It considers taking special orders if the costs involved will generate income in the long run. A special order occurs when a customer places an order near the end of the month, and prior sales have already covered the fixed cost of production for the month. As supervisor’s salary is a fixed cost unchanged by the work performed on this order, it is a non-relevant cost. All the required quantity of oil is currently available in stock.
What Is the Difference Between Relevant Cost and Sunk Cost?
Relevant cost is a managerial accounting term that describes avoidable costs that are incurred only when making specific business decisions. The concept of relevant cost is used to eliminate unnecessary data that could complicate the decision-making process. As an example, relevant cost is used to determine whether to sell or keep a business unit. 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.
The order would require 3000 units of electricity which is expected to cost $8,000. 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. Relevant costs stand out because they haven’t been incurred yet, can be avoided, and are only pursued if it’s believed the action will be profitable. Companies keep track of these costs and jobs could be in jeopardy if they don’t pay off. Relevant costs are avoidable and can differ depending on which action is taken. These costs are not static, will vary depending on which path is taken, and can be avoided.
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. Past costs may help you predict and estimate the future costs, but the past costs are otherwise irrelevant to the decision. That is why accountants will refer to a past cost as a sunk cost.
Types of Relevant Cost Decisions
- The opposite of relevant costs is sunk cost or irrelevant costs, which refers to the expenses already incurred.
- As these materials are not available in stock, these will have to be purchased at the market price which is their relevant cost.
- Labour and variable overheads are incurred at a rate of $16/machine hour and the finished products sell for $30 per unit.
- 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 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. 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 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.
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. 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. Also, by eliminating irrelevant costs from a decision, management is prevented from focusing on information that might otherwise incorrectly affect its decision.
What processing decision should the company make in order to maximise profits?
This represents the apportionment of general and administrative overheads based on the number of machine hours that will be required on the order. This represents the share of lease rentals of the factory plant for the number of days in which production for the order will take place. This represents the manufacturing equipment’s depreciation for the number learn how long to keep tax records of days in which production for the order will take place.
An objective measure of the cost of a business decision is the extent of cash outflows that shall result from its implementation. Relevant costing focuses on just that and ignores other costs which do not affect the future cash flows. A construction firm is in the middle of constructing an office building, having spent $1 million on it so far.
Thus, these costs increase as the production increases or drops with low production. Maintenance cost for machinery is $3,000, $2,000 for material, $2,500 for labor, and $1,500 for miscellaneous costs. Billy’s might continue with cheese production if the expenses are lower, like $ 7,500. A company that deals with making finished goods requires specific parts.
Continue Operating vs. Closing Business Units
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. 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. 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.
This represents the share of factory supervisor’s salary for the number of days in which production for the order will take place. 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. Material – if the buy-in option is accepted, the material cost increases from $12 to $15 per unit.
Relevant costs are future potential expenses, whereas sunk costs are existing expenses that have already been made. The order requires a special type of rubber.Only 25% rubber is currently available in stock. If the rubber is not used on this order, it will have to scraped at a price of $1,000.Remaining quantity shall have to be procured at the price of $7,000. 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.
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. The additional travel expenses to the new territory and the additional sales from the new territory are relevant to the decision. Relevant costs are future costs that will differ between two or more alternative actions.
Therefore, the machine running costs will not change, so are not relevant to the decision. Instead of carrying out Operation 1, the company could buy in components, for $15 per unit. This would the 5 best accounting software for small business allow production to be increased because the machine has to deal with only Operation 2.