Relevant Cost Analysis for Effective Decision-Making

Decision making involves choosing between such alternatives and to make the best choice a manager needs to identify the future cash flows for each decision. Costs that have already been incurred as a result of past decisions (sunk costs) are not relevant for decision making. Likewise, a future cost that will not be changed by a decision is irrelevant how to develop a chart of accounts for your small business to that decision. Fixed overhead and sunk costs are examples of irrelevant costs that would not affect the decision to shut down a division of a company, or make a product instead of purchasing it from a supplier. Likewise, the wages of employees retained after the sale of a division would be irrelevant to the decision to sell it.

  • If the vendor can provide the component part at a lower cost, the furniture manufacturer outsources the work.
  • In other words, these are the costs which shall be incurred in one managerial alternative and avoided in another.
  • 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.
  • For example, the cost of transportation in the automotive industry may differ from that in the electronics industry.

This represents the manufacturing equipment’s depreciation for the number of days in which production for the order will take place. The cost of oil that will be used on the order is $1,000.The current market value of the required quantity of oil is $1,200. If oil is not used on the order, it could be used in the production of other tires. Avoidable CostsOnly those costs are relevant to a decision that can be avoided if the decision is not implemented.

These costs include fixed and variable costs such as raw materials, labor, overhead, and maintenance costs. The costs directly impacted by the decision to continue or close production are considered relevant. For example, if a product is not selling well, the cost of continuing to produce it may outweigh the potential profits, and it may be more cost-effective to shut down production. In manufacturing, relevant cost refers to the costs that directly impact a business decision.

In exam questions look out for costs detailed as differential, specific or avoidable. Relevant costing attempts to determine the objective cost of a business decision. An objective measure of the cost of a business decision is the extent of cash outflows that shall result from its implementation.

An increase in demand for a product can result in higher prices for raw materials and labor, ultimately leading to higher production costs. Conversely, a decrease in demand can result in lower raw material and labor prices and lower production costs. Additionally, we will discuss how changes in market conditions can impact relevant costs and technology’s role in identifying and analyzing relevant costs. We will also examine how relevant costs vary between different manufacturing industries and how they impact a manufacturer’s decision to outsource or keep production in-house.

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. The costs incurred last year (material, labour, and overheads) are not relevant to the decision.

How Do Changes in Market Conditions Affect Relevant Costs in Manufacturing?

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. 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. Say, for example, that 4 hours of labour were simply removed by ‘sacking’ an employee for four hours, one less unit of Product X could be made. Using the contribution foregone figure of $24 is the net effect of losing the revenue from that unit and also saving the material, labour and the variable costs.

  • We will also explore the challenges manufacturers face when identifying and analyzing relevant costs and the common mistakes they make.
  • Non cash flow costs are costs which do not involve the flow of cash, for example, depreciation and notional costs.
  • However, even long term financial decisions such as investment appraisal may use the underlying principles of relevant costing to facilitate an objective evaluation.
  • Here, we will discuss some common challenges and how manufacturers can overcome them.

Incremental CostWhere different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered. Opportunity CostsCash inflow that will be sacrificed as a result of a particular management decision is a relevant cost. Relevant costing is just a refined application of such basic principles to business decisions. The key to relevant costing is the ability to filter what is and isn’t relevant to a business decision.

When Should Manufacturers Consider Relevant Costs When Making Decisions?

We will also explore the challenges manufacturers face when identifying and analyzing relevant costs and the common mistakes they make. Assume, for example, a passenger rushes up to the ticket counter to purchase a ticket for a flight that is leaving in 25 minutes. The airline needs to consider the relevant costs to make a decision about the ticket price. Almost all of the costs related to adding the extra passenger have already been incurred, including the plane fuel, airport gate fee, and the salary and benefits for the entire plane’s crew. Because these costs have already been incurred, they are “sunk costs” or irrelevant costs. It is important to note that identifying and analyzing relevant costs can be challenging, especially in a dynamic and ever-changing manufacturing environment.

Example of Relevant Costs in Manufacturing

It is not worthwhile to do this, as the extra costs are greater than the extra revenue. Types of decision
We will now look at some typical examples where you have to decide which costs are relevant to decision-making. We suggest that you try each example yourself before you look at each solution. The opposite of a relevant cost is a sunk cost, which has already been incurred regardless of the outcome of the current decision.

The cost of equipment and machinery is another relevant cost in manufacturing that can vary between different industries. For example, the cost of equipment and machinery in the aerospace industry may be different from the cost of equipment and machinery in the furniture industry. The technology required and the size and complexity of the equipment can impact the cost. Labor costs are another relevant cost in manufacturing that can vary between different industries. For example, the labor cost in the textile industry may differ from that in the semiconductor industry. The complexity of the manufacturing process and the skill level required for the workforce can impact the cost of labor.

What Role Does Technology Play in Identifying and Analyzing Relevant Costs in Manufacturing?

In particular, sunk costs are irrelevant, as are future costs that do not differ between alternatives. The relevant cost concept helps the management make the right decision by eliminating extraneous information from a particular decision-making process. In order to make good decisions, managers must be able to identify relevant costs and understand how they will be affected by a different courses of action. Only then can they make informed decisions that will lead to the best results for the company. The reason relevant costs are so important is that they are the only costs that can truly influence a decision. All other costs are sunk costs, meaning they have already been incurred and cannot be changed by the decision.

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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.

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. Classifying costs as either irrelevant or relevant is useful for managers making decisions about the profitability of different alternatives. Costs that stay the same, regardless of which alternative is chosen, are irrelevant to the decision being made. This means that the opportunity cost of using the material for the new job is Tk. 1,200, and this is the relevant cost that should be included in the price. All future revenues and/or costs that do not differ between the alternatives are irrelevant.