Question

WEEK 5: RELEVANT COSTS

Do you think that variable costs are always relevant? What do you think about fixed costs? Please explain with some examples.

Answer 1

Relevant costs refer to those costs that differ between alternatives in making of decisions. These costs are not categorised as variable costs or fixed costs; instead are costs that would or would not change under specific alternative. Variable costs will be termed relevant costs only when it differ in total among various alternatives under consideration. There are several situations when few or all variable costs would be the same for the alternatives under consideration and thus it will not be relevant always. Fixed cost remain constant relatively regardless of the level of production in a company thus are often considered sunk for the relevant cost. The fixed costs that cannot be utilized or eliminated for other purposes in production are not relevant for the decision.

Example: Equipment Y is being considered for replacement with Equipment X. The purchase of Equipment Y would enhance the capacity of production and sales by 50%. If sales and current production equals 1,000 units (full capacity) and the selling price is fixed at $100, it will increase the production and sales to 1,500 units. The cost of goods sold equals $ 80 per unit currently. On these assumptions, we can make below given analysis:

	Equipment X (Volume: 1000)	Equipment Y (Volume:500)	Differenec (500)
Sales Cost of goods sold Profit	10,000 8,000 2,000)	15,000 12,000 3,000)	5,000 4,000 1,000

In the above scenario both sales and cost of goods sold are relevant. But had volume not been higher with the Equipment Y, then cost of goods sold as well as sales would have been the same and, thus will not be relevant