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Relevant costs

The relevant cost concept helps the management make the right decision by eliminating extraneous information from a particular decision-making process. In order to make good decisions, managers must be able to identify relevant costs and understand how they will be affected by a different courses of action. Only then can they make informed decisions that will lead to the best results for the company.

  1. The apples were separated into high-quality Grade A apples (3,000 pounds) and lower-quality Grade B apples (7,000 pounds).
  2. As an example of how closely entangled this decision is with make-or-buy, remember that GM rebranded its car parts division as Delphi years before that division was spun-off.
  3. To help me make my next point about customer value, I’m going to make an analogy between companies’ quest to maximizing customer value and mining for copper.
  4. The right decision should be based only on relevant information.

However, the $50 of allocated fixed overhead costs are a sunk cost and are already spent. 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).

AccountingTools

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 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.

Purchase of property, machinery, and hired staff are all decisions taken and hence are considered irrelevant costs for any future decision making. Relevant costing aids management in making non-routine decisions by analyzing relevant costs and benefits. Relevant costs refer to those that will differ between different alternatives. Irrelevant costs will not be affected regardless of any decision.

What Is Relevant Cost?

BigCommerce helps growing businesses, enterprise brands, and everything in-between sell more online. 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. Note that the $2m total profit is the same as the profit of $6m from Production Line A and the loss of $4m from Production Line B as shown in the table at the start of this example.

By the same argument, book values are not relevant as these are simply the result of historical costs (or historical revaluation) and depreciation. 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. 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. If the desired target cost cannot be achieved, the company must go back to step 1 and reevaluate the features and price.

All these decisions are relevant cost or revenue decisions for the company as a whole. Irrelevant costs are those that will not cause any difference when choosing one alternative over another. Relevant https://1investing.in/ 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.

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. 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. Suppose Nike, Inc., has developed a new shoe that can be sold for $140 a pair.

5.1 Opportunity Cost

That value is usually added by making the input from scratch, but it doesn’t have to be. A firm isn’t likely to have a sell-or-process-further decision if it never decided to make an input. The two alternatives are again given away in the name of this traditional decision.

However, this move might compete with and hurt the sole supplier of a different input. Weakening this link in the value chain could have a very negative impact on long-term profits, exceeding any short-term improvement from selling rather than processing further. This is also sometimes called qualitative analysis and strategic cost management. They all refer to the same thing as far as this textbook is concerned. Strategic cost analysis, then, is a version of relevant cost analysis that asks what the different alternatives of a decision mean for long-term profit. This is an important skill for you to gain in a cost accounting class because these decisions come up again and again in business in one form or another.

Relevant cost analysis, as a way of evaluating different alternatives and making decisions, is very flexible. It allows one to make good profit maximization decisions in an enormous variety of settings. Over time, though, a few common flavors of this analysis keep coming up. These are what I call traditional relevant cost analysis decisions or just traditional decisions.

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 define relevant cost 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.

Notice that the charcoal barbecues product line shows a loss of $8,000 for the year. This is the reason management would like to consider dropping this product line. Pretecsa disclosed that it took 163,000 labor hours to produce the concrete panels and charged $2.5 million for all its services, including materials. Labor costs alone in the United States would have been $3 million.

These orders are usually high enough in volume to warrant special consideration by some form of manager or especially delegated decision-maker. They usually also involve a customer requesting a discount due to the size of the order. Special orders often arrive after the firm’s productive capacity has been planned and committed (which leads to the capacity constraint discussion below). Dropping one product line often affects related product lines’ sales, usually in the form of reduced revenues.

Business in Action 7.2

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 is regularly used in current manufacturing operations.

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