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- 5 Marks
Question
Costs may be classified as fixed or variable. This classification method is useful for decision-making because variable costs are relevant costs whereas fixed costs are irrelevant.
Required:
Explain this statement.
Answer
- Generally, the classification of costs as fixed or variable identifies those costs which change in total when activity changes (variable costs) and those whose total remains constant (fixed costs).
- Relevant costs are those which are affected by a decision, and since most decisions affect activity levels, variable costs (which change when activity changes) can be seen as relevant costs.
- However, it does not automatically follow that fixed costs are not relevant. Some fixed costs may be specific to a product or department and therefore may be avoidable. For example, a decision to discontinue a product will cause the product-specific cost to be saved.
- The general notion that fixed costs are not relevant is therefore incorrect. Each decision must be considered individually, as there will be circumstances when fixed costs must be considered relevant due to their avoidability.
- Topic: Relevant Cost and Revenue
- Series: NOV 2018
- Uploader: Joseph