Relevant cost definition
/What is a Relevant Cost?
A relevant cost is a cost that only relates to a specific management decision, and which will change in the future as a result of that decision. The relevant cost concept is extremely useful for eliminating extraneous information from a particular decision-making process. Also, by eliminating irrelevant costs from a decision, management is prevented from focusing on information that might otherwise incorrectly affect its decision.
This concept is only applicable to management accounting activities; it is is not used in financial accounting, since no spending decisions are involved in the preparation of financial statements.
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Types of Relevant Costs
There are four main types of relevant costs, which are noted below.
Make-or-Buy Decisions
This type of relevant cost involves deciding whether to produce a component internally or purchase it from an external supplier. Relevant costs include direct materials, labor, and any savings or additional costs from outsourcing. For example, a furniture manufacturer must decide whether to make wooden chair legs in-house or buy them from a supplier. If outsourcing saves on labor and overhead without sacrificing quality, buying may be more cost-effective.
Accept-or-Reject Special Orders
Special order decisions concern whether to accept a one-time order, usually at a lower price than normal. Relevant costs include additional materials, labor, and opportunity costs, but exclude fixed overheads. For example, a bakery receives a large custom cookie order at a discounted price. If the bakery has idle capacity and the order covers variable costs, it may accept it for the extra profit.
Add-or-Drop a Product Line
When deciding whether to add or drop a product line, the relevant costs include the revenue lost or saved and any avoidable fixed or variable costs associated with the decision. For example, a clothing retailer considers discontinuing a low-selling jacket line. If the line is consistently unprofitable and dropping it reduces storage and staffing costs, removing it could benefit the business.
Sell-or-Process Further Decisions
The sell-or-process further decision arises when a product can be sold as-is or processed further for a potentially higher price. The relevant costs are the additional processing costs compared to the incremental revenue. For example, a dairy company can sell cream directly or churn it into butter. If the butter brings in more revenue than the extra processing cost, it makes sense to process further.
Examples of Relevant Costs
Here are several examples of relevant costs and how they should be applied to business decisions:
Asset purchase decision. The Archaic Book Company (ABC) is considering purchasing a printing press for its medieval book division. If ABC buys the press, it will eliminate 10 scribes who have been copying the books by hand. The wages of these scribes are relevant costs, since they will be eliminated in the future if management buys the printing press. However, the cost of corporate overhead is not a relevant cost, since it will not change as a result of this decision.
Business shut-down decision. If the Archaic Book Company wants to close its medieval book division entirely, the only relevant costs will be those costs specifically eliminated as a result of the decision. Once again, the cost of corporate overhead is not a relevant cost when making this decision, since it will not change if the division is sold.
Relevant Costs vs. Sunk Costs
The reverse of a relevant cost is a sunk cost. A sunk cost is an expenditure that has already been made, and so will not change on a go-forward basis as the result of a management decision. When making a decision, you should always take relevant costs into consideration, and ignore all sunk costs.