The goal of relevant costing for decision-making is to select the decision that would result in the highest incremental benefit to the company. Sunk costs, on the other hand, are existing expenses that have already been incurred and are unrecoverable. Relevant costs can be thought of as future expenses that are incurred the inventory costing method that reports the earliest costs in ending inventory is 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. Operation 1 takes 0.25 hours of machine time and Operation 2 takes 0.5 hours of machine time.
What Is Relevant Cost in Accounting, and Why Does It Matter?
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. 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. Future Cash FlowsCash expense that will be incurred in the future as a result of a decision is a relevant cost.
- 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.
- These costs are relevant since these expenses change in the future due to the buying decision.
- 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.
- Material – if the buy-in option is accepted, the material cost increases from $12 to $15 per unit.
If the Wyoming branch is shut down, the company would most likely reallocate fixed costs and the remaining branches would be burdened with an additional $110,000 of fixed costs. The Wyoming branch wouldn’t be shown in the financials with a $110,000 loss. Instead, all the other branches would be less profitable by $110,000.
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. 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. Note that the $2m total profit is the same as the profit of $6m from Production Line A and the loss of $4m from Production Line B as shown in the table at the start of this example. Component B can be converted into Product B if $8,000 is spent on further processing.
Relevant costs are future potential expenses, whereas sunk costs are existing expenses that have already been made. Past costs may help you predict and estimate the future costs, but the past costs are otherwise irrelevant to the decision. 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. 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. The underlying principles of relevant costing are fairly simple and you can probably relate them to your personal experiences involving financial decisions.
What is a Relevant Cost?
Direct materials, direct labor, and various overhead costs are examples of the make or buy situation. 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. Undertaking certain business decisions has an impact on overall profit.
Examples
Eric is an accounting and bookkeeping expert for Fit Small Business. He has a CPA license in the Philippines and a BS in Accountancy graduate at Silliman University. Costs that are incremental to the decision are considered relevant. These incremental costs affect only online payroll submission a short period, usually less than a year.
An outsourcing decision arises when the company considers buying a component from a third-party supplier, even if it can make it internally. Managers are often faced with an outsourcing decision if there are talks about cutting costs. Take note that these decisions are nonroutine decisions, which means that you don’t make these decisions regularly. They arise only because of changes that may occur because of sudden and short-term changes in business operations.
Otherwise, continue the segment but make changes to how costs are allocated. For example, if a company is deciding whether to expand its sales territory, the real estate tax and depreciation on the company’s headquarters building is not relevant. The additional travel expenses to the new territory and the additional sales from the new territory are relevant to the decision. These costs are relevant since these expenses change in the future due to the buying decision. Relevant costs for decision-making help us determine the financial implications of business decisions.
For instance, purchasing advertising services from a marketing firm will increase advertising expenses but should bring in more sales to the company. When making this decision, you need to make sure that you’re maximizing every dollar invested and getting a high return. Along the line of business, there is the production of several units. Thus, these costs increase as the production increases or drops with low production. Maintenance cost for machinery is $3,000, $2,000 for material, $2,500 for labor, and $1,500 for miscellaneous costs. Billy’s might continue with cheese production if the expenses are lower, like $ 7,500.
Labour and variable overheads are incurred at a rate of $16/machine hour and the finished products sell for $30 per unit. 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. 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.
The main factor to consider would be the overall incremental profit. More likely than not, special orders aren’t considered in the budgeted production. It is possible for some companies to receive special orders when they’re already at full production capacity. It’s either the company will accept the order and forgo a portion of production or reject it. According to the above illustration, it will cost XYZ $250,000 to buy from a supplier.
What processing decision should the company make in order to maximise profits?
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. These costs will have to be compared to the contribution that can be earned by the new machine to determine if the overall investment in the asset is financially viable. Cost of machine – this is a relevant cost as $2.1m has to be paid out. It happens when the company opt-out of other activities that can save it from incurring expenses. If the product cost price is below production cost, the company can safely decide to take special orders. We assume the units in inventory will not be used—the selling price at $13.
Special Order Decision
Next we should consider whether the components should be further processed into the products. Electricity charges are incremental to this order and therefore 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. General OverheadsGeneral and administrative overheads which are not affected by the decisions under consideration should be ignored.