Relevant Costs

Definition

Relevant costs are the future costs that are expected to change based on a decision being considered. These costs are important in evaluating alternative courses of action and making informed business decisions.

5 Must Know Facts For Your Next Test

1. Relevant costs are crucial in evaluating whether to accept or reject a special order, as they help determine the profitability of the order.
2. When deciding whether to make or buy a component, relevant costs are used to compare the costs of in-house production versus outsourcing.
3. Relevant costs are essential in determining whether to keep or discontinue a segment or product, as they help identify the financial impact of the decision.
4. In the decision to sell or process a product further, relevant costs are used to analyze the incremental revenue and costs associated with each option.
5. Relevant costs exclude sunk costs, as they are past expenditures that cannot be recovered and should not influence future decisions.

Review Questions

• Explain how relevant costs are used in the decision to accept or reject a special order.
  • When evaluating whether to accept or reject a special order, relevant costs are the key consideration. The relevant costs include the incremental costs (such as direct materials, direct labor, and variable overhead) that would be incurred to fulfill the special order. By comparing the relevant costs to the revenue from the special order, the company can determine if the order would be profitable and worth accepting. Relevant costs exclude sunk costs, which are past expenditures that cannot be recovered, as they should not influence the decision.
• Describe how relevant costs are used in the decision to make or buy a component.
  • The decision to make or buy a component involves comparing the relevant costs of in-house production versus outsourcing. Relevant costs in this case would include the variable costs of manufacturing the component, such as direct materials, direct labor, and variable overhead. It may also include any fixed costs that would change based on the decision, such as the need for additional equipment or facilities. By comparing the relevant costs of making the component internally versus buying it from a supplier, the company can determine the more cost-effective option.
• Evaluate how relevant costs are used in the decision to keep or discontinue a segment or product.
  • When deciding whether to keep or discontinue a segment or product, relevant costs are essential in determining the financial impact of the decision. Relevant costs would include the variable costs directly associated with the segment or product, such as direct materials, direct labor, and variable overhead. It may also include any fixed costs that would be eliminated if the segment or product were discontinued. By comparing the relevant costs to the revenue generated by the segment or product, the company can assess the profitability and determine if it is best to keep or discontinue the offering. Relevant costs, rather than sunk costs, are the key consideration in this decision-making process.

Related terms

Sunk Costs: Sunk costs are past expenditures that cannot be recovered and should not be considered when making future decisions.

Opportunity Costs: Opportunity costs represent the benefits that are given up by choosing one alternative over another.

Differential Costs: Differential costs are the changes in total costs that result from a decision, such as the difference in costs between two alternatives.