Relevant Cost of Material

Relevant cost of material is the raw material cost that needs to be considered while taking a managerial decision. Relevant cost of material may be in the form of incremental cash flows or opportunity cost. The historical cost of material is irrelevant because it cannot be altered by new decisions.

Rules

The relevant cost of material shall include opportunity cost if any. When the availability of raw material is so limited that it restricts production volume, the opportunity cost is the contribution from next best alternative production. If the material has no alternative production use, the opportunity cost is its net disposal value. Other rules for determination of relevant cost are given below:

Consider whether the material is currently held in stock.

• The relevant cost of material which is not currently held in inventory is its purchase cost plus opportunity cost.
• If the material required is available in inventory, the next thing we need to look at is whether or not the material is actively being used for some other purpose.
• If yes, the relevant cost is its replacement cost plus opportunity cost. The raw material stock must be restored to fulfil regular usage needs. Replacement cost is the actual cost to restore the stock level.
• If no, the relevant cost of the material is its opportunity cost i.e. the estimated net disposal value.

The above rules may be presented in a chart as shown below:

Example

Company XD has received an offer to purchase 700 units of Product A at $75 per unit. Details about material required are as follows:  Material X Y Z Quantity required per unit 1.0 kg 1.5 kg 0.4 kg Total quantity available in stock 800 kg 400 kg 100 kg Limit on market availability None None 500 kg Total price per unit$14.25 $9.80$30.00 Total disposal value per unit $7.00$4.00 N/A Regularly used? Yes No Yes Quantity required for alternative use N/A N/A 400 kg Contribution per kg from second best alternative use. N/A N/A $25.00 Total relevant costs other than material are$5,000.

Required: Determine total relevant cost and decide whether or not XD should accept the offer assuming the decision won't affect regular sales.

Solution:

Material X required to complete the offer is 700 kg [=700×1.0kg], all of which is already available in stock. However material X is in regular use, therefore the relevant cost is its replacement cost which is $9,975 [=700kg×$14.25/kg]. Since the material is in regular use, the company has to incur an incremental cash flow in order to restore stock levels. There is no limit on availability so the opportunity cost is zero.

The company has 400 kg of material Y in stock which has no alternative use so the relevant cost of that portion is just its opportunity cost i.e. disposal value which $1,600 [=400kg×$4/kg]. However the total material required is 1,050 kg [=700×1.5kg] hence the company needs to purchase 650kg of material Y, the relevant cost of this second portion is its purchase price i.e. $6,370 [=650×$9.80]. The opportunity cost of this second portion is zero because the material X has not alternative use and also because there is no limit on availability. Total relevant cost of material Y is $7,970 [=$1,600+$6,370]. Material Z is tricky because there is a limit on availability which restricts production options. Material Z required for the offer is$180kg [=700×0.4kg]. First, since material Z is in regular use, its relevant cost shall include the replacement cost of $5,400 [=180kg×$30/kg]. Further, the company has to sacrifice alternative production based on material Z partially. Therefore the contribution lost as a result shall also be considered a relevant opportunity cost. Material Z shortage for alternative production caused if the company choses to fulfil the offer is 80kg [=400kg–(500kg+100kg–280kg)]. The opportunity cost is the contribution lost i.e. $2,000 [=80kg×$25/kg]. Total relevant cost of material Z is thus $7,400 [=$5,400+$2,000] Total relevant cost of material =$9,975 + $7,970 +$7,400 = $25,345 Total relevant cost =$25,345 + $5,000 =$30,345

Increase in income on accepting the offer = 700 × $75 =$52,500 – $30,345 =$22,155

Decision: Company XD should accept the offer.

Written by Irfanullah Jan