Chapter # 01

Introduction to
Project Appraisal
 Relevant Costs

Relevant Cost of Relevant Cost

Material Overheads
Relevant Cost of
Labour

Relevant Cost of Relevant Cost of

Investment in Existing
Working Capital Equipment
Relevant and irrelevant costs:
There are different types of relevant and irrelevant costs. Following are the main categories for those costs:
Relevant costs Irrelevant costs
Incremental cost: An incremental cost means an Sunk cost: Sunk cost means any cost that has already
additional cost that will be occurred and paid in cash been incurred or paid in past and that cost cannot be
due to implementation of a particular decision. reversed.
Avoidable cost: An avoidable cost is a cost that would Committed cost: It refers to any cost that was agreed
be saved or avoided or eliminated or reduced due to due to contractual obligation in past but cash will be
implementation of a particular decision. paid in future whether decision is implemented or not.
Differential cost: Any existing cost that will change in Unavoidable cost: Any cost which is not actually paid in
future as result of implementation of particular cash but accounted for calculation of accounting profit.
decision.
Opportunity cost: Opportunity cost is a possible future Notional cost: An unavoidable cost is a cost that will be
cash benefit of best alternative opportunity forgone due incurred anyway and cannot be saved/ avoided in any
to implementation of a particular decision. case.
(i) Relevant cost of materials:

Relevant costs of materials are the additional cash flows that will be incurred (or benefits that will be

lost) by using the materials for the purpose that is under consideration. If none of the required

materials are currently held as inventory, the relevant cost of the materials is simply their purchase

cost and if the required materials are currently held as inventory, the relevant costs are identified by

applying the certain rules. Historical cost of materials held in inventory cannot be the relevant cost of

the material, as the historical cost is a sunk cost. The relevant costs of materials can be described as

their ‘deprival value’. The deprival value of materials is the benefit or value that would be lost if the

company were deprived of the materials currently held in inventory

 Relevant Cost of Material

Out of Stock In Stock

Replacement Cost Regular Use Obsolete

Replacement Cost Higher of

Sale Substitute
(ii) Relevant cost of labor:
The relevant cost of labor for any decision is the additional cash expenditure (or
saving) that will arise as a direct consequence of the decision. If the cost of labor is a
variable cost, and labor is not in restricted supply, the relevant cost of the labor is its
variable cost. If labor is a fixed cost and there is spare labor time available, the relevant
cost of using labor is 0. The spare time would otherwise be paid for idle time, and
there is no additional cash cost of using the labor to do extra work. If labor is in limited
supply, the relevant cost of labor should include the opportunity cost of using the labor
time for the purpose under consideration instead of using it in its next most profitable
way.
 Relevant Cost of Labour

Casual Permanent

Busy Normal Idle Busy

Labour cost to be Take only

Incurred (Short Supply) Labour cost to be Contribution lost
NIL
+ incurred +
Contribution to be lost labour cost
Illustration # 09 Page # 16: (ICAP Example # 01)
A company is considering an investment in a major new information system. The investment will require the use
of six of the company’s IT specialists for the first one year of the project. These IT specialists are each paid Rs.
100,000 each per year. IT specialists are difficult to recruit. If the six specialists are not used on this project, they
will be employed on other projects that would earn a total contribution of Rs. 500,000.

Required:
Relevant cost of the IT specialist in Year 1 of the project would be?

Answer:
Rs.
Basic salaries 600,000
Contribution forgone 500,000
Total relevant cost 1,100,000
Illustration # 08 Page # 16: (ICAP Example # 02)
A Ltd. has been asked by a customer to carry out a special job. The work would require 20 hours of skilled labor
time. There is a limited availability of skilled labor, and if the special job is carried out for the customer, skilled
employees would have to be moved from doing other work compromising a contribution of Rs.60 Per Labor Hour.
Required: What is relevant cost of doing the job for the customer?

Answer:
Relevant cost of doing the job for the customer is the contribution that would be lost by switching employees from other
work. This contribution forgone (20 hours × Rs.60 = Rs. 1,200) would be an opportunity cost. This cost should be taken into
consideration as a cost that would be incurred as a direct consequence of a decision to do the special job for the customer. In
other words, the opportunity cost is a relevant cost in deciding how to respond to the customer’s request.
Conclusion:
(a) Variable cost is normally relevant for decision making like incremental, differential, avoidable, opportunity cost are
example of relevant cost.
(b) Fixed cost are normally irrelevant (other than incremental fixed cost) like Sunk or past cost, unavoidable, committed
cost are examples of irrelevant cost
(iii) Relevant cost of overheads:

Relevant costs of expenditures that might be classed as overhead costs should be

identified by applying the normal rules of relevant costing. Relevant costs are future

cash flows that will arise as a direct consequence of making a particular decision.
 Relevant Cost of Overheads

Variable Fixed

Cost to be Incurred Unavoidable Avoidable

NIL Cost to be Incurred

(iv) Relevant cost of existing machine:

When new capital equipment will have to be purchased for a project, the purchase

cost of the equipment will be a part of the initial capital expenditure, and so a

relevant cost. However, if an investment project will also make use of equipment that

the business already owns, the relevant cost of the equipment will be higher of:

 The current disposal value of the equipment, and

 The present value of the cash flows that could be earned by having an

alternative use for the equipment.

 Relevant Cost of Existing Machine

If offer does not consume the If offer consumes substantial

substantial part of machine part of the machine

NIL Regular use Obsolete

Difference of Difference in
replacement cost resale value
Illustration # 07 Page # 16: (ICAP Example # 03)
A company bought a machine six years ago for Rs. 125,000. Its written down value is now Rs.
25,000. The machine is no longer used for normal production work, and it could be sold now
for Rs. 17,500. A project is being considered that would make use of this machine for six
months. After this time the machine would be sold for Rs. 10,000.
Required:
Find relevant cost?
Answer:
Relevant cost = Sale value now – Sale value if it is used
This is the relevant cost of using the machine for the project.
Relevant cost = Rs. 17,500 - Rs. 10,000 = Rs. 7,500.
Some Important Exam Focus Points Related to above costs:

In the following cases the nature of labour should be considered as permanent.

1. If labour cannot be retrenched (‫)چھانٹی‬, cannot be reduced or cannot be terminated.
2. Idle wages.
3. Underutilized,
4. Employee
5. Transferred from one Department to other.
Otherwise, labour shall be treated as casual
If the nature of overhead is not mentioned clearly in question then presume overhead as fixed (unavoidable) &
called Sunk Cost.
Apportioned/Absorbed overhead always to be considered as Sunk.
If question is silent, machine shall always be treated as idle.
Fixed Cost is the cost which does not vary with the change in the volume of activity in the short run. These costs are
not affected by temporary fluctuation in activity of an enterprise. These are also known as period costs.
(v) Relevant cost of investment in working capital:

An investment in working capital is not a cash flow but as we include profits and not

cash flows in our revenues and costs discussions, these changes indirectly measure

the associated cash flows from revenues and expenditures. For example:

 When capital investment projects are evaluated, it is usual to estimate the cash

profits for each year of the project.

 Actual cash flows will differ from cash profits by the amount of increase or

decrease in working capital.

Illustration # 10 Page # 17: (ICAP Example # 04)
A company is considering whether to invest in the production of a new product. The project would have a six-
year life. Investment in working capital would be Rs. 30,000 at the beginning of Year 1 and a further Rs. 20,000 at
the beginning of Year 2. It is usually assumed that a cash flow, early during a year, should be treated as a cash
flow as at the end of the previous year.

Required:
The relevant cash flows for the working capital would be?

Year Rs.
1 (Cash Outflow) (30,000)
2 (Cash Outflow) (20,000)
6 (Cash Inflow) 50,000
 Rs.
Question # 20 Page # 50:
Material: A 2000 Kgs @ Rs. 10 per Kg. 20,000
Mr. Ramlal has been asked to quote a price for a special contract. He has already prepared
B 1,000 Kgs @ Rs. 15 per Kg 15,000
his tender but has asked you to review it for him & wants to quote a minimum price.
C 500 Kgs @ Rs. 40 per Kg 20,000
Material A: Material B: D 50 liters @ Rs. 12 per liter 600
1000 Kgs of this material is in stock at a cost Material B is in stock and it cost Rs. 18 per Labour: Skilled 1,000 hrs. @ Rs. 25 per hrs. 25,000
of Rs. 5 per Kg. Mr. Ramlal has no Kg. The current purchase price is Rs. 15 Semi -skilled 2,000 hrs. @ Rs. 15 per hour 30,000
alternative use for his material and intends per Kg. The material is constantly used by Unskilled 500 hrs. @ Rs. 10 per hour 5,000
selling it for Rs. 2 per Kg. However, if he sold Mr. Ramlal in his business. Fixed overheads 3,500 hrs. @ Rs. 12 per hour 42,000
any he would have to pay a fixed sum of Rs. Material D: Costs of preparing the tender:
300 to cover delivery costs. The Current There are 100 liters of this material in Mr. Ramlal’s time 1,000
purchase price is Rs. 10 per Kg. stock. It is dangerous and if not used in Other expenses 500
Material C: this contract will have to be disposed of at Minimum profit (10% of total costs) 15,450
The total amount in stock of 500 Kgs was a cost of Rs. 50 per liter. The current
Skilled Labour:
bought for Rs. 10,000 some time ago for purchase price is Rs. 12 per liter.
• Mr. Ramlal only hires skilled labour when he needs it.
another one-off contract that never Fixed Overheads:
• Rs. 25 per hour is the current hourly rate.
happened. Mr. Ramlal is considering selling This is considered by Mr. Ramlal to be an
Un- Skilled Labour:
it for Rs. 6,000 in total or using it as a accurate estimate of the hourly rate based
• Mr. Ramlal has a workforce of 50 semi-skilled laborers who are
substitute for another material, constantly on his existing production.
currently not fully utilized.
used in normal production. If used in this Profit: This is Mr. Ramlal’s minimum profit
• They are on annual contracts and the numbers of spare hours
latter manner it would save Rs. 8,000 of the margin which he believes is necessary to
currently available for this project are 1,500. Any hours in
other material. cover general day-to-day expenses of
excess of this will have to be paid for at time and a half.
Current purchase price is Rs. 40 per Kg. running a business.
• The normal hourly rate is Rs. 15 per hour.
Costs of Preparing the Tender: Mr. Ramlal has spent 10 hours working on this project at Un- Skilled Labour:
Rs. 100 per hour, which he believes in his charge-out rate. Other expenses include the • These are currently fully employed by Mr. Ramlal on jobs where
cost of travel and research spent by Mr. Ramlal on the project. they produce a contribution of Rs. 2 per unskilled labour hour.
Required: Calculate and explain for Mr. Ramlal what you believe the minimum tender
• Their current rate is Rs. 10 per hour, although extra could be
price should be.
hired at Rs. 20 an hour if necessary.
 Self Made Question:
Flasheart runs a business manufacturing aeroplanes. He has recently completed a special custom built aeroplane for a customer who has become insolvent and is
unable to take delivery. Fortunately, the customer had paid a non-returnable deposit of Rs. 5,000 on ordering the aeroplane and this money, together with the
cash proceeds of Rs. 4,000 now available from scrapping the aircraft, will cover Flashheart's costs. Flasheart has suddenly met a new customer, Bob, who is
interested in buying the aircraft but only after certain modifications. Bob wants to known how much the aeroplane will cost and has asked Flasheart to prepare a
tender for him. Flasheart investigated modification required and prepared costing statement: Rs.
Material A Material A: 5 kg @ Rs. 100 per kg 500
There are 12 kg in stock, originally purchased for Rs. 100 per kg. The price has recently Material B: 10 kg @ Rs. 150 per kg 1,500
risen to Rs. 130 per kg but Flasheart could only sell his stock for Rs. 120 per kg. Flasheart Material C: 10 kg @ Rs. 75 per kg 750
keeps stocks of material A as it is an essential component for all of his aeroplanes. Material D: 7 kg @ Rs. 10 per kg 70
Material B Skilled labour: 100 hours @Rs. 10 per hour 1,000
The price of Rs. 150 per kg for material B also represents the historical cost of purchase of Semi-skilled labour: 75 hours @Rs. 7 per hour 525
the 10 kg which are in stock. Flasheart normally sells material B to his customers as a Unskilled labour: 80 hours @Rs. 5 per hour 400
separate accessory. He has recently been buying stocks at Rs. 160per kg and selling them on Variable overhead: 255 hours @Rs. 3 per hour 765
for Rs. 200 per kg. Fixed overhead: 255 hours @ Rs. 2 per hour 510
Material C Cost of preparing statement 100
6,120
This is of no use elsewhere in the business, although Flasheart has 4 kg in stock and could
sell these for a total of Rs. 100. The price on the costing statement was the historical cost of Labour
purchase, which has not changed for some time. Skilled labour is paid on an hourly basis, at the rate shown in the
Material D statement above, with a guaranteed minimum wage of Rs. 300 per
There are 20 kg of this in stock and these are of no use elsewhere in the business. It will be week. Flasheart has 15 skilled workers, all of whom are working only
necessary to dispose of any remaining Material D at a lump sum cost of Rs. 200. 25 hours per week at present. Semi-skilled labour is currently fully
Overheads employed, but could be diverted from a product which earns a
The variable overhead recovery rate of Rs. 3 per labour hour worked was established by a contribution (after semi-skilled labour) of Rs. 6 per semi-skilled
detailed investigation of the business costs. The fixed overhead absorption rate of Rs.2 per labour hour. Alternatively, semi-skilled labour could be hired at a cost
hour is designed to cover general overheads of the whole business of Rs. 210, the rent of a of Rs. 20 per hour. Unskilled labour is hired on a casual basis. The
workshop, to carry out the modification work, of Rs. 100, and the hire of a special machine contract will need to be completed in one week.
costing Rs. 200 needed to shape the components. Required: Determine the minimum price to be tendered.