relevant and irrelevant cost
relevant and irrelevant cost

Notional costs such as depreciation, interest costs and absorbed fixed cost are not relevant cost. In this case, depreciation ($2,400) on the old machine is an irrelevant cost. The company would have to depreciate the old machine irrespective of whether or not it buys a new machine. The fixed cost of $20,000 is also not relevant as a company would have to incur it whether or not it buys a new machine.

  • It happens when the company opt-out of other activities that can save it from incurring expenses.
  • Likewise, the wages of employees retained after the sale of a division would be irrelevant to the decision to sell it.
  • The relevant cost is the addition of the loading and unloading charge of goods when it’s consigned or sold to the opposite party in a business.

Scrap or residual value involves the future receipt of cash when the asset is sold. The opposite of a relevant cost is a sunk cost, which has already been incurred regardless of the outcome of the current decision. 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. Immediately we can say that the $300,000 purchase cost is a sunk cost and the $50,000 book value and $25,000 depreciation charge are not cash flows and so are not relevant.

Examples of irrelevant costs:

This kind of cost cannot be changed any decision taken in the present or future. A relevant cost is also known to be told as differential costs. Keeping in view points and , the items should be sold through normal distribution channels which will involve a differential cost of Rs.2 (i.e. Rs.3 – Rs.1) per unit. Hence, the minimum recommended price is more than Rs.2 per unit so that there may be some addition to the profit of the company. Relevant costs are only the costs that will be affected by the specific management decision being considered. In business, a customer may request a one-time item from a company.

The company has to bear these costs, which are unwanted and unavoidable forcibly. 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. 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. The material has no use in the company other than for the project under consideration.

relevant and irrelevant cost

Irrelevant costs are costs that won’t be affected by a managerial decision. Relevant cost analysis is used to identify the avoidable Costs that should be considered when making business decisions. It is important to consider all Relevant Costs when making business decisions in order to make the best decision for the company. Irrelevant cost is an important concept in business decision-making, as it helps managers to focus on the factors that will actually affect the outcome of their decisions.

Cost of avoidable overheads Rs. 1,25,000 is the relevant cost to the contract and as such it has been added to the cost of the contract. 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. Material V is ordered for some other relevant and irrelevant cost product which is no longer required but payment for material will have to be made. Therefore, its cost is relevant but the relevant cost is the residual value of Rs.1,35,000 which can be realized. Additional costs incurred will be compared with the additional revenue arising by utilizing idle capacity.

This, in actuality, is not the cost of charges of fuel and transport in business. For example, geographers may want to learn how the climate of a region is changing. Relevant information would include changes in temperature, winds, and rainfall.

Committed costs are costs that would be incurred in the future but they cannot be avoided because the company has already committed to them through another decision which has been made. 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. Here depreciation of New Machine, say $4500, will be relevant cost. Company A will incur this cost only if it decides to buy the new machine. Another relevant cost will be the variable cost, as Company A will save $12,000 because of the new machine.

Relevant and irrelevant costs are two types of costs that should be considered when making a new business decision; thus, they are two main concepts in management accounting. Examples of relevant costs are marginal or variable cost, specific or avoidable fixed costs, incremental costs, opportunity costs, out of pocket costs etc. On the other hand, the irrelevant costs are general or absorbed fixed costs, committed costs, sunk costs etc.

Types of Relevant Cost Decisions

Companies use marginal analysis as to help them maximize their potential profits. Both costs also help to determine the total cost of operations. She has held multiple finance and banking classes for business schools and communities. Relevant costs are those which are stated to be avoidable while a decision is implemented. Cost of skilled labour Rs.5,70,000 is the extra cost to the company because of this contract. It is the replacement cost of semi-skilled labour by skilled labour.

relevant and irrelevant cost

The concept of relevant cost is used to eliminate unnecessary information that complicates the decision making process. In commercial entities, the cost accounting is a prominent aspect for internal control and decision making. Some of its salient functions are identification and application of various types of costs as well as controlling and managing those costs. These managerial functions often require the bifurcation of costs into various categories.

For example, a person has to choose between vacationing and spending time with their family. In this context, opportunity cost is the cost of the holiday and visiting new places if the person decides to go on vacation rather than stay home. It happens when the company opt-out of other activities that can save it from incurring expenses. It means that if there is zero production, there is no spending. E.g. In another 3 months’ time, HIJ has to increase the salaries of employees that incurs a total cost of $ 15,200.

Usually, lower management incurs the relevant costs, while top management oversees the spending of the irrelevant costs. Relevant Cost of material is the incremental cost of raw material, which will change depending on the production quantity. It is an additional avoidable cost, which only occurs when the specific decision is made. We only need the material when we decide to process the production. As mentioned earlier, relevant costs are those that will differ between different alternatives.

Continue Operating vs. Closing Business Units

The decision should be based on the relevant cost of repair versus the relevant cost of replacement. Michael is a part-time worker and is paid on hourly basis. As Michael’s labor cost varies directly as a result of the order, it should be considered as a relevant cost.

Irrelevant Cost in Business: Meaning and Examples

Hence the relevance and importance change from the viewpoint of decision making. 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.

Irrelevant Cost

The entity has already invested in these costs, and proper legal obligation has also been met, for which the Company cannot get out of this anymore. Hence these costs are irrecoverable and are fixed in the company’s accounts. Therefore, it is worth buying in as incremental revenue exceeds incremental costs. 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. Instead of carrying out Operation 1, the company could buy in components, for $15 per unit.

Opportunity CostsThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It’s essentially the cost of the next best alternative that has been forgiven. If the product cost price is below production cost, the company can safely decide to take special orders. Non-cash CostsNon-cash expenses are those expenses recorded in the firm’s income statement for the period under consideration; such costs are not paid or dealt with in cash by the firm. Are the costs that are non-erasable from the books of accounts. These costs are committed from the company’s point of view.