Relevant Cost Of Decisions

Examples of irrelevant factors are common costs and allocated costs. In general, costs that are avoidable are considered in the analysis. Instead of looking at the overall margin, try looking at the segment margin and see if it is still profitable without considering common costs. A big decision for a manager is whether to close a business unit or continue to operate it, and relevant costs are the basis for the decision. 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.

How Relevant Cost is used in Decision Making?

Component A can be converted into Product A if $6,000 is spent on further processing. 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. This represents the share of factory supervisor’s salary for the number of days in which production for the order will take place.

The company is concerned about the loss that is reported by Production Line B and is considering closing down that line. Closing down either production line would save 25% of the total fixed costs. 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.

In accounting, what is meant by relevant costs?

In this situation however, the labour is simply being redeployed so $24 understates can you cancel a po sent to a supplier the effect of this, as the labour costs are not saved. 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. Note that additional fixed costs caused by a decision are relevant. So, if you were evaluating the viability of a new production facility, then the rent of a building specially leased for the new facility is relevant.

1. Make vs. buy decisions are often an issue for a company that requires component parts to create a finished product.
2. Incremental CostWhere different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered.
3. 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.

If the vendor can provide the component part at a lower cost, the furniture manufacturer outsources the work. The cost effects relate to both changes in variable costs and changes in total fixed costs. 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. The opposite of relevant costs is sunk cost or irrelevant costs, which refers to the expenses already incurred.

However, even long term financial decisions such as investment appraisal may use the underlying principles of relevant costing to facilitate an objective evaluation. 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. In a continue-or-shutdown decision, you should look at the segment margin and not the overall net income.

Therefore, it is worth buying in as incremental revenue exceeds incremental costs. 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. For example, a person has to choose between vacationing and spending time with their family.

Special Order Decision

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 costs are avoidable costs that are incurred only when making specific business decisions. 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.

Non-Cash ExpensesNon-cash expenses such as depreciation are not relevant because they do not affect the cash flows of a business. Relevant cost, in managerial accounting, refers to the incremental and avoidable cost of implementing a business decision. Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the decision to invest. The material has no use in the company other than for the project under consideration. Types of decisionWe will now look at some typical examples where you have to decide which costs are relevant to decision-making. We suggest that you try each example yourself before you look at each solution.

For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. 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. 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.

If oil is not used on the order, it could be used in the production of other tires. Rubber Tire Company (RTC) received a request to provide a price quote for an order for the supply of 1000 custom made tires required for industrial vehicles. RTC is facing stiff competition from its business rivals and is therefore hoping to secure the order by quoting the lowest price.

What Is Another Name for a Relevant Cost?

It also helps assess if it’s worth pursuing a particular alternative course of action that will lead to an incremental benefit to the company as a whole. In general, most variable costs are relevant while most fixed costs are irrelevant. This general rule holds true most of the time since variable costs behave differently across activity levels while fixed costs remain constant nonetheless. However, fixed costs that can be removed under one alternative are relevant. 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.

A matter is relevant if there is a change in cash flow that is caused by the decision. If retained earnings def a company decides not to undertake an activity, the company can avoid some expenses. As these materials are not available in stock, these will have to be purchased at the market price which is their relevant cost. Incremental CostWhere different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered.