Relevant costs are those costs that will be incurred as a result of a decision and thus should be considered when making that decision.
In cost accounting, relevant costs are costs that will contribute to achieving the organisation’s revenue-generating objectives. For an organisation to achieve its profit objectives, the revenues must exceed the relevant costs. Relevant costs should be considered if the organisation’s purposes change.
The reason relevant costs are so important is that they are the only costs that can truly influence a decision. All other costs are sunk costs, meaning they have already been incurred and cannot be changed by the decision. As such, they should not be considered when making a decision.
The relevant cost concept helps the management make the right decision by eliminating extraneous information from a particular decision-making process. In order to make good decisions, managers must be able to identify relevant costs and understand how they will be affected by a different courses of action. Only then can they make informed decisions that will lead to the best results for the company.
Types of relevant cost
The relevant costs are as follows:-
- Future Cash Flows
- Avoidable Cost
- Opportunity Cost
- Increments Cost
Future Cash Flow
Any relevant cash flow that should arise in future. A manager must determine the relevant cash flows to evaluate the investment opportunities, such as total cash outflows or inflows. Any costs that occurred in the past are called suck costs. It should be excluded from the relevant cash flow.
Avoidable costs can be eliminated if a particular course of action is not taken or if any department is closed. For example, suppose an organisation chooses to complete a production line. In that case, the cost of the warehouse which stores the production unit is avoidable because you can sell the warehouse.
In general, we can say that variable cost is avoidable; on the other hand, a fixed cost is not avoidable.
Relevant costs are also opportunity costs. An opportunity cost is the value of sacrifices made or the benefit of opportunity gone to accept an alternative course of action. Opportunity cost plays a vital role in decision-making.
The term opportunity cost does not have a single, precise definition in all of its uses. However, it is often used to indicate the costs of a choice that we can make but can’t. Suppose we make a choice that requires us to forgo something (e.g., choosing between $y and $z, we are making a choice that gives up something, so we are forced to pay a cost. This cost is the price we have to pay not to get $x$. When we look at our choices and see the opportunity costs, we can see where we choose to spend our resources. So, in that sense, the opportunity cost compares to how the resources we choose to invest can be spent.
Opportunity cost is the cost of the one option that is not chosen. It measures how much something could have made you money or benefited you in some other way if it were selected. The total opportunity cost equals the benefit accrued from selecting an alternative, plus the cost of that alternative. Opportunity costs can be either positive or negative, but typically they are negative because there are usually significant unquantifiable costs associated with making a decision.
The incremental cost is a relevant cost for decision making, and the incremental cost is the increase in total costs resulting from increased production and other activities. The incremental cost is referred to as differential costing. For example, a company’s total cost increases from $2,20,000 to $2,40,000 due to increasing the production unit. The incremental cost is $40000.
Relevant cost for decision-making
Success managers’ essential task is making the right decision for the business. A manager has to choose between at least two alternatives to take the right decision. The decision process may be complicated due to irrelevant data, incomplete information, data volume, etc.
Decision-making is a process of identifying the best course of action. This can be difficult because many variables, factors, and possible outcomes exist. For instance, when considering whether to purchase a new computer system for your company, you must consider how much it will cost for yearly maintenance and the cost of replacement parts. These costs are not easy to calculate, but they must be relevant to your decision-making process.
The costs and benefits of different activities must be compared and contrasted before making the right business decision. The right decision should be based only on relevant information. The relevant information includes the predicted future cost or incremental cost and revenue that differ among the alternatives.
Any cost or revenue that does not differ between alternatives is called irrelevant cost and should be ignored in decision-making.
Sunk cost is irrelevant because it will be the same for any alternative. Future cash flow, opportunity costs, or incremental costs are relevant costs. All these costs help make managerial decisions.
The managers have to identify which costs are relevant in a particular situation and follow the three steps-
- First of all, eliminate the sunk costs.
- Eliminate all these costs and benefits that do not differ between alternatives.
- To make the proper right decision, a manager should compare the remaining costs and benefits that do not differ between alternatives.
There are different types of decisions, such as;-
Make or buy decision: – Make or buy decisions involve whether an organisation has to make a product internal or buy it from outsiders. A manager should compare the production cost with the buying cost to take the right decision.
Adding or dropping product line or other segments: – A manager has to decide whether a new product line should be added or delete any other product line or segments which create a loss.
Special orders: – Special orders are one-time orders that do not affect the company’s regular sales, and profits that arise from these special orders are equal to the incremental revenue less incremental cost. Special orders should be accepted when the total revenue exceeds the incremental costs.
Sell or process further decision:- A decision has to make about selling a joint product as is or processing it further if it is profitable to continue further processing a joint product when incremental revenue from such processing exceeds the incremental processing cost.