisions like fixing price, choosing products, preparing quotations, releasing or withholding inventory etc.

OBJECTIVE �

The objective of cost accounting is to provide information to internal managers for better planning and control of operations and taking timely decisions. In the early stages, cost accounting was considered as an extension of financial accounting. Cost records were maintained separately. Cost information and data aware collected from financial books,  since all monetary transactions are entered in the financial books only. After developing product cost or service cost and valuation of inventory , the costing profit and loss account is prepared. The profit and loss figures so derived by the two sets of books i.e. financial accounts and cost accounts would have to be reconciled, since some of the income and expenditure recorded in financial books do not enter into product cost, while some of the expenses are included in cost accounts on notional basis i.e. without having incurred actual expenses. However a system of integrated accounts has been developed subsequently wherein cost and financial accounts are integrated and one set of books can be maintained.  

Relevant cost-

The relevant cost is defined as that cost which has direct bearing upon the profitability of the company . For example the marginal cost is a relevant, which can be avoided if the production is not being undertaken. Where as the fixed cost is not a relevant cost because it has already been incurred and can not be avoided irrespective of whether production has been undertaken or not.

Relevant costing for decision making

There are other examples of relevant costs as follows-

A)    Differential Cost- It is defined as a technique used in the preparation of ad-hoc information in which only costs and income differences between alternative courses of action are taken in to consideration. Cost may increase or decrease due to change in production, sale , production method, product mix, etc.This change in total cost at a particular level of activity compared to another one is called differential costs, which are obtained by subtracting costs at one level from those at a higher level. Differential cost calculation includes both variable as well   fixed costs which are affected by the alternative course of action. Thus, absorption costing or marginal costing techniques can present the information.

Example-
    Activity Level        75%        60%        Differential
Units            7500        6000        1500

Costs Elements        15000        12500        2500
Direct Materials        7500        6000        1500
Variable Overhead    3600        3000        600
Fixed Overheads    3900        3500        400
            Total    30000        25000        5000

Thus, the differential cost of 1500 units is Rs 1500. in the above presentation , if the additional output does not involve additional fixed costs, then variable costs becomes differential costs and in that case, the latter will have no difference with marginal cost.

Differential Cost             Vs             Marginal Cost

In fact, differential costs are often confused with marginal costs. This is because of the fact that both marginal costing and differential cost analysis system stm from the basic behavior of cost,i.e. fixed and variable . When fixed cost remain unaffected, both marginal costs and differential costs are the same . However they are not the same. The difference are as follows which will not be so under marginal costing.

a) Differential cost is a total concept and applies to a fixed additional quantity of output.
a)Marginal Cost is an unit concept and app lies to output per unit basis.
b) Differential Costs are presented in totals in both formats, i.e. under marginal as well as absorption cost techniques.
    b) Marginal Costing is presented by showing contribution per unit and fixed cost as total amount.
c)Product cost under differential cost analysis may contain fixed cost    c) Product cost under marginal costing contain only variable cost.

Relevant costing for decision making1

Uses of Differential Cost Analysis �

Differential cost analysis may be useful technique in taking appropriate policy decisions such as :-
1)    Acceptance of an additional order at lower than existing price to a special customer,
2)    Acceptance of a export order, requiring additional quality.
3)    Introduction of a new product.
4)    Opening of a new sale territory or Channel of distribution.
5)    Processing of a by- product or joint product beyond the split-off point.

 

Conclusion:

In all such cases, the differential cost is compared with incremental revenue. As long as incremental revenue is more than or equal to incremental or differential cost, the additional activity is justified. However, if differential cost exceeds incremental revenue the project should be abandoned.

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