Relevant Cost Definition, Types, Examples, Decision Making

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. Relevant costs are costs that are affected by a managerial decision in a particular business situation. In other words these are the costs which shall be incurred in one managerial alternative and avoided in another.

These incremental costs affect only a short period, usually less than a year. In this scenario, there is no opportunity cost to accept the special order since we can produce the order without lowering other production. Therefore, the what is relevant cost cost to accept the order doesn’t include the lost CM per unit. If a company decides not to undertake an activity, the company can avoid some expenses. Assume, for example, a chain of retail sporting goods stores is considering closing a group of stores catering to the outdoor sports market.

1. Avoidable CostsOnly those costs are relevant to a decision that can be avoided if the decision is not implemented.
2. 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.
3. The relevant cost analysis thus helped the company to conclude that buying the part was a more financially sound decision.
4. Every successful business needs a well-planned strategy and implementation of these plans.
5. Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the decision to invest.
6. ABC Company is currently using a machine it purchased for $50,000 two years ago.

Relevant Costs and Pricing Strategies

Maintenance cost for machinery is $3,000, $2,000 for material, $2,500 for labor, and $1,500 for miscellaneous costs. Billy’s might continue with cheese production if the expenses are lower, like $ 7,500. 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.

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. The additional travel expenses to the new territory and the additional sales from the new territory are relevant to the decision. This effect is known as an opportunity cost, which is the value of a benefit foregone when one course of action is chosen in preference to another. In this case, the company has given up its opportunity to have a cash inflow from the asset sale. Relevant costs for decision-making help us determine the financial implications of business decisions.

This represents the manufacturing equipment’s depreciation for the number of days in which production for the order will take place. This represents the share of factory supervisor’s salary for the number of days in which production for the order will take place. General OverheadsGeneral and administrative overheads which are not affected by the decisions under consideration should be ignored. 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. 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. Component B can be converted into Product B if $8,000 is spent on further processing.

Re-apportionment of existing fixed costs are not relevant

Financial decision-making is a critical aspect of business management, where precision can mean the difference between profit and loss. Relevant cost analysis stands as a cornerstone in this process, guiding managers to make informed choices by focusing on costs that are pertinent to a specific decision. The company is concerned about the loss that is reported by Production Line B and is considering closing down that line. 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. Further processing Component B to Product B incurs incremental costs of $8,000 and incremental revenues of $11,000 ($15,000 – $4,000).

What Is Managerial Accounting? Purposes, Pillars & Types

The process of identifying relevant costs is a preliminary step in the decision-making framework. It involves distinguishing between costs that will be affected by the decision at hand and those that will remain unchanged. This differentiation is crucial as it ensures that only the costs that will impact the outcome of the decision are considered.

For example, assume you had been talked into buying a discount card of ABC Pizza for $50 which 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).

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. All relevant costs are future costs, no decision can be taken about past costs that are already committed.

Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the decision to invest. The material has no use in the company other than for the project under consideration. A matter is relevant if there is a change in cash flow that is caused by the decision. Because not all costs are relevant, it’s very possible that an unprofitable line should not be shut down. A company that needs a special item can either make one on its own or outsource it.