Relevant Cost

Relevant cost is a management accounting term that describes avoidable costs incurred when making specific business decisions. This concept is useful in eliminating unnecessary information that might complicate the management’s decision-making process. Businesses use relevant costs in management accounting to conclude whether a new decision is economical.

A particular cost may be relevant for one situation but irrelevant for another. The opposite of relevant costs is sunk cost or irrelevant costs, which refers to the expenses already incurred. Thus, incurring an expense may be avoided by deciding not to perform a certain activity.

• Relevant costs are expenses that require specific management decisions. Unlike sunk costs, they may change in the future according to the decision taken. They differ for different alternatives.
• Businesses use relevant costs in management accounting to make cost-effective business decisions. It helps to remove unnecessary data that can dilute a sound decision-making process.
• These costs are primarily considered for three major decisions: buying or selling, special orders, and keeping a business unit or stopping production.
• The relevant costs are future cash flows, incremental costs, opportunity costs, and avoidable costs.

Relevant cost analysis plays a significant role in decision-making. Let us check out some relevant cost examples:

1. ABC Company wants to introduce a self-care portal which will reduce the number of customer service personnel by five. Here, the relevant cost constitutes the salary of the five personnel.
2. A company wants to add a new unit that requires different raw materials.

Material A: 

With zero inventories, they will buy all 50 units at $10. 

Hence, relevant costs = 50 units x $10= $500

Material B:

We assume the units in inventory will not be used—the selling price at $13.

Hence, relevant cost of material B = $2,250 + $2,000 

                                           = $4,500

Material C:

$30 per unit is not relevant since the current price is $23. 

Therefore,

Relevant cost of Material C =100 units x $23=$2,300

The three main types of relevant cost examples considered during a business decision are:

• Whether to make or buy.
• Close a business unit or continue production.
• Special orders.

#1 - Make or Buy

A company that deals with making finished goods requires specific parts. The company has to decide whether to make the parts internally or outsource. Naturally, the lowest cost alternative is the best. Direct materials, direct labor, and various overhead costs are examples of the make or buy situation.

Suppose a company wants a part of some machine. They can buy the part from a vendor or make it in the factory. The company shall free some space that can be leased if it decides to outsource. The management can outsource to make an extra income from leased space. The relevant cost analysis thus helped the company to conclude that buying the part was a more financially sound decision.

For example;

XYZ Company manufactures motor vehicle spare parts that need a specific piece of equipment. Purchasing from a supplier costs $5 per unit. But the company can make the same piece internally as well. The company requires 50,000 units of spare parts per annum. By producing internally, the company incurs the following costs:

Direct materials=$2/unit

Direct labor=$4/unit

Overhead costs=$1/unit

Special tools=$40,000

According to the above illustration, it will cost XYZ $250,000 to buy from a supplier. And it will cost $390,000 to make the same internally. Therefore, XYZ should continue outsourcing.

#2 - Continue Production or Close Business Unit

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. Appropriate cost analysis form plays a primary role in making that decision.

For example;

The company Billy’s makes cheese worth $10,000 per month. Maintenance cost for machinery is $3,000, $2,000 for material, $2,500 for labor, and $1,500 for miscellaneous costs. Overall expenses amount to an income of $10,000. 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.

#3 - Special Orders

In business, a customer may request a one-time item from a company. They could have made this order right after the company had calculated all its costs on normal sales. The company shall then consider the lowest price for producing that order. It considers taking special orders if the costs involved will generate income in the long run.

Before accepting special orders, the company must put into consideration;

• If it has the necessary capacity to complete the order.
• If it has already covered the cost of production.
• If it has analysed all the fixed costs

If the product cost price is below production cost, the company can safely decide to take special orders.

There are four types of relevant costs;

• Avoidable costs
• Incremental costs
• Opportunity costs
• Future cash flows

#1 - Avoidable Costs

The term is also called variable costs. If a company decides not to undertake an activity, the company can avoid some expenses.

It happens when the company opt-out of other activities that can save it from incurring expenses. Variable costs vary with different levels of production. It means that if there is zero production, there is no spending.

Variable costs=Quantity output x Variable cost per unit output

#2 - Incremental Costs

Along the line of business, there is the production of several units. These additional units have a price tag. Thus, these costs increase as the production increases or drops with low production. They are called incremental costs.

Along the line of business, there is the production of several units. These additional units have a price tag. Thus, these costs increase as the production increases or drops with low production. They are called incremental costs.

#3 - Opportunity Costs

Opportunity costs are associated with choosing between two alternative options. The loss of benefit due to an alternative option is the opportunity cost, also known as the alternative cost.

For example, a person has to choose between vacationing and spending time with their family. In this context, opportunity cost is the cost of the holiday and visiting new places if the person decides to go on vacation rather than stay home.

#4 - Future Cash Flows

The future expenses that might occur due to a decision made in the present are called future cash flows. The current value is used to project future revenues to see if a decision will incur future costs. Here, we can price the expected ongoing-project revenues with the current value. Then, a discounted rate is formulated to arrive at discounted cash flows.

This has been a guide to what is Relevant Cost and its definition. Here we discuss the types, examples of relevant cost, and how it is used in decision making along with key takeaway. You may learn more about financing from the following articles –

• Process Costing
• Cost Pool
• Unit Cost