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

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. Since $3,000 (60% of $5,000) idle time pay will be incurred even if this order is not taken, the relevant cost is the incremental cost of $2,000 ($5,000 – $3,000). Opportunity CostsCash inflow that will be sacrificed as a result of a particular management decision is a relevant cost. Committed CostsFuture costs that cannot be avoided are not relevant because they will be incurred irrespective of the business decision bieng considered. Future Cash FlowsCash expense that will be incurred in the future as a result of a decision is a relevant cost.

Continue Operating vs. Closing Business Units

The concept of relevant costs eliminates unnecessary data that could complicate the decision-making process. A construction firm is in the middle of constructing an office building, having spent $1 million on it so far. 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.

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. Relevant costs help to eradicate unnecessary data that can complicate a decision-making process.

1. When deciding whether to produce more units of a product, this fixed cost remains unchanged and is therefore irrelevant to the incremental analysis.
2. Relevant costing attempts to determine the objective cost of a business decision.
3. Sunk cost is irrelevant because it does not affect the future cash flows of a business.
4. In the context of relevant cost analysis, opportunity costs are considered because they reflect the potential returns from the next best alternative use of the company’s resources.
5. Relevant costs refer to those that will differ between different alternatives.

Opportunity Costs

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. In the famous example of Toyota Japan; when they adapted the JUST IN TIME (JIT) approach, they outsourced many products to suppliers. That make or buy decision would not have been taken without careful considerations about product quality, costs, and profitability measures.

Understanding and Managing Holding Costs in Inventory Management

As the name suggests they are ‘relevant’ for managerial analysis and should be considered in all calculations made for the purpose. The classification of costs between relevant costs and irrelevant costs is important in the context of managerial decision-making. Sunk CostSunk cost is expenditure which has already been incurred in the past. Sunk cost is irrelevant because it does not affect the future cash flows of a business.

Relevant costing attempts to determine the objective cost of a business decision. An objective measure of the cost of a business decision is the extent of cash outflows that shall result from its implementation. Relevant costing focuses on just that and ignores other costs which do not affect the future cash flows. The final piece of the puzzle is the use of relevant cost analysis in evaluating financial performance.

For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. Calculate the relevant cost for the order and the price RTC should quote. 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. It’s up to your expertise what is relevant cost to determine which quantitative factors are relevant to the decision. The main factor to consider would be the overall incremental profit.

When making this decision, you need to make sure that you’re maximizing every dollar invested and getting a high return. 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. C.) The variable costs are relevant since the total variable cost will be different if the company chooses to buy the complementary machine.