This would allow production to be increased because the machine has to deal with only Operation 2. 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. 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. Cost of machine – this is a relevant cost as $2.1m has to be paid out. Relevant costs are sometimes also called avoidable costs or differential costs. Make vs. buy decisions are often an issue for a company that requires component parts to create a finished product.
How Relevant Cost is used in Decision Making?
An opportunity cost represents the benefit forgone as a result of choosing a particular option. Suppose I get paid every week to do a certain job. So, the opportunity cost is basically a benefit lost as a result of carrying out a certain 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. Next we should consider whether the components should be further processed into the what is relevant cost products.
Continuing the construction actually involves spending $0.5 million for a return of $1.2 million, which makes it the correct course of action. Absorption costing is where we take a piece of the fixed overhead and we allocate it and absorb it into each unit that’s produced. So, under absorption costing, the cost per unit includes a component of fixed costs. So in that regard, each unit that we produce, we’re attributing a component of fixed costs to that particular unit. The reason why absorption costing is not that appropriate for decision making is because we’re factoring the fixed costs into each unit. And so, in that regard, we’re actually considering fixed costs where we might not actually need to consider them.
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 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. Appropriate cost analysis form plays a primary role in making that decision. A company that deals with making finished goods requires specific parts.
Marginal Costing
- Relevant costs are cash transactions rather than accounting or paper transactions.
- There are two costing systems that we’re going to discuss.
- These costs are relevant since these expenses change in the future due to the buying decision.
- Sunk costs are costs that we have already incurred.
- 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.
- And so, in that regard, we’re actually considering fixed costs where we might not actually need to consider them.
We assume the units in inventory will not be used—the selling price at $13. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.
Almost all of the costs related to adding the extra passenger have already been incurred, including the plane fuel, airport gate fee, and the salary and benefits for the entire plane’s crew. Because these costs have already been incurred, they are “sunk costs” or irrelevant costs. We also need to consider non-relevant costs and revenues. These would be costs and revenues that we would not consider in short-term decision making.
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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. The cost effects relate to both changes in variable costs and changes in total fixed 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. We suggest that you try each example yourself before you look at each solution.
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. Depreciation is not a cash flow and is dependent on past purchases and somewhat arbitrary depreciation rates. By the same argument, book values are not relevant as these are simply the result of historical costs (or historical revaluation) and depreciation. 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.
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 is regularly used in current manufacturing operations. 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.
There are four main non-relevant costs that we’re going to run through – sunk costs, committed costs, notional costs, and fixed costs. The next feature is that relevant costs are incremental in nature. This means that the cost will increase or maybe the revenue will increase in direct relation to a particular decision.
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. Closing down either production line would save 25% of the total fixed costs. 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.