by 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.
The underlying principles of relevant costing are fairly simple and you can probably relate them to your personal experiences involving financial decisions.
Types of Relevant Costs |
Types of Non-Relevant Costs |
| Future Cash Flows
Cash expense that will be incurred in the future as a result of a decision is a relevant cost. |
Sunk Cost Sunk 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. |
| Avoidable Costs
Only those costs are relevant to a decision that can be avoided if the decision is not implemented. |
Committed Costs
Future costs that cannot be avoided are not relevant because they will be incurred irrespective of the business decision bieng considered. |
| Opportunity Costs
Cash inflow that will be sacrificed as a result of a particular management decision is a relevant cost. |
Non-Cash Expenses
Non-cash expenses such as depreciation are not relevant because they do not affect the cash flows of a business. |
| Incremental Cost
Where different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered. |
General Overheads
General and administrative overheads which are not affected by the decisions under consideration should be ignored. |
For example, assume you had been talked into buying a discount card of ABC Pizza for $50 which entitles you to a 10% discount on all future purchases. Say a pizza costs $10 ($9 after discount) at ABC Pizza and it subsequently came to your knowledge that a similar pizza is offered by XYZ Pizza for just $8. So the next time you would have ordered a pizza, you would have (hopefully) placed an order at XYZ Pizza realizing that the $50 you have already spent is irrelevant.
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.
Relevant costs
Relevant costs are generally divided into two categories
- Future Cost: Incurred in the future based on the potential decision made. This should vary from decision option to decision option. If this does not change based on the decision, then it is an irrelevant cost (see below).
- Opportunity Cost: The cost in lost opportunity depending on the decision made.
Irrelevant costs
Yes, irrelevant costs are those that should not be considered when making a decision because they can not be changed:
- Sunk Cost: Costs that have already been paid are considered irrelevant.
- Committed Cost: A future cost that is considered irrelevant. If the future cost must be paid regardless of the decision made then it is irrelevant.
What are relevant costs that online merchants should think about?
Executive management at a company decides that they want to develop a mobile application for Android-based mobile devices. They are presented with two options by the technical team: A web application wrapped to look like a mobile application or a mobile application written for Android. Each decision has several relevant costs:
- Development Time(Future cost): How much time will it take to develop each option?
- Developer Resources(Future cost): How many people, and at what wage, are required to build each option?
- Time to Market(Opportunity cost): How much will a difference in delivery time impact sales, and what is the difference?
- Perceived Performance (Opportunity cost): Is one option better performing than the other, and what is the expected abandonment rate based on that performance difference?
- Omnichannel Marketing (Future & Opportunity cost): Can one option fit the overall brand experience better than the other, and is there a cost associated with integrating the application into the brand?
There are also irrelevant costs that should be ignored:
- Existing Website(Sunk cost): The cost of the current website, even if it were reused for the application, is irrelevant. Any cost mitigation it provides would be accounted for in development time and resources.
- Testing Software(Committed cost): Regardless of the option chosen, the same testing software will be used.
- The cost of the iOS Application(Sunk cost): Like the existing website, the cost of the iOS application is irrelevant to this decision.
Relevant Costing and Costing for Decision Making
In management accounting, notion of relevant costing has great significance because these costs are pertinent with respect to a particular decision. A relevant cost for a particular decision is one that transforms if an alternative course of action is taken. Relevant costs are also termed as differential costs. Studies have demonstrated that relevant costs will make a difference in a decision. A relevant cost only relates to a particular management decision and which will alter in the future as a result of that decision. Other theorists described that relevant costs are future costs that will differ among alternatives. The main intent of relevant costing is to determine the objective cost of a business decision. An objective measure of the cost of a business decision is the degree of cash outflows that shall result from its execution. Relevant costing focuses on just that and overlooks other costs which do not influence the future cash flows. The fundamental principles of relevant costing are quite simple and managers can perhaps relate them to personal experiences involving financial decisions.
It is stated in theoretical literature that relevant costing is a management accounting toolkit that assists management team to make decisions when they have to deal with some issues such as whether to buy a component from an external vendor or manufacture it in house?, Whether to accept a special order?, What price to charge on a special order?, Whether to discontinue a product line?, How to utilize the scarce resource optimally?. CIMA describes relevant costs as: “the costs appropriate to a specific management decision”. A study of relevant costs and benefits assists to take wise decision. In order to meet the criteria for relevancy, a cost must have two criteria that include they affect the future and they differ among alternatives. Other group of theorists asserted that the relevant costs are applicable to decision. Costs are relevant, if they direct the executive towards the decision. It will be useful, if the costs are not only relevant but also precise. Relevance and accuracy are not alike concepts. Costs may be correct and irrelevant, costs may be incorrect but it can be relevant.
Relevant information is the predicted future costs and incomes that will differ among the alternatives relevant information. Relevant costs are the costs which would change as a result of the decision under consideration, where as irrelevant costs are those which would remain unchanged by the decision. Therefore only relevant cost would be included in the investigative framework. A relevant cost is also defined as a cost whose amount will be affected by a decision being made. Management should believe only future costs and revenues that will differ under each alternative. Relevant costs are accepted future costs and relevant profits are expected future revenues that differ among the alternative course of action being considered. In the arena of Management accounting, one feature of relevant cost is that they are future costs which have not been incurred. Hence the cost of material is relevant cost as long as the material not purchased because of deciding whether or not to purchase the material, one is to decide to sustain the cost or evade it. Therefore, all relevant costs are future costs. Whether particular costs and profits are relevant for decision making depends on decision circumstance and the options available. When selecting among different alternatives, manager must focus on the costs and revenues that differ across the decisions alternatives; these are relevant cost/revenues. The relevance of cost to decision alternative is determined by situation. The facts and policies explain situation. It is established that historical cost is not relevant, only future cost is relevant. All sunk costs are irrelevant.
Application & Limitations
While relevant costing is a useful tool in short-term financial decisions, it would probably not be wise to form it as the basis of all pricing decisions because in order for a business to be sustainable in the long-term, it should charge a price that provides a sufficient profit margin above its total cost and not just the relevant cost.
Examples of application of relevant costing include:
- Competitive pricing decisions
- Make or buy decisions
- Further processing decisions
For long term financial decisions such as investment appraisal, disinvestment and shutdown decisions, relevant costing is not appropriate because most costs which may seem non-relevant in the short term become avoidable and incremental when considered in the long term. However, even long term financial decisions such as investment appraisal may use the underlying principles of relevant costing to facilitate an objective evaluation.
