Chapter 14 cost concepts relating to decision making
Relevant cost
Relevant costs are those expected future costs that differ among different alternatives. The difference in total cost between two alternatives is an incremental cost. Synonyms for incremental costs are differential costs and net relevant costs.
Limiting factors
It may not be possible to produce unlimited quantities of product B because there could be a restriction on how many units could be sold or produced. Such restrictions are known as limiting factors or key factors.
Produce the product which provides the maximum contribution per unit of limiting factor employed.
Contribution per unit = unit contribution /limiting factor per unit
Opportunity cost is defined as the maximum available contribution that is forgone by using limited resources for a specific purpose or the value of the best alternative foregone.
Sunk costs
Accountants often use the terms sunk cost to refer to costs already incurred that will not be affected by subsequent decisions. I.e. undepreciated cost of a plant asset is a sunk cost.
Sunk costs are therefore not relevant to decision making because they cannot be changed regardless of what decisions are made.
Accounting practice——ratio analysis
Return on capital employed （ROCE）
1. Profit includes： operating profit ； net profit before interest and taxation ； net profit before taxation ； net profit after taxation； net profit after taxation and preference dividends；
2. Capital employed includes： total assets； total assets less current liabilities； shareholders‘ funds； shareholders’ funds less preference shares； shareholders‘ funds plus long-term liabilities.
3. We ought to take the average capital figures. It is customary to take a simple average of opening and closing capital balances.
4. ROCE=（profit/capital）X100%
Gross profit ratio
（Gross profit / total sale）X100%
Net profit with the sales
（Net profit before taxation and dividends / total sales）X100%
Liquidity ratio ；quick ratio； acid test ratio
（current assets less stocks / current liabilities） X100% '
quick ratio must be at least 1 to 1 ， but depends on type of business
Current ratio； working ratio
（Current assets / current liabilities） X100%
A current ratio of less than 2 to 1 may indicate a serious financial position
Stock turnover ratio
Cost of sales / average stock
Average stock =（opening stock + closing stock） /2
Debtor turnover ratio
Total credit sales / average trade debtors
It is most usually shown in the form of the Debtor Collection Period. The true average of debtors time taken to settle their debts， it would necessitate taking a daily amount outstanding.
Debtor collection period
（Average trade debtors / total credit sales） X 365 days
Credit payment period
（Average trade creditors / total credit purchase） X 365days
Dividend yield
（Dividend per share / market price per share） X 100%
Dividend cover
Net profit after taxation and preference dividend / ordinary dividends
If the dividend cover is 4 ，the company would be paying out one quarter of its earnings as an ordinary share dividend.
Earnings per share （ESP）
Net profit less preference dividends / weighted number of shares outstanding
Price earnings ratio （P/E）
Market price per share / earnings per share
An investor needs X years to recover the market price paid for the shares out of the earnings.
Gearing ratio
Gearing express the relationship between the proportion of fixed interest capital， e.g. debentures， to ordinary share capital. Where a company has a large proportion of its capital in the form of debentures in relation to ordinary shares， it is said to be high geared.
