Introduction to Relevant Costs Accounting for Managers

B.) The depreciation of the new additional machine, $10,000, is relevant since the company will incur such cost only when it decides to buy the new machine. As the relevant https://www.bookkeeping-reviews.com/small-business-line-of-credit/ cost is a net cash outflow, the machine should be sold rather than retained, updated and used. The material is regularly used in current manufacturing operations.

Irrelevant costs do not have any bearing when choosing over different alternatives. They do not make any difference and make no impact in making decisions. E.) After analyzing the relevant costs, the company will have a net annual savings of $18,000. The company will be able to decrease its variable costs by $28,000 but will incur in incremental costs of $10,000 due to increase in depreciation.

Instead of carrying out Operation 1, the company could buy in components, for $15 per unit. This would allow production to be increased because the machine has to deal with only Operation 2. This is not worthwhile as incremental costs exceed incremental revenues. 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. 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.

Relevant Costs vs. Sunk Costs

That is why accountants will refer to a past cost as a sunk cost. 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.

The company is contemplating on buying an additional machine worth $80,000, to be used in conjunction with the old. Though units produced will stay the same, the company expects a significant decrease in variable costs from $68,000 to $40,000, annually. Fixed costs other than depreciation expense will remain at $30,000. Sunk costs include historical costs that have been taken up or paid by the company, hence will not be affected by future decisions. Unavoidable costs are those that the company will incur regardless of the decision it makes.

As mentioned earlier, relevant costs are those that will differ between different alternatives. Relevant costs include expected costs to be incurred as well as benefits forgone when choosing one alternative over another (known as opportunity costs). Irrelevant costs will not be affected regardless of any decision. ABC Company is currently using a machine it purchased for $50,000 two years ago. It is depreciated using the straight-line depreciation over its useful life of 10 years.

Example of Relevant Costs

The company will hire new staff to meet this additional demand. Material — if the buy-in option is accepted, the material cost increases from $12 to $15 per unit. Next we should consider whether the components should be further processed into the products. 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. 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.

He is the sole author of all the materials on AccountingCoach.com.

In this case, the company has given up its opportunity to have a cash inflow from the asset sale. A.) The depreciation of the old machine, $5,000, is irrelevant since the company will continue to depreciate the machine until the end of its useful life. Whether the company purchases the new equipment or not, it will still incur who files schedule c: profit or loss from the $5,000 depreciation. Take note that the company has already paid for the old machine (a sunk cost) and will continue to use it. 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.

1. In this situation however, the labour is simply being redeployed so $24 understates the effect of this, as the labour costs are not saved.
2. Once again, the cost of corporate overhead is not a relevant cost when making this decision, since it will not change if the division is sold.
3. He is the sole author of all the materials on AccountingCoach.com.
4. The material is regularly used in current manufacturing operations.

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. The material has no use in the company other than for the project under consideration. 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. ‘Relevant costs’ can be defined as any cost relevant to a decision. A matter is relevant if there is a change in cash flow that is caused by the decision. Past costs may help you predict and estimate the future costs, but the past costs are otherwise irrelevant to the decision.

Module 11: Relevant Revenues and Costs

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. The cost effects relate to both changes in variable costs and changes in total fixed costs. Relevant costs refer to those that will differ between different alternatives. Irrelevant costs are those that will not cause any difference when choosing one alternative over another.

As another example, if ABC wants to close its medieval book division entirely, the only relevant costs will be those costs specifically eliminated as a result of the decision. Once again, the cost of corporate overhead is not a relevant cost when making this decision, since it will not change if the division is sold. 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. 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. Further processing Component A to Product A incurs incremental costs of $6,000 and incremental revenues of $5,000 ($12,000 — $7,000).

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. The closure of 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. 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.