Relevant Costing & Capital Budgeting: Tools for Smart Decisions

TAKEAWAYS:

• Relevant costing focuses only on differential costs (future, avoidable costs) and ignores sunk costs (past, unavoidable costs) for short-term decisions like make/buy or product mix.
• Capital budgeting evaluates long-term investments using NPV (net present value), IRR (internal rate of return), and payback period to rank projects.
• Opportunity costs (lost benefits from alternative choices) are critical in both relevant costing and capital budgeting decisions.
• Time value of money is the core principle behind discounting cash flows in capital budgeting.
• Decision rules:
  • Accept a project if NPV > 0 or IRR > required rate of return.
  • Choose the project with the highest NPV or shortest payback period (if risk is a concern).
• Common pitfalls: Ignoring working capital changes, tax effects, or inflation in capital budgeting calculations.

1. Relevant Costing: The Art of Ignoring Irrelevant Costs

Relevant costing is a decision-making tool that helps managers choose between alternatives by focusing only on differential costs (costs that differ between options) and differential revenues. It ignores sunk costs (past costs already incurred) and unavoidable costs (costs that remain the same regardless of the decision).

Key Concepts

classDiagram
    class Cost {
        <<abstract>>
        +isRelevant() bool
    }
    class SunkCost {
        +isRelevant() false
        +description "Past costs, already incurred"
    }
    class DifferentialCost {
        +isRelevant() true
        +description "Future costs that differ between alternatives"
    }
    class OpportunityCost {
        +isRelevant() true
        +description "Lost benefit from the next best alternative"
    }
    class UnavoidableCost {
        +isRelevant() false
        +description "Costs that remain the same regardless of decision"
    }
    Cost <|-- SunkCost
    Cost <|-- DifferentialCost
    Cost <|-- OpportunityCost
    Cost <|-- UnavoidableCost

Types of Costs in Decision Making

When to Use Relevant Costing?

Relevant costing is used for:

1. Make vs. Buy Decisions (e.g., should a company manufacture a part or buy it from a supplier?).
2. Product Mix Decisions (e.g., which products should a company prioritize given limited resources?).
3. Special Order Decisions (e.g., should a company accept a one-time order at a lower price?).
4. Keep vs. Drop Decisions (e.g., should a company discontinue a product line?).

2. Relevant Costing in Action: Worked Example

Scenario: Kathmandu Electronics is considering whether to manufacture a component in-house or buy it from a supplier. The company has the following data:

Additional Information:

• The company has idle capacity (can produce up to 10,000 units but currently produces only 8,000).
• If the company buys from the supplier, it can reduce fixed overhead by 20% (Rs 60,000/year).
• The supplier offers a discount of Rs 5/unit for orders above 5,000 units.

Step 1: Identify Relevant Costs

• Differential Costs:
  • Direct materials: Rs 100 (make) vs. Rs 120 (buy) → Difference: Rs 20/unit.
  • Direct labour: Rs 50 (make) vs. Rs 0 (buy) → Difference: Rs 50/unit.
  • Variable overhead: Rs 20 (make) vs. Rs 0 (buy) → Difference: Rs 20/unit.
  • Total variable cost difference: Rs 90/unit (make is cheaper).
• Opportunity Cost:
  • If the company buys, it can use the freed capacity to produce 2,000 additional units at a contribution margin of Rs 30/unit (assuming selling price Rs 200 and variable cost Rs 170).
  • Opportunity cost: Rs 60,000 (2,000 × Rs 30).
• Avoidable Fixed Overhead:
  • The company can reduce fixed overhead by Rs 60,000/year if it buys the component.

Step 2: Calculate Total Relevant Costs

Step 3: Make the Decision

• Make: Rs 1,600,000
• Buy: Rs 1,440,000
• Conclusion: The company should buy the component because it saves Rs 160,000/year.

3. In the Real World

Relevant costing and capital budgeting are used daily by Nepali and global businesses to make smart financial decisions:

1. eSewa (Nepal):

   • Relevant Costing: When deciding whether to outsource customer service to a call center (e.g., in India) or hire in-house agents, eSewa compares:
     • Differential cost of outsourcing: Rs 150/hr vs. Rs 200/hr for in-house agents.
     • Opportunity cost: Lost brand control vs. savings on office space.
   • Result: eSewa outsources non-critical services to reduce costs.

2. Ncell (Nepal):

   • Capital Budgeting: Before launching 5G infrastructure, Ncell evaluates:
     • NPV of 5G investment: Rs 20 billion initial cost vs. Rs 50 billion in 5-year revenues (discounted at 12%).
     • IRR: If IRR > 12%, the project is viable.
   • Result: Ncell proceeds with phased 5G rollouts based on NPV analysis.

3. Daraz (Nepal):

   • Product Mix Decision: Daraz uses relevant costing to decide which products to promote during sales (e.g., electronics vs. groceries).
     • Example: If selling a smartphone (high margin Rs 2,000) uses the same warehouse space as groceries (margin Rs 500), Daraz prioritizes smartphones because the differential revenue is higher.
   • Opportunity Cost: Lost sales from competitors if Daraz doesn’t stock a high-demand item.

4. Nepal Rastra Bank (NRB):

   • Loan Approval (Capital Budgeting): Before approving a Rs 50 million loan for a hydropower project, NRB calculates:
     • Payback period: 8 years (acceptable if < 10 years).
     • NPV: Rs 20 million (positive, so loan is approved).
   • Relevant Costs: Only future cash flows (project revenues minus operating costs) are considered; past loan applications (sunk costs) are ignored.

5. Pathao (Nepal):

   • Special Order Decision: When a corporate client (e.g., Hotel Yak & Yeti) requests bulk rides at a discounted rate, Pathao calculates:
     • Differential cost: Rs 50/ride (driver wages + fuel) vs. Rs 100/ride (normal fare).
     • Opportunity cost: Lost revenue from individual riders if routes are diverted.
   • Result: Pathao accepts the order if the differential revenue (Rs 50 × 1,000 rides = Rs 50,000) exceeds the opportunity cost.

4. Capital Budgeting: Evaluating Long-Term Investments

Capital budgeting involves analyzing large investments (e.g., buying machinery, expanding a factory, or launching a new product line) using discounted cash flow (DCF) techniques.

Key Techniques

Step-by-Step NPV Calculation

Scenario: Himalayan Dairy is considering buying a new Rs 5 million milk processing machine. The machine will:

• Increase annual cash inflows by Rs 1.5 million for 5 years.
• Have a salvage value of Rs 500,000 at the end of Year 5.
• The company’s required rate of return (discount rate) is 12%.

Step 1: Calculate Present Value (PV) of Cash Flows

Step 2: Calculate NPV $$NPV=PVofCashFlows-InitialInvestment=5,496,500-5,000,000=496,500$$

Decision: Since NPV > 0, Himalayan Dairy should buy the machine.

5. Comparing Relevant Costing and Capital Budgeting

6. Common Mistakes to Avoid

1. Including Sunk Costs:

   • ❌ Wrong: "We already spent Rs 2 million on this machine, so we must keep using it."
   • ✅ Correct: Focus on future costs (e.g., maintenance, salvage value).

2. Ignoring Opportunity Costs:

   • ❌ Wrong: "Buying this land costs Rs 50 million, so our cost is Rs 50 million."
   • ✅ Correct: If the land could earn Rs 2 million/year in rent, the opportunity cost is Rs 2 million/year.

3. Miscounting Cash Flows:

   • ❌ Wrong: Using accounting profit instead of cash flows in NPV.
   • ✅ Correct: NPV uses actual cash inflows/outflows, not net income.

4. Assuming All Fixed Costs Are Avoidable:

   • ❌ Wrong: "If we stop Product X, we save all Rs 1 million in fixed overhead."
   • ✅ Correct: Only avoidable fixed costs (e.g., rent for a dedicated factory) should be considered.

5. Not Adjusting for Inflation:

   • ❌ Wrong: Using nominal cash flows without adjusting for inflation.
   • ✅ Correct: Use real cash flows or adjust the discount rate for inflation.

7. Worked Example: Break-Even Analysis with Relevant Costing

Scenario: Kathmandu Bakery is deciding whether to add a new product line (gluten-free bread). The company has the following data:

Question: Should Kathmandu Bakery introduce gluten-free bread if it expects to sell 3,000 units/month?

Step 1: Calculate Contribution Margin per Unit

$$\text{Contribution Margin}=\text{Selling Price}-\text{Variable Cost}=150-80=\text{Rs 70/unit}$$

Step 2: Calculate Break-Even Point

$$\text{Break-Even Units}=\frac{\text{Fixed Costs}}{\text{Contribution Margin}}=\frac{50,000}{70}\approx 714\text{ units}$$

Decision: Since 3,000 > 714, the bakery should introduce gluten-free bread because it will cover fixed costs and generate profit.

Step 3: Calculate Profit at 3,000 Units

$$\text{Total Revenue}=3,000\times 150=\text{Rs 450,000}$$ $$\text{Total Variable Cost}=3,000\times 80=\text{Rs 240,000}$$ $$\text{Total Fixed Cost}=\text{Rs 50,000}$$ $$\text{Profit}=450,000-240,000-50,000=\text{Rs 160,000}$$

Opportunity Cost Consideration:

• If Kathmandu Bakery does not introduce gluten-free bread, it could increase regular bread sales by 2,000 units (contribution margin Rs 50/unit).
• Opportunity Cost: 2,000 × Rs 50 = Rs 100,000.
• Adjusted Profit: Rs 160,000 (gluten-free) - Rs 100,000 (opportunity cost) = Rs 60,000.

Final Decision: Still profitable, so proceed.

8. Capital Budgeting in Action: IRR vs. NPV

Scenario: Pokhara Textiles is evaluating two projects:

1. Project A: Rs 10 million initial investment, Rs 3 million/year for 5 years.
2. Project B: Rs 15 million initial investment, Rs 5 million/year for 5 years.

Discount Rate: 10%.

Step 1: Calculate NPV for Both Projects

Decision (NPV): Choose Project B (higher NPV).

Step 2: Calculate IRR for Both Projects

Decision (IRR): Choose Project B (higher IRR).

Conflict Resolution:

• If the company has limited capital, it might choose Project A (smaller investment, still positive NPV).
• If the goal is maximizing value, Project B is better despite higher risk.

Exam Tip

1. Relevant Costing Questions:

   • Always identify sunk costs and ignore them.
   • Calculate differential costs and opportunity costs separately.
   • Common Exam Traps:
     • Forgetting to include opportunity costs (e.g., lost revenue from alternative use of capacity).
     • Treating all fixed costs as avoidable (only avoidable fixed costs matter).
   • Example Question:

     "A company has idle capacity. Should it accept a special order at Rs 200/unit if variable cost is Rs 150/unit and fixed cost is Rs 50,000/month?" Answer: Yes, because contribution margin (Rs 50/unit) > 0, and no additional fixed costs are incurred.

2. Capital Budgeting Questions:

   • NPV is king—always calculate it first.
   • IRR is useful but can give conflicting signals if projects have different scales.
   • Payback period is simple but ignores time value of money.
   • Common Exam Traps:
     • Forgetting to discount cash flows (use the PV table or formula).
     • Ignoring working capital changes (e.g., initial investment includes inventory purchases).
     • Misapplying the discount rate (use the company’s required rate of return, not a random rate).
   • Example Question:

     "Calculate the NPV of a project with initial cost Rs 200,000 and cash inflows of Rs 80,000/year for 4 years at 12% discount rate." Solution: Year 1: $80,000/1.12=71,429$ Year 2: $80,000/1.12^2=63,756$ Year 3: $80,000/1.12^3=56,949$ Year 4: $80,000/1.12^4=50,752$ NPV = (71,429 + 63,756 + 56,949 + 50,752) - 200,000 = Rs 42,886 → Accept.

3. General Tips:

   • Draw diagrams (e.g., T-accounts for relevant costing, cash flow timelines for capital budgeting).
   • Label all assumptions (e.g., "Assuming no inflation," "Assuming straight-line depreciation").
   • Show all steps—examiners reward clear, logical flow.
   • Practice numericals—this unit is 50% numerical, so master calculations.

Final Mermaid Diagram: The Accounting Decision-Making Cycle

flowchart TD
    A["Decision Point\n(e.g., Make vs. Buy, Project Selection)"] --> B["Identify Relevant Costs\n(Differential, Opportunity, Avoidable)"]
    B --> C["Calculate Incremental Costs & Revenues"]
    C --> D["Apply Decision Rules\n(Relevant Costing: Choose Lower Cost\nCapital Budgeting: NPV > 0, IRR > Hurdle Rate)"]
    D --> E["Implement Decision"]
    E --> F["Monitor & Evaluate\n(Post-decision audit: Did we save money? Was NPV positive?)"]
    F -->|"Feedback"| A
    A -->|"New Decision"| B