This represents the apportionment of general and administrative overheads based on the number of machine hours that will be required on the order. The order would require 3000 units of electricity which is expected to cost $8,000. This represents the manufacturing equipment’s depreciation for the number of days in which production for the order will take place. Material – if the buy-in option is accepted, the material cost increases from $12 to $15 per unit. Next we should consider whether the components should be further processed into the products.
All relevant costs are future costs, no decision can be taken about past costs that are already committed. For example, costs incurred on a feasibility study before launching a new project are historic; these are called committed or sunk costs. All businesses are run by business managers at effectively three levels of operations, management, and strategic. Every successful business needs a well-planned strategy and implementation of these plans. These Managers make decisions regularly which may affect the businesses.
The above is just a short extract from our CIMA P1 Management Accounting course. Taught by former CIMA prizewinner, Hugh Martin, VIVA’s P1 course has over 15 hours of video lectures covering the entire syllabus, 800+ exam style questions and an online version of BPP’s 2019 textbook. Students can avail of the P1 course as part of our All Access membership. Electricity charges are incremental to this order and therefore relevant. General OverheadsGeneral and administrative overheads which are not affected by the decisions under consideration should be ignored. According to the above illustration, it will cost XYZ $250,000 to buy from a supplier.
- For example, a company’s total cost increases from $2,20,000 to $2,40,000 due to increasing the production unit.
- 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.
- According to the above illustration, it will cost XYZ $250,000 to buy from a supplier.
- In the famous example of Toyota Japan; when they adapted the JUST IN TIME (JIT) approach, they outsourced many products to suppliers.
Sell or Process Further
The decision process may be complicated due to irrelevant data, incomplete information, data volume, etc. Avoidable costs can be eliminated if a particular course of action is not taken or if any department is closed. For example, suppose an organisation chooses to complete a what is relevant cost production line.
Local radio and newspaper adverts have already been paid for. A television manufacturer is reviewing whether to continue to make the circuit boards used in production of the televisions, or buy them from an external company. For the cost to be considered ‘relevant’, it needs to satisfy all three criteria. This represents the share of lease rentals of the factory plant 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.
AccountingTools
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). Relevant cost, in managerial accounting, refers to the incremental and avoidable cost of implementing a business decision. Past costs may help you predict and estimate the future costs, but the past costs are otherwise irrelevant to the decision. 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.
Relevant costs refer to those that will differ between different alternatives. Irrelevant costs are those that will not cause any difference. 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.
Concept of Relevant Costs, Steps in Decision Making
For example, a bakery receives a large custom cookie order at a discounted price. If the bakery has idle capacity and the order covers variable costs, it may accept it for the extra profit. The costs and benefits of different activities must be compared and contrasted before making the right business decision. The right decision should be based only on relevant information. The relevant information includes the predicted future cost or incremental cost and revenue that differ among the alternatives.
- A manager has to choose between at least two alternatives to make the right decision.
- This means that the cost will increase or maybe the revenue will increase in direct relation to a particular decision.
- This involves understanding the situation and gathering relevant information to assess the current state and potential issues or opportunities.
- One critical aspect is examining how each alternative affects costs and future revenues.
Non-Relevant Costs
Opportunity costs are the potential benefits forgone by choosing one alternative over another. Say a manufacturing plant makes and sells t-shirts and is considering going into the business of selling pants also. They anticipate making 10,000 pairs of pants and they can either make the pants in-house using new and existing equipment, or purchase pants from another manufacturer and sell them.
Types of decisionWe will now look at some typical examples where you have to decide which costs are relevant to decision-making. We suggest that you try each example yourself before you look at each solution. 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.
It requires an additional $0.5 million to complete construction. 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. However, the $1 million is an irrelevant cost, and should be excluded.
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. Opportunity CostsCash inflow that will be sacrificed as a result of a particular management decision is a relevant cost. Future Cash FlowsCash expense that will be incurred in the future as a result of a decision is a relevant cost. 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.
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 cost effects relate to both changes in variable costs and changes in total fixed costs. Sunk, or past, costs are monies already spent or money that is already contracted to be spent. A decision on whether or not a new endeavour is started will have no effect on this cash flow, so sunk costs cannot be relevant.
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. 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. It means that if there is zero production, there is no spending.
We can use relevant costs to understand whether a specific business unit is worth keeping. 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. Also known as differential costs, these are additional costs incurred when choosing one option over another.
After implementation, it is essential to monitor and evaluate the outcomes of the decision. This helps in understanding whether the decision has met its objectives or requires adjustments. Regular review ensures that future decisions can be better informed. The first step is to recognize and clearly define the problem or opportunity. This involves understanding the situation and gathering relevant information to assess the current state and potential issues or opportunities. Avoidable costs can be eliminated or avoided if a particular decision is made.