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. The material has no use in the company other than for the project under consideration. 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. The opposite of a relevant cost is a sunk cost, which has already been incurred regardless of the outcome of the current decision.
Types of Relevant Cost Decisions
If the costs to be eliminated are greater than the revenue lost, the outdoor stores should be closed. When making a decision, one must take into account and weigh all relevant costs. Relevant costs are affected by a managerial choice in a certain business situation. In other words, these are the costs which shall be incurred in one managerial alternative and avoided in another.
If the vendor can provide the component part at a lower cost, the furniture manufacturer outsources the work. Relevant costs are costs that are affected by a managerial decision in a particular business situation. In other words these are the costs which shall be incurred in one managerial alternative and avoided in another. As the name suggests they are ‘relevant’ for managerial relevant and irrelevant cost analysis and should be considered in all calculations made for the purpose.
Some costs may stay the same regardless of which alternative is chosen while some costs may vary between the alternatives. The classification between relevant and irrelevant costs is useful in such situations. Fixed overhead and sunk costs are examples of irrelevant costs that would not affect the decision to shut down a division of a company, or make a product instead of purchasing it from a supplier. Likewise, the wages of employees retained after the sale of a division would be irrelevant to the decision to sell it. 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. Irrelevant costs are costs, either positive or negative, that would not be affected by a management decision.
For instance, the book value of a company’s equipment and machinery cannot change regardless of the managerial decision that is reached. Formal documentation of irrelevant costs is important, these costs are likely to be ignored when reaching decisions but they must be accurately documented. Also, it is important to note that it is possible for an irrelevant cost in a managerial decision to be a relevant cost in another managerial decision. In any managerial decision involving two or more alternatives, the prime focus of analysis is to find out which alternative is more profitable. The profitability of alternatives is determined by considering the revenues generated by and costs incurred under each alternative.
- It can be noted that fixed costs are often irrelevant because they cannot be altered in any given situation.
- As an example, relevant cost is used to determine whether to sell or keep a business unit.
- Any cost, fixed or variable that would be different for a particular course of action being analyzed is relevant for that alternative.
- The concept of relevant cost is used to eliminate unnecessary data that could complicate the decision-making process.
What processing decision should the company make in order to maximise profits?
Appropriate cost analysis form plays a primary role in making that decision. A company that deals with making finished goods requires specific parts. 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. 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.
Relevant costs include expected costs to be incurred as well as benefits forgone when choosing one alternative over another (known as opportunity costs). Sunk costs include historical costs that have been taken up or paid by the company, hence will not be affected by future decisions. Unavoidable costs are those that the company will incur regardless of the decision it makes.
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Irrelevant costs are costs that are not affected by the ultimate decision. In other words, these are the costs which shall be incurred in the all managerial alternatives being considered. Since they are the same in all alternatives, they become irrelevant and need not be considered in calculations made for managerial analysis. Cost data is important since they are the basis in making decisions that are geared towards maximizing profit, or attaining company objectives.
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. 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. Relevant costs refer to those that will differ between different alternatives. Irrelevant costs are those that will not cause any difference when choosing one alternative over another. A.) The depreciation of the old machine, $5,000, is irrelevant since the company will continue to depreciate the machine until the end of its useful life.
How Relevant Cost is used in Decision Making?
The company will be able to decrease its variable costs by $28,000 but will incur in incremental costs of $10,000 due to increase in depreciation. Not every cost is important to every decision a manager needs to make; hence, the distinction between relevant and irrelevant costs. As a bookkeeper, you need to track the relevant costs and expose the irrelevant ones for appropriate future decision making. These costs are relevant since these expenses change in the future due to the buying decision. If a client wants a price quote for a special order, management only considers the variable costs to produce the goods, specifically material and labor costs.
Fixed costs, such as a factory lease or manager salaries, are irrelevant because the firm has already paid for those costs with prior sales. ABC Company is currently using a machine it purchased for $50,000 two years ago. It is depreciated using the straight-line depreciation over its useful life of 10 years. The company is contemplating on buying an additional machine worth $80,000, to be used in conjunction with the old. Though units produced will stay the same, the company expects a significant decrease in variable costs from $68,000 to $40,000, annually. Fixed costs other than depreciation expense will remain at $30,000.
C.) The variable costs are relevant since the total variable cost will be different if the company chooses to buy the complementary machine. If a company decides not to undertake an activity, the company can avoid some expenses. 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.
Costs are categorized as either relevant or irrelevant for the purpose of managerial decisions. While relevant costs can change as a result of the decision reached by managers, irrelevant costs remain unchanged regardless of the decision that is reached. Fixed overhead and sunk costs are examples of irrelevant costs.