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 income tax calculator 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.
In accounting, what is meant by relevant costs?
The concept of relevant costs eliminates unnecessary data that could complicate the decision-making process. Assume a passenger rushes up to the ticket counter to purchase small business taxes and management a ticket for a flight that is leaving in 25 minutes. The airline needs to consider the relevant costs to make a decision about the ticket price. Almost all of the costs related to adding the extra passenger have already been incurred, including the plane fuel, airport gate fee, and the salary and benefits for the entire plane’s crew. Because these costs have already been incurred, they are “sunk costs” or irrelevant costs.
This represents the apportionment of general and administrative overheads based on the number of machine hours that will be required on the order. This represents the share of lease rentals of the factory plant for the number of days in which production for the order will take place. This represents the manufacturing equipment’s depreciation for the number of days in which production for the order will take place.
Relevant costs are future potential expenses, whereas sunk costs are existing expenses that have already been made. The order requires a special type of rubber.Only 25% rubber is currently available in stock. If the rubber is not used on this order, it will have to scraped at a price of $1,000.Remaining quantity shall have to be procured at the price of $7,000. The underlying principles of relevant costing are fairly simple and you can probably relate them to your personal experiences involving financial decisions. Relevant cost, in managerial accounting, refers to the incremental and avoidable cost of implementing a business decision.
As these materials are not available in stock, these will have to be purchased at the market price which is their relevant cost. Non-Cash ExpensesNon-cash expenses such as depreciation are not relevant because they do not affect the cash flows of a business. Opportunity CostsCash inflow that will be sacrificed as a result of a particular management decision is a relevant cost. Committed CostsFuture costs that cannot be avoided are not relevant because they will be incurred irrespective of the business decision bieng considered. Further processing Component B to Product B incurs incremental costs of $8,000 and incremental revenues of $11,000 ($15,000 – $4,000).
- Say, for example, that 4 hours of labour were simply removed by ‘sacking’ an employee for four hours, one less unit of Product X could be made.
- 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.
- The order would require 3000 units of electricity which is expected to cost $8,000.
- Along the line of business, there is the production of several units.
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.
This represents the share of factory supervisor’s salary for the number of days in which production for the order will take place. Production volume – this can increase by 50% because currently each item takes 0.5 hours in Operation 2, but 0.25 hours per unit will be released by Operation 1 which now will not be needed. Material – if the buy-in option is accepted, the material cost increases from $12 to $15 per unit.
Definition of Relevant Costs
General OverheadsGeneral and administrative overheads which are not affected by the decisions under consideration should be ignored. Next we should consider whether the components should be further processed into the products. According to the above illustration, it will cost XYZ $250,000 to buy from a supplier.
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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.
The order would require 3000 units of electricity which is expected to cost $8,000. Therefore, the closure of Production Line B is not a good idea as the revenue lost is greater than the value of the costs saved. Relevant costs stand out because they haven’t been incurred yet, can be avoided, and are only pursued if it’s believed the action will be profitable. Companies keep track of these costs and jobs could be in jeopardy if they don’t pay off. Relevant costs are avoidable and can differ depending on which action is taken. These costs are not static, will vary depending on which path is taken, and can be avoided.
The company has to decide whether to make the parts internally or outsource. Direct materials, direct labor, and various overhead costs are examples of the make or buy situation. Assume, for example, a chain of retail sporting goods stores is considering closing a group of stores catering to the outdoor sports market. The relevant costs are the costs that can be eliminated due to the closure as well as the revenue lost when the stores are closed. If the costs to be eliminated are greater than the revenue lost, the outdoor stores should be closed.
It requires an additional $0.5 million to complete construction. Because of a downturn in the real estate market, the finished building will not fetch its original intended price, and is expected to sell for only $1.2 million. However, the $1 million is an irrelevant cost, and should be excluded. Continuing the construction actually involves spending $0.5 million for a return of $1.2 million, which makes it the correct course of action.