MODULE 2 Cost Classification

Relevant and Irrelevant Costs

Avoidable and Unavoidable Costs

Avoidable costs are expenses that can be reduced when a company decides to change it's direction or projects. These costs are mostly applicable when deciding whether to discontinue a product. For example, a company is deciding whether to drop basketballs from their manufacturing line. The costs that can be reduced if the basketballs are dropped from the product line are usually variable costs like direct materials. Other costs that could be reduced when dropping the basketball from the production line include discretionary fixed costs such as:

marketing and sales expenses
research and development expenses

Unavoidable costs are also mostly applicable when deciding whether to discontinue a product. The costs that are still incurred if the basketballs are dropped from the product line are usually fixed costs like rental of factory.

Differential and Opportunity Cost

Differential costs are applicable when evaluating between the costs of different alternatives.

Opportunity costs are applicable when evaluating between the benefits (net profit) derived between different alternatives.

Sunk Cost

Sunk costs are past expenditure that are irrelevant in decision making.

Variable and Fixed Costs

Variable costs increases for every increase in unit of production.

Fixed costs does not vary with the volume of production.

Irrelevant or Non-Relevant Costs

These are also known as sunk costs, for example direct material which was purchased that is now obsolete and cannot be used for production. The costs of inventory should NOT be considered when making a decision.

Attributable Fixed Costs

These are fixed costs that are relevant costs. This usually arises when deciding to increase or decrease scale of operations. For example, in the case of a making a decision on whether to create or close down a department, the salaries of a department which are fixed in nature will increase or decrease respectively.

General fixed overheads are unaffected by decisions to increase or decrease scale of operations and should not be considered when making a decision unless incremental.

Absorbed Overhead

Is notional and should be disregard in decision making unless incremental.

Relevant Costs

To recap, relevant costs for decision making should only include:

Future costs
Cash flows information only
Incremental costs

Relevant Costs of Materials

Formula 1 replacement cost = Total units required for job X replacement cost
Formula 2 resale value = (Additional units that need to be purchased for job X replacement cost) + (units already in inventory X resale value)
Formula 3 alternative use = Total units that can be used as other material as a substitute X cost of substitute

Relevant Costs of Labour

Firstly, calculate both formula A and B.

Formula A = (direct labour hours required for job - spare capacity hours) X hourly labour rate for job
Formula B = (direct labour hours required for job X standard hourly labour rate) + (contribution earned per labour hour X labour hours required for job)

Relevant cost of labour is the lower of A or B.

Relevant Costs of Asset

To determine the deprival value of an asset follow the below diagram:

High-Low Method Formula

The formula for the high-low method for computing fixed and variable costs can be modified by the following:
((Total cost at high activity level - step up in fixed costs) - total cost at low activity level))/(Total units at high activity level - total units at low activity level) = variable cost per unit (v)

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