ACCA PM Notes: C1a Concept of Relevant Costing

relevant cost

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. 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.

What Is Another Name for a Relevant Cost?

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.
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.
They are studied by companies to determine if one decision is more cost-effective than another.

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. Production volume – this can increase by 50% because currently each item takes 0.5 hours in Operation 2, but 0.25 hours per unit will be released by Operation 1 which now will not be needed.

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relevant cost

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. Relevant costs stand out because they haven’t been incurred yet, can be avoided, and are only pursued if it’s believed the action will be profitable. Companies keep track of these costs and jobs could be in jeopardy if they don’t pay off. Relevant costs are avoidable and can differ depending on which action is taken.

Types of Relevant Costs

This is not worthwhile as incremental costs exceed incremental revenues. Sale proceeds – this is a relevant cost as it is a cash inflow which will occur in 10 years as a result of the decision to invest. As the relevant cost is a net cash outflow, the machine should be sold rather than retained, updated and used.

What is a Relevant Cost?

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 accounting vs payroll from that unit and also saving the material, labour and the variable costs. In this situation however, the labour is simply being redeployed so $24 understates the effect of this, as the labour costs are not saved. 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.

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. It happens when the company opt-out of other activities that can save it from incurring expenses. If the product cost price is below production cost, the company can safely decide to take special orders.

The cost of oil that will be used on the order is $1,000.The current market value of the required quantity of oil is $1,200. If oil is not used on the order, it could be used in the production of other tires. 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. RTC is facing stiff competition from its business rivals and is therefore hoping to secure the order by quoting the lowest price. Incremental CostWhere different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered.

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. Cost of machine – this is a relevant cost as $2.1m has to be paid out. A company that needs a special item can either make one on its own or outsource it. The decision to make or buy it depends on the cost-effectiveness of either alternative. If buying the item costs less than making it internally, the company opts for outsourcing it. For example, a person has to choose between vacationing and spending time with their family.

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. Relevant costs help to eradicate unnecessary data that can complicate a decision-making process. Management can use this concept to make cost-effective business decisions and avoid unnecessary expenses. 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.

These employees are difficult to recruit and the company retains a number of permanently employed staff, even if there is no work to do. There is currently 800 hours of idle time available and any additional hours would be fulfilled by temporary staff that would be paid at $14/hour. The material has no use in the company other than for the project under consideration. In business, a customer may request a one-time item from a company.

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. 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. Relevant costs are future potential expenses, whereas sunk costs are existing expenses that have already been made. The company is concerned about the loss that is reported by Production Line B and is considering closing down that line.

The decision could result in higher expenses or lower expenses as well as higher or lower revenue. Generally, the cost can be deemed worthwhile if it pays off and results in a higher overall profit. Opportunity costs only arise when resources are scarce and have alternative uses.

However, even long term financial decisions such as investment appraisal may use the underlying principles of relevant costing to facilitate an objective evaluation. These costs are relevant since these expenses change in the future due to the buying decision. Relevant costing attempts to determine the objective cost of a business decision. An objective measure the pros and cons of crowdfunding for business of the cost of a business decision is the extent of cash outflows that shall result from its implementation.

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