What Is Relevant Cost in Accounting, and Why Does It Matter?

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 define relevant cost has already paid for the old machine (a sunk cost) and will continue to use it. 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.

One aspect that companies must be aware of is the potential for cost assumptions to be wrong. Every effort must be made to make correct cost estimates so that the choice of an opportunity that a business ultimately makes doesn’t affect the company negatively. Incremental analysis is a problem-solving method that applies accounting information—with a focus on costs—to strategic decision-making. Similarly, managers don’t exactly know what customers want, what tickles their fancy, what they value, or what they need. Perhaps customers have an unmet need for a place to buy the lowest price groceries. So Walmart aims at that pocket of untapped customer value with everyday low prices.

In this textbook I will refer to both methods as relevant cost analysis because it’s not worth spending a lot of time on the distinction. An alternative way of handling the decision facing Colony Landscape Maintenance is simply to calculate profitability of the Brumfield account before deducting allocated fixed costs. Figure 7.12 „Summary of Differential Analysis for Colony Landscape Maintenance” shows a contribution margin of $30,000 for the Brumfield account. Deduct direct fixed costs of $25,000 and the customer has a remaining profit of $5,000. This explains why Colony’s overall profit would be $5,000 lower if it eliminated the Brumfield account. So, even though I concede that sunk costs can’t be incorporated into managers’ relevant cost analysis, I think sunk costs can play an important role in managers’ strategic cost analysis.

1. As the relevant cost is a net cash outflow, the machine should be sold rather than retained, updated and used.
2. The fourth column shows whether Alternative 1 is higher or lower than Alternative 2 for each line item.
3. I assume sales dollars will be the same under both make and buy (more on this assumption in Section 2.4.3).
4. Is the point at which identifiable products emerge from the production process.
5. The spinoff decision was as much about sell-or-process-further as it was a make-or-buy.

It costs a lot to blast the rock and transport it and leach it and catalyze it, so the company uses its best guess to aim for rock that contains pockets of high-density copper ore. Below I have a diagram for a multi-product firm, Investments ‘R’ Us, which is making all four traditional decisions. But even special orders with a set price can get complicated by two types of costs. Without too much extra work, you can use your knowledge of keep-or-drop decisions to make the decision of whether to add a product line too. Make-or-buy is a choice between the firm creating an input itself (make) or paying someone else for the input (buy). For example, the car-maker General Motors (GM) used to have an internal division that made many of the parts for its own cars.

Relevant & Strategic Cost Analysis

Also, shared resources between products might affect what costs are actually avoided by dropping this product. Then, from a profitability standpoint, they aren’t really two different alternatives. One could argue there’s no decision to be made at all because there is, effectively, only one possible profit outcome.

Add or Drop a Product Line (or Segment)

Even the best manager only has a finite amount of time and cognitive ability to spend on each decision. Focusing on the profit differences of possible alternatives is necessary to ensure important decisions get made well. Any historic cost given for materials is always a sunk cost and never relevant unless it happens to be the same as the current purchase price. In the famous example of Toyota Japan; when they adapted the JUST IN TIME (JIT) approach, they outsourced many products to suppliers. That make or buy decision would not have been taken without careful considerations about product quality, costs, and profitability measures.

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. Instead of carrying out Operation 1, the company could buy in components, for $15 per unit.

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. In this situation however, the labour is simply being redeployed so $24 understates the effect of this, as the labour costs are not saved. 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.

Even though it initially looked like we should drop the product line, the second table clarifies that it actually is more profitable to keep the product line. That’s all because of the interdependency between the two product lines. The general rule of thumb is that keep-or-drop decisions initially (before considering complicating factors) favor drop more than they should (after complicating factors are accounted for).

It’s obvious why the rule to always ignore them gets so much play in economics and business. Sunk costs can’t be avoided, so they literally can’t differ between alternatives. This means they’re never going to tip the balance in favor of a particular alternative in relevant cost analysis and are thus “irrelevant” by definition. For example, it might seem more profitable for one firm to sell one of its inputs on an external market, given results from a sell-or-process-further relevant cost analysis.

6 Special Order Decisions

A manufacturing facility often faces this situation when receiving a customized order. It is a managerial accounting concept, and it deals with decisions at all levels of the management. The https://1investing.in/ decision taken makes that cost relevant, meaning if that decision is not taken the costs will be avoided. When making a decision, one must take into account and weigh all relevant costs.

The figure below represents the product differentiation strategy. The top line is customer benefit and the bottom line is customer cost. Net book values are not relevant costs because like depreciation, they are determined by accounting conventions rather than by future cash flows.

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. 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. 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.

Further processing Component A to Product A incurs incremental costs of $6,000 and incremental revenues of $5,000 ($12,000 – $7,000). It is not worthwhile to do this, as the extra costs are greater than the extra revenue. Note that additional fixed costs caused by a decision are relevant. 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. Management’s goal is to loosen the constraint by providing more labor hours to department 4.

Quality testing cannot be performed fast enough to keep up with the inflow of computers coming from departments 1, 2, and 3. A limitation of labor hours available to perform testing is causing this backlog. Opportunity costs can also be included in the differential analysis format presented in Figure 7.6 „Product Line Differential Analysis for Barbeque Company”. Panel C of Figure 7.6 „Product Line Differential Analysis for Barbeque Company” is simply modified to reflect the opportunity cost, as shown.