The company Billy’s makes cheese worth $10,000 per month. Maintenance cost for machinery is $3,000, $2,000 for material, $2,500 for labor, and $1,500 for miscellaneous costs. So, the Billy’s might think of discontinuing the cheese unit. Billy’s might continue with cheese production if the expenses are lower, like $ 7,500. Note that additional fixed costs caused by a decision are relevant.
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. 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.
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. It happens when the company opt-out of other activities that can save it from incurring expenses. Variable costs vary with different levels of production. It means that if there is zero production, there is no spending.
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. 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.
In accounting, what is meant by relevant costs?
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. Relevant costs are future expenses related to a specific decision. They can be avoided and differ depending on which choice is taken.
What Are the Two Characteristics of Relevant Costs?
Relevant costs are avoidable costs that are incurred only when making specific business decisions. Many of the decisions company management make have a financial impact, such as, for example, choosing whether to shut down an operation or pursue an opportunity. The option taken has financial implications in terms of expenses and revenues and it’s up to management to work out, using all available data, which path is likely to be more profitable. 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.
These costs are relevant since these expenses change in the future due to the buying decision. Sunk costs what is relevant cost are costs that we have already incurred. They’re never relevant in short-term decision making.
Example of Relevant 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. 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.
Relevant Costs and Revenues
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. 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. 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.
Relevant costs are avoidable and can differ depending on which action is taken. With zero inventories, they will buy all 50 units at $10.
- Types of decisionWe will now look at some typical examples where you have to decide which costs are relevant to decision-making.
- If the vendor can provide the component part at a lower cost, the furniture manufacturer outsources the work.
- 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.
- Also, by eliminating irrelevant costs from a decision, management is prevented from focusing on information that might otherwise incorrectly affect its decision.
- We also need to consider non-relevant costs and revenues.
When making a decision, you should always take relevant costs into consideration, and ignore all sunk costs. A particular cost may be relevant for one situation but irrelevant for another. The opposite of relevant costs is sunk cost or irrelevant costs, which refers to the expenses already incurred. Thus, incurring an expense may be avoided by deciding not to perform a certain activity.
What Is the Difference Between Relevant Cost and Sunk Cost?
The company has to decide whether to make the parts internally or outsource. Naturally, the lowest cost alternative is the best. Direct materials, direct labor, and various overhead costs are examples of the make or buy situation. 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.