MBA Accounting

Notional Costs

Notional costs are also known as imputed cost. The primary objective of charging notional costs is to enable management to make clearer internal decisions by making sure that internal decision making become more realistic by assuming that the cost of all resources consumed reflects the full economic value - usually by applying market prices.

• Notional charges are typically used to charge responsibility centres.

• Notional interest is often charged for the use of internally generated funds.

Examples of using notional cost to enhance internal management making decisions:

• Charging of ’market rent’, where buildings have been purchased on a freehold basis. Such a mechanism helps to focus management attention on making best use of space so that surplus space across the whole organisation might then be sold or rented to another user.

• Intra division charges to enable management to see the “true” performance of certain departments

Sunk Costs:

Sunk cost is defined by ICMA terminology as

A past cost not directly relevant in decision making.

• If we refer to relevant costs, the main feature is that we are referring to FUTURE costs.
• As Sunk costs are cost which have already been incurred therefore it should be ignored when making any decisions.
• Sunk costs are irrelevant costs which are simply  costs that will not affect the decision.
• By analyzing these type of sunk costs, management will be wasting their time and efforts as these costs do not affect the decision they are going to make.

In short term decision making, fixed costs are generally regarded as sunk costs.

Illustration:

Say Company A has a factory which produced product A. Earlier last year it has extended and renovated the factory at an additional cost of $200,000 to produce product B. Now management is thinking of whether to let outsiders produce product B or not. Should this $200,000 be considered?

$200,000 is sunk costs which existed as a result of previous decision.

Committed Costs:

• These costs are similar to sunk costs in that they exist as a result of previous decisions although the ‘charge’ has yet to be incurred or the cash released.
• Committed costs are costs that have been committed by management.
• Examples are like renovation of factory premises, capital expenditures being incurred as company’s purchase orders have been issued or workdone is partially completely and payment to suppliers still outstanding

However, the abovementioned costs committed contractually is effectively a sunk cost.

Illustration:

Question:

Say company A is unable to rent out its building/workshop but there is a need to sign off a contract to spend $70,000 on an air conditioning system. Would this make any difference to management decision?

Answer:
None whatsoever. This type of situation might be awkward but past costs (and mistakes) should not impact upon the logic of financial decision making. The $70,000 that has been committed contractually is effectively a sunk cost.

[ Also refer to earlier articles on Relevant Costs ]

OPPORTUNITY COST

Represents the opportunities which have been forgone by following one course of action rather than an alternative course.

The opportunity cost in this case is the profit foregone by utilizing scarce resources for one particular course of action.

Illustration:

Company A may either manufacture or buy a component from an outside supplier.

If it buys from outside, the spare capacity can be rented out to another manufacturer for $20,000.

The opportunity cost of making the component would be to lose the opportunity to earn the $20,000

Note that the opportunity cost does not involve cash transaction but it is “relevant” to decision making.

INCREMENTAL OR DIFFERENTIAL COST

Incremental cost is used interchangeably with differential cost.

Incremental cost is the additional cost and revenue that may result from each degree of change in the level or nature of activity.

Whilst Differential cost is the difference in the cost and revenue between two alternatives.

Illustration:

Company A need to consider whether or not to accept a special order.

One relevant piece of information will be the variable cost.

The relevant cost before taking this special order is $25,000 and after taking the order it is $35,000.

Therefore the differential or incremental cost is $35,000-$25,000 which is $10,000

AVOIDABLE COST

Is cost that can be avoided if a given alternative is not adopted.

Illustration:

Assuming that a manufacturer decides not to proceed with a new product line which enable total savings in direct material, labor, direct expenses and variable costs of $10,000.

In this case, the differential cost of $10,000 can be avoided. The $10,000 is the avoidable cost.

RELEVANT COSTS

Management needs sufficient and relevant information make the correct decisions.

Hence, the need to understand relevant costs.

A relevant cost relates to future expected costs that will differ with each alternative used.

Because of the difference amongst alternative, hence it has a bearing on the decision to be made.

Irrelevant costs simply are costs that will not affect the decision. By analyzing these type of irrelevant costs, management will be wasting their time and efforts as these costs do not affect the decision they are going to make.

FEATURES or CRITERIA of Relevant Costs:

· Relevant cost is a cost that will be incurred in the future. Historical costs are sunk costs which has no relevancy in the decision making.

· The costs must differ between alternatives. If a cost is the same whether we choose alternative A or B then this is an irrelevant cost. A good example is factory rental which remains the same irrespective of management wanting to manufacture product A or B.

· Only CASH flow item And Incremental fixed costs are relevant. Non cash item like depreciation and absorbed fixed overheads are not relevant costs as they do not involve any additional cash flow.

AREAS OF SHORT TERM DECISIONS WHERE RELEVANT COSTS ARE APPLIED:

· Limiting factor due to scarce resources;

· Make or Buy decision;

· Accept or Reject special order;

· To continue or discontinue or shut down decisions;

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