1. Costs for decision making
Financial Decision Making 2 Costs for decision making

2. Costs for decision making
Relevant costs
Cost behaviour
Reading: Drury chapter 2
Financial Decision Making 2 Costs for decision making

3. Financial Decision Making 2 Costs for decision making
What is a cost?
The amount of resources, usually measured in monetary terms, sacrificed to achieve a particular objective.
This is not necessarily the same as the amount paid.
Financial Decision Making 2 Costs for decision making

4. Relevant costs for decisions
Example:
You paid £3,000 for a car at an auction. You have just been offered £5,000 for the car. What is the cost to you of keeping the car for your own use?
By retaining the car you are forgoing cash of £5,000. Any decision should take this into account.
£5,000 is the ‘opportunity cost’ of the decision.
Financial Decision Making 2 Costs for decision making

5. Which costs are relevant?
Costs which relate to the objective
Costs which vary from one possible outcome to another.
Opportunity costs
Future (outlay) costs
Financial Decision Making 2 Costs for decision making

6. Which costs are not relevant?
Historic (sunk) costs
Committed costs
Future costs which do not vary as a result of the decision
Financial Decision Making 2 Costs for decision making

7. Relevant costs activity 1
A garage business has an old car that it bought several months ago. The car needs a replacement engine before it can be driven. It is possible to buy a reconditioned engine for £300. This would take seven hours to fit by a mechanic who is paid £12 an hour. At present the garage is short of work, but the owners are reluctant to lay off any mechanics or even to cut down their basic working week because skilled labour is difficult to find and an upturn in repair work is expected soon.
The garage paid £3,000 to buy the car. Without the engine it could be sold for an estimated £3,500. What is the minimum price at which the garage should sell the car with a reconditioned engine fitted?
From Accounting – an Introduction, McLaney and Atrill (Pearson Education Ltd, 2008), activity 8.2
Financial Decision Making 2 Costs for decision making

8. Relevant costs activity 2
Assume exactly the same circumstances as in activity 1, except that the garage is quite busy at the moment. If a mechanic is to be put on the engine-replacement job, it will mean that other work that the mechanic could have done during the seven hours, all of which could be charged to a customer, will not be undertaken. The garage’s labour charge is £40 an hour, although the mechanic is paid only £12 an hour.
What is the minimum price at which the garage should sell the car, with a reconditioned engine fitted, under these altered circumstances?
From Accounting – an Introduction, McLaney and Atrill (Pearson Education Ltd, 2008), activity 8.3
Financial Decision Making 2 Costs for decision making

9. Financial Decision Making 2 Costs for decision making
Cost behaviour
Different items of expenditure behave in different ways
Looking at the way costs change as the level of activity changes
Financial Decision Making 2 Costs for decision making

10. Financial Decision Making 2 Costs for decision making
Variable costs
Total costs change with the level of activity
Variable cost per unit is constant
When output zero, cost zero
Example – raw materials
No of units
Total cost
Cost per unit
Financial Decision Making 2 Costs for decision making

11. Financial Decision Making 2 Costs for decision making
Fixed costs
Stay the same, irrespective of changes in activity
When output zero, cost still exists
Example - rent of shop premises
No of units
Total cost
Cost per unit
Financial Decision Making 2 Costs for decision making

12. Financial Decision Making 2 Costs for decision making
Stepped fixed costs
Fixed over a certain activity range
At particular point, step increase in a fixed cost
Example – rent of premises for a hairdressing business
No of units
Total cost
Financial Decision Making 2 Costs for decision making

13. Financial Decision Making 2 Costs for decision making
Semi-variable costs
Variable rate per unit in addition to a constant fixed charge
Example – telephone bill
Line rental /Standing charge fixed
Calls / units used variable
No of units
Total cost
Cost per unit
Financial Decision Making 2 Costs for decision making

14. Purpose of cost behaviour analysis
Predict costs at different levels of activity
Forecasting and extrapolating
Budgeting
Decision-making
Financial Decision Making 2 Costs for decision making

15. Problems with cost behaviour analysis
Oversimplification?
Accuracy of data about past costs
Assumes only volume changes affect costs
Assumes costs follow a straight line
Only applies in the short term
Need to regularly review cost behaviour
Financial Decision Making 2 Costs for decision making