Definition
Relevant Cost refers to the future costs that will be affected by a managerial decision. These costs vary depending on the alternatives considered, making them essential for the decision-making process. Costs that have already been incurred, known as sunk costs, are not relevant for current decision-making. Similarly, future costs that remain unchanged regardless of the decision are considered non-relevant.
Examples
Example 1: Special Selling-Price Decision
A company has been struggling to sell 10 doors due to their unpopular design. The costs incurred last year for each door were:
- Materials: £100
- Labour: £200
- Overheads: £200
A customer offers to buy these doors for £400, provided specific locks are fitted. The modification involves:
- Locks: £100
- Labour: £60
- Delivery: £50
Irrelevant Costs
The material, labour, and overhead costs from the previous year are sunk costs and thus irrelevant.
Relevant Costs
The relevant costs include:
- Cost of locks: £100
- Labour cost for fitting: £60
- Delivery cost: £50
The total relevant cost is £210, making the customer’s offer of £400 favorable.
Example 2: Make or Buy Decision
A company needs a component for their product. If they make it in-house, the relevant costs include materials, labour, and machinery upkeep. If they buy it from an external supplier, the cost is the purchase price and any delivery or import fees.
Frequently Asked Questions (FAQ)
What are relevant costs?
Relevant costs are future costs that will differ among alternatives in a decision-making process.
What are sunk costs?
Sunk costs are past costs that have already been incurred and cannot be recovered. They are irrelevant for future decision-making.
Why are only future costs considered relevant?
Only future costs can be influenced by decisions made now, unlike past or sunk costs which have already been incurred.
What decisions require an understanding of relevant costs?
Decisions such as special selling prices, product mix under capacity constraints, equipment replacement, outsourcing, and discontinuing a product or department.
Are fixed costs ever relevant?
Fixed costs can be relevant if they change as a result of the decision being considered.
Related Terms
Sunk Costs
Costs that have already been incurred and cannot be recovered.
Differential Analysis
A technique used to compare the differences in the costs and benefits of different alternatives.
Opportunity Cost
The cost of forgoing the next best alternative when making a decision.
Online References
- Investopedia - Relevant Costs
- AccountingCoach - Relevant Costs for Decision Making
- Corporate Finance Institute - Relevant Cost
Suggested Books for Further Studies
- “Managerial Accounting: Tools for Business Decision Making” by Weygandt, Kimmel, and Kieso
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan
- “Managerial Accounting for Managers” by Eric Noreen, Peter Brewer, and Ray Garrison