Relevant Costing
A relevant cost is a cost affected by a manager’s decision or managerial decision making. When making a decision, one must take into account and weigh all relevant costs. Relevant costs stand out because they haven’t been incurred yet, can be avoided, and are only pursued if it’s believed the action will be profitable. Companies keep track of these costs and jobs could be in jeopardy if they don’t pay off. Assume, for example, a chain of retail sporting goods stores is considering closing a group of stores catering to the outdoor sports market. The relevant costs are the costs that can be eliminated due to the closure as well as the revenue lost when the stores are closed.
Relevant Costs in Financial Performance Analysis
Various types of relevant costs are variable or marginal costs, incremental costs, specific costs, avoidable fixed costs, opportunity costs, etc. The irrelevant costs are fixed costs, sunk costs, overhead costs, committed costs, historical costs, etc. The presence of irrelevant costs can also complicate the budgeting process. When these costs are included in financial projections, they can distort the true picture of a company’s financial health. This distortion can lead to overestimations or underestimations of available resources, affecting everything from operational planning to strategic initiatives. Distinguishing between relevant and irrelevant costs is a fundamental aspect of financial analysis.
- It is not worthwhile to do this, as the extra costs are greater than the extra revenue.
- 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.
- A difference is observed in the relevant cost per each alternative decision.
- The students need to remember that the relevancy of a cost is seen only in relation to certain activities or decisions.
- Moreover, the psychological impact of irrelevant costs cannot be underestimated.
- She has held multiple finance and banking classes for business schools and communities.
Irrelevant Cost in Business: Meaning and Examples
Financial decision-making is a critical aspect of business management, where precision can mean the difference between profit and loss. Relevant cost analysis stands as a cornerstone in this process, guiding managers to make informed choices by focusing on costs that are pertinent to a specific decision. Irrelevant costs are those that will not cause any difference when choosing one alternative over another. 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. An example of this can be when a new piece of furniture is purchased and replaced with an item of old furniture, then the cost of that old furniture is said to be the sunk cost. For example, a company truck carrying some goods from city A to city B, is loaded with one more ton of goods.
Definition of Relevant Costs
Component B can be converted into Product B if $8,000 is spent on further processing. Component A can be converted into Product A if $6,000 is spent on further processing. She has held multiple finance and banking classes for business schools and communities.
The determination of pricing strategies is another area where relevant costs must be carefully considered. Setting the price for a product or service involves not just covering the costs but also ensuring competitive positioning in the market. Direct costs that vary with the level of production, such as raw materials and direct labor, are particularly important in this analysis.
Fixed costs other than depreciation expense will remain at $30,000. The classification of costs as relevant and irrelevant is of great importance in cost and profitability analysis, especially when management has to choose between alternatives. The book value of fixed assets like machinery, equipment, and inventory is another example of irrelevant sunk costs. The book value of a machine is a sunk cost that does not affect a decision involving its replacement. Relevant costs for decision-making help us determine the financial implications of business decisions.
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. Along the line of business, there is the production of several units.
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. In business, a customer may request a one-time item from a company. 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 change in the relevant and irrelevant cost 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 kind of cost cannot be changed by any decision taken in the present or future. A company that needs a special item can either make one on its own or outsource it.