Relevant Costing

[Jeremy007]

Could anyone kindly help me understand the logic behind this question?
The following data apply to a non-current asset.
Net realisable value $5000
historic cost $6000
Net present value in ue $7500
replacement cost $10000
the relevant cost os the asset is 7500, according to the anser provided.

The suggested solution is a bit like the following (sorry, can't draw a diagram here):

When facing a choice between disposal value and economic value, choose the one with higher value
Then compare the choice obtained from above with the replacement cost, then choose the one with lower value.
But I can't understand why those choices have to be made in the way shown above?
Your help will be highly appreciated.

[hetal]

Hello there!
I would request you to raise this question under the relevant subject-forum.
I think it belongs to F3, right?

:confused:

[Jeremy007]

Hi, Hetal,
I don't think the question was put in the wrong place. As far as I know, the question is on F2 syllabus. You could have a look at here: ****DELETED by ADMIN****. Hopefully, somebody can help. Cheers

[hetal]

Oops! Sorry.
I am trying to explain you.
Relevant costs are the costs pertinent to the making of a specific managerial decision. These are essentially future costs and should differ amongst the possible alternative course of action. The features of relevant cost are
1. differential costs are relevant
2. future costs are relevant
3. only cash costs are relevant

In the context of non-current assets the amount of money an organisation would like to receive if it were deprived of the asset is to be considered.
 The carrying amount of the historical cost of the non-current asset is a sunk cost and is of no relevance in decision making.
 The residual value or resalable value and replacement cost of an asset is relevant.
 If capital expenditure remains unchanged under different alternatives, then it is irrelevant to decision.
 Depreciation is not relevant as it does not result in a future cash flow.


Considering this, Steps to find the relevant cost of non-current asset are:
1. Find the higher value of residual value and revenue expected to be generated if asset continues in operation.
2. Compare the resultant figure of step 1 with replacement cost of asset; the lower value of two is deprival (relevant cost) value.

hope it helps!
I found this useful text from GTG study text and would suggest you to use the same for easy understanding.

[Jeremy007]

Oops! Sorry.
I am trying to explain you.
Relevant costs are the costs pertinent to the making of a specific managerial decision. These are essentially future costs and should differ amongst the possible alternative course of action. The features of relevant cost are
1. differential costs are relevant
2. future costs are relevant
3. only cash costs are relevant

In the context of non-current assets the amount of money an organisation would like to receive if it were deprived of the asset is to be considered.
 The carrying amount of the historical cost of the non-current asset is a sunk cost and is of no relevance in decision making.
 The residual value or resalable value and replacement cost of an asset is relevant.
 If capital expenditure remains unchanged under different alternatives, then it is irrelevant to decision.
 Depreciation is not relevant as it does not result in a future cash flow.


Considering this, Steps to find the relevant cost of non-current asset are:
1. Find the higher value of residual value and revenue expected to be generated if asset continues in operation.
2. Compare the resultant figure of step 1 with replacement cost of asset; the lower value of two is deprival (relevant cost) value.

hope it helps!
I found this useful text from GTG study text and would suggest you to use the same for easy understanding.


Many thanks, Hetal, for taking the time to answer my question. It'll be even more helpful if you tell me in a bit more detail why it's necessary to find the higher value in step 1 and find the lower value in step 2. This is the crucial point which I find it hard to get my head round.
Looking forwrd to your reply soon. Cheers

[hetal]

Hi,
I will try.
First you revise which costs are relevant for decision making.

In the first step we are comparing the net releasable value (income on sale of asset) with the net present value {total present value of future cash flows (incomes)}.
Both are the incomes and it is obvious that we always choose option with the higher income. That is why we will choose higher among these two.
Net realizable value = $5,000 and Net present value = $7,500.
Answer is $7,500.

In second step we compare the answer of the 1st step with replacement cost (cost to replace an asset at current price). In other words replacement cost is the price that will be paid to replace existing asset with the similar asset. The reason may be that the existing machine is not in proper working condition.
Now the answer of 1st step (NPV) is an opportunity cost. Opportunity cost is the benefit forgone for not choosing that alternative.
When we compare these two costs, we would choose the lowest one.
In simple words Cost should be minimum and profit should be maximum.
NPV= $7,500 and replacement cost = $10,000
Answer is $7,500
:biggrin:

[Jeremy007]

Hetal, thanks a lot for your clear and patient explanations. I think I've got it now.

[akkianjana]

Very well explained HETAL !!!