Relevant Cost Analysis for Financial Decision-Making

They arise only because of changes that may occur because of sudden and short-term changes in business operations. Therefore, it is worth buying in as incremental revenue exceeds incremental 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. Cost of machine – this is a relevant cost as $2.1m has to be paid out.

Relevant Costing and Non-Routine Decisions

In short, they are never considered when a decision is taken regarding a cost. When it comes to running a business, a person has to make up many costs. There are many types of costs that are made, such as fixed costs, variable costs, operating costs, sinking costs, etc. Maintenance cost for machinery is $3,000, $2,000 for material, $2,500 for labor, and $1,500 for miscellaneous costs.

Relevant costs are those that will change depending on the managerial decision being made. They are future-oriented and directly related to a specific business decision. Irrelevant costs, on the other hand, are costs that will not be affected by the decision.

If the segment remains unprofitable even after removing irrelevant costs, it’s best to shut down the segment. Otherwise, continue the segment but make changes to how costs are allocated. 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.

Types of Relevant Costs

A common example of an irrelevant cost is depreciation on existing equipment. Since depreciation is a non-cash expense that has already been allocated, it does not affect the cash flow and should not impact decision-making for future investments or operations. Managers must filter out these irrelevant costs to focus on the information that will actually affect the financial outcomes of their decisions.

1. 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.
2. For example, a cost which is relevant in respect of a particular activity or decision may turn out to be irrelevant for another one.
3. Fixed costs, such as long-term lease agreements or salaries, remain constant regardless of the level of production or sales.
4. The company is contemplating on buying an additional machine worth $80,000, to be used in conjunction with the old.

Main Differences Between Relevant cost and Irrelevant Cost

Real-world examples illustrate the pitfalls of failing to recognize irrelevant costs in decision-making. Consider a manufacturing company that invested heavily in a new production line, only to find that the market demand for the product was far lower than anticipated. The initial investment, now a sunk cost, should not influence the decision to discontinue the product line. However, if the company continues to factor this cost into its decision-making, it may persist with an unprofitable venture, draining resources that could be better utilized elsewhere. Non-cash expenses, such as depreciation and amortization, represent the allocation of past expenditures over time rather than actual cash outflows. These costs are recorded in financial statements to reflect the usage of assets, but they do not impact the company’s cash flow directly.

We suggest that you try each example yourself before you look at each solution. 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. Incremental cost refers to the increase in cost when choosing an alternative. 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. Eric is an accounting and bookkeeping expert for Fit Small Business.

There are four types of irrelevant costs are the sunk cost which is the cost of the old furniture in the example, and the committed cost, which cannot be altered as it’s a future relevant and irrelevant cost cost. Non-cash expenses include the depreciation of an asset and the overheads during the administration work. Relevant costs are avoidable costs that are incurred only when making specific business decisions. Many of the decisions company management make have a financial impact, such as, for example, choosing whether to shut down an operation or pursue an opportunity.