Relevant costs

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 tips for finding the right tax accountant 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.

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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.

Irrelevant 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.

1. 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.
2. Machine running costs – the machine is already fully utilised on Operations 1 and 2 and will remain fully utilised, but only on Operation 2.
3. Irrelevant costs do not have any bearing when choosing over different alternatives.
4. Good examples include committed fixed costs such as insurance and current depreciation.

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.

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.

Definition of Relevant Costs

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 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.

However, the cost of corporate overhead is not a relevant cost, since it will not change as a result of this decision. 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. Operation 1 takes 0.25 hours of machine time and Operation 2 takes 0.5 hours of machine time. Labour and variable overheads are incurred at a rate of $16/machine hour and the finished products sell for $30 per unit. This effect is known as an opportunity cost, which is the value of a benefit foregone when one course of action is chosen in preference to another.

Introduction to Relevant Costs

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 https://www.bookkeeping-reviews.com/shareholder-equity-se-definition/ 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.

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).

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.