What Is Relevant Cost?
Relevant cost is a managerial accounting term that describes avoidable costs that are incurred only when making specific business decisions. The concept of relevant cost is used to eliminate unnecessary data that could complicate the decision-making process. As an example, relevant cost is used to determine whether to sell or keep a business unit.
The opposite of a relevant cost is a sunk cost, which has already been incurred regardless of the outcome of the current decision.
Key Takeaways
- Relevant costs are only the costs that will be affected by the specific management decision being considered.
- The opposite of a relevant cost is a sunk cost.
- Management uses relevant costs in decision-making, such as whether to close a business unit, whether to make or buy parts or labor, and whether to accept a customer's last-minute or special orders.
Example of Relevant Cost
Assume, for example, a passenger rushes up to the ticket counter to purchase a ticket for a flight that is leaving in 25 minutes. The airline needs to consider the relevant costs to make a decision about the ticket price. Almost all of the costs related to adding the extra passenger have already been incurred, including the plane fuel, airport gate fee, and the salary and benefits for the entire plane’s crew. Because these costs have already been incurred, they are "sunk costs" or irrelevant costs.
The only additional cost is the labor to load the passenger’s luggage and any food that is served mid-flight, so the airline bases the last-minute ticket pricing decision on just a few small costs.
Types of Relevant Cost Decisions
Continue Operating vs. Closing Business Units
A big decision for a manager is whether to close a business unit or continue to operate it, and relevant costs are the basis for the decision. Assume, for example, a chain of retail sporting goods stores is considering closing a group of stores catering to the outdoor sports market. The relevant costs are the costs that can be eliminated due to the closure, as well as the revenue lost when the stores are closed. If the costs to be eliminated are greater than the revenue lost, the outdoor stores should be closed.
Make vs. Buy
Make vs. buy decisions are often an issue 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 would then be finished in-house by adding handles and other details. The relevant costs in this decision are the variable costs incurred by the manufacturer to make the wood cabinets and the price paid to the outside vendor. If the vendor can provide the component part at a lower cost, the furniture manufacturer outsources the work.
Factoring in a Special Order
A special order occurs when a customer places an order near the end of the month, and prior sales have already covered the fixed cost of production for the month. If a client wants a price quote for a special order, management only considers the variable costs to produce the goods, specifically material and labor costs. Fixed costs, such as a factory lease or manager salaries, are irrelevant because the firm has already paid for those costs with prior sales.
FAQs
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.
Why is relevant cost important? ›
Relevant costs help to eradicate unnecessary data that can complicate a decision-making process. Management can use this concept to make cost-effective business decisions and avoid unnecessary expenses.
What are relevant costs in simple words? ›
'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. The change in cash flow can be: additional amounts that must be paid.
What is an example of a relevant cost? ›
For example, If a decision can affect the cash flow, then the matter is relevant, and the costs of that decision are worth consideration. Businesses base their decisions around the projected relevant costs in order to minimize unnecessary spending and to determine profitable investments .
Why relevant cost is so important in managerial decision-making? ›
Relevant costs are critical to making the right choices because financial planning involves identifying future cash flows linked to a particular decision. Past costs (sunk costs) have no role in this type of decision making, and disregarding them reduces the amount of information you need to consider.
Which of the following best describes a relevant cost? ›
A) Option b, is correct Expected future cost which differs amongst alternatives. Explanation- Relevent cost is the cost which is to be incurred if a specified alternative is proceeded with.
What is the difference between costs and relevant costs? ›
A relevant cost is any business expense that can be avoided when making specific business decisions. A irrelevant cost is any cost that has already been paid or accounted for when considering certain business decisions.
What are relevant costs also known as? ›
A relevant cost (also called avoidable cost or differential cost) is a cost that differs between alternatives being considered. In order for a cost to be a relevant cost it must be: Future. Cash Flow.
What is relevant costing also known as? ›
Definition: Relevant cost, also called differential cost, is a management accounting term decsribing costs that pertain to a particular decision. Relevant costs will vary based on the context of the decision, such as an omnichannel business analysis by a multi-platform retailer.
What is the difference between relevant and not relevant costs? ›
Relevant costs are costs that will be affected by a managerial decision. Irrelevant costs are those that will not change in the future when you make one decision versus another. Examples of irrelevant costs are sunk costs, committed costs, or overheads as these cannot be avoided.
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.
What are the disadvantages of relevant cost? ›
Limitation of relevant costing:
It is not proper to proceed on the assumption in the context of relevant costing. The cost so indicated on the relevant cost statement is valid only at a given level of activity. Experts stated that in relevant costing, period of comparison is often incomplete or incomparable.
What are the assumptions of relevant costing? ›
Some of the assumptions made in relevant costing are as follows: a) Cost behaviour patterns are known, e.g. if a department closes down, the attributable fixed cost savings would be known. b) The amount of fixed costs, unit variable costs, sales price and sales demand are known with certainty.
What are the two types of relevant cost? ›
The relevant cost is the cost relevant to the company's decision. The two types of relevant costs are Avoidable cost and Opportunity cost.
What is the principle of relevant cost? ›
Relevant cost is a managerial accounting term that describes avoidable costs that are incurred only when making specific business decisions. The concept of relevant cost is used to eliminate unnecessary data that could complicate the decision-making process.
What are the characteristics of relevant cost? ›
Characteristics of Relevant Costs
Two important characteristic features of relevant costs are 'Occurrence in Future' and 'Different for Different Alternatives. ' This does not mean that all costs which occur in the future are not relevant costs. For a cost, item to be relevant, both the conditions should be present.
What is a relevant cost quizlet? ›
What are relevant costs? Relevant costs are costs that differ between alternatives. When making the decision, the company should consider relevant costs. An avoidable cost is a cost that can be eliminated, in whole or in part, by choosing one alternative over another.
What are relevant costs best described as quizlet? ›
Relevant costs are incurred in the future (if you are deciding to buy a new car). Costs cannot be incurred in the past if they are to be considered relevant for decision making. Irrelevant costs are costs that do not affect your decision.
What are relevant costs and revenues? ›
A relevant cost is one that we incur as a direct response to a particular decision. And likewise, a relevant revenue is the same, just instead of a cost, we incur a revenue as a result of a particular decision. This would normally be a management decision.
What are relevant costs of materials? ›
In manufacturing, relevant cost refers to the costs that directly impact a business decision. This can include costs related to materials, labor, overhead and any other expenses that would be affected by a specific course of action.
