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. ‘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 furniture manufacturer is considering an outside vendor to assemble and stain wood cabinets, which would then be finished in-house by adding handles and other details. The relevant costs in this decision are the variable costs incurred by the manufacturer to make the wood cabinets and the price paid to the outside vendor. If the vendor can provide the component part at a lower cost, the furniture manufacturer outsources the work.
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. 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. Whether the company purchases the new equipment or not, it will still incur the $5,000 depreciation.
With that information, management can make better-informed decisions that can affect profitability. Any historic cost given for materials is always a sunk cost and never relevant unless it happens to be the same as the current purchase price. 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. Relevant costing aids management in making non-routine decisions by analyzing relevant costs and benefits.
Irrelevant costs do not have any bearing when choosing over different alternatives. They do not make any difference and make no impact in making decisions. Assume, for example, 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.
Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the decision to invest. 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. 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.
Take note that the company has already paid for the old machine (a sunk cost) and will continue to use it. Irrelevant costs are those that will not cause any difference when choosing one alternative over another. 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.
Relevant costs refer to those that will differ between different alternatives. 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.
The cost effects relate to both changes in variable costs and changes in total fixed costs. They are future costs and revenues – as it is not possible to change what has happened in the past, then relevant costs and revenues must be future costs and revenues. 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.
- For instance, the book value of a company’s equipment and machinery cannot change regardless of the managerial decision that is reached.
- It is depreciated using the straight-line depreciation over its useful life of 10 years.
- When making a decision, one must take into account and weigh all relevant costs.
- 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.
- Costs are categorized as either relevant or irrelevant for the purpose of managerial decisions.
The order would require 3000 units of electricity which is expected to cost $8,000. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is the sole author of all the materials on AccountingCoach.com.
Incremental Analysis: Definition, Types, Importance, and Example
Irrelevant costs will not be affected regardless of any decision. E.) After analyzing the relevant costs, the company will have a net annual savings of $18,000. 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. As mentioned earlier, relevant costs are those that will differ between different alternatives.
What Is Relevant Cost in Accounting, and Why Does It Matter?
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. As the relevant cost is a net cash outflow, the machine should be sold rather than retained, updated and used. The material is regularly used in current manufacturing operations. For example, if a company has two year lease for piece of machinery, that cost will not be relevant to a decision on whether to use that machinery on a new project which will last for the next month. Committed costs are costs that would be incurred in the future but they cannot be avoided because the company has already committed to them through another decision which has been made. General and administrative overheads that are not incurred directly as a result of this order should be considered irrelevant.
https://www.wave-accounting.net/ 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. However, the $50 of allocated fixed overhead costs are a sunk cost and are already spent.
Irrelevant Costs
Relevant costs include expected costs to be incurred as well as benefits forgone when choosing one alternative over another (known as opportunity costs). 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. Incremental analysis models include only relevant costs, and typically these costs are broken into variable costs and fixed costs. Cost data is important since they are the basis in making decisions that are geared towards maximizing profit, or attaining company objectives.
The company has excess capacity and should only consider the relevant costs. Therefore, the cost to produce the special order is $200 per item ($125 + $50 + $25). Net book values are not relevant costs because like depreciation, they are determined by accounting conventions rather than by future cash flows. They are incremental – relevant costs are incremental costs and it is the increase in costs and revenues that occurs as a direct result of a decision taken that is relevant. In exam questions look out for costs detailed as differential, specific or avoidable.
What is an Irrelevant Cost?
As these materials are not available in stock, these will have to be purchased at the market price which is their a quick guide to understand invoice payment terms. Incremental CostWhere different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered. 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. Relevant cost, in managerial accounting, refers to the incremental and avoidable cost of implementing a business decision. When making a decision, one must take into account and weigh all relevant costs.
Once again, the cost of corporate overhead is not a relevant cost when making this decision, since it will not change if the division is sold. 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. For example, assume you had been talked into buying a discount card of ABC Pizza for $50 which entitles you to a 10% discount on all future purchases.