Relevant Costs for Decision-making & How They Apply To Common Decisions

It has a residual value of CU3,000 in another two years and a current disposal value of CU8,000. If used in the project it is estimated that the disposal value in one year’s time will be CU6,000. This material has just been purchased at a cost of CU60,000. It is toxic; if not used in this project, it must be disposed of at a cost of CU5,000. Calculate the relevant cost for the order and the price RTC should quote. All the required quantity of oil is currently available in stock.

Relevant costing is used only for short-term and nonroutine decisions. While relevant costs are important, managers should also consider nonquantitative factors in decision-making. In this article, we’ll go over the process of relevant costing and how you can apply it in a sample of common business decisions.

More likely than not, special orders aren’t considered in the budgeted production. It is possible for some companies to receive special orders when they’re already at full production capacity. It’s either the company will accept the order and forgo a portion of production or reject it. An outsourcing decision arises when the company considers buying a component from a third-party supplier, even if it can make it internally.

Otherwise, continue the segment but make changes to how costs are allocated. In general, most variable costs are relevant while most fixed costs are irrelevant. This general rule holds true most of the time since variable costs behave differently across activity levels while fixed costs remain constant nonetheless. However, fixed costs that can be removed under one alternative are relevant. Along the line of business, there is the production of several units. Thus, these costs increase as the production increases or drops with low production.

As these materials are not available in stock, these will have to be purchased at the market price which is their relevant cost. The order requires a special type of rubber.Only 25% rubber is currently available in stock. The rubber was purchased 2 years ago at the cost of $3,000. 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. Incremental CostWhere different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered. Non-Cash ExpensesNon-cash expenses such as depreciation are not relevant because they do not affect the cash flows of a business.

What is Relevant Cost?

1. If used in the project it is estimated that the disposal value in one year’s time will be CU6,000.
2. Committed CostsFuture costs that cannot be avoided are not relevant because they will be incurred irrespective of the business decision bieng considered.
3. The decision to make or buy it depends on the cost-effectiveness of either alternative.
4. The project utilises a special microscope which cost CU18,000 three years ago.
5. When making a decision, one must take into account and weigh all relevant costs.

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.

Identifying Relevant Costs

Unavoidable costs are those that the company will incur regardless of the decision it makes. Good examples include committed fixed costs such as insurance and current depreciation. A relevant cost, in managerial accounting and decision-making, refers to a cost that will be affected by a specific management decision. These costs differ between various alternatives being considered and have a bearing on the future. Relevant costs are essential for evaluating different options because they provide a clear picture of the financial implications of one choice versus another. However, even long term financial decisions such as investment appraisal may use the underlying principles of relevant costing to facilitate an objective evaluation.

What processing decision should the company make in order to maximise profits?

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.

What Is the Difference Between Relevant Cost and Sunk Cost?

The company shall free some space that can be leased if it decides to outsource. The management can outsource to make an extra income from leased space. The relevant cost analysis thus helped the company to conclude that buying the part was a more financially sound decision. Relevant costs are future expenses related to a specific decision. 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.

The company has to decide whether to make the parts internally or outsource. Direct materials, direct labor, what is relevant cost 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.

Assume a passenger rushes up to the ticket counter to purchase a ticket for a flight that is leaving in 25 minutes. The airline needs to consider the relevant costs to make a decision about the ticket price. 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.

#2 – Continue Production or Close Business Unit

1. If the Wyoming branch is shut down, the company would most likely reallocate fixed costs and the remaining branches would be burdened with an additional $110,000 of fixed costs.
2. B.) The depreciation of the new additional machine, $10,000, is relevant since the company will incur such cost only when it decides to buy the new machine.
3. 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.
4. Relevant costs have three features, and then there are also two other types of relevant costs that we need to be aware of.
5. Examples of irrelevant factors are common costs and allocated costs.

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 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.