The concept of relevant costs eliminates unnecessary data that could complicate the decision-making process. Business management uses relevant costs to finalize a decision. Relevant costs help to eradicate unnecessary data that can complicate a decision-making process. Management can use this concept to make cost-effective business decisions and avoid unnecessary expenses. A particular cost may be relevant for one situation but irrelevant for another.
Management would review the cost of continuing to produce the circuit boards themselves compared to outsourcing the materials and labour to another business. This is because, over a long time period, most costs are relevant. Lease rentals are a committed cost which cannot be avoided by withdrawing from this order which is why they should be ignored for the purpose of this analysis. Calculate the relevant cost for the order and the price RTC should quote. All the required quantity of oil is currently available in stock. 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.
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No matter what decision we make, we’ve already incurred that cost. Therefore, it’s a sunk cost and it’s never relevant in short-term decision making. Moreover, relevant costs are avoidable, meaning they can be altered or eliminated by selecting a particular course of action. A managerial accounting term for costs that are specific to management’s decisions.
The analysis goes beyond a mere quantitative comparison, delving into the qualitative aspects of the decision. Special order decisions concern whether to accept a one-time order, usually at a lower price than normal. Relevant costs include additional materials, labor, and opportunity costs, but exclude fixed overheads.
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All other costs are sunk costs, meaning they have already been incurred and cannot be changed by the decision. As such, they should not be considered when making a decision. If we decide to produce the product, we will have incurred that cost anyway.
Re-apportionment of existing fixed costs are not relevant
Continuing the construction actually involves spending $0.5 million for a return of $1.2 million, which makes it the correct course of action. A company decides to buy loading machinery for a factory unit. This machine can save the wage expenses of 20 manual laborers. These costs are relevant since these expenses change in the future due to the buying decision.
Closing down either production line would save 25% of the total fixed costs. This is not worthwhile as incremental costs exceed incremental revenues. The material has no use in the company other than for the project under consideration.
Concept of Relevant Costs, Steps in Decision Making
After evaluating the alternatives, the next step is to select the best option that aligns with the desired outcomes. This requires weighing the potential risks and rewards and choosing the alternative that offers the greatest benefit. In cases involving equipment, replacement costs (the cost of acquiring a new asset) can be relevant when comparing options to replace or repair existing assets. Opportunity cost represents the potential benefit lost when one alternative is chosen over another. For instance, using a factory space for one product may forego profits from producing another. Relevant costs are those costs that will be incurred as a result of a decision and thus should be considered when making that decision.
Irrelevant costs for the business decision:
These relevant costing decisions occur at the strategic level of management. For example, a construction company working on several projects will decide whether to take any new project before shutting down any of the ongoing ones. Relevant cost analysis holds pivotal importance in guiding strategic decision-making within businesses. Its significance stems from its ability to provide decision-makers with a clear and informed perspective on the financial implications of different alternatives.
- The first step is to recognize and clearly define the problem or opportunity.
- Special order decisions concern whether to accept a one-time order, usually at a lower price than normal.
- After implementation, it is essential to monitor and evaluate the outcomes of the decision.
- Therefore, it’s a sunk cost and it’s never relevant in short-term decision making.
- This would allow production to be increased because the machine has to deal with only Operation 2.
For example, if a business is planning for the next decade, then all types of costs would have to be considered, including any fixed and sunk costs that may be incurred. For example, assume you had been talked into buying a discount card of ABC Pizza for $50 which entitles what is relevant cost 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).
- Thus, these costs increase as the production increases or drops with low production.
- In this scenario, the original manufacturing cost of the defective printers ($70) is a sunk cost and therefore not relevant to the decision.
- As any long term decision will require considering other factors too.
- However, it is often used to indicate the costs of a choice we can make but can’t.
- Management would review the cost of continuing to produce the circuit boards themselves compared to outsourcing the materials and labour to another business.
- There are four main non-relevant costs that we’re going to run through – sunk costs, committed costs, notional costs, and fixed costs.
RTC is facing stiff competition from its business rivals and is therefore hoping to secure the order by quoting the lowest price. Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the decision to invest. The material is regularly used in current manufacturing operations. A change in the cash flow can 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.
Relevant costs include direct materials, labor, and any savings or additional costs from outsourcing. For example, a furniture manufacturer must decide whether to make wooden chair legs in-house or buy them from a supplier. If outsourcing saves on labor and overhead without sacrificing quality, buying may be more cost-effective.
Labour and variable overheads are incurred at a rate of $16/machine hour and the finished products sell for $30 per unit. 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. 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. 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.
The opposite of relevant costs is sunk cost or irrelevant costs, which refers to the expenses already incurred. Thus, incurring an expense may be avoided by deciding not to perform a certain activity. Absorption costing is where we take a piece of the fixed overhead and we allocate it and absorb it into each unit that’s produced.
Variable costs fluctuate with changes in production levels, such as raw materials and direct labor. These costs are often relevant because they directly correlate to activity changes. An opportunity cost is the value of sacrifices made or the benefit of opportunity gone to accept an alternative course of action. That means that a relevant cost is one that we will incur in the future as a direct result of a management decision. A franchise based company will decide on the profitability of different franchise branches and make the decision about closing or continuity of a particular branch.
If oil is not used on the order, it could be used in the production of other tires. 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.
