Relevant costs are future potential expenses, whereas sunk costs are existing expenses that have already been made. 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. As you’ll recall from earlier on in this article, in order to be considered a relevant cost, it has to be a cash transaction.
#2 – Continue Production or Close Business Unit
The company has to decide whether to make the parts internally or outsource. Direct materials, direct labor, and various overhead costs are examples of the make or buy situation. 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.
- Based on the relevant costs, repairing the printers would cost TechGlow $80 per printer, while replacing would cost $120 per printer.
- It is toxic; if not used in this project, it must be disposed of at a cost of CU5,000.
- For example, a person has to choose between vacationing and spending time with their family.
- This concept is useful in eliminating unnecessary information that might complicate the management’s decision-making process.
- All the required quantity of oil is currently available in stock.
- RTC plans to quote a price at 10% above its relevant cost.
Relevant cost, in managerial accounting, refers to the incremental and avoidable cost of implementing a business decision. The material has no use in the company other than for the project under consideration. Depreciation is not a cash flow and is dependent on past purchases and somewhat arbitrary depreciation rates. 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. If a company decides not to undertake an activity, the company can avoid some expenses.
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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.
Identifying Relevant Costs
- Fixed costs other than depreciation expense will remain at $30,000.
- Future Cash FlowsCash expense that will be incurred in the future as a result of a decision is a relevant cost.
- Businesses use relevant costs in management accounting to conclude whether a new decision is economical.
- 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.
- We assume the units in inventory will not be used—the selling price at $13.
- The goal of relevant costing for decision-making is to select the decision that would result in the highest incremental benefit to the company.
A relevant cost is one that we incur as a direct response to a particular decision. And likewise, a relevant revenue is the same, just instead of a cost, we incur a revenue as a result of a particular decision. Relevant costs have three features, and then there are also two other types of relevant costs that we need to be aware of. 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.
We also need to consider non-relevant costs and revenues. These would be costs and revenues that we would not consider in short-term decision making. There are four main non-relevant costs that we’re going to run through – sunk costs, committed costs, notional costs, and fixed costs. The next feature is that relevant costs are incremental in nature. This means that the cost will increase or maybe the revenue will increase in direct relation to a particular decision. A relevant cost for decision-making is a cost that varies when evaluating two or more alternatives.
The concept of relevant costs eliminates unnecessary data that could complicate the decision-making process. Absorption costing is where we take a piece of the fixed overhead and we allocate it and absorb it into each unit that’s produced. So, under absorption costing, the cost per unit includes a component of fixed costs. So in that regard, each unit that we produce, we’re attributing a component of fixed costs to that particular unit. The reason why absorption costing is not that appropriate for decision making is because we’re factoring the fixed costs into each unit. And so, in that regard, we’re actually considering fixed costs where we might not actually need to consider them.
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. The company Billy’s makes cheese worth $10,000 per month.
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. 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.
If you think of that example that we had above, where we have excess capacity, we don’t need to consider fixed costs in those types of short-term decisions. 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. When making a decision, you should always take relevant costs into consideration, and ignore all sunk costs. A construction firm is in the middle of constructing an office building, having spent $1 million on it so far. It requires an additional $0.5 million to complete construction. Because of a downturn in the real estate market, the finished building will not fetch its original intended price, and is expected to sell for only $1.2 million.
Whether the company purchases the new equipment or not, it will still incur the $5,000 depreciation. Take note that the company has already paid for the old machine (a sunk cost) and will continue to use it. A current or future cost that what is relevant cost will differ among alternatives. 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.