 Namaste. In our earlier sessions, we have been discussing about CVP, BEP analysis, different types of decision making scenarios. We have seen how it can be used for profit planning. We have seen product mix, key factor base decision making and so on. Now, let us learn and discuss a few more concepts and then we will again go back to further cases. So, now, we are going to talk about relevant costs in decision making. So, we will see the difference between relevant versus sunk cost, make or buy decision, shut down decision, joint product, allocation of joint product costs and so on. Now, what is a relevant cost? Now, when it comes to decision making, it is very important for a manager to be able to identify the relevant cost. In financial accounting, we look at the historical cost, but here the relevant cost is not a historical cost, but it is a future cost which is associated with different inputs and activities for a particular decision. So, relevant cost depends on the decision which we want to take because as per decision what cost is relevant needs to be considered. Now, this is the expected future cost which differs with alternative course. Normally, variable costs are relevant and fixed costs are not relevant. Of course, I have said normally or usually, it may not be every time. Now, let us take an example of make or buy or special pricing decision. In make or buy scenario, what cost will be relevant? Suppose we are producing it ourselves, fixed costs are anyway not going to change. So, what matters is a variable cost of manufacture versus the purchase cost. If there is any change in the transport cost, we will add the transport cost to purchase cost. So, we compare the variable cost of making versus variable cost of buying. Do not involve fixed cost into it because it is a short term decision and it is not going to change by make or buy. That is why in make or buy scenario, variable cost of manufacture is an important relevant cost. Similarly, in case of special pricing, by special pricing what we mean is if this pricing is not going to disturb our normal market prices or it is not going to affect our normal customers, we can afford to sell at much lower prices. We can just sell at cost enough to cover our variable costs. If you remember one of the cases, we had discussed about pricing for government contract which was not to affect the normal market. So, variable cost was 72, normal selling price was around 152. We had sold, they taken a decision to sell it at just at 92. So, that we can cover variable cost, any incremental fixed cost, not total fixed cost, just the incremental fixed cost and a small profit maybe. This is how a special pricing can be done and it is very important for us to identify the relevant cost and just charge the relevant cost. Though as a general rule, we say that variable costs are mostly relevant and fixed costs are not. It is not that it is always true. So, it is not necessary that every variable cost is relevant. Similarly, every fixed cost may not be irrelevant. Again, if you remember the earlier case of government contract, there was going to be some increase in the production fixed costs. Then that incremental part of fixed cost was considered as relevant. Suppose you are doing a make or buy decision, normally as we discussed, variable cost of manufacture is relevant versus the variable cost of buying is relevant. But suppose some of the raw materials are lying idle with us and they are close to expiry date and they will have to be thrown out if we do not use. In such scenario, since the raw material is lying idle, we may not consider the cost of raw material as relevant because anyway it is going vested. So, there is no point is including it in the variable cost of manufacture. Are you getting it? One more of a day to day example, not a business kind of example. Let us say in summers, water is in sharp short supply. People pay for buying water. The cost of water increases substantially. If the season changes and rainy season starts and lot of water is pouring through rains, perhaps the cost of water will become 0. Though it is a variable cost, it is irrelevant now because now we do not have to pay for it. Of course, from environmental angle the water remains very very important. But just from course perspective, what I am trying to say is depending on the availability and depending on change in the course as per the decision, we will have to be very much particular about what is relevant and what is irrelevant cost. Now, relevant cost draw our alternative to those elements of cost which are important for decision. For example, fixed cost of project x is 5 lakhs and for alternate project it is 7 lakhs. Now, since the two projects are involving change in the fixed cost, we in this case we cannot say that the fixed cost is irrelevant. Fixed cost at least to the extent of change will be considered as a relevant cost. Now, other type of cost is called as sunk cost. Now, all those costs which are not relevant are called as sunk. They have been already incurred or they have been committed in the past and they cannot be changed by the decision. Then there is no point in considering those costs in decision making. Those costs are called as sunk costs. For example, the cost of research for the product, when we are taking a decision on launching or not launching of that product, the research cost becomes irrelevant. That does not mean research is not important. But let us say we have already spent 1 crore rupees on research. The product is ready now technically sound, but we have to just take a decision from an economic and managerial angle should we float the product or no. Now, if the sales of the product is likely to be 2 crore and the cost of manufacture is 1.5 crore, should the product be launched Now, if you go by total costing you will feel that the sale is 2 crores, cost of manufacture is 1.5 plus cost of research is 1 that means cost is 2.5 versus sale of 2. So, answer may be no for launching of the product. But actually this is not a correct decision because the cost of research has already been taken, it is completely incurred and it is no way to reduce that cost now. Now, it makes sense to ignore that cost and just look at the cost of operations or cost of manufacture which is 1.5 and the revenue is 2. So, by launching the product we will be able to make a positive contribution of 0.5 crore, although considering the total research cost of 1 crore we will be still in loss, but by not launching a product we will be incurring a loss of 1 crore which is our research cost. It will make a better sense to launch the product and at least recover 50 lakhs. Are you getting me? So, it is necessary that we identify sunk costs and ignore them for decision making. Now, sunk costs have already been incurred and they cannot be reversed and that is why they play no role in the decision making. They do not affect any future cost. One more example is spending on advertising. Now, when the product is launched lot of money is spent on advertising, that money cannot be recovered. We spent it with the hope that it will improve the demand for the product. In case in future the product demand has not increased or whether it has increased either whether cost of advertising once incurred becomes sunk. When we are taking decision of going for advertising or no at that time it is relevant, but once we have taken decision and once we have incurred the cost later on for calculating the profitability of the product the advertising cost becomes sunk. Are you getting? So, as per scenario it is very important for us to identify relevant costs and sunk costs. Giving one more example, suppose you are doing portfolio management or you are doing buying and selling of shares and you have purchased a particular share for 1000. Later on the price of shares come down to comes down to say 800. Should you buy, should you sell or not sell that share? You may feel that since the purchase cost is 1000 and the current price is 800 you will incur loss of 200, so better not sell. But in case the future price is likely to be 700 actually it makes sense to sell it because the current losses are 200 they are going to increase to 300. So, it is better to come out at 800 and not wait till prices to go down to 700. Actually the purchase cost of 1000 is irrelevant now. What is relevant is current price of 800 and what is likely to be the future price. Your decision of either selling or not selling or buying or not buying essentially depends on future costs on future prices not dependent on the past costs. Got it? Now, let us look at one or two more scenarios that is make or buy. Now, make or buy is often a tactical choice. A particular product can be made internally or we can outsource it get it from outside supplier. Now, two factors become very important whether surplus capacity is available. In case we already have enough capacity to make that instead of considering the total cost we will just consider the marginal cost of manufacture versus the cost of the supplier. Now, the elements of make analysis include there are some other factors which you should consider like incremental inventory carrying costs that by making it ourselves do you have to keep more inventory or whether when you get from outside you have to keep more inventory if the supplies are not regular from outside you may have to buy it in bulk quantities. So, though that factor becomes important then direct labor cost become important because it being a direct cost it is variable in nature then is there any incremental factory overheads then what about the delivered purchase material cost does it require any transportation cost these factors will be considered for make or buy decision. Few more factors like incremental managerial cost any follow up action particularly because of quality considerations incremental purchasing cost incremental capital cost like need for some new equipment all these factors will be important for make decisions. Now, when it comes to buy decision that is we have got offer from some supplier we can buy it from outside please look into the cost aspects one is of course the purchase price but apart from purchase price transportation receiving an inspection cost incremental purchasing cost any follow up cost because of quality or service issues these factors will be considered. So, we will take total of buy related cost and we will take total of make related cost and then comparing the two the make or buy decision will be taken getting it. Now, let us look at shutdown sometimes it becomes necessary to make a temporary shutdown because if the demand for the product goes down or if there is lack of availability of raw material or labour or some of the inputs instead of paying hefty variable cost or instead of not being able to sell our product it might be advisable to temporarily close down the product especially if selling price is below variable cost it is better to close. But if selling price is able to recover at least the variable cost it makes sense to continue the production when you close a manufacturing facility there may be some extra fixed costs like security similarly some of the fixed costs may be reduced like maintenance. So, we will have to consider those relevant costs only to the extent they are going to change. So, the decision should be based on whether the contribution is more than the difference between fixed overhead expenses in the normal cost and fixed overheads when the plant is closed. Normally the fixed cost will reduce when the plant is shut down. So, there will be some saving in the fixed cost we will compare it with the contribution generated by being able to operate it based on the comparison of the two shut down decision can be taken. Now, the next one is introducing new product. Now, there are certain reasons why while launching a commercial new venture what are the important aspects we consider? One is the demand or the interest from the customers we will also look whether there is a sustainable enough demand for starting to make a new product or for launching of a new product. So, for any successful enterprise we would look at the customer demand and take that call. But at the same time we have to ensure that all relevant costs are being recovered over the period of product life. Sometimes it may not be possible to recover the cost in the first year or in the first month or even in the one and a half years or two years time. But over the whole life of the product we do have to consider whether it is able to recover the cost and make enough surplus then there will be a point in launching a new product. Now, let us look at one more aspect that is known as joint products. Now, when there are two or more products being produced together they are called as joint products. In other words these two products up to a point of time are made from the same process then they separate out and you have two different products which may or may not require further processing. For example, in coke production coal becomes a raw material and you just do not get coke you also get other products like for example sulphate of light oil. So, all these three are considered as joint products. Similarly in a refinery crude oil is a raw material normally we get petrol, diesel and gas as joint products. This is how the graph looks like. So, crude oil is an input we need to pass it through refining process which is a joint production process. So, the costs which are incurred in the process are joint costs. At a split of point the two products for example, here petrol and diesel separate out and you may have to incur some extra costs post separation they are called as separate processing costs and then you will be able to finally, sale the product. Now, there are also scenarios of byproduct. Byproduct is a product of relatively insignificant or a very small value. So, what are coming out as joint products are the main products along with that we may get some product which just evolves and having relatively smaller economic value that will be considered as a byproduct. Now, the value which you generate from byproduct is normally credited to the main product. Example of byproduct is in case of coke manufacture you may get some gas and tar or in lumber mills you may get some saw dust or in cotton cleaning processes some cotton seeds or in coconut oil industry you get coca sales. All these are examples of byproducts they are very small value. So, they are not charged with any cost rather their sale value or their realizable value is credited to the main product. Some of the small terminologies now a joint product process is a process which results in two or more products. The costs which are incurred up to a split off point are considered a joint product cost at split off point the two products separate. Now, the cost issue involved is whatever is a cost which is incurred up to the split off needs to be carefully separated and charged to two products because there are some of the methods which are popularly used. If two products have reasonably same economic value you may go for physical unit method. So, for example, if petrol and diesel they have similar value sale value it can be based on number of liters produced. If the values are different you can go for relative sale value method sometimes at split off point you know their market value then you can go for market or sale value of split off or sometimes it will be based on net realizable value. Now, each of the methods are just explained again in physical unit method it is allocation based on some physical measure like weight or based on number of liters and so on. Similarly, it can be done by other methods there is one more method known as constant gross margin method where is assumed that the gross margin is constant and reducing that much of gross profit the cost is estimated and in case of net realizable value first we know the value of the sale price or value or the sale price after separation we reduce the post separation costs to get the net realizable value and allocation will be based on net realizable value. So, I hope you have got this with this we will stop here. Namaste.