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Relevant Costs Defined

Relevant Costs Defined

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"Profitability ratios measure two aspects of a corporation’s profits:
(1) those elements of operations that contribute to profit and ;
(2) the relationship of profit to total investment and investment by stockholders. "
"Profitability ratios measure two aspects of a corporation’s profits:
(1) those elements of operations that contribute to profit and ;
(2) the relationship of profit to total investment and investment by stockholders. "

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Published by: ClassOf1.com on Nov 15, 2013
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06/24/2014

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Subject: Finance
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The Homework solutions from Classof1 are intended to help students understand the approach to solving the problem and not for submitting the same in lieu of their academic submissions for grades.
Relevant Costs Defined
Relevant costs possess two characteristics: (1) They are future costs and (2) They differ across alternatives.  All pending decisions relate to the future; accordingly, only future costs can be relevant to decisions. However, to be relevant, a cost must not only be a future cost but must also differ from one alternative to another. If a future cost is the same for more than one alternative, then it has no effect on the decision. Such a cost is irrelevant. The same relevance characteristics also apply to benefits. One alternative may produce an amount of future benefits different from another alternative (e.g., differences in future revenues). If future benefits differ across alternatives, then they are relevant and should be included in the analysis. The ability to identify relevant and irrelevant costs (and revenues) is a very important decision-making skill. Another type of relevant cost is opportunity cost. Opportunity cost is the benefit sacrificed or foregone when one alternative is chosen over another. Therefore, an opportunity cost is relevant because it is both a future cost and one that differs across alternatives. While an opportunity cost is never an accounting cost, because accountants do not record the cost of what might happen in the future (i.e., they do not appear in financial statements), it is an important consideration in decision making. For example, if you are deciding whether to  work full time or to go to school full time, the opportunity cost of going to school would be the  wages you give up by not working. Companies also include opportunity costs in many of their decision analyses.
 
Subject: Finance
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The Homework solutions from Classof1 are intended to help students understand the approach to solving the problem and not for submitting the same in lieu of their academic submissions for grades.
Depreciation represents an allocation of a cost already incurred. It is a sunk cost, a cost that cannot  be affected by any future action. Although we allocate this sunk cost to future periods and call that allocation depreciation, none of the original cost is avoidable. Sunk costs are always the same across alternatives and, therefore, always irrelevant. Thus, depreciation costs, like all sunk costs, fail to possess the two characteristics required of relevant costs and, therefore, always are irrelevant. In choosing between the two alternatives, the original cost of the power saws and their associated depreciation are not relevant factors. However, it should be noted that salvage value of the machinery is a relevant cost for certain decisions. For example, if Audio-Blast decides to transform itself into a distributor, not a producer, of speakers, the amount that can be realized from the sale of the power equipment will be relevant and will be included as a benefit of the switch to distributor status. Finally, it is i
mportant to note the psychology behind managers’ treatment of sunk
costs. Although managers should ignore sunk costs for relevant decisions, such as whether or not to continue funding a particular product in the future, it unfortunately is human nature to allow sunk costs to affect these decisions. For example, Toshiba and its HD DVD product team engaged in a fierce, multi-year battle with Sony and its Blu-ray product team for recognition as the universally accepted format in the growing next-generation high-definition DVD market.

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