Further processing Component B to Product B incurs incremental costs of $8,000 and incremental revenues of $11,000 ($15,000 – $4,000). 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. Types of decisionWe will now look at some typical examples where you have to decide which costs are relevant to decision-making.
That is why accountants will refer to a past cost as a sunk cost. 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.
They could have made this order right after the company had calculated all its costs on normal sales. The company shall then consider the lowest price for producing that order. It considers economic lot size model 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.
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.
What Is Relevant Cost?
Sunk, or past, costs are monies already spent or money that is already contracted to be spent. A decision on whether or not a new endeavour is started will have no effect on this cash flow, so sunk costs cannot be relevant. The company shall free some space that can be leased if it decides to outsource.
How Relevant Cost is used in Decision Making?
A major dilemma regarding any business at some point is whether to continue operation or close business units. 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. Committed costs are future costs that cannot be avoided because of decisions that have already been made.
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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. 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. 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. Direct labor is paid idle time equal to 60% of the normal pay in order to retain them.
Example of Relevant Costs
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.
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. Relevant costing is just a refined application of such basic principles to business decisions. The key to relevant costing is the ability to filter what is and isn’t relevant to a business decision. The how do you calculate the gain or loss when an asset is sold 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.
- They could have made this order right after the company had calculated all its costs on normal sales.
- Fixed costs, such as a factory lease or manager salaries, are irrelevant because the firm has already paid for those costs with prior sales.
- 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).
- Along the line of business, there is the production of several units.
- Expressed another way, relevant costs are the costs that will make a difference when making a decision.
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. 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.
When an alternative course of action is given up, the financial benefits lost are known as opportunity costs. The underlying principles of relevant costing are fairly simple and you can probably relate them to your personal experiences involving financial decisions. Past costs may help you predict and estimate the future costs, but the past costs are otherwise irrelevant to the decision.
Many of the decisions company management make have a financial impact, such as, for example, choosing whether to shut down an operation or pursue an opportunity. The option taken has financial implications in terms of expenses and revenues and it’s up to management to work out, using all available data, which path is likely to be more profitable. A managerial accounting term for costs that are specific to management’s decisions. 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 a ticket for a flight that is leaving in 25 minutes.
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 of this order should be considered irrelevant. Calculate the relevant cost for the order and the price RTC should quote. 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.
