Relevant Costs – Meaning and Pitfalls

Relevant costs are those expected future costs that vary under various alternatives. These are the costs that are affected due to decision-making.

Non-recognition of relevant costs can also lead to wrong decisions. For example, in whether to retain or replace an old machine, the realisable value and dismantling cost of the old machine are relevant costs, but the present written-down value (WDV) of the old machine will be irrelevant.

Characteristics of Relevant Costs

Relevant expenses have two primary characteristics: they are either future potential costs to be incurred or they are incremental or avoidable expenditures. What do these features entail in practice?

It simply indicates that a cost that has already been incurred (has become a past expense) no longer qualifies as a relevant cost.

Similarly, if the expense is inescapable in nature and must be incurred regardless of whether the investment generates profit or loss, it does not qualify as a significant cost.

Importance of Relevant Costs

Relevant costs play a crucial role in cost accounting as they provide valuable information for decision-making. These costs are important because they directly impact future or upcoming choices and have the potential to influence the outcome of those decisions. Here are some key reasons why relevant costs are significant in cost accounting:
1. Decision Making: Relevant costs help managers make informed decisions regarding product pricing, outsourcing, product mix selection, make or buy decisions, discontinuation of products or segments, and more. By considering only the relevant costs that will change as a result of a particular decision, managers can avoid unnecessary expenses and make economically sound choices.

2. Cost Control: Identifying and analyzing relevant costs allows businesses to focus their attention on areas where adjustments can be made to reduce costs without compromising quality or profitability. This enables better cost control measures and helps streamline operations, maximize efficiency, and improve overall financial performance.

3. Budgeting and Planning: Relevant costs aid in accurate budgeting and planning processes by providing realistic estimates based on current market conditions. By taking into account only the significant cost factors associated with a specific task or project, organizations can develop more effective budgets that reflect expected outcomes more accurately.

4. Pricing Strategies: Relevant costs are instrumental in determining optimal pricing strategies for products or services. By identifying variable costs directly related to production quantities or units sold, companies can calculate appropriate prices that cover these expenses while ensuring profitability.

5. Performance Evaluation: Assessing relevant costs enables businesses to compare actual performance against budgeted expectations or previous periods’ results accurately. This facilitates meaningful performance evaluation and aids in identifying areas of improvement or potential cost-saving opportunities.

Two Common Pitfalls in Relevant Cost Analysis

1. The first pitfall is to assume that all variable costs are relevant. All variable costs are not relevant. Variable costs that remain unchanged under various alternatives are not relevant but the variable costs that differ under different alternatives are relevant.
2. The second pitfall is to assume that all fixed costs are irrelevant. All fixed costs are not relevant. Fixed costs that remain unchanged under different alternatives are irrelevant but fixed costs which differ under various alternatives are relevant.