Component A can be converted into Product A if $6,000 is spent on further processing. Kenneth W. Boyd, a former CPA, has over twenty-nine years of experience in accounting, education, and financial services. He is the owner of St. Louis Test Preparation (), where he provides online tutoring in accounting and finance to both graduate and undergraduate students. Relevant costs are avoidable and can differ depending on which action is taken.
The current value is used to project future revenues to see if a decision will incur future costs. Here, we can price the expected ongoing-project revenues with the current value. Then, a discounted rate is formulated to arrive at discounted cash flows. A particular cost may be relevant for one situation but irrelevant for another.
Good examples include committed fixed costs such as insurance and current depreciation. The rent, which gives the business the legal right to occupy the building, provides 15,000 square feet of retail and storage space. Irrelevant costs are costs that are not useful or rather not at all considered when a company is making a business decision. However, it doesn’t mean such costs will remain irrelevant for longer and may become relevant if the business environment or priorities change.
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. It considers taking special orders if the costs involved will generate income in the long run. A relevant cost is a cost affected by a manager’s decision or managerial decision making. This is not worthwhile as incremental costs exceed incremental revenues.
The cost effects relate to both changes in variable costs and changes in total fixed costs. 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.
Irrelevant Costs vs. Relevant Costs
Sunk costs, on the other hand, are existing expenses that have already been incurred and are unrecoverable. Relevant costs are future potential expenses, whereas sunk costs are existing expenses that have already been made. Salary to the advertising campaign team is irrelevant when we are making a business decision to buy specialized equipment for the launching of a new product. However, when advertising that same product comes as a business decision, then the salary of the advertising campaign becomes relevant. Hence the relevance and importance change from the viewpoint of decision making. Classifying costs as either irrelevant or relevant is useful for managers making decisions about the profitability of different alternatives.
What processing decision should the company make in order to maximise profits?
Costs that stay the same, regardless of which alternative is chosen, are irrelevant to the decision being made. 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. Depreciation is not relevant and irrelevant cost a cash flow and is dependent on past purchases and somewhat arbitrary depreciation rates.
Irrelevant costs
The decision to make or buy it depends on the cost-effectiveness of either alternative. If buying the item costs less than making it internally, the company opts for outsourcing it. For example, a person has to choose between vacationing and spending time with their family. In this context, opportunity cost is the cost of the holiday and visiting new places if the person decides to go on vacation rather than stay home. If the product cost price is below production cost, the company can safely decide to take special orders. We assume the units in inventory will not be used—the selling price at $13.
What Are the Two Characteristics of Relevant Costs?
The opposite of relevant costs is sunk cost or irrelevant costs, which refers to the expenses already incurred. Thus, incurring an expense may be avoided by deciding not to perform a certain activity. As mentioned earlier, relevant costs are those that will differ between different alternatives.
The company shall free some space that can be leased if it decides to outsource. The management can outsource to make an extra income from leased space. The relevant cost analysis thus helped the company to conclude that buying the part was a more financially sound decision. 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.
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. 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.
- Some costs may stay the same regardless of which alternative is chosen while some costs may vary between the alternatives.
- Costs are categorized as either relevant or irrelevant for the purpose of managerial decisions.
- Relevant costs include expected costs to be incurred as well as benefits forgone when choosing one alternative over another (known as opportunity costs).
- A company that deals with making finished goods requires specific parts.
- Relevant costs are sometimes also called avoidable costs or differential costs.
It happens when the company opt-out of other activities that can save it from incurring expenses. It means that if there is zero production, there is no spending. Instead of carrying out Operation 1, the company could buy in components, for $15 per unit.
By the same argument, book values are not relevant as these are simply the result of historical costs (or historical revaluation) and depreciation. 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. 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. ‘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. Relevant costs can be thought of as future expenses that are incurred only if an opportunity is pursued.
Make vs. buy decisions are often an issue for a company that requires component parts to create a finished product. These costs are not static, will vary depending on which path is taken, and can be avoided. 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. 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.
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