In accounting, what is meant by relevant costs?

examples of relevant costs

Good examples include committed fixed costs such as insurance and current depreciation. 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. Using the contribution foregone figure of $24 is the net effect of losing the revenue from that unit and also saving the material, labour and the variable costs. In this situation however, the labour is simply being redeployed so $24 understates the effect of this, as the labour costs are not saved. 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.

  1. When making a decision, one must take into account and weigh all relevant costs.
  2. Types of decisionWe will now look at some typical examples where you have to decide which costs are relevant to decision-making.
  3. Instead of carrying out Operation 1, the company could buy in components, for $15 per unit.
  4. If the new product is made, this sale won’t happen and the cash flow is affected.

When making a decision, one must take into account and weigh all relevant costs. D.) The other fixed costs of $30,000 are irrelevant since it will not differ under the two choices. The difference in costs in choosing one alternative over another is known as differential cost. Incremental cost refers to the increase in cost when choosing an alternative.

As mentioned earlier, relevant costs are those that will differ between different alternatives. Relevant costs include expected costs to be incurred as well as benefits forgone when choosing one alternative over another (known as opportunity costs). Irrelevant costs will not be affected regardless of any decision. 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.

Relevant and irrelevant costs

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.

examples of relevant costs

Cost data is important since they are the basis in making decisions that are geared towards maximizing profit, or attaining company objectives. Costs, when classified according to usefulness in decision-making, may be classified into relevant and irrelevant costs. For example, the Archaic Book Company (ABC) is considering purchasing a printing press for its medieval book division. If ABC buys the press, it will eliminate 10 scribes who have been copying the books by hand. The wages of these scribes are relevant costs, since they will be eliminated in the future if management buys the printing press.

As another example, if ABC wants to close its medieval book division entirely, the only relevant costs will be those costs specifically eliminated as a result of the decision. 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. 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. 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. Further processing Component A to Product A incurs incremental costs of $6,000 and incremental revenues of $5,000 ($12,000 – $7,000).

That is why accountants will refer to a past cost as a sunk cost. 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.

It is not worthwhile to do this, as the extra costs are greater than the extra revenue. 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. They will arise when one alternative is chosen over others. C.) The variable costs are relevant since the total variable cost will be different if the company chooses to buy the complementary machine.

What is a Relevant Cost?

Material B – The 100 units of the material already in inventory has no other use in the company, so if it is not used on the new product, then the assumption is that it would be sold for $12/unit. If the new product is made, this sale won’t happen and the cash flow is affected. The original purchase price of $10 is a sunk cost and so is not relevant. 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.

examples of relevant costs

A sunk cost is an expenditure that has already been made, and so will not change on a go-forward basis as the result of a management decision. The material has no use in the company other than for the project under consideration. Irrespective of what treatment is used in the company’s management accounts to split up costs, if the total costs remain deductible business expenses 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. Past costs may help you predict and estimate the future costs, but the past costs are otherwise irrelevant to the decision.

What processing decision should the company make in order to maximise profits?

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. 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. 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. 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.

Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the decision to invest. 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. 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. This concept is only applicable to management accounting activities; it is is not used in financial accounting, since no spending decisions are involved in the preparation of financial statements.

Types of decisionWe will now look at some typical examples where you have to decide which costs are relevant to decision-making. We suggest that you try each example yourself before you look at each solution. Note that additional fixed costs caused by a decision are relevant. 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.

However, the cost of corporate overhead is not a relevant cost, since it will not change as a result of this decision. 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. 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. 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.

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. 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.