Cost data is vital for a business as it helps in decision-making regarding maximizing profit or meeting other business objectives. But, not all costs are essential to a company when making a particular decision. Thus, to improve decision-making or to make better decisions, a business needs to understand the difference between relevant cost vs. irrelevant cost. A relevant cost is any cost that will be different among various alternatives.

In other words these are the costs which shall be incurred in one managerial alternative and avoided in another. As the name suggests they are ‘relevant’ for managerial analysis and should be considered in all calculations made for the purpose. An opportunity cost is a hypothetical cost incurred by selecting one alternative over the next best available alternative.

In context of business decisions, the relevancy of a cost depends on its nature in a particular situation. If the nature of a particular cost allows managers to control, avoid or impact its quantum in reference to a particular business activity, the cost would be categorized as relevant, and otherwise irrelevant. In above example of CPT Inc., the list of costs has been classified on the basis of this concept. 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. When an alternative course of action is given up, the financial benefits lost are known as opportunity costs.

Some years ago, a company bought a piece of machinery for $300,000. The company could spend $100,000 on updating the machine and the products subsequently made on it could generate a contribution of $150,000. Alternatively, if the machine is not updated, the company could sell it now for $75,000. The material is regularly used in current manufacturing operations. Relevant costs are those which are stated to be avoidable while a decision is implemented.

Example of Relevant Cost

That’s still a savings on each inmate out of jail, but it’s much less than the $73 a day the county has generally used for those calculations. Mind you, talking of escalating rail costs, I do think we should continue to support Crossrail. Always interesting to see examples of projects being continued with long after they are in reality no longer worth it.

• A relevant cost is also defined as a cost whose amount will be affected by a decision being made.
• Irrelevant costs will not be affected regardless of any decision.
• Take note that the company has already paid for the old machine and will continue to use it.
• Here the £5 pay-off arises from the decision to employ Van Gall in the first place.
• Another issue in relevant costing is handling the opportunity cost.

The opportunity cost is time spent studying and that money to spend on something else. A farmer chooses to plant wheat; the opportunity cost is planting a different crop, or an alternate use of the resources . Two important characteristic features of relevant costs are ‘Occurrence in Future’ and ‘Different for Different Alternatives.

Once again, the cost of corporate overhead is not a relevant cost when making this decision, since it will not change if the division is sold. For example, suppose your retail business pays an annual building rent of $200,000, which is a fixed cost . The rent, which gives the business the legal right to occupy the building, provides 15,000 square feet of retail and storage space. \nFor example, suppose your retail business pays an annual building rent of $200,000, which is a fixed cost . I usually give the example of the sacked football manager whose contract still needs to be paid even after he has been replaced as an example of committed costs.

Relevant and irrelevant prices are two kinds of prices that ought to be considered when making a new enterprise determination; thus, they are two major ideas in management accounting. Now the business can either automate the production process for $10,000 or it can hire manual labor for $12,000 to complete the production. The $2,000 difference of cost between these two options will be considered as the differential cost for the business. Differential cost is the difference between the costs of different alternative projects or opportunities. Differential costing is applied when a business entity has an option to pursue a single project or opportunity but has a variety of projects or opportunities to choose from.

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It is therefore the difference between the costs of two alternatives. A differential cost is an amount by which future costs will be higher or lower, if a particular course of action is chosen. Differential cost is relevant cost and should be considered while evaluating different alternatives, provided that this differential cost is a cash flow and not a notional cost. For example, if a decision is to be taken whether idle capacity should be utilized or not.

The company would insure the new machine against damage for $5,000 per annum. 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. This, in actuality, is not the cost of charges of fuel and transport in business. E.g. In another 3 months’ time, HIJ has to increase the salaries of employees that incurs a total cost of $ 15,200. E.g. HIJ incurred a cost of $ 85,400 to conduct a market research to collect data regarding the preference for their products by customers. E.g., HIJ is a furniture manufacturing company that plans to undertake a new order which will result in a net cash flow of $ 500,000 within a period of 6 months.

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. 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.

Difference Between Relevant and Irrelevant Cost

Stylish Manufacturers & Co. uses a machine for manufacturing joggers. Machine was acquired under a lease agreement which has one year remaining. The firm has been incurring losses on the manufacture and sale of joggers and is considering closing this division and starting the manufacture of high quality shoes. Machine would no longer be required but the firm would be liable to pay a penalty equal to 40% of the remaining rentals i.e. $20,000 on early termination of lease agreement.

An irrelevant cost is a managerial accounting term that represents a cost that would not be affected by a management decision. 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. 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. Fixed costs, such as a factory lease or manager salaries, are irrelevant because the firm has already paid for those costs with prior sales.

For example, costs incurring due to a change in depreciation policy will not be counted as relevant costs. The relevant costs always increase the already committed costs and affect revenue. It is a managerial accounting concept, and it deals with decisions at all levels of the management. The decision taken makes that cost relevant, meaning if that decision is not taken the costs will be avoided.

What is relevant and irrelevant cost?

As these relevant and irrelevant cost depend on the decision and can be saved if a particular decision is made, therefore avoidable costs are relevant costs. 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. As mentioned earlier, relevant costs are those that will differ between different alternatives.

Costs that have been incurred in the past are totally irrelevant to any decision that is being made ‘now’. Incremental cost must be compared with incremental revenues to take decision. Outline the treatment of Direct Materials, Direct Labour, Direct Expenses and Fixed Costs when a business has chosen to use Relevant Costing to calculate the cost of production. Describe the different treatments of costs for materials in Relevant Costing. If you have already paid for their time, then you only have to pay for more hours when they are working at full capacity. That gets talked about here in the context of skilled labour but assumes that all unskilled is on essentially zero hours contracts.

In other words, these are the https://1investing.in/ which shall be incurred in one managerial alternative and avoided in another. Such costs are called past costs or sunk costs and are irrelevant. The marginal cost of production includes all of the costs that vary with that level of production. For example, if a company needs to build an entirely new factory in order to produce more goods, the cost of building the factory is a marginal cost. A student spends three hours and $20 at the movies the night before an exam.

Relevant cost vs. Irrelevant Cost – Differences

Costs, when classified according to usefulness in decision-making, may be classified into relevant and irrelevant costs. The students need to remember that the relevancy of a cost is seen only in relation to certain activities or decisions. For example, a cost which is relevant in respect of a particular activity or decision may turn out to be irrelevant for another one.