Relevant Costing

Relevant costing is a management accounting toolkit that helps managers reach decisions when they are posed with the following questions:

  1. Whether to buy a component from an external vendor or manufacture it in house?
  2. Whether to accept a special order?
  3. What price to charge on a special order?
  4. Whether to discontinue a product line?
  5. How to utilize the scarce resource optimally?, etc.

Relevant costing is an incremental analysis which means that it considers only relevant costs i.e. costs that differ between alternatives and ignores sunk costs i.e. costs which have been incurred, which cannot be changed and hence are irrelevant to the scenario.

Example

Company A manufactures bicycles. It can produce 1,000 units in a month for a fixed cost of $300,000 and variable cost of $500 per unit. Its current demand is 600 units which it sells at $1,000 per unit. It is approached by Company B for an order of 200 units at $700 per unit. Should the company accept the order?

Solution

A layman would reject the order because he would think that the order is leading to loss of $100 per unit assuming that the total cost per unit is $800 (fixed cost of $300,000/1,000 and variable cost of $500 as compared to revenue of $700).

On the other hand, a management accountant will go ahead with the order because in his opinion the special order will yield $200 per unit. He knows that the fixed cost of $300,000 is irrelevant because it is going to be incurred regardless of whether the order is accepted or not. Effectively, the additional cost which Company A would have to incur is the variable cost of $500 per unit. Hence, the order will yield $200 per unit ($700 minus $500 of variable cost).

Written by Obaidullah Jan