Relevant cash flows (relevant revenues and cash flows) are those cash flows that differ across different decision alternatives. Drury (2012) observes that relevant cash flows are those cash flows that are:
Incremental cash flows – relevant cash flows represents the incremental revenues or costs of different decision alternatives. The relevant cash flows include the marginal revenues or marginal costs associated with each decision alternative. Cash flows that will remain unchanged are irrelevant cash flows. Therefore, committed costs such as salaries for full time employees are irrelevant cash flows.
Future cash flows – relevant cash flows must be future cash flows. Past costs have already been incurred and cannot be affected by the decision at hand. Past costs are treated as sunk costs and are irrelevant cash flows.
Opportunity costs are relevant costs because they represent the cost of the foregone alternative.
Specifically relevant cash flows exclude:
Non-cash flow expenses such as depreciation and notional costs. Depreciation is an accounting concept that allows the charging of the cost of an asset over its useful life (Drury, 2012). Notional cost are costs that are imaginary costs that are included in the cost centres in order to make the profit calculation more realistic (Drury, 2012). For instance, the Library can estimate notional costs on internally generated software in order to make the profit calculation more comparable to their competitors or make the profit calculations more realistic.
Financing costs such as interest charges are irrelevant cash flows because project appraisal discounts the cash flows at the firm’s cost of capital.
Allocated overheads are irrelevant cash flows because they represent costs that will be incurred regardless of what decision alternative is taken. Allocated overheads simply represent a fair share of overheads to various cost centres.
Committed costs are costs that cannot be avoided irrespective of what decision is taken (Drury, 2012). For instance, lease rentals on a lease that has already been signed.
The calculations and explanations of the relevant cash flows of the proposed IT system are as follows:
Increase in income of €10,000 is a relevant revenue because it is incremental revenue that would arise from implementing the IT system. The incremental revenue is what the library will either gain if they opt to introduce the IT system, or forego, if they choose not to introduce the IT system.
Direct costs are wholly attributable to the IT system. The direct costs of the IT system will not be incurred if the system is not implemented and therefore, the direct cost of €2,000 is a relevant cost.
Overhead costs of €3,000 are not attributable to the introduction of the IT system and the overheads will still be incurred irrespective of whether the Library implements the new IT system. Therefore, the overhead costs of €3,000 are irrelevant.
The €2,000 paid to the consultant represent a past costs that has already been incurred and represent a sunk cost. While sunk costs may be included in profit calculations by the accountants, sunk costs are irrelevant because whether the new IT system is introduced or not the money spent paying the consultant is irrecoverable.
The staff training of €1,500 is a future cost that will be incurred if the library decides to implement the new IT system. Therefore, the staff training costs are a relevant cost that needs to be considered in the decision on whether or not to introduce the new IT system.
The space needed to set up the IT system is currently used to store DVDs that generate an annual contribution of €2000. The lost contribution is an opportunity cost that is relevant to the decision. Therefore, the contribution lost will be considered as part of the costs associated with the introduction of the IT system.
The investment will be financed from the Littoral’s existing cash in the bank that is currently earning an interest at the rate of 10% per year. The foregone interest of €2,500 (10% x€25,000) is an opportunity cost that is relevant to the decision. However, if the Littoral were to take a loan to purchase the IT system, the interest charges on the loan would be irrelevant costs.
Since the library has no spare capacity, the library will have to deploy staff from other areas of the library to operate the new IT system. The staff opportunity cost is the €7,000 contribution that will be lost if the staff is to be deployed to operate the new IT system. If the library would have spare capacity to implement the new IT system, the relevant cost would have been nil.
Using relevant costs to appraise the proposed IT system considers not just the accounting income and expenses, but the opportunity costs that will arise from the introduction of the IT system. A review of the relevant cash flows indicate that the proposed IT System will result in a loss of €5,000 and not a profit of €1,500 as earlier calculated. The earlier calculations had erroneously omitted opportunity costs amounting to €9,500 (€7,000 for labour, and €2,500 for lost interest), and included overhead costs of €3,000 giving a profit figure of €1,500 instead of a loss of €5,000. Therefore, the management should not implement the new IT system, as it will lead to an annual loss of € 5,000.
Reference list
Drury, C. (2012) Management and cost accounting, eighth edition. Andover: Cengage Learning.
