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The concept of relevant costs eliminates unnecessary data that could complicate the decision-making process. A construction firm is in the middle of constructing an office building, having spent $1 million on it so far. 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. Continuing the construction actually involves spending $0.5 million for a return of $1.2 million, which makes it the correct course of action. If any fixed cost is future cost and if it is differential between alternatives, then that fixed cost can be said to be relevant. We should remember that there are two kinds of fixed costs, avoidable and unavoidable.

For example, suppose a manufacturer has already invested a significant amount of money in a non-profitable project. In that case, they may continue to invest in the project because they feel they have already invested too much money to abandon it. This can lead to further losses and harm the company’s overall profitability. Manufacturing companies operate in a complex environment where they must make critical decisions that can impact their profitability and overall success.

Changes in Raw Material Prices

They use financial models to analyze data and provide insights into the financial impact of a particular decision. Financial analysts work with managers and accountants to identify relevant costs and provide recommendations based on their analysis. Another critical difference is that relevant costs can help manufacturers make more informed decisions, while sunk costs can lead to irrational decision-making. If sunk costs are considered in decision-making processes, manufacturers may make irrational decisions that are not in the company’s best interests. Furthermore, we will compare relevant costs with sunk costs and examine how they differ.

  • For example, a manufacturer may produce a product internally rather than outsourcing it to a supplier.
  • Conversely, a decrease in the price of raw materials can result in lower production costs and increased profitability.
  • Component A can be converted into Product A if $6,000 is spent on further processing.
  • The book value of fixed assets like machinery, equipment, and inventory is another example of irrelevant sunk costs.
  • Therefore, it is worth buying in as incremental revenue exceeds incremental costs.

A big decision for a manager is whether to close a business unit or continue to operate it, and relevant costs are the basis for the decision. Assume, for example, a chain of retail sporting goods stores is considering what does ‘we are going to get one thing on the books’ imply 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.

In the context of manufacturing, relevant costs can vary between different industries. 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). As these materials are not available in stock, these will have to be purchased at the market price which is their relevant cost.

AccountingTools

Sunk costs (costs already irrevocably incurred) are always irrelevant since they will be the same for any alternative. Relevant costs are costs that change with respect to a particular decision. A relevant cost for a particular decision is one that changes if an alternative course of action is taken. This list includes only a small sample of the possible applications of the relevant cost concept. The term opportunity cost does not have a single, precise definition in all of its uses.

What Is Relevant Cost in Accounting, and Why Does It Matter?

Conversely, decreased transportation costs can result in lower production costs and increased profitability. Irrelevant costs are costs, either positive or negative, that would not be affected by a management decision. Irrelevant costs, such as fixed overhead and sunk costs, are therefore ignored when that decision is made. However, it’s critical for a manager to be able to distinguish an irrelevant cost in order to potentially save the business. Increases in labor costs, such as wages and benefits, can result in higher production costs.

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

Intellectual property protection is another relevant cost impacting the decision to outsource or keep production in-house. If intellectual property protection is weaker in a foreign country, outsourcing may not be the best choice. However, outsourcing may be more cost-effective if a foreign country’s intellectual property protection is strong. Quality control costs are another relevant cost impacting the decision to outsource or keep production in-house if quality control costs are lower in a foreign country. However, if quality control costs are relatively low in the domestic market, keeping production in-house may be the better choice. Considering relevant costs is critical for manufacturers to make informed decisions that impact their bottom line.

In other words, these are the costs which shall be incurred in one managerial alternative and avoided in another. 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 production line. In that case, the cost of the warehouse which stores the production unit is avoidable because you can sell the warehouse. Relevant costs are those costs that will be incurred as a result of a decision and thus should be considered when making that decision. CFO Consultants, LLC has the skilled staff, experience, and expertise at a price that delivers value.

Technology has also enabled manufacturers to optimize their supply chains to reduce costs and improve efficiency. With supply chain management software, manufacturers can track the movement of raw materials and finished goods, identify bottlenecks, and optimize transportation routes. This can result in reduced transportation costs, improved inventory management, and overall cost savings. The manufacturer has already determined that there is a potential market for the product and that it can be sold at a profitable price. However, the manufacturer must analyze the product’s relevant costs before deciding.

The wages of these scribes are relevant costs, since they will be eliminated in the future if management buys the printing press. However, the cost of corporate overhead is not a relevant cost, since it will not change as a result of this decision. A relevant cost is any cost that will be different among various alternatives. There is seldom a “one-size fits all” situation for relevant or irrelevant costs.

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.

Finally, considering relevant costs is important because it allows manufacturers to remain agile and responsive to changes in the market. Market conditions can change rapidly, and manufacturers must be able to adjust their operations quickly to remain competitive. Manufacturers can better understand the true costs and benefits by identifying and analyzing the costs directly impacted by a decision. This can help them make more accurate and effective decisions aligning with their goals and objectives.