Definition
Relevant cost refers to the prospective future costs related to a specific business decision, and that could vary based on the decision made. These costs are only associated with the particular decision at hand and do not include sunk, or past, costs. In essence, relevant costs are those that will make a difference to a company’s future costs and revenues.
Phonetic
The phonetics of the keyword “Relevant Cost” is /ˈrɛlɪvənt kɔːst/.
Key Takeaways
- Decision Making: Relevant costs are essential in deciding business operations, such as production levels, pricing, and product lines. They help in making crucial decisions based on cost-volume-profit analysis, budgeting, and planning.
- Cost Management: By identifying the relevant cost, businesses can effectively manage their expenses, maintain profitability, and ensure optimal allocation of resources. These costs are directly related to specific business decisions, hence providing a clear insight into the cost behavior and their impact.
- Opportunity Cost: Relevant cost considers the opportunity cost, i.e., the cost of the alternative foregone. This aids in understanding the comparative advantage of two or more alternatives. Hence, it adds a strategic dimension to the decision-making process, enabling businesses to choose the most profitable alternatives.
Importance
Relevant cost is a significant term in business finance as it aids in making efficient and effective business decisions. This cost refers to the potential future costs associated with a business decision that can influence the cash flows. Importantly, it only includes those costs that will differ between available alternatives. This means it excludes sunk costs, which have already been incurred and cannot change. By examining relevant costs, managers can choose between different options based on their respective potential future costs, thus promoting more efficient use of company resources and helping to maximize profitability and financial health.
Explanation
The primary purpose of relevant cost, a concept in management accounting, is to aid in making sound business decisions. It provides management with the associated expenses that could be incurred for each potential alternative during decision-making processes. Relevant cost only considers the costs and revenues that will change as a direct result of the decision made. These costs can be related to making or buying a product, replacing equipment, price-setting or accepting an order at a special price, among others. The use of relevant costs can help a company avoid making decisions based on inaccurate cost data, thereby improving business performance and facilitating good management decision-making.In business operations, the calculation and analysis of relevant costs support different sectors, including production, marketing, investment, and financing. For instance, in production, it’s used to determine whether manufacturing or buying components would be more cost-effective. In marketing, relevant costs could assist in deciding the pricing of a new product. In investment and financing, the concept of relevant cost is vitally important when making decisions on new projects or investments. Updated relevant cost information plays a crucial role in ensuring efficient resource allocations, maximizing profits, and subsequently achieving long-term business objectives.
Examples
1. Decision Making on New Projects: Suppose ABC Corporation is considering the launch of a new product line. The costs associated with manufacturing, marketing, and distributing this new product will be considered as relevant costs. Existing fixed costs such as the rent of the company’s premises, however, would not be considered as relevant, because they will be incurred regardless of the decision to launch the new product or not.2. Equipment Replacement: Let’s say a restaurant owner is considering replacing their old kitchen equipment with new ones. The relevant costs here would include the cost of the new equipment, installation cost, and the disposal cost of the old equipment. The improvement in the efficiency of operations or reduction in maintenance cost are also to be considered. However, the original cost of the old equipment is an irrelevant cost as it is a past or sunk cost, which won’t affect the future.3. Make or Buy Decisions: Imagine a company that typically produces its own components for its products, but is considering outsourcing this to an external supplier. Relevant costs to consider would include the price quoted by the supplier, any changes in delivery costs and taxes, and potential savings from not having to produce the components in-house – such as reduction in labor, maintenance or raw material costs. Irrelevant costs would be any costs that will remain the same whether the components are made or bought, like the cost of rent for the company’s factory.
Frequently Asked Questions(FAQ)
What is relevant cost?
Relevant cost refers to the specific costs associated with a particular business decision that are directly under consideration or will be affected by that decision. These costs are future costs that differ between alternatives.
Can relevant costs be both variable and fixed?
Yes, relevant costs can be both variable and fixed, provided they change depending on the decision made. These costs can be direct materials, direct labor, variable overhead, special equipment, or additional overhead costs.
What is an example of a relevant cost?
A typical example of a relevant cost is the cost of raw materials required for a specific production process. If a business is considering whether to manufacture a product or buy it from an external supplier, the cost of those raw materials becomes relevant to the decision.
Are all future costs considered relevant costs?
Not necessarily. Only future costs that will differ between the alternatives under consideration are relevant costs.
Can a sunk cost be a relevant cost?
No, a sunk cost cannot be a relevant cost. Sunk costs are costs that have already been incurred and cannot be recovered. They should not be considered in decision-making processes as they will not be affected by future decisions.
How can identifying relevant costs aid in business decisions?
Identifying relevant costs can help businesses make informed decisions by providing clarity on the financial implications of various options. It enables them to distinguish costs that will be incurred or saved based upon the decision made, making for accurate cost-benefit analyses.
Is opportunity cost a type of relevant cost?
Yes, opportunity cost is indeed a type of relevant cost. This is the cost related to the next best alternative that a company foregoes when it makes a decision to pursue a certain action.
How does relevant cost affect pricing decisions?
Relevant costs play a crucial role in pricing decisions. When setting a price for a product, companies need to ensure that it covers all the relevant costs involved in producing and selling the product, in addition to generating a suitable profit margin.
Related Finance Terms
- Opportunity Cost
- Sunk Cost
- Direct Cost
- Indirect Cost
- Incremental Cost
Sources for More Information
