If a client wants a price quote for a special order, management only considers the variable costs to produce accounting receipt 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. A construction firm is in the middle of constructing an office building, having spent $1 million on it so far. 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.
What is a Relevant Cost?
Billy’s might continue with cheese production if the expenses are lower, like $ 7,500. 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.
The current value is used to project future revenues to see if a decision will incur future costs. Here, we can price the expected ongoing-project revenues with the current value. Then, a discounted rate is formulated to arrive at discounted cash flows.
Material – if the buy-in option is accepted, the material cost increases from $12 to $15 per unit. 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 processing. Electricity charges are incremental to this order and therefore relevant.
ACCA PM Syllabus C. Decision-making Techniques – Concept of Relevant Costing – Notes 1 / 3
- If buying the item costs less than making it internally, the company opts for outsourcing it.
- Sunk CostSunk cost is expenditure which has already been incurred in the past.
- Depreciation is not a cash flow and is dependent on past purchases and somewhat arbitrary depreciation rates.
- Component A can be converted into Product A if $6,000 is spent on further processing.
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. The future expenses that might occur due to a decision made in the present are called future cash flows.
Types of Relevant Cost Decisions
Machine running costs – the machine is already fully utilised on Operations 1 and 2 and will remain fully utilised, but only on Operation 2. 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. 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.
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. 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.
AccountingTools
A company that deals with making finished goods requires specific parts. The company has to decide whether xero accounting software blog and news 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.
Relevant costs can be thought of as future expenses that are incurred only if an opportunity is pursued. They are studied by companies to determine if one decision is more cost-effective than another. The opposite of a relevant cost is a sunk cost, which has already been incurred regardless of the outcome of the current decision. Since $3,000 (60% of $5,000) idle time pay will be incurred even if this order is not taken, the relevant cost is the incremental cost of $2,000 ($5,000 – $3,000).
We and our partners process data to provide:
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.
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). Relevant costs are future costs that will differ between two or more alternative actions. Expressed another way, relevant costs are the costs that will make a difference when making a decision. This effect is known as an opportunity cost, which is the value of a benefit foregone when one course of action is chosen in preference to another. In this case, the company has given up its opportunity to have a cash inflow from the asset sale.
Committed CostsFuture costs that cannot be avoided are not relevant because they will be incurred irrespective of the business decision bieng considered. 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.
The order would require 3000 units of electricity which is expected to cost $8,000. These costs are not static, will vary depending on which path is taken, and can be avoided. So they are the lost contribution from the best use of the alternative forgone. 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.
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.
