How do we determine what costs are relevant vs. irrelevant in making decisions about such things as accepting a special low-price order, buying or producing a component, or selling vs. further refining a by-product? How about in deciding whether to buy a new machine to replace one we purchased two years ago and has an expected five year life? What are some common attributes? Discuss broadly. This topic is extremely important!
(Answered): How do we determine what costs are relevant vs. irrelevant in making decisions about such things as accepting a special low-price order, bu…
Expert Answer
Relevant Cost may be understood as expected future costs which are different in each alternative course of action being planned.
Relevant Cost are those which will be affected by the decision being taken. For ex. Variable Cost , Avoidable Fixed Overhead.
Non-relevant costs will remain unaltered regardless of the decision being taken. For ex. Fixed overhead that will continue to occur , committed coat I.e. expense that will be incurred in future due to present obligation.
In accepting a low price order , suppose the order is for production of cars and right now company is producing 5000 cars in a year working at 100% capacity and received an order of 1000 cars.
Now relevant cost will be Material Cost, labour cost, all cost which is being exclusively incurred for production of 1000 cars plus for making this 1000 cars co will add contribution to be lost on 1000 cars (as co. Is working at100% capacity and to complete order co. Will stop production of 1000 cars from his regular demand) . therefore these all are relevant Cost while fixed cost such as rent , manager salary will be irrelevant cost as it will continue to occur.
In buying or producing a component, a statement of comparative cost Will be prepared in which cost under both the option will be dealt with and option with least cost will be selected such as purchase cost, ordering cost, inspection cost, transportation cost, manufacturing cost these all cost will be relevant for this purpose but cost which will continue to occur whether co. Buy or produce is considered to be irrelevant cost.
Selling vs further refining a by product. In further refining a by product extra cost has to be incurred by the co. And therefore co will get additional contribution thus here co is to decide whether to sale the product as it is or to sell it after refining thus relevant Cost will be the cost incurred in refining the by product.
While considering a proposal for machine replacement by the existing machine , the original Cost and the present depreciated book value of the old machinery are irrelevant as the have no impact on the decision for replacement just going to be taken place. However the expected sales value of the existing machine is relevant as it just goes to reduce the amount of Investment to be made in new machinery and so it has an influence on decision making.
Relevant Cost helps in decision making while irrelevant cost has no role in decision making.
