Concept of Relevant Costs, Steps in Decision Making
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
Cash expense that will be incurred in the future as a result of a decision is a relevant 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.
Only those costs are relevant to a decision that can be avoided if the decision is not implemented.
Future costs that cannot be avoided are not relevant because they will be incurred irrespective of the business decision bieng considered.
Cash inflow that will be sacrificed as a result of a particular management decision is a relevant cost.
Non-cash expenses such as depreciation are not relevant because they do not affect the cash flows of a business.
Where different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered.
General and administrative overheads which are not affected by the decisions under consideration should be ignored.
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.
Limitation of relevant costing:
There are many limitations of relevant costing:
If the correct and accurate results are to be obtained, then proper thought has to be given to the matter. Each cost item apparent or hidden needs proper attention before assumption are built in the solution. 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. Timing of cost and benefit is not important in the technique of relevant costing. On the contrary, the financial analyst considers the cash flow along with the timing of it. The consideration of time factors allows the discontinuation in the cash flow in financial management theories. Relevant costing suffers the limitation on this count but serves the practical objective of profit. Another issue in relevant costing is handling the opportunity cost. The difficulty of estimating opportunity cost can be temporarily overcome by extending relevant costing solution into the calculation of accounting rate of return. It is also termed as average rate of return. A return as a percentage of investment is calculated (Allied Publishers, 1997).
To summarize, decision making is an integral part of any business of human life. But business life presupposes the conscious level of decision making instead of rash decision. Before taking the decision, managers must identify the variables that may have bearing on the decision and try to get information about those variables. Relevant cost, in managerial accounting, denotes to the incremental and unnecessary cost of implementing a business decision. Relevant cost analysis is a cost accounting based evaluation technique. It is just an improved application of basic principles to business decisions. The major factor in relevant costing is the capacity to clean what is and is not pertinent to a business choice. This technique is applicable to all special or non-routine situations.