Relevant Cost and Decision Making
Relevant cost of labor is the incremental and avoidable cost of labor that is incurred as a consequence of a business decision.
Direct labor includes personnel that are directly involved in the production process (e.g. assembly line workers).
Relevant cost of direct labor depends on how the labor requirements of a proposed business action are planned to be met.
The following diagram summarizes the impact of different scenarios on the relevant cost of direct labor:
Scenario 1: Availability of spare capacity
This is applicable where the labor hours available exceed the labor hours currently being utilized, i.e. spare capacity exists.
Where spare capacity is available, relevant cost is the incremental cost of utilizing additional labor hours, i.e. variable cost of each additional hour.
Fixed costs which do not change as a result of the change in labor hours consumed should not be considered as relevant. For instance, if direct labor is guaranteed idle time pay equal to 60% of the normal pay during periods of lower demand, the relevant cost of labor shall be only 40% of the normal pay because 60% of the cost will be incurred irrespective of any additional work undertaken.
Scenario 2: Overtime and Additional Staff
When existing labor is already being fully utilized, any additional labor requirement may be met either by offering overtime to current staff or by hiring new employees.
The relevant cost of direct labor in this scenario shall be the total cost of additional labor hours required for the proposed business action.
Scenario 3: Divert Labor Resources
As a last preference, direct labor engaged in current production may be diverted towards the new business proposition where no spare capacity exists and neither can new labor be hired externally.
The relevant cost of direct labor in this scenario shall be the variable cost of labor to be utilized plus any loss of contribution resulting from the discontinuation of current production activities. The lost contribution represents the opportunity cost of using labor on a new project when current production has to be sacrificed.
Indirect labor consists of employees that are not directly involved in the production such as managerial and administrative staff.
Relevant cost of indirect labor is the incremental cost, i.e. the additional cost that results directly from the implementation of the proposed business action.
Unlike direct labor, the cost of indirect labor is largely fixed and unaffected by variations in output in the short term in most cases because managerial and administrative staff is usually salaried. Therefore, for very short term decisions (e.g. pricing decisions of special orders), the relevant cost of indirect labor would often be negligible.
The Guitar Company (TGC) is a small company specializing in the manufacture of hand-made acoustic guitars.
TGC has received a request to submit their price quote for the supply of 50 custom made acoustic guitars. TGC has a policy of pricing custom orders at a markup of 50% above their relevant cost.
Detail and relevant cost of labor that will be utilized on the order is as follows:
|5||$15||This represents the estimated time that will be spent on the order by the procurement manager Liza on the purchase of tools and materials for the order.
$15 is the average hourly cost of Liza's monthly salary.
|-||Since Liza's salary cost is fixed and does not increase as a result of this order, her relevant cost is nil.
Designer & Cutter
|200||$10||Designing and cutting of guitars will be done by Michael.
Michael is a part-time worker and is paid on hourly basis.
|$2,000||(200 hours x $10)
As Michaels's labor cost varies directly as a result of the order, it should be considered as a relevant cost.
Gluing & Binding Specialist
|100||$13||Gluing & binding of guitar parts is usually done by Sam who is paid $13 per hour. Sam however will only be able to work 100 out of the 250 hours required for this order due to his commitment on other orders.||$1,300||(100 hours x $13)
Sam's cost represents a variable expense and is therefore relevant.
|150||$15||The remaining 150 hours required for gluing and binding of guitars will need to be contracted to Bob who has agreed to work for TGC on a 3-months contract for a fixed fee of $500 plus $15 per hour of work.||$2,250|
(150 hours x $15)
The fixed fee and the variable cost both are relevant because they shall be incurred directly as a result of the acceptance of the order. Conversely, the entire cost can be avoided if the order is not undertaken.
|150||$15||Smith is responsible for shaping the guitars. He is paid $15 per hour of work.
For the foreseeable time, Smith will be occupied in the completion of other orders. As there is currently no replacement of Smith available, he will have to discontinue work on other orders in order to work on the new order.
A contribution of $10,000 will be lost as a result of the discontinuation of work on other orders.
|(150 hours x $15)
Relevant cost is the sum of variable cost ($2,250) and the contribution from other orders that will be lost ($10,000) if the new order is undertaken.
The lost contribution represents the opportunity cost of accepting the new order.
|100||$18||Gibson handles the finishing of guitars.
As one of the most senior employees, Gibson is paid a fixed monthly salary of $1,400 (equal to an average of $8 per hour) along with $10 per every hour of work.
(150 hours x $15)
(100 hours x $10)
Only the variable element of Gibson's labor cost ($10 / hour) is relevant to the order because the fixed portion ($1400) shall be incurred even if the order is not accepted, i.e. it is unavoidable.