Relevant Cost and Decision Making

Source: Accounting-Simplified

Definition

Relevant cost, in managerial accounting, refers to the incremental and avoidable cost of implementing a
business decision.

Concept

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.

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 (see sunk cost below).

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.

Types of Relevant Costs Types of Non-Relevant Costs

Future Cash Flows Sunk Cost

Cash expense that will be incurred in the future Sunk cost is expenditure which has already been
as a result of a decision is a relevant cost. incurred in the past. Sunk cost is irrelevant
because it does not affect the future cash flows
of a business.

Avoidable Costs Committed Costs

Only those costs are relevant to a decision that Future costs that cannot be avoided are not
can be avoided if the decision is not relevant because they will be incurred
implemented. irrespective of the business decision being
considered.
 Opportunity Costs Non-Cash Expenses

Cash inflow that will be sacrificed as a result of a Non-cash expenses such as depreciation are not
particular management decision is a relevant relevant because they do not affect the cash
cost. flows of a business.

Incremental Cost General Overheads

Where different alternatives are being General and administrative overheads which are
considered, relevant cost is the incremental or not affected by the decisions under consideration
differential cost between the various alternatives should be ignored.
being considered.

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.