Managerial Accounting and Finance Module BS2512/BS2561 Decision Relevance Self-Study and Revision Pack

This pack contains several sample questions, with suggested answers: Decision-relevance (DR) is the least accounting-oriented of all the topics we study on this module except that it often involves altering or even ignoring the accounting interpretation! For an item to be decision-relevant, two key tests have to be met: 1. Does the item involve a future cash flow? AND 2. Does the future cash flow vary between the range of options available (in other words, does our decision make a difference to cash flows in future)? The dreaded opportunity cost is an example of a potential cash flow that varies between options: it usually doesnt happen as a consequence of the decision, but it would have done otherwise! Only if BOTH tests are met does an item qualify as relevant under DR principles. Many people are put off attempting such questions in exams because they are long typically up to two pages of text. Please bear in mind, however, that answers tend to be correspondingly shorter especially the numerical sections and that little in the way of calculation is involved I have attached four sample questions, with suggested answers: 1) Goosander Group is a reasonably testing DR question involving a minimum price calculation that reworks an accounting-based schedule. It includes some nasty tricks like an inter-company mark-up (which will not represent a cash cost for the organisation as a whole) and a cash discount with a confusing accounting treatment. Oblomov & Gogol Ltd is from the 2007 examination. It involves a can we make money on the quoted price? problem and includes a negative opportunity cost and a searching range of irrelevant committed costs. Geminiani Ltd is another can we match the price? exercise with some awkward items (for example, an unsubmitted bill for a pre-production feasibility study clearly represents a future cash flow, but is it relevant?). Its main interest is in a testing discussion question which very few students engaged with fully in the exam. The Saruman Group is another minimum price calculation, this time from a resit exam.

2) 3)

4)

If you need help on an individual basis, please dont hesitate to come and ask or post a comment onto the discussion board

Natalie Forde (R09) Email forden@cardiff.ac.uk

GOOSANDER GROUP Goosander Group Ltd specialises in building enormous model railway layouts for the super-rich. They have just completed a commission for a client who, it turns out, had been misled by a junk mail letter into thinking he had won millions. The client cannot afford the layout and they are advised that there is no point in suing him for the money. A rock star has offered to buy the layout, subject to extensive modifications being made, but she is not prepared to pay more than 200,000. Goosanders accountant suggests that her offer should be rejected as unprofitable and has produced the following schedule setting out a calculation of the full cost of the modifications: Original manufacturing cost of the layout 97,000 Less: deposit paid by original client 9,700 87,300 Add: legal advice on pursuing claim against the original client: 5,400 92,700 Modification materials at cost: Material X 12,300 Material Y 7,000 Material Z 15,200 Conversion kits at transfer price 58,200 Direct labour: Goosander employees 4,200 External contractors 5,500 Depreciation of specialist equipment 5,000 Rental charges for machinery to be used 500 Variable overheads 8,400 Fixed overheads 8,400 Delivery charges 2,400 On-site assembly charges after delivery 5,000 Total cost of conversion: 224,800 The following information is also available: A. The original deposit was paid partly in cash (100) and partly by cheque (9,600). The bank has today returned the cheque unpaid. B. An in-house lawyer who charges a flat fee of 1,000 per case provided the legal advice. The 5,400 represents the standard legal costs that would have been sought from the original client had the case gone to court. C. Modification materials consist of three items. X is always in stock and is frequently used. Its book cost is 12,300; the supplier has recently announced a 5% price increase. Y has a book value of 5,000 and would be scrapped if not used on this project; its scrap value is 500. However, only 38 metres of Y are in stock and another 12 metres would need to be bought in for 2,000. Z is in stock, having been bought for another project which is not due to start for 4 months. Replacing Z will cost 20,000. D. The conversion kits will be used for converting replica engines and carriages into the types specified by the new customer. The kits are supplied by Gander Ltd, a wholly-owned trading subsidiary of Goosander, and will be transferred to Goosander at an inter-company mark-up of

E.

F. G. H. I. J.

25% on purchase cost to match the open market price that would be charged to an external customer. This mark-up is included in the 58,200 scheduled above. Direct labour represents the cost of four technicians who will work on the project. 2,000 relates to two full-time employees whose contractual minimum wages will be 750 each, with overtime of 250 each. 1,000 relates to a freelance worker who is paid a weekly retainer of 50 for making himself available at short notice and who will be paid another 450 per week for the two weeks he will work on the job. 1,200 relates to a retired landscape modeller who already receives a weekly pension of 300 and who will return to work for two weeks on the conversion for a further 300 per week. The sum charged to the project for external contractors represents the contractors charges plus an administrative mark-up of 10% that Goosander routinely charges to clients when contractors are employed. The specialist equipment was to have been sold for a current scrap value of 2,000. Its value after use on the project will be 1,600. Its current book value is 6,600 and the depreciation charge represents the write-down from book value to scrap value if it is used on the project. The 500 for machinery rental represents normal hire rates. As a frequent user of the hire firm, Goosander receives a 10% discount. This has not been included in the calculation above, since it is Goosanders policy that discounts are not accounted for at an individual project level. Variable and fixed overheads have been included at a standard charge based on 200% of labour costs. It is estimated that variable overheads attributable to this project will not exceed 2,200. Delivery charges and on-site assembly charges are based on a standard pricing formula applied by Goosander. The actual costs of delivery will be 3,400, but on-site assembly will be performed by full-time employees who are paid a minimum wage, without overtime. Their travel and accommodation expenses are however estimated at 500 in total.

REQUIRED: (a) Prepare a revised draft of the accountants schedule using the principles of decision-relevance. Provide concise explanations of each item on the original schedule that you have retained, modified or excluded, and of any additional items you have included that are not in the original schedule. What is the minimum price that Goosander Ltd could charge to leave itself no better and no worse off in cash terms by taking on the project? (17 Marks) (b) Identify and explain FOUR differences between conventional full cost accounting and decisionrelevance, illustrating your explanations from your calculations in (a) above. (8 Marks) (Total 25 Marks)

Suggested answer: Goosander Group a) Redraft of schedule Item: Detail: A. Original manufacturing cost and deposit are both sunk cash flows historical items which cannot be changed by the decision of whether or not to proceed with the conversion. B. Legal advice is also irrelevant to the decision whether or not to proceed. The distinction between the 5,400 and the flat fee of 1,000 is therefore a red herring! C. Modification materials: 12.3k of material X: the book value of X is a sunk cost but, because it is regularly used, its replacement cost, the consequential cost to the company of using it, is a relevant cashflow (12,300 + 5%) Scrap value of Y is the opportunity cost of use (original cost is sunk) Buy-in costs of extra Y are incremental cashflow Zs 15.2k book cost is sunk but replacement cost is relevant Conversion kits: as the 58,200 includes a 25% inter-company mark-up which is not a cash cost to the organisation, this needs to be deducted. The transfer price is 125% of the original purchase cost and so the calculation to retrieve the original cost is: (58,200 x 100/125) = 46.560 Flat-rate wages (750 x 2 technicians) are committed costs which will be paid anyway. Only their overtime is incremental. The retainer is a committed cost: incremental wages are relevant The pension is being paid anyway: only incremental cashflow is relevant External contractors: the mark-up is not an incremental cashflow that is relevant in computing the minimum price (5,500 x 10/11) Depreciation is always irrelevant as the allocation of a sunk cost Loss of resale value (from current resale value of 2,000 to future value of 1,600) is a valid consequence of proceeding The actual cash rental cost to Goosander is 500 less 10% discount (the accounting treatment is not relevant as it does not affect how much is actually paid) Standard mark-ups for overheads can be ignored as they do not relate to any proven incremental cash flows Actual variable overheads are incremental to proceeding Delivery and on-site assembly: 3,400 plus 500 is the only cashflow incurred by the whole firm Total incremental cash impact of proceeding, and thus minimum price to leave the firm no better and no worse off: 12,915 500 2,000 20,000

D.

E.

46,560 500 900 600 5,000 400 450

F. G. H. I. J.

2,200 3,900 95,925

(b) The key conflict between decision-relevant principles and normal financial reporting lies in the areas of (i) cost allocation for product costing; and (ii) the principle of matching between costs and revenues for computing the profit in a period. Allocation-based accounting reflects all transactions that relate to the period being measured, whereas decision-relevance narrows this to future differential cash flows. Cost allocation aspects of this include: Depreciation of a fixed asset (e.g. the depreciation in the question that is an accounting cost of undertaking the project) would be ignored entirely, whereas the loss of scrap value involved by using that asset on a contract would be considered a direct consequence. Unless activity-based, this depreciation would be booked on a time basis for accounting purposes whether or not a particular project was undertaken. Conventional accounting would not distinguish between the flat-rate wages paid to existing staff and their overtime. Both would be costed to the project as direct wage costs. From a decision-relevance point of view, however, the former would be paid whether or not the project went ahead, while the latter are consequential costs of proceeding cash outflows that result directly from the decision. Fixed costs are always reflected in conventional accounting (accounting standards insist that product cost must reflect both the variable and fixed elements of manufacturing overhead costs). Pricing formulae (as in the standard hourly charge to cover fixed overheads) are usually constructed to ensure full cost recovery (at least, on average across the entire range of expected outputs) even when pricing decisions are delegated. Decision-relevance ignores fixed costs that are committed or unavoidable, but includes them if they are incremental cash flows that happen to be classified as fixed costs under accounting nomenclature. Conventional accounting tends to consider only the amount paid for a resource as being a cost, while decision-relevance considers wider impacts on the whole organisation. An example is the cost of material Z, bought for a delayed project elsewhere. Normal accounting would treat the acquisition cost as incremental costs of the current project, and would probably charge the other, delayed project with the higher replacement costs. Decision-relevance would ignore the irretrievable acquisition cost and charge the current project with the consequential cost of using stock that needs ultimately to be replaced. The matching concept sets out to marry up the income of a period with an appropriate proportion of the costs involved in earning that income. This may include direct matching, as in matching stock usage with sales, or indirect matching (where for example the annual depreciation of long-term fixed assets, or the total wages paid in a period, are treated as a charge against that income for no other reason than that they occur in the same time period). Decision-relevance takes a much narrower view of matching: only the incremental cash inflows and outflows arising from a decision are matched.

OBLOMOV & GOGOL LTD Oblomov & Gogol Ltd (OGL) builds protective vehicles for politicians in dangerous areas. A high profile contract involving six Mercedes conversions for a president of Druryland has recently been cancelled. The president of Catatonia has now expressed an interest in buying the converted cars, but only after major modifications. He is prepared to pay 400,000 per car. OGLs finance department has advised against the deal because it will be unprofitable, as the following schedule shows: Original completion cost for Druryland: Modification materials at cost or NRV: Additional wage costs: Painting and spraying: Electrical installations: Variable overheads: Depreciation of specialist equipment: Additional fixed overheads: Total cost of contract: The following information is also available: i) ii) iii) The original completion cost was calculated after a mark-up of 400,000 to cover the firms fixed overhead recovery. A deposit of 10% was paid personally by the president of Druryland and has been retained by OGL. This has not been reflected in the above calculation because the finance department is concerned that the government of Druryland may seek to reclaim it. Modification material consists of three categories. Material A, which originally cost 120,000, is already in stock. If not used on this contract it would be used to make explosion-proof clothing, saving the company a purchase cost of 150,000 for an alternative. Modification material B, which originally cost 200,000, has already been written down to its net realisable value of 80,000 following deterioration in storage; however, a suitable alternative material could now be bought in for 60,000. Material C was ordered in error six months ago and has no alternative use except on the Catatonia contract. Its purchase price of 100,000 has not yet been paid because OGL are in dispute with the suppliers. This material has no scrap value. OGLs full-time staff are paid a flat-rate minimum wage for a guaranteed working week. Wages in the schedule consist of 200,000 of flat-rate full-time wages and 80,000 of overtime payments because the job would need to be completed to tight deadlines. A further 30,000 of wage costs have been allocated to cover employers pension contributions which are contractually paid at 15% of flat-rate full-time wages. 140,000 of wage costs are the basic wages of temporary workers who would be hired to help finish the contract in time, and another 50,000 reflects the cost of full-time supervisors who would be transferred from another department without being replaced. Painting and spraying costs include a fixed availability charge of 10,000 per month for the painting service, which OGL uses regularly. Two months work would be involved. The painting company always offers OGL a 5% regular customer discount on its invoices but these are not allocated to individual contracts by the finance department. 1,900,000 300,000 500,000 200,000 100,000 50,000 20,000 150,000 3,220,000

iv)

v)

vi)

vii) viii)

ix)

Electrical installations would involve a fee of 25,000 paid to external contractors, and 75,000 to cover the cost of audio equipment that OGL would supply from its own stock. The supplier of this equipment, which OGL regularly uses in its luxury conversions, has just increased prices by 10%. Variable overheads have been allocated based on a standard pricing formula. It is estimated that actual variable overheads will be 55,000. A specialist machine which was about to be sold second-hand for 67,000 would be retained and used for the modifications. The depreciation has been calculated on a unit of output basis. If the machine is used for this job then the intended sale will not proceed and the machine can only be sold for its scrap value of 14,000. Fixed overheads have again been allocated to the modification project using a standard markup based on labour hours. The hire charges for a specialist machine, totalling 12,000, have been excluded from this because the standard allocation of overheads already covers more than this amount.

REQUIRED: (a) Redraft the schedule, using the principles of decision-relevance, to show whether it is worth OGL accepting the contract in cash terms. Explain briefly why you have excluded or amended any items on the original schedule, or included items not on the schedule. (15 marks) (b) Draft a report to the management of OGL recommending a course of action and explaining why the principles you have applied produce a different result from the profit-based calculations of the finance department. (10 marks) (Total 25 marks)

Suggested answer: Oblomov & Gogol Ltd Original completion cost: irrelevant to the decision, as already paid (sunk cost). The inclusion of a fixed overhead mark-up (even if real costs were involved) is also irrelevant to any future decision and should be ignored. Deposit: sunk income once more, whether or not the deposit will be reclaimed has no bearing on the decision whether to proceed Modification materials: A: original cost of 120,000 is sunk but the alternative use value is a potential future saving (= the opportunity cost of using it for this project) B: original cost is irrelevant, as has already been accepted. If used on this project, B will represent an opportunity cost of 80,000 (scrap value forgone) but commercial common sense suggests that OFL will prefer to sell B and buy in the alternative material for 60,000. This nets to a cash benefit of 20,000 (a negative opportunity cost) C: whatever price is eventually paid for C, while a future cash flow, is irrelevant to this decision as it arises from a past commitment. As C has no scrap value and no alternative use its opportunity cost is zero. Staff wages: 200,000 flat-rate wages would be paid anyway and are committed costs. Overtime = an incremental cost of proceeding Pension contributions are a committed cost (contributions due on overtime would be incremental) Temporary workers wages are a direct consequence of hiring staff for the project Supervisors wages: assumed to be paid anyway a committed cost Painting and spraying costs: 20,000 is a committed cost which the firm will pay regardless, but the balance of 180,000 less 5% discount is incremental (as the question can be ambiguously interpreted, also allow 180,000 less 5% x 200,000 = 170,000 as a valid interpretation!). The discount is a cash consequence of the decision, however accounted for. Electrical installations: Contractors: 25,000 is an incremental outflow Equipment: stock value is a sunk item but as this is regularly used it will need replacing at a price increase of 10% Variable overheads: the actual value is a relevant cash outflow Specialist equipment: Unit of output depreciation: depreciation is the accounting allocation of a sunk or committed cost and is ALWAYS irrelevant Loss of sale value: the opportunity cost of proceeding Fixed overheads: the standard mark-up is a convenience to allow pricing decisions to be delegated. Fixed overheads (by definition) are normally committed costs unless there are incremental cash outflows (here, the specialist machine hire) that happen to be labelled fixed by the accounting system. Relevant cost of proceeding: Price offered by Catatonia

150,000

(20,000) 80,000 140,000 171,000

25,000 82,500 55,000 53,000 12,000 748,500 2,400,00 0

Cash surplus from acceptance:

1,651,50 0

(b) Students should draft answers in report format addressed to the management of OGL. Key points: Proceeding with the modification will leave the firm over 1.5 million better off in cash terms than not proceeding. This may not produce the same result as a profit-based assessment - and in this case a profit-based assessment would suggest an accounting loss. Decision-relevance focuses on identifying future cash flows that are either incremental to a decision (inflows such as the price to be paid for the cars, outflows such as the overtime wage costs) or opportunity costs potential cash benefits forgone by adopting one course of action but which must be imputed to establish its economic cost. Conventional accounting uses several principles that almost contradict these ideas. Examples in the finance dept statement include: o The historic cost convention, where items such as stock are valued at acquisition cost until matched with a sale. Decision-relevance, in contrast, regards historic cost as an irrelevant sunk cost (as in the original value of the audio equipment) and substitutes either replacement cost (the replacement value of the equipment), alternative use value (as in material A), or scrap value (for example, material B) according to the circumstances. (The only overlapping feature between conventional accounting and decision-relevance is the lower of cost and NRV rule that has already been applied for B). o The matching concept sets out to marry up the income of a period with an appropriate proportion of the costs involved in earning that income. This may include direct matching, as in matching stock usage with sales, or indirect matching (where for example the annual depreciation of long-term fixed assets, or the total wages paid in a period, are treated as a charge against that income). This process has been described by Arnold and Turley (1996) as matching or recovering past costs. Decisionrelevance takes a much narrower view of matching: only the incremental cash inflows and outflows arising from a decision are matched. Depreciation of a fixed asset (even the output based depreciation in this instance that is an incremental accounting cost of undertaking the project) would be ignored entirely, whereas the loss of scrap value involved by using that asset on a contract would be considered a direct consequence; flat-rate wages that would be paid anyway are considered to be committed costs and ignored, whereas extra overtime that is incurred as a consequence of an action is included. o Conventional accounting would not distinguish between the flat-rate wages paid to existing staff and the wages paid to the newly hired staff in the question. Both would be costed to the project as direct wage costs. From a decision-relevance point of view, however, the former would be paid whether or not the project went ahead, while the latter are consequential costs of proceeding cash outflows that result directly from the decision. o Fixed costs are always reflected in conventional accounting (accounting standards insist that product cost must reflect both the variable and fixed elements of manufacturing overhead costs). Pricing formulae (as in the standard charge to cover fixed overheads) are usually constructed to ensure full cost recovery even when pricing decisions are delegated. Decision-relevance ignores fixed costs that are committed or unavoidable, but includes them if they are incremental cash flows.

GEMINIANI LTD Geminiani Ltd (GL) has been asked to tender for a contract to supply 20,000 Bumffree selfemptying in-trays, a combined document storage device and shredder that is aimed at overworked university staff. The maximum price per unit has been set by the potential customer at 30 and, while GLs management are keen to offer a competitive price because of the prestige nature of the contract, they are not prepared to lose money on the deal. GLs finance department has advised against tendering as the estimated cost of manufacturing the devices is well above 30. The calculations are set out below. Pre-production feasibility study 60,000 Cost of components already held in stock 90,000 Stock value of electric motors to be used in shredders 60,000 Cost of components to be bought in new 88,000 Designers fees 15,000 Unskilled labour, 5,000 hours at 10 per hour 50,000 Skilled labour, 3,000 hours at 18 per hour 54,000 Supervision costs, 2,000 hours at 25 per hour 50,000 Depreciation of production equipment 20,000 Allocation of factory space rental 14,000 General fixed overhead allocation, 8,000 hours at 10 per hour 80,000 External contractors charges 32,000 Safety testing and certification, 1 per unit 30,000 Storage and delivery costs 45,000 Total cost of manufacture: 688,000 Cost per unit for 20,000 Bumffrees: 34.40

After further enquiries you discover the following additional information: i) The pre-production feasibility study, intended to establish whether or not the product could be made, was carried out for GL by an amnesiac Professor of Engineering who has not yet submitted his bill. On the basis of his advice, GL decided that it should continue to research the tender. Of the components already held in stock, items with a book value of 40,000 are no longer used by GL and could be sold second-hand for 8,000. The remaining 50,000 of components are regularly used but would cost only 44,000 to replace as market prices have fallen. If not used for the Bumffree, the electric motors would have a second-hand value of 28,000, but could be reworked by external contractors at a cost of 6,000 and then used in another project to replace motors that would cost 90,000 to buy in new. The designers fees include a monthly commitment fee of 4,000 which is paid to the design company to ensure its availability for GLs projects. Staff are paid a flat-rate wage for a guaranteed working week in which overtime is not normally incurred. Any overtime worked is paid at standard hourly rates over and above the flat-rate wage. Unskilled labour in the schedule includes 500 hours of overtime and skilled labour 400 hours of overtime.

ii)

iii) iv) v)

vi) vii) viii) ix)

x) xi) xii)

Four supervisors would be required for the production. Three of these are already employed by the company but the fourth would need to be employed on a temporary contract. The equipment to be used for the Bumffree project has a net book value of 240,000 and one year of its projected useful life remaining. It could be sold for 50,000 if not used on this project, but its second-hand value will reduce by 12,000 if it is used. The factory space used by the Bumffree project is approximately one-third of the production area, for which GL pays 42,000 per month in rent on a 20-year lease that was signed five years ago. Fixed overheads have been allocated to the project using GLs standard overhead allocation of 10 per labour hour. You are told that additional costs of 11,000 for specialist tool and welding equipment hire have not been reflected in the schedules since they are more than covered by the standard allocations for fixed costs. External contractors charges do not reflect an expected 5% bulk discount which GLs accounting policy does not allocate to individual projects. Safety testing and certification is carried out in-house by a specialist department of GL which charges external customers a mark-up of 50% on cost. The schedule reflects this 50% markup. Storage and delivery costs include an allocation of 17,000 fixed warehouse rent that GL is committed to paying.

REQUIRED: (a) Redraft the schedule using the principles of decision-relevance and indicate why you have excluded or amended any items on the original schedule or included items not on the schedule. (15 marks) (b) Only those costs and benefits which differ between alternatives are relevant in a decision (Seal et al. 2006). Using your answer to part (a) above for illustration, critically evaluate this statement. (10 marks) (Total 25 marks)

Suggested answer: Geminiani Ltd a) Redraft of schedule Item: Detail: (i) Feasibility study: a committed cost if the professor ever remembers to submit his bill and payable whether or not the tender is continued (ii) Components in stock: 40k of material no longer used: sunk costs Scrap value represents opportunity cost of use 50k at cost: sunk and therefore irrelevant, but the consequential cost of using it is the replacement cost of 44k (iii) Motors: original cost of 60k is sunk The opportunity cost of using them is 84k (the alternative use value of 90k minus the rework cost of 6k), which is higher than the competing opportunity cost of selling them second-hand Components bought-in new: an incremental outflow of proceeding (iv) 4,000 of designers fees would be paid anyway The balance of 11,000 is assumed incremental (v) Flat-rate wages (10 x 4,500 hours and 18 x 2,600 hours) are committed costs which will be paid anyway 500 hours unskilled overtime x 10 is incremental cashflow 400 hours skilled overtime x 18 is incremental (vi) 1,500 hours of supervision wages are committed costs 500 hours x 25 supervision on a temporary contract is incremental (vii) Depreciation is always irrelevant as the allocation of a sunk cost Loss of resale value is a valid consequence of proceeding (viii) Factory rental is assumed to be a committed cost and payable anyway (ix) Standard mark-ups for overheads can be ignored as they do not relate to any proven incremental cash flows Additional hire costs are incremental to proceeding (x) While the contractors charges are incremental the discount is relevant (xi) The net cost of 20,000 (20,000 + 50% = 30,000) is the only cashflow incurred by the whole firm (xii) Storage & delivery: the 17,000 committed cost is excluded Total incremental cash impact of proceeding: Number of units to be produced: Incremental cost per unit: (b) Students are expected not simply to illustrate the differences between conventional accounting and the principles of decision-relevance but also to focus on the critical evaluation asked for in the question. Good answers should pick up on the critical analysis angle of this question and may well argue that there is an inherent conflict between decision-relevant principles and allocation-based accounting, particularly when a companys financial results or senior managers individual performance are being 8,000 44,000 84,000 88,000 11,000 5,000 7,200 12,500 12,000 11,000 30,400 20,000 28,000 361,100 20,000 18.06

judged on the latter. Ultimately, all costs (relevant or not) must be covered (preferably by a large margin) or a companys standing and financial viability may be threatened. The quotation as presented, Only those costs and benefits which differ between alternatives are relevant to a decision, is in fact lamentably vague in several key respects: 1. Costs and Benefits need to be more narrowly defined as incremental cash flows. If not, then it suggests that decisions might also be influenced by mere accounting entries that differ between alternatives. An obvious example is the 20,000 depreciation of production equipment in the question. This equipment would be sold at an accounting loss of 190,000 if not used for the project (NBV of 240,000 minus proceeds of 50,000) and at an accounting loss of 182,000 if used for the project (NBV of 240k, minus depreciation of 20k, minus proceeds of 38k) an apparent accounting difference of only 8k. The only relevant cash flow, other costs being irretrievably sunk, is the 12k loss of resale value. Similarly, unless the incremental cash flow test were applied, activity-based depreciation (an incremental variable cost in related techniques such as CVP) would be considered relevant to a decision. Deferred income (a sunk and therefore irrelevant cash flow in strict decisionrelevance terms) might also be recognised in line with different patterns of activity under accounting principles. 2. Except for very short-term decisions (where the opportunity cost of funds and the time value of money can effectively be ignored), even the definition of incremental cash flows may need to be amended. It may make more sense to evaluate differential cash flows not in money terms but in economic terms by adjusting on a DCF basis at the firms cost of capital. For any project involving either substantial amounts of money and/or timeframes in excess of a few months, time values should be reflected. 3. The short-term time horizon of many decision-relevance principles, which effectively treats underlying cash flows that do not differ between alternatives as irrelevant, is fine for one-off, operating decisions that can be treated in isolation as separate items from the firms core business stream. This is analogous to the principles of variable costing, which focus on identifying differential costs and revenues and treat all fixed costs as period expenses; these principles are widely recognised as more useful in decision-making than full cost allocation techniques. However, it is also arguable that short-term operating decisions are, in effect, freeloading on the firms mainstream business. Cash inflows from this mainstream business must be big enough to cover a whole raft of underlying cash flows fixed costs such as rent, and direct costs such as basic minimum wages which have to be covered for the firm to survive. On a reduction ad absurdum basis, a firm whose entire business portfolio consisted of one-off projects might rapidly run into trouble if it treated each on a standalone basis, without regard for the ability of the entire portfolio to generate surplus cash to cover its underlying fixed cost base irrelevant to each one-off decision though such costs undoubtedly are. Subject to the above qualification, the key conflict between decision-relevant principles and normal financial reporting lies in the areas of (i) cost allocation for product costing and (ii) the principle of matching between costs and revenues for computing the profit in a period. Allocation-based accounting reflects all transactions that are considered relevant to the period being measured; decisionrelevance adopts a far narrower, differential cash flow-based approach.

SARUMAN GROUP The Saruman Group has just completed 12 long-range guns for an overseas client. The client cannot take delivery, having been invaded by barbarian hordes, and no alternative customer has offered a satisfactory price for the guns. There have been discussions with a local dictator who requires 12 mobile laser cannon. Similar purpose-built cannon are normally sold for 300,000 each and the dictator would be prepared to offer 2,750,000 for all twelve guns if satisfactorily converted to laser cannon. Sarumans accountant has calculated the cost of converting the guns and concluded that the company will lose money. The calculation is: Original manufacturing cost of guns: 1,500,000 Less: deposit paid by original customer: 150,000 1,350,000 Conversion costs: Electronics department salaries 200,000 Production department wages 598,000 Materials and components at cost 348,000 Variable overhead allocation 120,000 Fixed overhead allocation 600,000 1,866,000 Other costs: Supervisory expenses 88,000 Certification and inspection costs 66,000 Delivery costs 47,000 Total cost of project: 3,417,000 The following additional information is available: i) ii) Electronics department salaries are a fixed rate of 3,000 per month. The conversion will involve 60 staff-months, with overtime payments accounting for the balance of the 200,000. The production workforce is paid a fixed wage which is not dependent on productivity. Overtime is not normally worked, but, because the department is working near full capacity, an estimated 10,000 hours of overtime at 12 per hour has been included in the costings for the project. Temporary labour costing a total of 98,000 will also need to be hired by the production department to ensure that another urgent project is completed on time: this cost is not included in the conversion costing. 150,000 of special components will need to be bought in. The remaining materials in the schedule consist of items that are currently in stock. 100,000 of this material has no alternative use and would otherwise be worth 40,000 as scrap, but the other 98,000 of material is used regularly and will cost 109,000 to replace after a supplier price increase. Variable overheads are allocated to projects at a standard rate based on a percentage of production wages. The accountant tells you that actual overheads will not exceed 20,000, but this amount is not in the schedule since it is more than covered by the overhead allocation anyway.

iii) iv)

v)

vi) vii)

viii) ix) x)

Fixed overheads are allocated to projects at a standard rate of 300% of electronics department wages. An additional cost of 70,000 for the hire of specialist machinery has not been reflected in the schedule because it is lower than the standard overhead allocation. Supervisory costs consist of the basic salaries of four specialist supervisors who will be transferred from another department to the project for 6 months. These supervisors are not paid overtime. To replace them, two supervisors will be hired from outside the company on a 6 month contract at a cost of 20,000 each, while two more, currently earning 15,000 each per year in-house, will receive temporary promotion and be paid 2,000 per month each for six months. Costs of certification and inspection will be 5,500 per cannon. This is an internal recharge from a subsidiary company of Saruman and includes a standard mark-up of 2,000 per cannon above cost. Delivery costs include 13,000 of drivers and security staffs salaries. 11,000 of this represents contractual minimum wages. If the project does not go ahead, the best alternative offer for all twelve guns has been 45,000 each from a local scrap metal merchant.

REQUIRED: (a) Redraft the accountants schedule using the principles of decision-relevance and explain why you have excluded any items on the schedule or included items not on the schedule. What is the minimum price that would leave the Saruman Company no better and no worse off in cash terms if it proceeds with the conversion? (15 marks) (b) Only future cash flows that differ between one or more of the options available are relevant to short-term operating decisions. Conventional accounting mixes up the past and the future. Illustrate from your answer to (a) above the main differences between traditional accounting and the principles of decision-relevance. (10 marks) (Total Marks 25)

Suggested answer: Saruman Group a) Redraft of schedule Item: Detail: Original manufacturing cost is a sunk cost: Deposit paid by original customer is sunk revenue (i) Conversion costs: Electronic dept 60 staff-months paid at fixed rate of 3,000: committed costs Balance (200,000 - 180,000) is incremental overtime 20,000 (ii) Production department fixed wages: committed and therefore irrelevant, but overtime of 12 x 10,000 hours is incremental 120,000 (iii) Temporary labour: even if not costed to this project, this is a consequential cost of taking it on and thus a relevant cash flow 98,000 (iv) Materials and components: Incremental special components are a relevant cost 150,000 Material with no alternative use is a sunk 100,000, but its scrap value of 40,000 is an opportunity cost 40,000 98,000 value of regular use material is sunk but its replacement cost is a consequential cash impact of using it for this project 109,000 (v) The standard mark-up for variable overheads is not incremental However, the identified incremental VOHs are relevant 20,000 (vi) Standard mark-ups for fixed overheads can also be ignored as they do not relate to any proven incremental cash flows However, specialist machinery hire costs are incremental cash flow however they are labelled by the accounting system 70,000 (vii) Basic salaries of all four supervisors can be assumed to be paid anyway Cost of replacements in the other department is a consequential cash flow and relevant to this project (2 x 20,000) 40,000 Incremental promotion pay for the other two replacements is also a relevant cash consequence (2 x 2,000 x 6 months) = 24,000, minus 2 x 7,500 of existing salaries that would be paid anyway 9,000 (viii) Incremental cost to the company for certification is only 12 x 3,500 42,000 (ix) Only the incremental wages above and beyond the committed minimum are relevant (13,000 11,000) 2,000 Other costs (47,000 13,000) must be assumed incremental 34,000 (x) Scrap value for the guns (12 x 45,000) is an opportunity cost of proceeding 540,000 Total incremental cash impact of proceeding therefore: 1,294,000 Price offered by local dictator: 2,750,000 Potential cash surplus on project: 1,456,000 (B) see, for example, the suggested answer to Goosander Group above.