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

Expressed another way, relevant costs are the costs that will make a difference when making a decision. 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. Along the line of business, there is the production of several units.

These employees are difficult to recruit and the company retains a number of permanently employed staff, even if there is no work to do. There is currently 800 hours of idle time available and any additional hours would be fulfilled by temporary staff that would be paid at $14/hour. The material has no use in the company other than for the project under consideration. In business, a customer may request a one-time item from a company. 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.

How Relevant Cost is used in Decision Making?

Relevant costs are future potential expenses, whereas sunk costs are existing expenses that have already been made. The order requires a special type of rubber.Only 25% rubber is currently available in stock. 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. The underlying principles of relevant costing are fairly simple and you can probably relate them to your personal experiences involving financial decisions. Relevant cost, in managerial accounting, refers to the incremental and avoidable cost of implementing a business decision.

This represents the share of factory supervisor’s salary for the number of days in which production for the order will take place. 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.

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).

Definition of Relevant Costs

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. A managerial accounting term for costs that are specific to management’s decisions.

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. The future expenses that might occur due to a decision made in the present are called future cash flows. The current value is used to project future revenues to instructions 2021 see if a decision will incur future costs. Here, we can price the expected ongoing-project revenues with the current value.

Continue Operating vs. Closing Business Units

1. 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.
2. Sunk costs, on the other hand, are existing expenses that have already been incurred and are unrecoverable.
3. 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.
4. Sunk CostSunk cost is expenditure which has already been incurred in the past.
5. Component B can be converted into Product B if $8,000 is spent on further processing.

The company has to decide whether 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. The relevant costs are the costs that can be eliminated due to the closure as well as the revenue lost when the stores are closed. If the costs to be eliminated are greater than the revenue lost, the outdoor stores should be closed.

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.

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. 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.

Examples

As these materials are not available in stock, these will have to be purchased at the market price which is their relevant cost. Non-Cash ExpensesNon-cash expenses such as depreciation are not relevant because they do not affect the cash flows of a business. 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. Further processing Component B to Product B incurs incremental costs of $8,000 and incremental revenues of $11,000 ($15,000 – $4,000).

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.

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. Continuing the construction actually involves spending $0.5 million for a return of $1.2 million, which makes it the correct course of action.

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 what is inventory shrinkage to a business 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. 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 order would require 3000 units of electricity which is expected to cost $8,000. 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. Relevant costs stand out because they haven’t been incurred yet, can be avoided, and are only pursued if it’s believed the action will be profitable. Companies keep track of these costs and jobs could be in jeopardy if they don’t pay off. 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.