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Relevant Cost

Updated on April 5, 2024
Article byAaron Crowe
Edited byAaron Crowe
Reviewed byDheeraj Vaidya, CFA, FRM

What is 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 costSunk CostSunk costs are all costs incurred by the firm in the past with no hope of recovery in the future and are not considered while making any decisions since these costs will not change regardless of the decision's outcome.read more or irrelevant costsIrrelevant CostsIrrelevant costs are those that are not useful or are not considered when a company makes a business decision. However, this does not imply that such costs will be irrelevant for an extended period and may become relevant if the business environment or priorities change.read more, which refers to the expenses already incurred. Thus, incurring an expenseExpenseAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.read more may be avoided by deciding not to perform a certain activity.

Relevant Costs vs SUnk Cost

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Key Takeaways

  • 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.

Examples

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 materialsRaw MaterialsRaw materials refer to unfinished substances or unrefined natural resources used to manufacture finished goods.read more.
Material A:  Nil inventoryunits required 50The cost per unit is $10 per unit
Material B:  Inventory 150 units at $15 per unitunits required 200Cost per unit $17. Inventory units can also be sold at $13
Material C:  Inventory 90 units at $30 per unit units required 100 Current cost per unit $23 fully used in production

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

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How Relevant Cost is used in Decision Making?

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 outsourceOutsourceOutsourcing refers to contracting out specific business processes to a third-party or specialized service provider, i.e., an individual or company.read more. Naturally, the lowest cost alternative is the best. Direct materialsDirect MaterialsDirect materials are raw materials that are directly used in the manufacturing process of a company's goods and/or services and are an essential component of the finished goods manufactured.read more, direct labor, and various overhead costsOverhead CostsOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc.read more are examples of the make or buy situation.

Suppose a company wants a part of some machine. They can buy the part from a vendorVendorA vendor refers to an individual or an entity that sells products and services to businesses or consumers. It receives payments in exchange for making items available to end-users. They constitute an integral part of the supply chain management for providing raw materials to manufacturers and finished goods to customers.read more 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

ItemCost per unitTotal cost for 50,000 units
Direct materials$2$100,000
Direct labor$4$200,000
Overhead costs$1$50,000
Special tools$40,000
$390,000

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

Types of Relevant Costs

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 costsVariable CostsThe variable costing formula evaluates the direct cost and other variable manufacturing expenses incurred on each product unit. It is computed as the sum of direct labor cost, direct raw material cost, and variable manufacturing overhead divided by the total number of units produced.read more. 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 costsOpportunity CostsThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It's essentially the cost of the next best alternative that has been forgiven.read more 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 revenuesRevenuesRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more 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 flowsDiscounted Cash FlowsDiscounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company's future performance.read more.

Types of Relevant Costs

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Frequently Asked Questions (FAQs)

What is a relevant cost example?

A company decides to buy loading machinery for a factory unit. This machine can save the wage expenses of 20 manual laborers. These costs are relevant since these expenses change in the future due to the buying decision.

What are the relevant costs in a make or buy decision?

A company that needs a special item can either make one on its own or outsource it. The decision to make or buy it depends on the cost-effectiveness of either alternative. If buying the item costs less than making it internally, the company opts for outsourcing it.

Why are relevant costs important in decision-making?

Business management uses relevant costs to finalize a decision. 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.

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 –