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.
Relevant costs are cash transactions rather than accounting or paper transactions. This means that a relevant cost is not going to be depreciation or notional rent, for example. When making a decision, one must take into account and weigh all relevant costs. D.) The other fixed costs of $30,000 are irrelevant since it will not differ under the two choices. The difference in costs in choosing one alternative over another is known as differential cost. Incremental cost refers to the increase in cost when choosing an alternative.
What is the relevant cost of the materials required for manufacture of the new product?
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.
What are the relevant costs of the new machine purchase?
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.
Types of Relevant Costs
If a client wants a price quote for a special order, management only considers the variable costs to produce the goods, specifically material and labor costs. Fixed costs, such as a factory lease or manager salaries, are irrelevant because the firm has already paid for those costs with prior sales. 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.
- Sunk costs, on the other hand, are existing expenses that have already been incurred and are unrecoverable.
- They do not make any difference and make no impact in making decisions.
- 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.
- Then, a discounted rate is formulated to arrive at discounted cash flows.
- 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.
Revenues forgone (given up) because of a decision are relevant
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.
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.
- Sunk costs include historical costs that have been taken up or paid by the company, hence will not be affected by future decisions.
- While relevant costs are important, managers should also consider nonquantitative factors in decision-making.
- Instead of looking at the overall margin, try looking at the segment margin and see if it is still profitable without considering common costs.
- These would be costs and revenues that we would not consider in short-term decision making.
- Undertaking certain business decisions has an impact on overall profit.
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.
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. The order would require 3000 units of electricity which is expected to cost $8,000. 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 what is relevant cost be released by Operation 1 which now will not be needed.
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.