Relevant cost is a term used in management accounting to refer to those costs that are accompanied by the management’s decision. They aid the management in making decisions (Colin, 2009). These costs are used to eliminate the complications that may come with the decision making process.
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A cost will be referred to as a relevant cost if it affects a decision. In order for a cost to affect a decision, it must have a future incremental effect or otherwise especially on the cash flows (Jae & Joel, 2008). The incremental effect due to the decision that was made means that expenditure will be incurred by the organization or it can be avoided.
However, it should be noted that any cost that will be incurred or avoided without the decision being made is not a relevant cost. An example of irrelevant costs is the sunk costs (Jay, 2004). Costs are considered to be sunk if they are already incurred and no future decision can be affected by them. Examples of sunk cost includes; depreciation, research cost and development expenditures (Agriculture and Consumer Protection, ND).
The management requires relevant costing making decision as to whether they should keep a certain business unit or they should sell it, the management has to make a decision to buy or sell a certain item or product and as to accept a certain special order from a supplier or not to accept (Siegel & Shim, 2006).
In order to understand the topic of relevant cost versus irrelevant costs, California Pizza Kitchen will be used as the case study. The California pizza kitchen was established in the year 1985 by Rick Rosenfield and Larry Flax. They wanted to start a restaurant that would serve hearth baked pizzas with global flavors and tastes.
This organization has witnessed its growth into a recognized leader in the production of authentic California-style cuisine. It also has a well-recognized brand name and has large following from loyal customers. California pizza kitchen now has 265 outlets spread in 25 states of the US and 10 outlets in the foreign countries.
The California pizza kitchen runs a restaurant at Albuquerque, New Mexico. The restaurant serves Hawaiian Recipe Frozen Personal Pizza and it has witnessed this pizza turnover decline due to its unpopularity and therefore the management has to decide whether to keep or eliminate it. In order that the management makes the right decision it has to compute the contribution margin of this pizza using all relevant costs that have an effect on the decision that will be made. The calculations are as follows:
Segment of the income statement – Hawaiian Recipe Frozen Personal Pizza
A question then arises, should the management of this restaurant stop the production of this pizza? To come up with the relevant answers concerning this dilemma, the management should evaluate whether if they drop this particular pizza the restaurant will be able to avoid more in the fixed costs than it will lose in the contribution margin.
If the management is able to ascertain that it will reduce this fixed cost by dropping this product then it should go ahead and eliminate it, but if it does not, then they should continue with its production, despite the net losses being made from this particular product. This would lead to a statement that looks as follows.
This means that the restaurant will lose $40,000 if they drop this pizza every year. This therefore means to the management of this restaurant should not drop this pizza.
Agriculture and Consumer Protection. (ND). Relevant Costs for Decision Making, Retrieved from: http://www.fao.org/3/W4343E/w4343e06.htm
Colin, D. (2009). Management and cost accounting. Upper Saddle River: Cengage.
Jae, K. S., & Joel, G. S. (2008).Schaum’s Outline of Theory and Problems of Managerial Accounting. New York: McGraw-Hill.
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Jay, B. (2004). Relevant costs for decision-making, Retrieved from: https://www.accountancy.com.pk/opinion/2982/relevant-costs-for-decision-making/
Siegel, J. G. & Shim, J. K. (2006). Accounting handbook. 4th Edition. New York: Barron’s.