4: How Are Relevant Revenues and Costs Used to Make Decisions? Business LibreTexts

Almost all of the costs related to adding the extra passenger have already been incurred, including the plane fuel, airport gate fee, and the salary and benefits for the entire plane’s crew. Because these costs have already been incurred, they are “sunk costs” or irrelevant costs. The reason relevant costs are so important is that they are the only costs that can truly influence a decision. All other costs are sunk costs, meaning they have already been incurred and cannot be changed by the decision.

• These amendments are accounting adjustments, and therefore do not have any impact on a business’ cash flow.
• The term opportunity cost does not have a single, precise definition in all of its uses.
• Variable costs per copy will remain at 5 cents, but production of the restaurant flyers will require a special copy machine part that costs $250.
• If the variable cost is a fixed charge per unit and fixed costs remain the same, it is possible to determine the fixed and variable costs by solving the system of equations.
• Negative amounts appearing in the Differential Amount column indicate Alternative 1 is lower than Alternative 2.

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.

Determining Differential Product Costs

In fact, Bob offered to pay Jim a bonus equal to 25 percent of any production cost savings the company achieves during the coming year. For example, reapportioning existing fixed costs and salary of existing staff. Management would review the cost of continuing to produce the circuit boards themselves compared to outsourcing the materials and labour to another business. These salary costs are relevant since these expenses change in the future due to the buying decision. Relevant costs are items of expenditure that will change as a result of making a particular business decision. As these materials are not available in stock, these will have to be purchased at the market price which is their relevant cost.

• For example, assume you had been talked into buying a discount card of ABC Pizza for $50 which entitles you to a 10% discount on all future purchases.
• Students can avail of the P1 course as part of our All Access membership.
• As discussed earlier in the chapter, this presentation summarizes the differential revenues and costs.
• The costs and benefits of different activities must be compared and contrasted before making the right business decision.

Avoidable costs can be eliminated if a particular course of action is not taken or if any department is closed. For example, suppose an organisation chooses to complete a production line. In that case, the cost of the warehouse which stores the production unit is avoidable because you can sell the warehouse. Keyboard, Inc., a manufacturer of pianos, typically sells each of its pianos for $1,480. The cost of manufacturing and marketing one piano at the company’s usual monthly volume of 6,000 units is shown. Target pricing is used for products with lots of competition and easily determined price that customers will pay.

Relevant costs

However, the “cost per unit” of a fixed cost will increase (or decrease) depending on the level of activity of the airplane. It considers the total dollars of the mixed costs at the highest volume of activity and the total dollars of the mixed costs at the lowest volume of activity. The total amount of fixed costs is assumed to be the same at both points of activity. The change in the total costs is thus the variable cost rate times the change in the number of units of activity. The profit margin is the difference between the price charged to the customer and the cost to manufacture a good. Over the long-run, increasing the price charged for each bicycle may lead consumers to Mr. Spoke’s competition if the price of their bicycles is lower than that of Rider Bicycle.

Relevant Cost: Definition, Types and Examples

Fixed costs, as opposed to variable costs, are defined as costs that remain the same over a period of time. Conversely, variable costs are subject to change and include things like fuel, oil, maintenance, landing fees, etc. An aircraft’s fixed costs remain the same no matter how many hours you fly your plane.

Types of relevant cost

The factor of costs incurred by hiring an outside vendor to complete the work represents the decision’s actual relevant cost. The most cost-effective course of action is to outsource the product’s manufacturing and collector greene county production if an external vendor can do so for less money than it would cost to do so internally. For example, a company’s total cost increases from $2,20,000 to $2,40,000 due to increasing the production unit.

The charcoal barbecues’ allocation for rent would simply be reallocated to the other two products. Thus rent for the retail store is an example of an allocated fixed cost that is not a differential cost for the two alternatives facing Barbeque Company. The high-low method involves taking the highest level of activity and the lowest level of activity and comparing the total costs at each level.

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. 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. Depreciation is not a cash flow and is dependent on past purchases and somewhat arbitrary depreciation rates.

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