Relevant Cost

In financial accounting and decision-making, the concept of “relevant cost” is pivotal. Relevant costs are those costs that should be considered when making decisions. This concept is used primarily in the context of managerial accounting to help managers make more informed financial decisions. The distinguishing feature of relevant costs is their ability to affect future decisions. They are directly tied to specific management actions.

For a cost to be considered relevant, it must meet two criteria:

  1. It must be a future cost.
  2. It must differ between alternatives.

This definition indicates that past costs, also known as sunk costs, should be disregarded as they cannot be affected by present or future decisions. Let’s delve deeper into these aspects and explore the concept of relevant cost in more detail.

Future Costs vs. Sunk Costs

Sunk Costs

Sunk costs are expenses that have already been incurred and cannot be recovered. Traditional accounting methods may capture these costs, but they should not influence managerial decisions since they remain unaffected by the outcome of the decisions.

Future Costs

Future costs refer to those expenditures that will be incurred depending on a particular decision. These costs underscore the importance of focusing only on the data points that can be altered by current managerial choices.

Differential Costs

Differential costs, also known as incremental costs, focus on the difference in total cost between two alternatives. These costs help managers to understand how a decision can influence the financial state of the business.

Example

Consider a company deciding whether to accept a special order for its product. The differential cost would include only the additional costs directly associated with producing and fulfilling the special order, such as extra raw materials, direct labor, and shipping costs.

Types of Relevant Costs

Relevant costs can come in various forms depending on the situation and the specific decisions being made. Common types are:

  1. Avoidable Costs: Costs that can be eliminated if a particular action is taken. For instance, discontinuing a product may help a company avoid costs related to its production and marketing.

  2. Opportunity Costs: The potential revenue lost when one alternative is chosen over another. For example, using a factory space to produce one type of product means you’re forgoing the potential revenue from producing a different product in the same space.

  3. Incremental Costs: Costs that specifically change as a result of a decision. These are additional costs incurred, for example, when increasing production levels.

  4. Marginal Costs: Costs incurred by producing one additional unit of a good or service. Understanding marginal costs assists companies in determining the optimal level of production and pricing.

Applications in Decision Making

The concept of relevant cost is crucial for several types of decision-making scenarios.

1. Make-or-Buy Decisions

Companies often decide between manufacturing a product in-house or purchasing it from an external supplier. Relevant costs in this context would include the costs directly associated with manufacturing the item, such as raw materials, direct labor, and utilities, compared to the purchase price from a supplier.

2. Special Orders

When a company receives a special order, it must determine whether fulfilling the order is beneficial. The relevant costs here would be the unique costs incurred to fulfill that order. Fixed costs that the company will pay regardless should be disregarded in this calculation.

3. Discontinuing a Product Line

When evaluating whether to discontinue a product, companies must consider the costs that will cease if the product is no longer produced. Relevant costs here will include controllable fixed costs and variable costs linked to the product.

4. Equipment Replacement Decisions

When deciding whether to replace old equipment with new, relevant costs include the new equipment’s purchase price, the disposal value of the old equipment, and the operating and maintenance costs associated with both. Sunk costs, like the original purchase price of the old equipment, should be ignored.

Numerical Example

To illustrate, consider a factory contemplating whether to accept a special order that is priced below its normal selling price. If the only additional costs are variable costs (direct materials, direct labor, and variable overhead), then the decision should be based on whether the incremental revenue exceeds the incremental costs:

In this case, accepting the order would result in an incremental benefit of $15,000 ($80,000 - $65,000), making it a relevant decision.

Limitations

While relevant costing is invaluable for decision-making, it does have limitations:

  1. Assumes Rationality: The concept assumes all managers will make rational decisions based on the data. In reality, decisions may be influenced by non-financial factors.

  2. Short-Term Focus: Relevant cost analysis tends to focus on short-term decisions. It doesn’t necessarily consider long-term strategic implications and broader financial conditions.

  3. Quantitative Focus: The model is heavily dependent on easily quantifiable costs and benefits, often neglecting intangible factors such as employee morale, brand reputation, or customer satisfaction.

Conclusion

Understanding relevant costs is essential for effective managerial accounting and decision-making. They streamline the decision process by focusing on pertinent data and excluding irrelevant information, thus optimizing outcomes.

In summary, relevant costs are those future costs and revenues that vary with the decision being considered. They are crucial for short-term, tactical decision-making and are primarily used in scenarios such as make-or-buy decisions, special orders, product discontinuation, and equipment replacement decisions. However, managers must also consider the limitations of relevant costing, particularly its focus on short-term and quantitative factors. This, combined with a comprehensive long-term strategic view, can significantly enhance operational and financial decision-making processes.