By the same argument, book values are not relevant as these are simply the result of historical costs (or historical revaluation) and depreciation. ‘Relevant costs’ can be defined as any cost relevant to a decision. A matter is relevant if there is a change in cash flow that is caused by the decision. Future Cash FlowsCash expense that will be incurred in the future as a result of a decision is a relevant cost. Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the decision to invest.
It is worthwhile to do this, as the extra revenue is greater than the extra costs. Further processing Component A to Product A incurs incremental costs of $6,000 and incremental revenues of $5,000 ($12,000 – $7,000). It is not worthwhile to do this, as the extra costs are greater than the extra revenue.
What Is Relevant Cost in Accounting, and Why Does It Matter?
Component B can be converted into Product B if $8,000 is spent on further processing. Component A can be converted into Product A if $6,000 is spent on further faqs on the 2020 form w processing. Electricity charges are incremental to this order and therefore relevant.
For example, a furniture manufacturer is considering an outside vendor to assemble and stain wood cabinets, which would then be finished in-house by adding handles and other details. The relevant costs in this decision are the variable costs incurred by the manufacturer to make the wood cabinets and the price paid to the outside vendor. If the vendor can provide the component part at a lower cost, the furniture manufacturer outsources the work. Material B – The 100 units of the material already in inventory has no other use in the company, so if it is not used on the new product, then the assumption is that it would be sold for $12/unit.
- 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.
- The material has no use in the company other than for the project under consideration.
- Past costs may help you predict and estimate the future costs, but the past costs are otherwise irrelevant to the decision.
- Relevant costs help to eradicate unnecessary data that can complicate a decision-making process.
Example of Relevant Costs
The company shall free some space that can be leased if it decides to outsource. The management can outsource to make an extra income from leased space. The relevant cost analysis thus helped the company to conclude that buying the part was a more financially sound decision. Sunk CostSunk cost is expenditure which has already been incurred in the past. Sunk cost is irrelevant because it does not affect the future cash flows of a business. The total fixed costs of $24m have been apportioned to each production line on the basis of the floor space occupied by each line in the factory.
The decision to make or buy it depends on the cost-effectiveness of either alternative. If buying the item costs less than making it internally, the company opts for outsourcing it. The decision could result in higher expenses or lower expenses as well as higher or lower revenue. Generally, the cost can be deemed worthwhile if it pays off and results in a higher overall profit.
It means that if there is zero production, there is no spending. If the product cost price is below production cost, the company can safely decide to take special orders. We assume the units in inventory will not be used—the selling price at $13. Relevant costs are sometimes also called avoidable costs or differential costs. General and administrative overheads that are not incurred directly as a result target costing and how to use it of this order should be considered irrelevant. Calculate the relevant cost for the order and the price RTC should quote.
AccountingTools
These costs will have to be compared to the contribution that can be earned by the new machine to determine if the overall investment in the asset is financially viable. Cost of machine – this is a relevant cost as $2.1m has to be paid out. For example, a person has to choose between vacationing and spending time with their family. In this context, opportunity cost is the cost of the holiday and visiting new places if the person decides to go on vacation rather than stay home. It happens when the company opt-out of other activities that can save it from incurring expenses.
Thus, incurring an expense may be avoided by deciding not to perform a certain activity. For example, assume you had been talked into buying a discount card of ABC Pizza for $50 which entitles you to a 10% discount on all future purchases. Say a pizza costs $10 ($9 after discount) at ABC Pizza and it subsequently came to your knowledge that a similar pizza is offered by XYZ Pizza for just $8. So the next time you would have ordered a pizza, you would have (hopefully) placed an order at XYZ Pizza realizing that the $50 you have already spent is irrelevant (see sunk cost below).
Add or Drop a Product Line (or Segment)
A sunk cost is an expenditure that has already been made, and so will not change on a go-forward basis as the result of a management decision. When making a decision, you should always take relevant costs into consideration, and ignore all sunk costs. However, even long term financial decisions such as investment appraisal may use the underlying principles of relevant costing to facilitate an objective evaluation. Relevant costing attempts to determine the objective cost of a business decision.
What is a Relevant Cost?
Then, a discounted rate is formulated to arrive at discounted cash flows. If a client wants a price quote for a special order, management only considers the variable costs to produce the goods, specifically material and labor costs. Fixed costs, such as a factory lease or manager salaries, are irrelevant because the firm has already paid for those costs with prior sales.
Here, the management needs to consider whether the units are making expected income or have high maintenance costs. Appropriate cost analysis form plays a primary role in making that decision. Relevant costs are future expenses related to a specific decision. They can be avoided and differ depending on which choice is taken. Sunk costs, on the other hand, are existing expenses that have already been incurred and are unrecoverable.
This is not worthwhile as incremental costs exceed incremental revenues. Sale proceeds – this is a relevant cost as it is a cash inflow which will occur in 10 years as a result of the decision to invest. As the relevant cost is a net cash outflow, the machine should be sold rather than retained, updated and used. The material is regularly used in current manufacturing operations. Committed costs are costs that would be incurred in the future but they cannot be avoided because the company has already committed to them through another decision which has been made.
Direct labor is paid idle time equal to 60% of the normal pay in order to retain them. Incremental CostWhere different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. Machine running costs – the machine is already fully utilised on Operations 1 and 2 and will remain fully utilised, but only on Operation 2.