 Hello and welcome to the session in which you would look at relevant and irrelevant costs. This topic is covered in managerial accounting, the CPA exam, as well as the CMA exam. It's very important to differentiate between what is relevant for our decision-making and what's not relevant. In this context we're going to be learning about three terms that we need to be familiar with, which are differential cost, opportunity cost, and sunk cost. Whether you are an accounting student or a CPA candidate, I strongly suggest you take a look at my website, farhatlectures.com. I don't replace your CPA review course. I'm a useful addition to your CPA review course. I provide you alternative explanation, alternative resource to your CPA preparation. I can add maybe seven, 10, 15 points to your CPA exam, which will help you get that 75 and move on with your life. Your risk is one month of subscription. Your potential gain is passing the exam. If I was in your shoes, I will give it a try for a month. And if not for anything, take a look at my website to find out how well or not well your university is doing on the CPA exam. I do have resources for other college courses, intermediate accounting, auditing, cost, financial accounting. I have the previously CPA release questions. And my CPA courses are designed to mirror image, to align with your backer, with your Wiley, with your Gleam, with your Roger, so on and so forth. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation, like this recording, share it with other, connect with me on Instagram, Facebook, Twitter, and Reddit. So let's talk about what is routine decisions and non-routine decisions, because that's very important to understand why do we have to care about what's relevant and what's irrelevant in terms of costing decision. Routine decisions are routine, which means they are made frequently to run a business. Some examples of routine decisions will be ordering supplies on a regular basis, paying vendors, processing payrolls, so on and so forth. For non-routine decision, the company might use a different set of cost and revenue criteria to accept or not accept those non-routine decisions. Now, what are those non-routine decisions? I'm going to go over those non-routine decisions today, but bear in mind, we have a whole chapter designed to go over those non-routine decisions. For example, if we are in a manufacturing facility, we might have to make a decision whether to manufacture the product itself, some of our ingredient, or to buy it. And this is not a routine decision. We're going to make that decision once, whether to, let's assume we're producing a motorcycle. Are we going to buy the exhaust, or are we going to manufacture the exhaust for that motorcycle ourselves? That's a one-time decision, make or buy. Ensourcing or outsourcing, very similar. Are we going to do the work ourselves, or are we going to outsource this task to an outside party? Special order, we get a special order from someone they want a discount. Are we going to accept or not accept? Keep or drop a line or a division. Are we going to keep that line of product or it's not profitable? Maybe we should get rid of it. Maybe it doesn't serve our business. Are we going to keep that division or sell it? Keep or drop. We make this decision once. It's not a routine decision. Sell something or process further. Are we going to keep selling? Are we going to keep processing this product? Or are we going to sell it as is, as unfinished product to someone else who can use it? Those are all called non-routine decisions. For non-routine decisions, we have to be aware of what criterias are relevant for us in making that decision and what criterias are irrelevant in terms of cost. And as I mentioned earlier, we need to be familiar with three concepts, differential cost, opportunity cost, and sunk cost when it comes to those decisions. What is differential cost? And the first thing I need to tell you, differential cost is a relevant cost. Well, simply we have to do a differential analysis. What does that mean? It means we have to examine the future cost. What's going to happen to our cost? That's going to differ among the alternative, among buying or making, among dropping or keeping. This cost, usually called the incremental cost or the incremental cost. What's going to happen to our cost? It's going to go up, is it going to come down as a result of that decision. So the goal of making a decision is to identify those costs that are relevant, okay, that are relevant to us and identify the one that are irrelevant to make the decision. So simply put, if the cost stay the same, it doesn't make a difference for us. We want to look at a cost that differentiates. And the cost that differentiates will be relevant for us. What cost that could differentiate if you really think about it? We learned so far about various type of cost, like we have direct material, direct labor, manufacturing overhead. So what costs do you think will differ? I will think future variable production costs, such as direct material, direct labor and variable overhead will differ. Why? Because those costs, they are incurred as we produce more units. So for every unit, for every motorcycle, we need an exhaust. Therefore the exhaust is direct material. For every motorcycle we need to produce, we need to incur direct labor. So those will be considered. So simply put, variable costs are relevant. Why? Because they differ. They differ. We're going to incur them and they differ. It's going to make a difference. It's going to increase our total cost. Variable costs also to sell or ship, because if you need to ship it, you need to sell it, you're going to incur that additional cost. Fixed costs incurred exclusively for a particular order. For example, if you need to buy a new machine, that new machine is specifically for that order. For example, we need to maybe put a special logo on the product and we need a new machine to do so. For buying that new machine specifically for that project, then it's considered relevant. If that new machine is a fixed cost that's going to be with us, then technically a fixed cost is irrelevant for us because it doesn't make a difference, whether we incur this cost or not. And this is what a differential cost revenue analysis would look like. For example here, we are making a choice about our present situation where we are selling through retailers and we want to change from retailers and the proposed is to use sales representative. Okay, what's going to happen to sales? Sales will go from 700 to 800,000. This is called the differential revenue because we're talking about revenue. Well, is this relevant? Of course, because it differ, so it's a differential revenue. Cost of goods sold is variable. It's going to go from 350 to 400,000. Our cost of goods sold will go up. That's a differential cost. Why? Why do you think that's the case? Because if we sell more, we're going to be incurring more as sales commission most likely. Advertising, it's a fixed cost. It's a fixed cost retailer right now. We incur 80,000 if we are a retailer. If there are salespeople, we cut down on advertising costs because our salespeople will do the advertising themselves. Therefore, it differ, differ by 35,000. Commission, we have zero commission if we stay as is. If we use sales people, we have to pay them commission and the cost will go up. And by the way, ignore what I said about cost of goods sold about commission because commission doesn't go into cost of goods sold. So there's some other reason why our cost of goods sold will go up. Commission will obviously go up. It's a differential cost. Warehouse depreciation goes from 50 to 80. It's going to go up. That's a differential cost. Other expenses, they stay the same. They don't change. Total expenses as an overall will go up. Total revenue also will go up. And we're going to have $15,000 more if we take this proposed using sales representative. So this is how we look at differential cost and differential revenue in making our decision. Another concept we need to be familiar with is something called opportunity cost. And that's relevant. It's considered relevant cost. Opportunity cost is really an econ concept rather than an accounting concept. Because in the real world, we always have to make choices. Why? Because we have limited resources. We have something called scarcity of resources. So what is opportunity cost? Simply put, it's the value that you don't receive by giving up your options. For example, the value, I'm sorry, the value that you could have received but gave up to pursue another option. So in other words, the potential benefit that you gave up to select one alternative over the other. For example, if you're listening to this lecture right now, you are given up time to do something else. Given up that time is your opportunity cost. From our perspective, we're going to be looking at the contribution margin loss. So when we discontinue a product, what's going to happen is we're going to get rid of it. That product might be contributing some profit to our company. So the contribution margin loss is an opportunity cost because we are getting rid of that option. Or sometimes it's called the road not taking. So what road you did not take is the opportunity cost. Why? Because you took another road. The road not taken is an opportunity cost. Again, opportunity cost is not found in the accounting record because we don't keep track of the opportunity cost. But we have to think of the opportunity cost when we are making a decision. For example, if you wait in line to get a free coffee, it's not really free coffee because you're given up that time to earn money. So if you have to wait an hour to get a free coffee in an hour, you can make $15. Guess what? Your coffee costs you $15 because you could be working someplace else and earning $15. Now assuming you can work that hour. So it's the best thing you give up to do something else. For example, you can paint your apartment yourself or if you are a freelancer, you can take that time to build a website. So if you paint the apartment, you might save yourself $1,000 but also you don't have time to build that website as a freelancer. Therefore, when you give up building the website, that's your opportunity cost. You might say, but I don't have to pay for my, I save myself paying a painter. Yes, but that time is devoted to, you could have devoted that time to your website. Therefore, there is a cost. That's the opportunity cost. So if you save yourself $1,000, but you could have built that website as a freelancer and make $3,000, charge the customer $3,000, you gave up really $2,000. That's, that's what you really lost. Attendant school, when you attend school for five or four to five years, what you're doing, you are paying for the tuition through, but also you are given up earning potential because you could be working somewhere else and making $30,000 a year times four, you gave up $120,000 in earnings because you're attending school. Now the reason you attend school is to invest in yourself and earn more into the future. The point I'm trying to make is to illustrate that when you do something, you give up something else. You cannot do everything. Therefore, what you give up, the next best thing you give up is the opportunity cost. And here I'm saying, if you are not working, that's the next best thing, the next best thing after going to school. Therefore, that's your opportunity cost. So we have to take opportunity costs into account when we are making a decision. Some cost, it's going to be considered irrelevant. And some cost is usually a psychological cost or an economic cost. Again, it's not part of the accounting record, but we have to make sure we're aware of it. What is some cost? Some cost is a cost that already been incurred. So it's, we already spend the money on it. And guess what? There's nothing we can do to change the past, to change it now or in the future. There's nothing we can do. That type of cost, once we know, once we say this cost is a some cost, it should be ignored for future decision. Assuming you purchase a desktop computer for $1,000 and suddenly that computer became obsolete or not serving your purpose. Now you need something else. You need maybe a laptop rather than a desktop or you need a tablet where your old purchase is a sunk cost. Whether you want to buy a laptop or a tablet, you cannot say, well, I invested $1,000 in my desktop. It's too late. It's a sunk cost. It's irrelevant. And that's what we mean by sunk cost. Basically, don't, it's like basically a spoiled milk. It's done. It's over. Move on. For decision making, you don't take it into account. Let's take a look at this example to find out what will be the incremental manufacturing cost. What is the additional incremental manufacturing cost? The cost per unit for DHL Corporation is as follows. Direct material, direct labor, variable manufacturing, fixed manufacturing, sales commission, variable administrative expense and fixed selling and administrative. So what is the incremental manufacturing cost? That's the question. If the production increases from 9,000 to 9,999 and we're assuming this is still within the relevant range, remember, the relevant range deals with fixed costs. That means we don't have to increase our fixed cost. What is our incremental manufacturing cost per unit? To be more specific, per unit. Well, guess what? Is direct material, we think it's a relevant cost? What's going to happen to our total cost if we produce? Are we going to incur more direct material? I would say yes. So direct material is relevant. Direct labor. Do we have to incur more cost in direct labor if we produce more units? I would say yes. Variable manufacturing overhead. Would it change with our production? Of course it will. It's variable. That's two dollars. Fixed manufacturing overhead. And we are told we are within the relevant range. Then fixed manufacturing overhead is not relevant for us. Sales commission, hold on a second. Be careful here. We're looking for manufacturing cost. Sales commission is not a manufacturing cost. Variable administrative expense. Again, not a manufacturing cost. Fixed selling and administrative expense. Again, administrative expense is not a manufacturing cost. And if you add all of those, this will be your incremental cost. Incremental cost for that decision, whatever that answer happens to be. If you want to practice additional multiple choice, prepare for your CPA exam. I strongly suggest you take a look at my website, farhatlectures.com. Once again, I don't replace your CPA review course. I'm going to give you alternative resources, multiple choice, true-false, alternative explanation through lectures that's going to help you understand the material better. Invest in yourself. Invest in your career. The CPA is worth it. And remember, I do have resources for other courses as well, including previously released AI CPA questions. Good luck, study hard, and of course, stay safe.