por The relevant costs They are an accounting term that only relates to a specific managerial decision and will change in the future as a result of that decision. They try to determine the objective cost of a business decision.
An objective measure of the cost of a business decision is the extent of cash outflows that will result from its implementation. The relevant cost focuses only on that and ignores other costs that do not affect future cash flows.
This concept is used to remove unnecessary data that could complicate a particular decision-making process. As an example, the relevant cost is used to determine whether a business unit should be sold or maintained.
Also, by removing irrelevant costs from a decision, management is prevented from focusing on information that might otherwise incorrectly affect its decision.
The opposite of relevant costs are sunk costs. These costs are the expenses that have already been made, so they will not change progressively as a result of a management decision.
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Characteristics
Two important characteristics of relevant costs are «future occurrence» and «different for different alternatives.» For a cost element to be relevant, both conditions must be present.
A future cost has to be different for a different alternative to be a relevant cost for decision making. That is, the costs that do not change with an alternative situation are irrelevant costs.
Relevant and irrelevant costs are mutually exclusive. A cost element in a situation cannot be both a relevant and an irrelevant cost at the same time.
The underlying principles of relevant costs are quite simple. They can probably relate to personal experiences involving financial decisions.
For example, suppose we obtained an ABC Pizza discount card for $50, which entitles us to a 10% discount on all future purchases. A pizza is $10 ($9 after discount) at ABC Pizza.
However, we later learned that XYZ Pizza offered a similar pizza for only $8. The next time we order a pizza, we’ll place the order at XYZ Pizza, realizing that the $50 we’ve already spent is irrelevant.
-Types of relevant costs
future cash flows
A cash expense that will be incurred in the future as a result of a decision is a relevant cost.
avoidable costs
These costs are relevant only for a decision that can be avoided if the decision is not implemented.
opportunity costs
The cash inflow that will be forgone as a result of a particular managerial decision is a relevant cost.
incremental cost
When different alternatives are considered, the relevant cost is the incremental or differential cost between the different alternatives being considered.
-Application and limitations
Although the relevant cost is a useful tool for short-term financial decisions, it probably would not be prudent to establish it as the basis for all pricing decisions.
This is because for a company to be sustainable in the long term, it should charge a price that provides a sufficient profit margin, above its full cost and not just the relevant cost. Examples of relevant cost application include:
– Competitive pricing decisions.
– Decision making about what to do or buy.
– Prosecution decisions.
For long-term financial decisions, such as investment, divestment, and closure decisions, relevant costs are not appropriate, because most costs that might appear irrelevant in the short term may be so when considered in the long term.
However, even for long-term financial decisions, such as investment evaluation, the principles underlying the relevant costs can be used to facilitate an objective assessment.
examples
Suppose a passenger rushes to the ticket counter to buy a ticket for a flight that leaves in 25 minutes. The airline must consider the relevant costs to make a decision regarding the price of the ticket.
Almost all of the costs associated with adding the additional passenger have already been incurred, such as the fuel for the plane, the gate fee, and salary and benefits for the entire crew of the plane.
Because these costs have already been incurred, they are not relevant. The only additional cost is the labor to load the passenger’s luggage and any food served, so the airline bases the ticket price decision on a few small costs.
Deciding the future of a business unit
A big decision for a manager is whether to close a business unit or continue to operate that division of the company. The relevant costs are the basis of the decision.
Suppose, for example, that a chain of sporting goods retailers is considering closing a group of stores that serve the outdoor sports market.
Relevant costs are costs that can be eliminated due to closure, as well as revenue lost when stores are closed. If the costs to be eliminated are greater than the revenue to be lost, outdoor stores should be closed.
Deciding between making or buying
The make-versus-buy decision is often a problem for a company that requires component parts to create a finished product.
For example, a furniture manufacturer is considering an outside vendor to assemble and stain wood cabinets, which will then be finished with the addition of wood handles and other details.
The relevant costs are the variable costs incurred by the manufacturer to make the wooden cabinets and the price paid to the external supplier. If the supplier can provide the component at a lower cost, the furniture manufacturer will subcontract the work.
Factor a special order
A special order occurs when a customer places an order near the end of the month and previous sales have already covered the fixed cost of production for the month.
If a customer wants a price quote for a special order, management will only consider the variable costs to produce the goods, specifically the costs of materials and labor.
Fixed costs, such as factory rent or manager salaries, are irrelevant, because the company has already paid for those costs from past sales.
References
Will Kenton (2019). Relevant Cost. Investopedia. Taken from: investopedia.com. Steven Bragg (2018). Relevant cost. Accounting Tools. Taken from: accountingtools.com. Accounting Simplified (2019). Relevant Cost and Decision Making. Taken from: accounting-simplified.com. Sanjay Bulaki Borad (2019). Relevant Costs. Financial Management. Taken from: efinancemanagement.com. Wikipedia, the free encyclopedia (2019). Relevant cost. Taken from: en.wikipedia.org.