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5.12. Irrelevance of past costs

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Core Concepts of Accounting – Numbers and People

Moscow Institute of Physics and Technology

4.9 (10 ratings) | 1.1K Students Enrolled

Course 3 of 5 in the Understanding Modern Finance Specialization

Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them. Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation. This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects. The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

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From the lesson

Activity-Based Costing (ABC). Relevant Costs

In Week 5 we will study the more advanced approaches to costing – activity-based costing (ABC) and relevant costs – that provide for the more accurate costing of products, projects, and divisions, and allow to reveal actual relationship between numbers and people. We start with the analysis of ABC on an example of a small retail firm. Then we move on to the more detailed example of the use of ABC in manufacturing. Both examples will help us gain insight in the role of ABC in identifying ways to improve performance. Finally, we analyze the idea of relevant costs and its application to managerial actions –make-or-buy decisions, product mix under capacity constraints, customer profit analysis. Of special attention will be the role of relevant and opportunity costs in valuation.

5.1. Activity-based costing (ABC) – an overview8:38

5.2. ABC for a retail firm (1)9:01

5.3. ABC for a retail firm (2)13:21

5.4. ABC in manufacturing (1)13:37

5.5. ABC in manufacturing (2)13:21

5.6. Insights provided by ABC8:30

5.7. Relevant costs – an idea10:53

5.8. Make-or-buy decisions (1)6:04

5.9. Make-or-buy decisions (2)10:30

5.10. Product mix under capacity constraints8:33

5.11. Customer profit, ABC, and relevant costs7:32

5.12. Irrelevance of past costs10:43

Taught By

Konstantin Kontor
Director and Professor of Finance and Strategy

Transcript

Now we will study the very important application of relevant costs.

Namely, its in their influence on the decision of keeping or

replacing the equipment.

Now here we openly deal with the idea of sunk costs.

And as you remember, from corporate finance and also from the discussion in

this course, that sunk costs they occur in the past and you can not change them.

So clearly sunk costs are always irrelevant.

Because remember, relevance, this is the concept that deals with future

alternatives, and does not deal with what happened in the past.

Now I prepared, again, this table for you,

so you can see that we are studying the following choice.

So we have a machine that is still up and running, and this is the existing machine.

So it was acquired some time ago, and

we can see that actually that happened 3 years ago, it's current age.

And it's useful life is 5 years, so it has 2 years to go.

Now we use straight-line depreciation, so by over 3 years it has

accumulated a depreciation of $720,000, all numbers here are in thousands.

And therefore the book value, 480.

And it can be sold right now at a small price of just 48,000 but

well, it's better than nothing.

And the whole idea of replacing stems from the fact that we

see that annual operating costs for

this machine is $960,000, which is quite high.

Now we have an option to get rid of this machine and replace it with the other one.

That has the cost of 720, so it's cheaper.

It has an annual cost of just $550, almost half of what we have right now.

The only problem is that this machine has a useful life of just 2 years.

So after two years, we'll have to throw it away.

So this is the set of inputs for the analysis of these machines.

So we can see here these numbers for useful life, 5, 2.

But the horizon of useful life remaining is the same, 2 years and 2 years.

Here we have some numbers on our balance sheet.

And the new machine are not yet acquired, so

we do not have either book value or disposable price or whatever.

Now if we sold the old machine right now,

we would have an accounting loss of 432, why?

Because the book value of the machine is 480,

this is the original cost less accumulated depreciation.

And we would sell it only at one-tenth of the price.

So one sort of human idea here is that if you sold the machine,

you would incur a loss over this year, and a significant loss.

And no one is happy in showing losses.

But now I would like to approach this,

keeping in mind the idea of what is relevant and what is irrelevant.

And here we have to analyze some important components.

And those will be, first of all, book value of old machine.

Then I'll put current disposal price.

So this is 48, this is 480.

Then 3, this is gain loss.

So this is the notorious 432.

And then, obviously, the cost of new machine.

So, this is 720.

Now let's analyze what is relevant and what is not.

Well, let's start with relevant costs.

Well, clearly current disposal, this a cash inflow, but this is relevant.

Because in one case, if we don't sell the machine, we have nothing.

If we do sell the old machine, we have $48,000 in cash.

By the same token,

if we buy a new machine, this outflow of 720 is also relevant.

Because if we don't replace, we don't have to pay this amount.

If we do, then we pay.

However, the remaining two, they're irrelevant.

Because book value of the old machine, why it's irrelevant?

Because the machine was bought before.

We cannot change this amount.

By the same token, this gain and loss is also irrelevant because

it's a combination of something irrelevant and something relevant.

And unfortunately, you cannot make irrelevant things from one relevant and

the other irrelevant.

So strictly speaking, we can see that our analysis of relevant cost,

we have to be more careful.

And in order to do so, we will proceed, and

we proceed to the following prepared table.

We will analyze the choice over 2 years.

Remember, 2 years is the useful life of both machines.

It's the remaining useful life of the old one or

the total useful life of the new one.

And here we have two options, keep and replace, and

then in red as always we put the difference.

Now sales, this 2,700,000, I put just for reference because

one thing is that regardless of which machine we use, we have the same sales.

That's an assumption, but in this assumption,

we just have a sort of built-in assumption that the capacity of both

machines is enough to meet all the market demands for our products.

So let's see what we have here.

This line is important.

This is cash operating cost.

That that is 960 for two years and this is 550 for two years.

Again, here for simplicity, we ignore discounting,

because some of these costs they occur later, we ignore that altogether.

Now comes the interesting part.

So this is the old machine, it has a book value of 480.

It can be either depreciated over 2 years if we keep it,

or written off as a lump sum if we sell it.

And the key story is that in this case,

we depreciated and there's no lump sum write-off.

If we replace, there is no depreciation, and lump sum write-off.

So you can see that the combination of that has no difference.

We don't care whether we write it off right now or

in two installments of depreciation charges.

Again, discounting is ignored here for simplicity.

Now current disposal, like I said, this is occurs only in case of replacement.

And contributes here and new machine, again,

it's new machine if it's purchased.

Yeah, this is a 720, and then it will be just depreciated over this period of time.

So we can see how this goes.

Now the key finding is that this situation is irrelevant.

So you can see that our operating income is 300,

indicates that we keep the old machine.

And 448 indicates we replace that with a new machine.

And the key story is that we save on cash operating costs.

You can see that this is a huge saving of 820.

So you can see that we save this amount.

We also collect 48, and

then the only outflow we have, this is for the new machine.

So all other items are irrelevant.

And the contribution of that is 148.

So the decision based on relevant costs is to replace.

Now here, this is summarized in this table.

So we have keep, replace, and difference.

And I put all of these relevant costs that I analyzed in the previous table, so

you can see that the ones that I just mentioned.

So we can see that there is only one relevant cost in the analysis of keeping

the old machine.

And three components in the analysis of buying the new ones.

And the combined result is that we save $148 on these costs.

So you can see now that it is the analysis of these relevant

costs that completely ignores things like quoted losses or

this we still have some book value equipment.

This is not relevant to this choice.

And therefore, we can see a close link to what we have in corporate finance.

We can see that in making investment decisions,

we have to keep in mind these relevant costs at the close link

to the ideal that opportunity costs, that is key in validation.

And at this time, we've found some additional support to that for

the analysis of relevant costs in the way it is done in managerial accounting.

While I'm wrapping up this week, it's also been quite long.

Actually, all weeks in this course are quite long because

we have to put together quite a few ideas and concepts.

And we do not have that much ability to stretch this out.

But for now, we are stopping here and

I wish you all good luck with your assignments for this week.

And I'll see you next week, which is the final for this course.

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