Relevant cost

Definition – Relevant cost

A future incremental cash flow arising as a direct result of a decision is called relevant cost.

Management needs to make different decisions in the normal course of business. Decisions can range from short-term to long-term. For example, management makes decisions about:

  • launching new products in the markets or withdrawing loss-making products from the market,
  • opening a new branch or closing an existing branch,
  • accepting a customer order and quoting a price,
  • buying a new non-current asset, or selling an old one,
  • hiring new employees or utilizing existing employees for a project, etc. 

To take correct and informed decisions, they need financial information. A management accountant is a concerned person who makes a detailed financial evaluation of a decision.

When preparing financial evaluation, the management accountant considers the concept of relevant cost. He only includes those costs or revenues which are directly affected by the decision. The costs or revenues which are irrelevant i.e., they are not affected by the decision shall not be a part of the analysis and financial report.

The simple rule applies “what we are going to pay or receive and what we are going to lose due to this decision”.

Analysis of relevant cost definition

Future incremental cash flows arising as a direct result of a decision.

In this definition, three words are important to understand that are explained below:

Future

We shall consider only the future expected cost by taking the decision. It means the past cost is not considered. The cost which has already been incurred in the past is SUNK COST.

For instance, the business needs to buy a new machine; they have incurred $1,000 in market research. Now management has to decide whether they should buy the machine or not. They will not consider the already incurred market research cost at the time of decision as that cost cannot be recovered whether they buy the machine or not.

Incremental

The marginal or additional cost that will arise due to the decision shall be taken into account. It means the cost which you have to incur in future whether you make a decision or not, shall be excluded. This type of cost is commonly called COMMITTED COST.

For example, management wants to estimate the costs relating to the product which they are planning to launch. The product will be produced in the existing factory for which rent is to be paid every quarter.  Rent of the factory shall not be included in the estimates as this is a committed cost that the business has to pay, irrespective of the decision in consideration.

Cash flows

Management considers cash flows while taking decisions. Profits are subjective as they can be manipulated by applying various accounting policies. It is the cash that makes the business run in the long term. So, any non-cash items like depreciation and notional costs like absorbed overheads shall not be added to the estimates.

In a nutshell, just follow the below-given list of relevant and irrelevant costs that will make things much easier.

Relevant cost

  • Variable cost
  • Incremental fixed cost
  • Opportunity cost (Explained below)

Irrelevant cost

  • Sunk cost
  • Committed cost
  • Non-cash cost
  • Notional cost
  • General fixed cost

Incremental fixed cost

Generally, fixed cost is irrelevant but if the fixed cost is changing due to a decision, then it is relevant. For example, if the business plans to use the existing factory for a new product, then the rent of the factory is an irrelevant cost as it is a committed cost. However, if the business plans to set up a new factory at a new site, then the rent of this new site will be relevant as it will arise if business launches a new product.

Opportunity cost

The value of benefit lost by taking one option instead of the other is called opportunity cost. Let us take an example of a salaried person who is taking $3,000 a month. He is considering starting his own business. He is evaluating different options for businesses. While evaluating each option, he will set a minimum benchmark of $3,000. He will consider an option only if its monthly return exceeds $3,000. In this case, his current salary is an opportunity cost.

Now, let us understand this concept from a business perspective. Let’s say we have a machine that is not being used in production. We are planning to sell it in the second-hand market. In the meanwhile, a special customer order comes, in which this machine could be used. If we decide to use the machine in the customer order, then its current market price will be the opportunity cost. That’s what we are losing by using the machine in the customer order instead of selling it in the market.

For more comprehension, follow the numerical examples below.

Examples of relevant cost

Example – 1

A special customer order requires:

  • Material (100 kg @ $6 per kg)
  • Labour (80 hours @ $7 per labour hour)
  • Rent of factory ($1,000)
  • Insurance of plant ($200)

What is the relevant cost?

SOLUTION

In this example, material and labour costs are relevant as the business needs to buy materials and hire labour for the given hours to fulfil the order. However, rent of the factory and insurance of the plant are committed costs, and they are irrelevant to this customer’s order

Relevant cost = Material (100kg x $6) + Labour (80 hours x $7)

Relevant cost = $600 + $560

Relevant cost = $1,160

Example – 2


A special customer order requires:

  • Material (350 kg @ $10 per kg)
  • Labour (150 hours @ $8 per labour hour)
  • Rent of extra site to be hired ($500)
  • Production Manager’s salary ($1,000)

The Production Manager will spend 10% of his time on this order.

What is the relevant cost?

Solution

  • It is understood that material and labour costs are relevant.
  • Rent of extra site is an incremental fixed cost as the business will pay rent for completing this order. So, it is relevant.
  • The salary of a production manager is a committed cost. The business has to pay him a fixed salary no matter where he works. So, it is an irrelevant cost.

Relevant cost = Material (350kg x $10) + Labour (150 hours x $8) + Site rent ($500)

Relevant cost = $3,500 + $1,200 + $500

Relevant cost = $5,200