Relevant costs

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. If the product cost price is below production cost, the company can safely decide to take special orders. Therefore, it is worth buying in as incremental revenue exceeds incremental costs. 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.

What Is Relevant Cost in Accounting, and Why Does It Matter?

As you’ll recall from earlier on in this article, in order to be considered a relevant cost, it has to be a cash transaction. So, a non-cash transaction or a non-cash item would be depreciation or notional rent, or maybe a translation gain or loss on foreign exchange. The material has no use in the company other than for the project under consideration. ‘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. For example, a person has to choose between vacationing and spending time with their family.

Component A can be converted into Product A if $6,000 is spent on further processing. Paid at $8 per hour and existing staff are fully utilised. The company will hire new staff to meet this additional demand. The above is just a short extract from our CIMA P1 Management Accounting course.

In this situation however, the labour is simply being redeployed so $24 understates the effect of this, as the labour costs are not saved. 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. If a company decides not to undertake an activity, the company can avoid some expenses.

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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. A construction firm is in the middle of constructing an office building, having spent $1 million on it so far. It requires an additional $0.5 million to complete construction. 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. However, the $1 million is an irrelevant cost, and should be excluded.

An opportunity cost represents the benefit forgone as a result of choosing a particular option. Suppose I get paid every week to do a certain job. So, the opportunity cost is basically a benefit lost as a result of carrying out a certain decision.

What is Relevant Cost?

Past costs may help you predict and estimate the future costs, but the past costs are otherwise irrelevant to the decision. That is why accountants will refer to a past cost as a sunk cost. The first feature is that it they are future oriented. That means that a relevant cost is one that we will incur in the future as a direct result of a management decision.

If you think of that example that we had above, where we have excess capacity, we don’t need to consider fixed costs in those types of short-term decisions. Business management uses relevant costs to finalize a decision. Relevant costs help to eradicate unnecessary data that can complicate a decision-making process.

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. The cost effects relate to both changes in variable costs and changes in total fixed costs.

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. 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. 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.

This would allow production to be increased because the machine has what is relevant cost to deal with only Operation 2. 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. Sale proceeds – this is a relevant cost as it is a cash inflow which will occur in 10 years as a result of the decision to invest. Cost of machine – this is a relevant cost as $2.1m has to be paid out. Relevant costs are sometimes also called avoidable costs or differential costs. Make vs. buy decisions are often an issue for a company that requires component parts to create a finished product.

A committed cost is one that we’ve committed to and so, regardless of whichever decision we intend to make or whichever decision we decided to choose, we will incur this cost regardless. Therefore, it is a non-relevant cost because we will incur this regardless of whether we decide to pursue a particular course of action or not. This is not worthwhile as incremental costs exceed incremental revenues. Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the decision to invest. As the relevant cost is a net cash outflow, the machine should be sold rather than retained, updated and used. These employees are difficult to recruit and the company retains a number of permanently employed staff, even if there is no work to do.

1. The company shall then consider the lowest price for producing that order.
2. If the costs to be eliminated are greater than the revenue lost, the outdoor stores should be closed.
3. An opportunity cost represents the benefit forgone as a result of choosing a particular option.

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 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. A company that deals with making finished goods requires specific parts.

Continuing the construction actually involves spending $0.5 million for a return of $1.2 million, which makes it the correct course of action. 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. So, under absorption costing, the cost per unit includes a component of fixed costs. So in that regard, each unit that we produce, we’re attributing a component of fixed costs to that particular unit. The reason why absorption costing is not that appropriate for decision making is because we’re factoring the fixed costs into each unit. And so, in that regard, we’re actually considering fixed costs where we might not actually need to consider them.