Business management uses relevant costs to finalize a decision. Relevant costs help to eradicate unnecessary data that can complicate a decision-making process. Management can use this concept to make cost-effective business decisions and avoid unnecessary expenses.
Costs, when classified according to usefulness in decision-making, may what is relevant cost be classified into relevant and irrelevant costs. This example illustrates how focusing on relevant costs – costs that will be incurred in the future and are different between decision alternatives – can help in making informed decisions. Relevant costs for decision-making help us determine the financial implications of business decisions. It also helps assess if it’s worth pursuing a particular alternative course of action that will lead to an incremental benefit to the company as a whole. If the segment remains unprofitable even after removing irrelevant costs, it’s best to shut down the segment.
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.
Change in Profit Decision
In a continue-or-shutdown decision, you should look at the segment margin and not the overall net income. It is possible that a segment’s overall net income will include allocated costs and unavoidable costs. Ensure you remove these irrelevant costs and see if the segment margin becomes positive. If the new product is made, this sale won’t happen and the cash flow is affected.
A special order decision arises when customers request to buy a special product that’s not part of the normal product line. For example, the famous chocolate candy brand M&M’s offers “party favors” to customers who want personalized M&M candies with their names printed on them. This type of order can be a special order since it’s not part of M&M’s regular product line. 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. Next we should consider whether the components should be further processed into the products.
Further processing Component B to Product B incurs incremental costs of $8,000 and incremental revenues of $11,000 ($15,000 – $4,000). It is worthwhile to do this, as the extra revenue is greater than the extra costs. 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.
Relevant and irrelevant costs
- The company is concerned about the loss that is reported by Production Line B and is considering closing down that line.
- Relevant costs help to eradicate unnecessary data that can complicate a decision-making process.
- 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.
- An outsourcing decision arises when the company considers buying a component from a third-party supplier, even if it can make it internally.
When making this decision, you need to make sure that you’re maximizing every dollar invested and getting a high return. The goal of relevant costing for decision-making is to select the decision that would result in the highest incremental benefit to the company. 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.
What are Relevant 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. Irrelevant costs include sunk costs and unavoidable costs.
The decision could result in higher expenses or lower expenses as well as higher or lower revenue. Generally, the cost can be deemed worthwhile if it pays off and results in a higher overall profit. The project utilises a special microscope which cost CU18,000 three years ago.
Types of Relevant Costs
Closing down either production line would save 25% of the total fixed costs. 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. A major dilemma regarding any business at some point is whether to continue operation or close business units. Here, the management needs to consider whether the units are making expected income or have high maintenance costs. Appropriate cost analysis form plays a primary role in making that decision.
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. If the vendor can provide the component part at a lower cost, the furniture manufacturer outsources the work. Irrelevant costs will not be affected regardless of any decision. As mentioned earlier, relevant costs are those that will differ between different alternatives. Relevant costs include expected costs to be incurred as well as benefits forgone when choosing one alternative over another (known as opportunity costs). A managerial accounting term for costs that are specific to management’s decisions.
- The decision could result in higher expenses or lower expenses as well as higher or lower revenue.
- Past costs may help you predict and estimate the future costs, but the past costs are otherwise irrelevant to the decision.
- In this scenario, there is no opportunity cost to accept the special order since we can produce the order without lowering other production.
- The underlying principles of relevant costing are fairly simple and you can probably relate them to your personal experiences involving financial decisions.
- They could have made this order right after the company had calculated all its costs on normal sales.
- Because these costs have already been incurred, they are “sunk costs” or irrelevant costs.
Paid at $8 per hour and existing staff are fully utilised. The company will hire new staff to meet this additional demand. It has already been decided that, when work on this project ceases, the research department will be closed. Research wages for the year are CU60,000, and redundancy and severance pay has been estimated at CU15,000 now, or CU35,000 in one year’s time. The above is just a short extract from our CIMA P1 Management Accounting course.