Relevant Cost Definition, Types, Examples, Decision Making

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. 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.

Continue or Shutdown Decision

Students can avail of the P1 course as part of our All Access membership. There are two costing systems that we’re going to discuss. Electricity charges are incremental to this order and therefore relevant.

What are Relevant Costs?

1. This represents the manufacturing equipment’s depreciation for the number of days in which production for the order will take place.
2. Relevant costing is just a refined application of such basic principles to business decisions.
3. Otherwise, continue the segment but make changes to how costs are allocated.
4. The current value is used to project future revenues to see if a decision will incur future costs.
5. 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.
6. Relevant costs are sometimes also called avoidable costs or differential costs.

Based on the relevant costs, repairing the printers would cost TechGlow $80 per printer, while replacing would cost $120 per printer. Therefore, from a cost perspective, it would be more economical for TechGlow to choose to repair the defective printers. In this scenario, the original manufacturing cost of the defective printers ($70) is a sunk cost and therefore not relevant to the decision.

Some small businesses probably had to close completely rather than sustain continued losses because of poor sales and rising costs. 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 cost to accept the order doesn’t include the lost CM per unit. 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. The company is concerned about the loss that is reported by Production Line B and is considering closing down that line.

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C.) The variable costs are relevant since the total variable cost will be different if the what is relevant cost company chooses to buy the complementary machine. The underlying principles of relevant costing are fairly simple and you can probably relate them to your personal experiences involving financial decisions. Undertaking certain business decisions has an impact on overall profit. For instance, purchasing advertising services from a marketing firm will increase advertising expenses but should bring in more sales to the company.

What processing decision should the company make in order to maximise profits?

An opportunity cost represents the benefit forgone as a result of choosing a particular option. So, the opportunity cost is basically a benefit lost as a result of carrying out a certain decision. 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. Cost data is important since they are the basis in making decisions that are geared towards maximizing profit, or attaining company objectives.

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 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.

Factoring in a Special Order

Since we are at full capacity, we will be unable to sell 200 units to normal customers. Hence, we will lose a $7.5 ($29 – $5.25 – $8.75 – $7.50) CM per unit. The closure of Production Line A would also result in the revenue lost being greater than the value of the costs saved, so this isn’t a good idea either.

1. A special order decision arises when customers request to buy a special product that’s not part of the normal product line.
2. We suggest that you try each example yourself before you look at each solution.
3. This machine can save the wage expenses of 20 manual laborers.
4. Relevant costs are essential for evaluating different options because they provide a clear picture of the financial implications of one choice versus another.
5. A special order occurs 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.
6. D.) The other fixed costs of $30,000 are irrelevant since it will not differ under the two choices.
7. 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.

Machine running costs – the machine is already fully utilised on Operations 1 and 2 and will remain fully utilised, but only on Operation 2. Therefore, the machine running costs will not change, so are not relevant to the decision. Cost of machine – this is a relevant cost as $2.1m has to be paid out. As the relevant cost is a net cash outflow, the machine should be sold rather than retained, updated and used. For example, a person has to choose between vacationing and spending time with their family.

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. Avoidable CostsOnly those costs are relevant to a decision that can be avoided if the decision is not implemented. It’s up to your expertise to determine which quantitative factors are relevant to the decision. The main factor to consider would be the overall incremental profit.

Managers are often faced with an outsourcing decision if there are talks about cutting costs. Take note that these decisions are nonroutine decisions, which means that you don’t make these decisions regularly. They arise only because of changes that may occur because of sudden and short-term changes in business operations.