The difference between relevant and irrelevant cost is based on whether the cost will have to be incurred additionally due to a new decision. Yet, it helps in make or buy decision, accepting or rejecting an offer, extra shift decision, plant replacement, foreign market entry, shut down decisions, analyzing profitability, etc. Sunk costs include costs like insurance that has already been paid by the company, hence it cannot be affected by any future decision. Unavoidable costs are those that the company will incur regardless of the decision it makes, e.g. committed fixed costs like depreciation on existing plant.
- Further processing Component B to Product B incurs incremental costs of $8,000 and incremental revenues of $11,000 ($15,000 – $4,000).
- The relevant cost is the cost of loading and unloading the additional cargo, and not the cost of the fuel, driver salary, etc.
- (3) Rs.35,000 paid as salary to two members of the supervisory staff who can replace other positions is the relevant cost for the contract.
- Relevant costs for decision making are expected future costs that will differ under various alternatives.
- Managers have to figure out the best way to utilize these capacities.
- Only the incremental or differential costs related to the different alternatives, are relevant costs.
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. As mentioned earlier, relevant costs are those that will differ between different alternatives. Relevant costs include expected costs to be incurred https://1investing.in/ as well as benefits forgone when choosing one alternative over another (known as opportunity costs). 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.
Sunk costs are irrelevant, as they do not affect the future cash flows. There is seldom a “one-size fits all” situation for relevant or irrelevant costs. Irrelevant cost is a term used in business decision-making that refers to any cost that does not affect the outcome of the decision. Irrelevant costs are therefore not taken into account when making decisions, as they will not change regardless of which option is chosen. It is also important to note that relevant costs are not always easy to identify, as some can be both relevant and irrelevant depending on the situation.
Future costs, which cannot be altered, are not relevant as they will have to be incurred irrespective of the decision made. This information can be used to determine the cost of a product or service, which is important for pricing purposes. It can only be used on another product, the material for which is available at Rs.1, 35,000 (Material X requires some adaptation to be used and costs Rs.27,000).
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. 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. This is not worthwhile as incremental costs exceed incremental revenues. 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.
Relevant and Irrelevant Cost (Accounting) – Explained
A relative cost is a type of cost that is different at different places. Future costs are considered while making decisions regarding relative costs. An irrelevant cost remains the same throughout the decision-making process.
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. In the context of accounting, relevant costs are used to help decision-makers determine the best course of action by taking into account only the costs that will change due to their decision. Relevant costs (also referred to as differential costs) are expected future costs relevant to a decision and also differ among different alternatives. Relevant costs are costs that are affected by a managerial decision in a particular business situation. In other words these are the costs which shall be incurred in one managerial alternative and avoided in another.
- 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.
- (i) Historical cost of Rs.11.50 per unit of 5,000 units of product produced last year (which is no longer in demand) is irrelevant cost being a sunk cost.
- Whether the company purchases the new equipment or not, it will still incur the $5,000 depreciation.
- Depreciation expenses and taxes are also considered irrelevant costs, as current decisions cannot alter them.
So, if you were evaluating the viability of a new production facility, then the rent of a building specially leased for the new facility is relevant. While relevant costs are useful in short-term; but for the long-term, price should provide a sufficient profit margin above the total cost and not just the relevant costs. Most costs which are irrelevant in the short term become avoidable and relevant in the long term.
Irrelevant Costs vs. Relevant Costs
Also, by eliminating irrelevant costs from a decision, management is prevented from focusing on information that might otherwise incorrectly affect its decision. While evaluating two alternatives, the focus of analysis is on finding out which alternative is more profitable. The profitability is judged by considering the revenues generated by and costs incurred.
On the other hand, irrelevant costs do not vary based on the choices made by management. Examples of these include sunk costs – past expenses already spent on previous actions – fixed overheads such as rent or salaries unrelated to any specific project or product line. Usually, most variable costs are relevant as they vary depending on selected alternative. Fixed costs are thought to be irrelevant assuming that the decision does not involve doing anything that would change these fixed costs. But, a decision alternative being considered might involve a change in fixed costs, e.g. a bigger factory shade. In the long term, both relevant and irrelevant costs become variable costs.
Difference between Relevant Costs and Irrelevant Costs
In the following paragraphs, we will delve deeper into the concept of relevant and irrelevant costs. Relevant costs are costs that will change as a result of a particular decision and, therefore, must be taken into consideration when making that decision. Generally speaking, most variable costs are relevant because they depend on which alternative is selected. Fixed costs are irrelevant assuming that the decision at hand does not involve doing anything that would change these stationary costs.
Additional costs incurred will be compared with the additional revenue arising by utilizing idle capacity. Sale proceeds – this is a relevant cost as it is a cash inflow which will occur in 10 years as a result of the decision to invest. As the relevant cost is a net cash outflow, the machine should be sold rather than retained, updated and used. 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. Cash expense, which will be incurred in future because of a decision, is a relevant cost. The difference in costs in choosing one alternative over another is known as differential cost.
In other words, it’s a cost that will change depending on whether you take a particular course of action or not. This kind of cost cannot be changed by any decision taken in the present or future. A relevant cost is a cost affected by a manager’s decision or managerial decision making. Any cost, fixed or variable that would be different for a particular course of action being analyzed is relevant for that alternative. Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the decision to invest. These employees are difficult to recruit and the company retains a number of permanently employed staff, even if there is no work to do.
Irrelevant costs are used in managerial accounting to describe costs that are relevant to managerial decisions but do not change as a result of the decision made. 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. However, the $1 million is an irrelevant cost, and should be excluded.