Relevant costs can be thought of as future expenses that are incurred only if an opportunity is pursued. They are studied by companies to determine if one decision is more cost-effective than another. The opposite of a relevant cost is a sunk cost, which has already been incurred regardless of the outcome of the current decision.
Continue Operating vs. Closing Business Units
Incremental costs will increase as a direct result to making a specific business decision ie the costs on top of what was happening previously. Relevant costs are items of expenditure that will change as a result of making a particular business decision. Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the decision to invest. The material has no use in the company other than for the project under consideration.
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. Relevant cost is a management accounting term that describes avoidable costs incurred when making specific business decisions. This concept is useful in eliminating unnecessary information that might complicate the management’s decision-making process. Businesses use relevant costs in management accounting to conclude whether a new decision is economical.
Relevant Cost of Decisions
Say a pizza costs $10 ($9 after discount) at ABC Pizza and it subsequently came to your knowledge that a similar pizza is offered by XYZ Pizza for just $8. So the next time you would have ordered a pizza, you would have (hopefully) placed an order at XYZ Pizza realizing that the $50 you have already spent is irrelevant (see sunk cost below). Relevant costing is just a refined application of such basic principles to business decisions. The key to relevant costing is the ability to filter what is and isn’t relevant to a business decision.
- When deciding whether or not to accept this order, the management decide that the relevant cost to produce the extra garments would be more profitable than their standard operation, so they accept.
- Sunk costs, on the other hand, are existing expenses that have already been incurred and are unrecoverable.
- A company that needs a special item can either make one on its own or outsource it.
- Here, we can price the expected ongoing-project revenues with the current value.
- This is not worthwhile as incremental costs exceed incremental revenues.
However, the $1 million is an irrelevant cost, and should be excluded. Continuing the construction actually involves spending $0.5 million for a return of $1.2 million, is advertising a variable cost which makes it the correct course of action. The cost effects relate to both changes in variable costs and changes in total fixed costs. The company shall free some space that can be leased if it decides to outsource.
The underlying principles of relevant costing are fairly simple and you can probably relate them to your personal experiences involving financial decisions. Relevant cost, in managerial accounting, refers to the incremental and avoidable cost of implementing a business decision. The relevant costs would be the cost of keeping production in house, or the cost of buying externally. Past costs may help you predict and estimate the future costs, but the past costs are otherwise irrelevant to the decision.
What Is the Difference Between Relevant Cost and Sunk Cost?
To help make this decision, they would look to compare the relevant costs incurred from closing the stores, with the relevant costs from the proposed marketing campaign to make them profitable. Therefore, after a specific business decision is made, these relevant costs would need to come out of the company bank account. 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. 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.
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. 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. In this case, the company has given up its opportunity to have a cash inflow from the asset sale. 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.
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. 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 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.
This would allow production to be increased because the machine has to deal with only Operation 2. 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. Cost of machine – this is a relevant cost as $2.1m has to be paid out.
$5,000 represents the cost that would be paid to direct labor in respect of the time that they work on the order.If direct labor is not utilized on this order, they remain idle for the entire time. Direct labor is paid idle time equal to 60% of the normal pay in order to retain them. Incremental CostWhere different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered. For this reason, non-cash items such as depreciation would not be classed as a relevant cost. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.
They can be avoided and differ depending on which choice is taken. Sunk costs, on the other hand, are existing expenses that have already been incurred and are unrecoverable. Assume, for example, a chain of retail sporting goods stores is considering closing a group of stores catering to the finance outdoor sports market. The relevant costs are the costs that can be eliminated 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.