As supervisor’s salary is a fixed cost unchanged by the work performed on this order, it is a non-relevant cost. The order requires a special type of rubber.Only 25% rubber is currently available in stock. If the rubber is not used on this order, it will have to scraped at a price of $1,000.Remaining quantity shall have to be procured at the price of $7,000. Rubber Tire Company (RTC) received a request to provide a price quote for an order for the supply of 1000 custom made tires required for industrial vehicles. RTC is facing stiff competition from its business rivals and is therefore hoping to secure the order by quoting the lowest price. Instead of carrying out Operation 1, the company could buy in components, for $15 per unit.

Relevant costs refer to those that will differ between different alternatives. Irrelevant costs are those that will not cause any difference when choosing one alternative over another. These relevant costing decisions occur at the strategic level of management. For example, a construction company working on several projects will decide whether to take any new project before shutting down any of the ongoing ones. Relevant costing aids management in making non-routine decisions by analyzing relevant costs and benefits. Relevant costs are future costs that will differ between two or more alternative actions.

1. A big decision for a manager is whether to close a business unit or continue to operate it, and relevant costs are the basis for the decision.
2. The airline needs to consider the relevant costs to make a decision about the ticket price.
3. In this scenario, there is no opportunity cost to accept the special order since we can produce the order without lowering other production.
4. This effect is known as an opportunity cost, which is the value of a benefit foregone when one course of action is chosen in preference to another.

#2 – Incremental Costs

These often include sunk costs, which are past expenditures that cannot be recovered and should not influence current decisions. Relevant costs are avoidable costs that are incurred only when making specific business decisions. Many of the decisions company management make have a financial impact, such as, for example, choosing whether to shut down an operation or pursue an opportunity. The option taken has financial implications in terms of expenses and revenues and it’s up to management to work out, using all available data, which path is likely to be more profitable. The determination of pricing strategies is another area where relevant costs must be carefully considered. Setting the price for a product or service involves not just covering the costs but also ensuring competitive positioning in the market.

What processing decision should the company make in order to maximise profits?

Component A can be converted into Product A if $6,000 is spent on further processing. A special order decision arises when customers request to buy a special product that’s not part of the normal product line. For example, the famous chocolate candy brand M&M’s offers “party favors” to customers who want personalized M&M candies with their names printed on them. This type of order can be a special order since it’s not part of M&M’s regular product line. Electricity charges are incremental to this order and therefore relevant. Lease rentals are a committed cost which cannot be avoided by withdrawing from this order which is why they should be ignored for the purpose of this analysis.

In any managerial decision involving two or more alternatives, the prime focus of analysis is to find out which alternative is more profitable. The profitability of alternatives is determined by considering the revenues generated by and costs incurred under each alternative. Some costs may stay the same regardless of which alternative is chosen while some costs may vary between the alternatives. The classification between relevant and irrelevant costs is useful in such situations. Irrelevant costs do not have any bearing when choosing over different alternatives. They do not make any difference and make no impact in making decisions.

Accounting for Managers

An outsourcing decision arises when the company considers buying a component from a third-party supplier, even if it can make it internally. Managers are often faced with an outsourcing decision if there are talks about cutting costs. Take note that these decisions are nonroutine decisions, which means that you don’t make these decisions regularly. They arise only because of changes that may occur because of sudden and short-term changes in business operations. For example, a person has to choose between vacationing and spending time with their family.

A manufacturing what is relevant cost facility often faces this situation when receiving a customized order. General and administrative overheads that are not incurred directly as a result of this order should be considered irrelevant. Direct labor is paid idle time equal to 60% of the normal pay in order to retain them.

In general, most variable costs are relevant while most fixed costs are irrelevant. This general rule holds true most of the time since variable costs behave differently across activity levels while fixed costs remain constant nonetheless. However, fixed costs that can be removed under one alternative are relevant. These costs are relevant since these expenses change in the future due to the buying decision.