RELEVANT COSTS

I. Decisions and Relevant Costs

A. Consider the final stages of the decision process. The decision is made on the basis of the difference in the effect of the various options on future performance. In other words, we ask what difference does it make?

The relevant information to the decision is the expected future data that is expected to differ between the alternatives or the expected future data that will be avoided if the alternative option is chosen.

Managerial accounting has an important role in the decision process as a means of collecting and reporting relevant data; information that will lead the decision maker to the best decision.

It is important to recognize that past or historical data have not direct bearing on the decision. Past data, in themselves, are not relevant because they are not expected future data. Decisions affect the future; nothing can alter what has already happened.

B. Examples:

1. What type of costs are always relevant in decision‑making?

Answer: Those costs that are expected to be different in the future or those costs that can be avoided.

2. What type of costs are always irrelevant in decision‑making?

Answer: Past or sunk costs

3. Want to drop Product A.

Annual sales, $200,000

Variable expenses, $140,000

Fixed expenses chargeable to the product, $90,000, of which $40,000 will continue even if Product A is dropped.

If Product A is dropped, what will be the effect on net income?

Answer: Net income will decrease by $10,000

4. In considering a special order situation that will enable a firm to make use of presently idle capacity, what type of costs would be irrelevant? Name one.

Answer: Any fixed capacity cost such as depreciation of equipment.

5. Want to sell in a special market.

Capacity, 8,000 units per month

Current sales, 7,000 units per month

Order to sell 1,000 units at $20 per unit in special market

Costs and expenses:

Production:

Direct materials $4

Direct labor $5

Variable overhead $2

Fixed overhead $8

Selling/other:

Variable $1

Fixed $6

If order is accepted, profits will increased or decrease and by how much?

Answer: Profits will increase by $8,000

6. Offer to buy parts outside.

Current production cost:

Direct materials $12

Direct labor $8

Variable overhead $3

Fixed overhead ($100,000) $10

Outside supplier offered to provide parts for $27 per unit on a long‑term contract. If offer is accepted, 30% of fixed overhead will continue. If offer accepted, the dollar advantage or disadvantage will be?

Answer: $3 advantage

7. Scrap or remachine.

1,000 obsolete units of product in inventory, cost $50,000.

Cost to remachine, $12,500

Selling price if remachined, $22,500

Selling price if scrapped, $1,000

Should the units be remachined or scrapped and what is the total relevant cost for the alternative chosen?

Answer: Remachine and $12,500