PM - Decision Making Techniques
Contents
Relevant Costing.......................................................................................................................... 2
DEFINITIONS: ........................................................................................................................... 2
RELEVANT COST OF MATERIALS: ............................................................................................. 2
RELEVANT COST OF LABOUR: .................................................................................................. 4
RELEVANT COST OF OVERHEADS: ........................................................................................... 6
RELEVANT COST OF NON-CURRENT ASSETS: .......................................................................... 7
Limiting Factors ........................................................................................................................... 8
Linear Programming .................................................................................................................. 10
Pricing Decisions........................................................................................................................ 14
PRICING FACTORS: ................................................................................................................. 14
DEMAND-BASED PRICING:..................................................................................................... 15
COST-BASED PRICING: ........................................................................................................... 16
MARKET-BASED PRICING: ...................................................................................................... 17
Limiting Factors - Shadow Prices ............................................................................................... 19
EXAMPLE 1 - SINGLE LIMITING FACTOR ................................................................................ 19
EXAMPLE 1 - SOLUTION: ........................................................................................................ 20
EXAMPLE 2 - MULTIPLE LIMITING FACTORS.......................................................................... 20
EXAMPLE 2 - SOLUTION: ........................................................................................................ 21
1
,Relevant Costing
DEFINITIONS:
Relevant cost may be defined as a future incremental cash flow.
Future cost is the expense that will be incurred in the future as a result of a decision. Any costs
incurred in the past, referred to as sunk costs, are ignored.
Incremental cost is the increase in total costs resulting from an increase in production or other
activity. Costs which are not specific or fixed are ignored.
Relevant costing is only concerned with cash flows. Non-cash flow items, such as depreciation,
are not relevant.
RELEVANT COST OF MATERIALS:
2
, Scenario 1:
A Ltd is considering a project which requires 100 kg of material. The material is in regular use
within the business. There are 400 kg of material in stock which were purchased for $1.40 per
kg. The current purchase price is $2 per kg. What is the relevant cost of the material to A Ltd?
Solution:
As the material is in regular use, whatever is taken from stock will ultimately need to be
replaced. 100 kg of material is needed, all of which is currently available in inventory. So, these
100 kg would need to be replaced at $2 per kg meaning a total material cost of $200. This
represents the future cash outflow in respect of material as a result of the decision of A Ltd to
undertake the project (i.e., it is the relevant cost of material)
The $1.40 is a sunk cost and is not relevant to the decision.
Scenario 2:
B Ltd is considering a project that requires 100 kg of material. The company has 500 kg in
inventory, which were purchased some years ago for $1.50 per kg. However, this material is no
longer in use within the business. The current purchase price is $2 per kg of material. B Ltd
could sell each kg for $0.90. What is the relevant cost of the material to B Ltd?
Solution:
As the material is no longer in use within the business, any stock taken will not need to be
replaced. However, taking 100 kg of inventory from the warehouse means that B Ltd will not
receive the resale value (or scrap value) of $0.90 for each kg. Thus, the cash flow impact of
using 100 kg of material is $90 (being 100kg * $0.90 each). This represents the relevant cost of
the material to B Ltd.
The $1.50 is a past cost (or sunk cost) and is excluded from our analysis. Also, the current
purchase price of $2 is not considered here.
Scenario 3:
C Ltd is considering a job that requires 100 kg of material. 350 kg of material are in inventory.
The material is no longer available to purchase and if it is not used by C Ltd on this proposed job
it would be used in the manufacture of product K. Each unit of product K uses 4 kg of material
and generates a contribution of $10. What is the relevant cost of the material to C Ltd?
Solution:
3
Contents
Relevant Costing.......................................................................................................................... 2
DEFINITIONS: ........................................................................................................................... 2
RELEVANT COST OF MATERIALS: ............................................................................................. 2
RELEVANT COST OF LABOUR: .................................................................................................. 4
RELEVANT COST OF OVERHEADS: ........................................................................................... 6
RELEVANT COST OF NON-CURRENT ASSETS: .......................................................................... 7
Limiting Factors ........................................................................................................................... 8
Linear Programming .................................................................................................................. 10
Pricing Decisions........................................................................................................................ 14
PRICING FACTORS: ................................................................................................................. 14
DEMAND-BASED PRICING:..................................................................................................... 15
COST-BASED PRICING: ........................................................................................................... 16
MARKET-BASED PRICING: ...................................................................................................... 17
Limiting Factors - Shadow Prices ............................................................................................... 19
EXAMPLE 1 - SINGLE LIMITING FACTOR ................................................................................ 19
EXAMPLE 1 - SOLUTION: ........................................................................................................ 20
EXAMPLE 2 - MULTIPLE LIMITING FACTORS.......................................................................... 20
EXAMPLE 2 - SOLUTION: ........................................................................................................ 21
1
,Relevant Costing
DEFINITIONS:
Relevant cost may be defined as a future incremental cash flow.
Future cost is the expense that will be incurred in the future as a result of a decision. Any costs
incurred in the past, referred to as sunk costs, are ignored.
Incremental cost is the increase in total costs resulting from an increase in production or other
activity. Costs which are not specific or fixed are ignored.
Relevant costing is only concerned with cash flows. Non-cash flow items, such as depreciation,
are not relevant.
RELEVANT COST OF MATERIALS:
2
, Scenario 1:
A Ltd is considering a project which requires 100 kg of material. The material is in regular use
within the business. There are 400 kg of material in stock which were purchased for $1.40 per
kg. The current purchase price is $2 per kg. What is the relevant cost of the material to A Ltd?
Solution:
As the material is in regular use, whatever is taken from stock will ultimately need to be
replaced. 100 kg of material is needed, all of which is currently available in inventory. So, these
100 kg would need to be replaced at $2 per kg meaning a total material cost of $200. This
represents the future cash outflow in respect of material as a result of the decision of A Ltd to
undertake the project (i.e., it is the relevant cost of material)
The $1.40 is a sunk cost and is not relevant to the decision.
Scenario 2:
B Ltd is considering a project that requires 100 kg of material. The company has 500 kg in
inventory, which were purchased some years ago for $1.50 per kg. However, this material is no
longer in use within the business. The current purchase price is $2 per kg of material. B Ltd
could sell each kg for $0.90. What is the relevant cost of the material to B Ltd?
Solution:
As the material is no longer in use within the business, any stock taken will not need to be
replaced. However, taking 100 kg of inventory from the warehouse means that B Ltd will not
receive the resale value (or scrap value) of $0.90 for each kg. Thus, the cash flow impact of
using 100 kg of material is $90 (being 100kg * $0.90 each). This represents the relevant cost of
the material to B Ltd.
The $1.50 is a past cost (or sunk cost) and is excluded from our analysis. Also, the current
purchase price of $2 is not considered here.
Scenario 3:
C Ltd is considering a job that requires 100 kg of material. 350 kg of material are in inventory.
The material is no longer available to purchase and if it is not used by C Ltd on this proposed job
it would be used in the manufacture of product K. Each unit of product K uses 4 kg of material
and generates a contribution of $10. What is the relevant cost of the material to C Ltd?
Solution:
3
