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.
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
Accounting Basics: “Relevant Cost” Fundamentals Quiz
### What is the primary characteristic of relevant costs?
- [ ] They are always variable costs.
- [ ] They are fixed costs.
- [x] They will differ among alternatives.
- [ ] They are historical costs.
> **Explanation:** Relevant costs are those that will differ among the alternatives being considered. This characteristic makes them crucial in decision-making processes.
### Are sunk costs considered relevant?
- [ ] Yes, they are important for future decisions.
- [x] No, they have already been incurred.
- [ ] Only if they affect future cash flows.
- [ ] If they are both fixed and variable.
> **Explanation:** Sunk costs have already been incurred and cannot be recovered, making them irrelevant for future decisions.
### What category would the cost of new materials for a special order fall under?
- [x] Relevant cost
- [ ] Sunk cost
- [ ] Fixed cost
- [ ] Opportunity cost
> **Explanation:** The cost of new materials is relevant as it impacts the future costs associated with fulfilling a special order.
### What type of analysis is used to compare relevant costs?
- [ ] Horizontal analysis
- [ ] Vertical analysis
- [x] Differential analysis
- [ ] Trend analysis
> **Explanation:** Differential analysis is used to compare the differences in relevant costs and benefits between alternatives.
### How should irrelevant costs be treated in decision-making?
- [ ] They should be included for a complete analysis.
- [x] They should be ignored.
- [ ] They should be reporteLoremipd seperately.
- [ ] None of the above.
> **Explanation:** Irrelevant costs do not affect the decision and should therefore be ignored in the decision-making process.
### Why might fixed costs be relevant in some decisions?
- [ ] They are always variable.
- [x] They change due to the decision.
- [ ] They are never relevant.
- [ ] Only when they are sunk costs.
> **Explanation:** Fixed costs can be relevant if they change as a result of the decision being considered.
### What type of cost are labor costs for a new production process?
- [x] Relevant if they affect future decisions.
- [ ] Sunk costs.
- [ ] Always fixed costs.
- [ ] Always opportunity costs.
> **Explanation:** Labor costs for a new production process are relevant if they affect future decisions and are future-oriented.
### Does the cost of delivering a special order classify as a relevant cost?
- [x] Yes, if it affects the decision.
- [ ] No, it is a sunk cost.
- [ ] Only if it is fixed.
- [ ] Only for regular orders.
> **Explanation:** Delivery costs for a special order are relevant if they affect the decision-making process.
### How does understanding relevant costs benefit managers?
- [ ] It minimizes all types of expenses.
- [x] It helps make better decisions between alternatives.
- [ ] It simplifies accounting entries.
- [ ] It eliminates irrelevant financial data.
> **Explanation:** Understanding relevant costs helps managers to make better decisions by focusing on the costs that will be affected by the alternatives considered.
### In the decision to discontinue a product, what type of costs are most considered?
- [ ] Sunk costs
- [x] Relevant costs
- [ ] Irrelevant costs
- [ ] Historical costs
> **Explanation:** Relevant costs are most considered in the decision to discontinue a product as they directly impact the future financial outcomes of the decision.
