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.

Relevant costs are avoidable and can differ depending on which action is taken. With zero inventories, they will buy all 50 units at $10.

The company Billy’s makes cheese worth $10,000 per month. Maintenance cost for machinery is $3,000, $2,000 for material, $2,500 for labor, and $1,500 for miscellaneous costs. So, the Billy’s might think of discontinuing the cheese unit. Billy’s might continue with cheese production if the expenses are lower, like $ 7,500. Note that additional fixed costs caused by a decision are relevant.

1. 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.
2. In this case, the company has given up its opportunity to have a cash inflow from the asset sale.
3. A current or future cost that will differ among alternatives.
4. 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.

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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. Assume a passenger rushes up to the ticket counter to purchase a ticket for a flight that is leaving in 25 minutes. The airline needs to consider the relevant costs to make a decision about the ticket price.

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.

What are Relevant Costs?

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 products.

Marginal Costing

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.

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.

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. Relevant costs are future expenses related to a specific decision. They can be avoided and differ depending on which choice is taken.

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.

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. Relevant costs are cash transactions rather than accounting or paper transactions. This means that a relevant cost is not going to be depreciation or notional rent, for example.

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 what is relevant cost is the sole author of all the materials on AccountingCoach.com.