The Concept of Relevance

Learning Objective 2 Distinguish relevant from irrelevant information in decision situations

Much of this chapter focuses on Step 4 in Exhibit 12-1 and on the concepts of relevant costs and relevant revenues when choosing among alternatives.

Relevant Costs and Relevant Revenues

Relevant costs are expected future costs, and relevant revenues are expected future revenues that differ among the alternative courses of action being considered. Costs and revenues that are not relevant are called irrelevant. Relevant costs and relevant revenues must

The question is always “What difference will a particular action make?”

Exhibit 12-2 presents the financial data underlying the choice between the do-not-reorganize and reorganize alternatives for Precision Sporting Goods. Managers can analyze the data in two ways: by considering “all costs and revenues” or considering only “relevant costs and revenues.”

Exhibit 12-2

Determining Relevant Revenues and Relevant Costs for Precision Sporting Goods

Table shows the relevant revenues and costs for precision sporting goods under various categories.

The two main divisions listed in the table include all revenues and costs and relevant revenues and costs.

The details of alternatives 1 and 2 of each division under various categories are as follows. The unavailable data have been marked as nil.

A. All Revenues and Costs

a. Alternative 1: Do Not Reorganize

1. Revenues: $6,250,000

• It implies 25,000 units multiplied by $250 per unit equal to $6,250,000

2. Direct materials cost: $1,250,000

• It implies 25,000 units multiplied by $50 per unit equal to $1,250,000

3. Manufacturing labor cost: $640,000

• It implies 20 workers multiplied by 2,000 hours per worker multiplied by $16 per hour equal to $640,000

4. Manufacturing overhead cost: $750,000

5. Marketing cost: $2,000,000

6. Reorganization costs: Nil

7. Total costs: $4,640,000

8. Operating income: $1,610,000

b. Alternative 2: Reorganize

1. Revenues: $6,250,000

• It implies 25,000 units multiplied by $250 per unit equal to $6,250,000

2. Direct materials cost: $1,250,000

• It implies 25,000 units multiplied by $50 per unit equal to $1,250,000

3. Manufacturing labor cost: $480,000

• It implies 15 workers multiplied by 2,000 hours per worker multiplied by $16 per hour equal to $480,000

4. Manufacturing overhead cost: $750,000

5. Marketing cost: $2,000,000

6. Reorganization costs: $90,000

7. Total costs: $4,570,000

8. Operating income: $1,680,000

B. Relevant Revenues and Costs

a. Alternative 1: Do Not Reorganize

1. Revenues: Nil

2. Direct materials cost: Nil

3. Manufacturing labor cost: $640,000

• It implies 20 workers multiplied by 2,000 hours per worker multiplied by $16 per hour equal to $640,000

4. Manufacturing overhead cost: Nil

5. Marketing cost: Nil

6. Reorganization costs: Nil

7. Total costs: $640,000

8. Operating income: $640,000 within parentheses.

b. Alternative 2: Reorganize

1. Revenues: Nil

2. Direct materials cost: Nil

3. Manufacturing labor cost: $480,000

• It implies 15 workers multiplied by 2,000 hours per worker multiplied by $16 per hour equal to $480,000

4. Manufacturing overhead cost: Nil

5. Marketing cost: Nil

6. Reorganization costs: $90,000

7. Total costs: $570,000

8. Operating income: $570,000 within parentheses.

The difference between the operating income of alternatives 1 and 2 of both the divisions all revenues and costs and relevant revenues and costs is $70,000 each.

The first two columns describe the first way and present all data. The last two columns describe the second way and present only relevant costs: the $640,000 and $480,000 expected future manufacturing labor costs and the $90,000 expected future reorganization costs that differ between the two alternatives. Managers can ignore the revenues, direct materials, manufacturing overhead, and marketing items because these costs will remain the same whether or not Precision Sporting Goods reorganizes. These costs do not differ between the alternatives and, therefore, are irrelevant.

Notice that the past (historical) manufacturing hourly wage rate of $14 and total past (historical) manufacturing labor costs of $560,000 (20 workers×2,000 hours per worker per year×$14 per hour) do not appear in Exhibit 12-2. Although they may be a useful basis for making informed predictions of the expected future manufacturing labor costs of $640,000 and $480,000, historical costs themselves are past costs that, therefore, are irrelevant to decision making. Past costs are also called sunk costs because they are unavoidable and cannot be changed no matter what action is taken.

The analysis in Exhibit 12-2 indicates that reorganizing the manufacturing operations will increase predicted operating income by $70,000 each year. Note that the managers at Precision Sporting Goods reach the same conclusion whether they use all data or include only relevant data in the analysis. By confining the analysis to only relevant data, managers can clear away the clutter of potentially confusing irrelevant data. Focusing on relevant data is especially helpful when all the information needed to prepare a detailed income statement is unavailable. Understanding which costs are relevant and which are irrelevant helps the decision maker concentrate on obtaining only the pertinent data.