According to the above illustration, it will cost XYZ $250,000 to buy from a supplier. And it will cost $390,000 to make the same internally. Material – if the buy-in option is accepted, the material cost increases from $12 to $15 per unit. Component B can be converted into Product B if $8,000 is spent on further processing.
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. If the product cost price is below production cost, the company can safely decide to take special orders. Therefore, it is worth buying in as incremental revenue exceeds incremental costs. Machine running costs – the machine is already fully utilised on Operations 1 and 2 and will remain fully utilised, but only on Operation 2. Therefore, the machine running costs will not change, so are not relevant to the decision. Instead of carrying out Operation 1, the company could buy in components, for $15 per unit.
The closure of what is relevant cost Production Line A would also result in the revenue lost being greater than the value of the costs saved, so this isn’t a good idea either. Therefore, the closure of Production Line B is not a good idea as the revenue lost is greater than the value of the costs saved. The only additional cost is the labor to load the passenger’s luggage and any food that is served mid-flight, so the airline bases the last-minute ticket pricing decision on just a few small costs. The decision could result in higher expenses or lower expenses as well as higher or lower revenue. Generally, the cost can be deemed worthwhile if it pays off and results in a higher overall profit. These costs are not static, will vary depending on which path is taken, and can be avoided.
What Is the Difference Between Relevant Cost and Sunk Cost?
The future expenses that might occur due to a decision made in the present are called future cash flows. The current value is used to project future revenues to see if a decision will incur future costs. Here, we can price the expected ongoing-project revenues with the current value. Then, a discounted rate is formulated to arrive at discounted cash flows.
Continue Operating vs. Closing Business Units
A relevant cost is a cost that only relates to a specific management decision, and which will change in the future as a result of that decision. The relevant cost concept is extremely useful for eliminating extraneous information from a particular decision-making process. Also, by eliminating irrelevant costs from a decision, management is prevented from focusing on information that might otherwise incorrectly affect its decision. For example, a furniture manufacturer is considering an outside vendor to assemble and stain wood cabinets, which would then be finished in-house by adding handles and other details. The relevant costs in this decision are the variable costs incurred by the manufacturer to make the wood cabinets and the price paid to the outside vendor. If the vendor can provide the component part at a lower cost, the furniture manufacturer outsources the work.
14: Introduction to Relevant Costs
Sunk costs, on the other hand, are existing expenses that have already been incurred and are unrecoverable. 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. Relevant costs are future potential expenses, whereas sunk costs are existing expenses that have already been made. Relevant costs can be thought of as future expenses that are incurred only if an opportunity is pursued. They are studied by companies to determine if one decision is more cost-effective than another. The opposite of a relevant cost is a sunk cost, which has already been incurred regardless of the outcome of the current decision.
The company shall free some space that can be leased if it decides to outsource. The management can outsource to make an extra income from leased space. The relevant cost analysis thus helped the company to conclude that buying the part was a more financially sound decision.
The additional travel expenses to the new territory and the additional sales from the new territory are relevant to the decision. Relevant costs are future costs that will differ between two or more alternative actions. Expressed another way, relevant costs are the costs that will make a difference when making a decision. There are two other types of relevant cost that we need to be aware of.
In all examples we ignore the time value of money. 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. 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 you think of that example that we had above, where we have excess capacity, we don’t need to consider fixed costs in those types of short-term decisions. Business management uses relevant costs to finalize a decision. Relevant costs help to eradicate unnecessary data that can complicate a decision-making process.
- Component B can be converted into Product B if $8,000 is spent on further processing.
- The relevant cost concept is extremely useful for eliminating extraneous information from a particular decision-making process.
- Relevant costs are future costs that will differ between two or more alternative actions.
- The current value is used to project future revenues to see if a decision will incur future costs.
- Relevant costs are costs that are relevant to short term decisions, or one-off decisions, and we’ll be looking at some of the key features of relevant costs.
For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. 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. 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.
If we decide to produce the product, we will have incurred that cost anyway. No matter what decision we make, we’ve already incurred that cost. Therefore, it’s a sunk cost and it’s never relevant in short-term decision making. A sunk cost is an expenditure that has already been made, and so will not change on a go-forward basis as the result of a management decision.
Management can use this concept to make cost-effective business decisions and avoid unnecessary expenses. A company decides to buy loading machinery for a factory unit. This machine can save the wage expenses of 20 manual laborers.
Material B – The 100 units of the material already in inventory has no other use in the company, so if it is not used on the new product, then the assumption is that it would be sold for $12/unit. If the new product is made, this sale won’t happen and the cash flow is affected. The original purchase price of $10 is a sunk cost and so is not relevant. In addition, another 50 units are needed for the new product and these will need to be bought in at a price of $14/unit. They can buy the part from a vendor or make it in the factory.