In accounting, what is meant by relevant costs?

Relevant costing attempts 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 shall result from its implementation. Relevant costing focuses on just that and ignores other costs which do not affect the future cash flows. Relevant costing aids management in making non-routine decisions by analyzing relevant costs and benefits.

• Relevant costs have three features, and then there are also two other types of relevant costs that we need to be aware of.
• After evaluating the alternatives, the next step is to select the best option that aligns with the desired outcomes.
• This concept is useful in eliminating unnecessary information that might complicate the management’s decision-making process.

Relevant Cost of Decisions

Relevant costs refer to those that will differ between different alternatives. Irrelevant costs are those that will not cause any difference. This effect is known as an opportunity cost, which is the value of a benefit foregone when one course of action is chosen in preference to another. In this case, the company has given up its opportunity to have a cash inflow from the asset sale.

• Types of decisionWe will now look at some typical examples where you have to decide which costs are relevant to decision-making.
• The analysis goes beyond a mere quantitative comparison, delving into the qualitative aspects of the decision.
• Only then can they make informed decisions that will lead to the best results for the company.
• It requires an additional $0.5 million to complete construction.
• A construction firm is in the middle of constructing an office building, having spent $1 million on it so far.

For example, extra labor costs to meet increased production demand. 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 we can make but can’t. 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 above is just a short extract from our CIMA P1 Management Accounting course. Taught by former CIMA prizewinner, Hugh Martin, VIVA’s P1 course has over 15 hours of video lectures covering the entire syllabus, 800+ exam style questions and an online version of BPP’s 2019 textbook. Students can avail of the P1 course as part of our All Access membership. Electricity charges are incremental to this order and therefore relevant. General OverheadsGeneral and administrative overheads which are not affected by the decisions under consideration should be ignored. According to the above illustration, it will cost XYZ $250,000 to buy from a supplier.

What types of relevant costs are there?

Types of decisionWe will now look at some typical examples where you have to decide which costs are relevant to decision-making. We suggest that you try each example yourself before you look at each solution. A major dilemma regarding any business at some point is whether to continue operation or close business units. Here, the management needs to consider whether the units are making expected income or have high maintenance costs.

Purchase of property, machinery, and hired staff are all decisions taken and hence are considered irrelevant costs for any future decision making. These costs are often relevant costs, as at operations level the management makes decisions that are always relevant costs and revenues. For example, a manufacturing facility has skilled labor and receives a customized order from a regular customer, the decision here will the best utilization of the labor hours. Costs have that already been incurred in the past (sunk costs) cannot be changed, and while these sunk costs can help to predict future costs, they are largely irrelevant to any future decisions. A construction firm is in the middle of constructing an office building, having spent $1 million on it so far.

All relevant costs are future costs, no decision can be taken about past costs that are already committed. For example, costs incurred on a feasibility study before launching a new project are historic; these are called committed or sunk costs. All businesses are run by business managers at effectively three levels of operations, management, and strategic. Every successful business needs a well-planned strategy and implementation of these plans. These Managers make decisions regularly which may affect the businesses.

Irrelevant costs for the business decision:

Relevant costing is just a refined application of such basic principles to business decisions. The key to relevant costing is the ability to filter what is and isn’t relevant to a business decision. The cost effects relate to both changes in variable costs and changes in total fixed costs. Sunk, or past, costs are monies already spent or money that is already contracted to be spent. A decision on whether or not a new endeavour is started will have no effect on this cash flow, so sunk costs cannot be relevant.

That make or buy decision would not have been taken without careful considerations about product quality, costs, and profitability measures. A manufacturing facility often faces this situation when receiving a customized order. These are costs that differ between alternative courses of action.

Relevant cost for decision-making

If the butter brings in more revenue than the extra processing cost, it makes sense to process further. However, this method should not be considered as a sole decision making tool in itself. As any long term decision will require considering other factors too.

Products

If a company decides not to undertake an activity, the company can avoid some expenses. Maintenance cost for machinery is $3,000, $2,000 for material, $2,500 for labor, and $1,500 for miscellaneous costs. So, the Billy’s might think of discontinuing the cheese unit. Billy’s might continue with cheese production if the expenses are lower, like $ 7,500. For example, a company’s total cost increases from $2,20,000 to $2,40,000 due to increasing the production unit.

This can include data, facts, opinions, and insights that are relevant to the decision. The quality of information collected greatly influences the final decision. BigCommerce helps growing businesses, enterprise brands, and everything in-between sell more online. Non-relevant – Flyers and posters have already been printed and distributed.

Relevant costs are expenses that pertain to a specific business decision. They can be costs that are already in place and thus will be removed after the decision, or they can be new costs that would be incurred due to a decision. Because all her existing equipment is already being used and she did not need to incur any additional costs to acquire new equipment or a storefront, none of those expenses are considered relevant. Sunk CostSunk cost is expenditure which has already been incurred in the past. Sunk cost is irrelevant because it does not affect the future cash flows of a business.

Relevant costs are also only relevant to decisions made in the short term, or one-off decisions. Incremental CostWhere different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered. Non-Cash ExpensesNon-cash expenses such as depreciation are not relevant because they do not affect the what is relevant cost cash flows of a business. Therefore, it is worth buying in as incremental revenue exceeds incremental costs. The company is concerned about the loss that is reported by Production Line B and is considering closing down that line.

Depreciation is not a cash flow and is dependent on past purchases and somewhat arbitrary depreciation rates. By the same argument, book values are not relevant as these are simply the result of historical costs (or historical revaluation) and depreciation. ‘Relevant costs’ can be defined as any cost relevant to a decision. A matter is relevant if there is a change in cash flow that is caused by the decision. There are four main types of relevant costs, which are noted below. This step involves assessing the pros and cons of each alternative based on factors such as cost, benefits, risks, and alignment with objectives.