Thus, these costs increase as the production increases or drops with low production. Maintenance cost for machinery is $3,000, $2,000 for material, $2,500 for labor, and $1,500 for miscellaneous costs. Billy’s might continue with cheese production if the expenses are lower, like $ 7,500. A company that deals with making finished goods requires specific parts.
An objective measure of the cost of a business decision is the extent of cash outflows that shall result from its implementation. Relevant costing focuses on just that and ignores other costs which do not affect the future cash flows. A construction firm is in the middle of constructing an office building, having spent $1 million on it so far.
What Are the Two Characteristics of Relevant Costs?
Types of decisionWe will now look at some typical examples where you have to decide which costs are relevant to decision-making. We suggest that you try each example yourself before you look at each solution. Depreciation is not a cash flow and is dependent on past purchases and somewhat arbitrary depreciation rates.
It considers taking special orders if the costs involved will generate income in the long run. A special order occurs when a customer places an order near the end of the month, and prior sales have already covered the fixed cost of production for the month. As supervisor’s salary is a fixed cost unchanged by the work performed on this order, it is a non-relevant cost. All the required quantity of oil is currently available in stock.
What is a Relevant Cost?
For example, if a company is deciding whether to expand its sales territory, the real estate tax and depreciation on the company’s headquarters building is not relevant. The additional travel expenses to the new territory and the additional sales from the new territory are relevant to the decision. Relevant costs are future costs that will differ between two or more alternative actions.
Add or Drop a Product Line (or Segment)
Therefore, the machine running costs will not change, so are not relevant to the decision. Instead of carrying out Operation 1, the company could buy in components, for $15 per unit. This would allow production to be increased because the machine has to deal with only Operation 2.
If the new product is made, this sale won’t happen and the cash flow is affected. The original purchase price of $10 is a sunk cost and so is not relevant. In addition, another 50 units are needed for the new product and these will need to be bought in at a price of $14/unit. A relevant cost is a cost that only relates to a specific management decision, and which will change in the future as a result of that decision. The relevant cost concept is extremely useful for eliminating extraneous information from a particular decision-making process. Also, by eliminating irrelevant costs from a decision, management is prevented from focusing on information that might otherwise incorrectly affect its decision.
Relevant cost is a managerial accounting term that describes avoidable costs that are incurred only when making specific business decisions. The concept of relevant cost is used to eliminate unnecessary data that could complicate the decision-making process. As an example, relevant cost is used to determine whether to sell or keep a business unit. Relevant cost is a management accounting term that describes avoidable costs incurred when making specific business decisions. This concept is useful in eliminating unnecessary information that might complicate the management’s decision-making process. Businesses use relevant costs in management accounting to conclude whether a new decision is economical.
- Relevant costs are avoidable costs that are incurred only when making specific business decisions.
- Further processing Component B to Product B incurs incremental costs of $8,000 and incremental revenues of $11,000 ($15,000 – $4,000).
- The company is concerned about the loss that is reported by Production Line B and is considering closing down that line.
- Continuing the construction actually involves spending $0.5 million for a return of $1.2 million, which makes it the correct course of action.
AccountingTools
Operation 1 takes 0.25 hours of machine time and Operation 2 takes 0.5 hours of machine time. Labour and variable overheads are incurred at a rate of $16/machine hour and the finished products sell for $30 per unit. Irrespective of what treatment is used in the company’s management accounts to split up costs, if the total costs remain the same, there is no cash flow effect caused by the decision. If a company decides not to undertake an activity, the company can avoid some expenses. A major dilemma regarding any business at some point is whether to continue operation or close business units.
A change in the cash flow can rationalizing fraud be identified by asking if the amounts that would appear on the company’s bank statement are affected by the decision, whether increased or decreased. This concept is only applicable to management accounting activities; it is is not used in financial accounting, since no spending decisions are involved in the preparation of financial statements. Make vs. buy decisions are often an issue for a company that requires component parts to create a finished product.
The cost of oil that will be used on the order is $1,000.The current market value of the required quantity of oil is $1,200. If oil is not used on the order, it could be used in the production of other tires. Rubber Tire Company (RTC) received a request to provide a price quote for an order for the supply of 1000 custom made tires required for industrial vehicles. RTC is facing stiff competition from its business rivals and is therefore hoping to secure the order by quoting the lowest price.
Avoidable CostsOnly those costs are relevant to a decision that can be avoided if the decision is not implemented. Therefore, it is worth buying in as incremental revenue exceeds incremental costs. The closure of Production Line A would also result in the revenue lost being greater than the value of the costs saved, so this isn’t a good idea either. A company that needs a special item can either make one on its own or outsource it.
What Is the Difference Between Relevant Cost and Sunk Cost?
Say, for example, that contributions 4 hours of labour were simply removed by ‘sacking’ an employee for four hours, one less unit of Product X could be made. Using the contribution foregone figure of $24 is the net effect of losing the revenue from that unit and also saving the material, labour and the variable costs. In this situation however, the labour is simply being redeployed so $24 understates the effect of this, as the labour costs are not saved. Note that additional fixed costs caused by a decision are relevant. So, if you were evaluating the viability of a new production facility, then the rent of a building specially leased for the new facility is relevant. A big decision for a manager is whether to close a business unit or continue to operate it, and relevant costs are the basis for the decision.
These costs are relevant since these expenses change in the future due to the buying decision. The cost effects relate to both changes in variable costs and changes in total fixed costs. A particular cost may be relevant for one situation but irrelevant for another. The opposite of relevant costs is sunk cost or irrelevant costs, which refers to the expenses already incurred.
Relevant costing aids management in making non-routine decisions by analyzing relevant costs and benefits. Relevant costs refer to those that will differ between different alternatives. Past costs may help you predict and estimate the future costs, but the past costs are otherwise irrelevant to the decision. That is why accountants will refer to a past cost as a sunk cost.