In accounting, what is meant by relevant costs?

relevant cost

Closing down either production line would save 25% of the total fixed costs. Along the line of business, there is the production of several units. Thus, these costs increase as the production increases or drops with low production. Maintenance cost for machinery is $3,000, $2,000 for material, $2,500 for labor, and $1,500 for miscellaneous costs.

Relevant costing focuses on just that and ignores other costs which do not affect the future cash flows. The cost effects relate to both changes in variable costs and changes in total fixed costs. A particular cost may be relevant for one situation but irrelevant for another.

Further processing Component B to Product B incurs incremental costs of $8,000 and incremental revenues of $11,000 ($15,000 – $4,000). It is worthwhile to do this, as the extra revenue is greater than the extra costs. Further processing Component A to Product A incurs incremental costs of $6,000 and incremental revenues of $5,000 ($12,000 – $7,000). It is not worthwhile to do this, as the extra costs are greater than the extra revenue. Types of decisionWe will now look at some typical examples where you have to decide which costs are relevant to decision-making.

In accounting, what is meant by relevant costs?

relevant cost

That is why accountants will refer to a past cost as a sunk cost. Operation 1 takes 0.25 hours of machine time and Operation 2 takes 0.5 hours of machine time. Labour and variable overheads are incurred at a rate of $16/machine hour and the finished products sell for $30 per unit. Irrespective of what treatment is used in the company’s management accounts to split up costs, if the total costs remain the same, there is no cash flow effect caused by the decision. If a company decides not to undertake an activity, the company can avoid some expenses.

What Is Relevant Cost in Accounting, and Why Does It Matter?

They could have made this order right after the company had calculated all its costs on normal sales. The company shall then consider the lowest price for producing that order. It considers taking special orders if the costs involved will generate income in the long run. A special order occurs profit margin definition when a customer places an order near the end of the month, and prior sales have already covered the fixed cost of production for the month. As supervisor’s salary is a fixed cost unchanged by the work performed on this order, it is a non-relevant cost. All the required quantity of oil is currently available in stock.

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. 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.

Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the decision to invest.
The additional travel expenses to the new territory and the additional sales from the new territory are relevant to the decision.
This is not worthwhile as incremental costs exceed incremental revenues.
Here, we can price the expected ongoing-project revenues with the current value.
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.
If the product cost price is below production cost, the company can safely decide to take special orders.

Any short term decisions should be approached using relevant costing principles

General OverheadsGeneral and administrative overheads which are not affected by the decisions under consideration should be ignored. Next we should consider whether the components should be further processed into the products. According to the above illustration, it will cost XYZ $250,000 to buy from a supplier.

If the vendor can provide the component part at a lower cost, the furniture manufacturer outsources the work. Material B – The 100 units of the material already in inventory has no other use in the company, so if it is not used on the new product, then the assumption is that it would be sold for $12/unit. If the new product is made, this sale won’t happen and the cash flow is affected.

relevant cost definition

The material is regularly used in current manufacturing operations. Committed costs are costs that would be incurred in the future but they cannot be avoided because the company has already committed to them through another decision which has been made. A change in the cash flow can be identified by asking if the amounts that would appear on the company’s bank statement are affected by the decision, whether increased or decreased. This concept is only applicable to management accounting activities; it is is not used in financial accounting, since no spending decisions are involved in the preparation of financial statements. Make vs. buy decisions are often an issue for a company that requires component parts to create a finished product. Direct labor is paid idle time equal to 60% of the normal pay in order to retain them.

AccountingTools

As these materials are not available in stock, these will have to be purchased at the market price which is their relevant cost. The order requires a special type of rubber.Only 25% rubber is currently available in stock. If the rubber is not used on this order, it will have to scraped at a price of $1,000.Remaining quantity shall have to be procured at the price of $7,000. Non-Cash ExpensesNon-cash expenses such as depreciation are not relevant because they do not affect the cash flows of a business. Opportunity CostsCash inflow that will be sacrificed as a result of a particular management decision is a relevant cost. Relevant cost, in managerial accounting, refers to the incremental and avoidable cost of implementing a business decision.

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 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. 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.

Relevant cost is a managerial accounting term that describes avoidable costs that are incurred only when making real estate financial modeling services 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. Relevant cost is a management accounting term that describes avoidable costs incurred 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. A managerial accounting term for costs that are specific to management’s decisions. The concept of relevant costs eliminates unnecessary data that could complicate the decision-making process. Assume a passenger rushes up to the ticket counter to purchase a ticket for a flight that is leaving in 25 minutes.

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