Relevant costs are those that differ between alternatives. They will arise when one alternative is chosen over others. A.) The depreciation of the old machine, $5,000, is irrelevant since the company will continue to depreciate the machine until the end of its useful life.
What Are the Two Characteristics of Relevant Costs?
The company is contemplating on buying an additional machine worth $80,000, to be used in conjunction with the old. Though units produced will stay the same, the company expects a significant decrease in variable costs from $68,000 to $40,000, annually. Fixed costs other than depreciation expense will remain at $30,000. Relevant costing attempts to determine the objective cost of a business decision.
- Irrelevant costs will not be affected regardless of any decision.
- If a company decides not to undertake an activity, the company can avoid some expenses.
- Relevant costs are costs that are relevant to short term decisions, or one-off decisions, and we’ll be looking at some of the key features of relevant costs.
- 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.
- Incremental CostWhere different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered.
- The decision to discontinue operations involves looking at factors that are relevant only to the segment, not those that are outside its control.
E.) After analyzing the relevant costs, the company will have a net annual savings of $18,000. The company will be able to decrease its variable costs by $28,000 but will incur in incremental costs of $10,000 due to increase in depreciation. Sunk costs include historical costs that have been taken up or paid by the company, hence will not be affected by future decisions.
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.
However, the $1 million is an irrelevant cost, and should be excluded. Continuing the construction actually involves spending $0.5 million for a return of $1.2 million, which makes it the correct course of action. In managerial accounting, relevant costs to a particular decision are those that vary between the alternatives being considered. For instance, a relevant cost to a particular decision could decrease in revenue with alternative A compared to alternative B. The cost effects relate to both changes in variable costs and changes in total fixed costs.
What are Relevant Costs?
These incremental costs affect only a short period, usually less than a year. 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. The Wyoming branch wouldn’t be shown in the financials with a $110,000 loss. Instead, all the other branches would be less profitable by $110,000. Deciding whether to continue or shut down a segment or product line is a tough decision. Perhaps, during the height of the COVID-19 pandemic, many businesses had to shut down all or a portion of their operations.
Relevant and irrelevant costs
- Relevant costs are cash transactions rather than accounting or paper transactions.
- With zero inventories, they will buy all 50 units at $10.
- The order requires a special type of rubber.Only 25% rubber is currently available in stock.
- It is not worthwhile to do this, as the extra costs are greater than the extra revenue.
- Rubber Tire Company (RTC) received a request to provide a price quote for an order for the supply of 1000 custom made tires required for industrial vehicles.
Therefore, it is worth buying in as incremental revenue exceeds incremental costs. Instead of carrying out Operation 1, the company could buy in components, for $15 per unit. This would allow production to be increased because the machine has to deal with only Operation 2. Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the decision to invest.
‘Relevant costs’ can be defined as any cost relevant to a decision. A matter is relevant if there is a change in cash flow that is caused by the decision. In business, a customer may request a one-time item from a company. They could have made this order right after the company had calculated all its costs on normal sales.
Sunk cost is irrelevant because it does not affect the future cash flows of a business. Relevant costing is just a refined application of such basic principles to business decisions. The key to relevant costing is the ability to filter what is and isn’t relevant to a business decision. For example, assume you had been talked into buying a discount card of ABC Pizza for $50 which what is relevant cost entitles you to a 10% discount on all future purchases. Say a pizza costs $10 ($9 after discount) at ABC Pizza and it subsequently came to your knowledge that a similar pizza is offered by XYZ Pizza for just $8. So the next time you would have ordered a pizza, you would have (hopefully) placed an order at XYZ Pizza realizing that the $50 you have already spent is irrelevant (see sunk cost below).
Irrelevant costs are those that will not cause any difference when choosing one alternative over another. Relevant costs are future costs that will differ between two or more alternative actions. Expressed another way, relevant costs are the costs that will make a difference when making a decision. The reason why Wyoming is at a net loss is due to irrelevant fixed costs, such as common costs allocated to the branch. If we remove those costs, we can say that Wyoming is profitable with a segment margin of 25% of sales. The decision to discontinue operations involves looking at factors that are relevant only to the segment, not those that are outside its control.