One of the most critical responsibilities of management is decision making and for this, managers often turn to relevant costing. Relevant costing is a very common and useful tool to assist the managers and entrepreneurs in such decision making. According to relevant costing technique, only relevant costs and benefits should be considered while evaluating the financial and economic features of a decision.
Managers often have to select between two or more alternatives and in making such decisions, the prime objective is usually either to:
- Increase profitability or value of the entity; or
- Reduce costs and improve productivity
Relevant cost is a future cost that will occur as a direct consequence of choosing a particular alternative or making a particular decision. Key features of relevant costs are:
- Relevant costs are costs that will be occurred in the future. If a cost has already been incurred, it cannot be relevant to a decision related to future.
- Relevant costs are costs that will be incurred only because of making a particular decision (direct consequence of a decision). If that decision is not made, those costs will be avoided.
- Relevant costs are real costs and not merely notional costs. Relevant cost should result in outflow of cash or economic benefits of the entity.
Irrelevant costs are costs which are NOT incurred as a direct consequence of choosing a particular alternative or making a particular decision. These costs will be incurred anyway whether one alternative is chosen or the other and is not affected by the decision made. As the name suggests, irrelevant costs should not be considered in decision making.
Following are some useful terms used in relevant costing:
Incremental Cost is an additional cost that will be incurred as a direct consequence of choosing a particular alternative or making a particular decision. Incremental cost is relevant cost and should be considered while evaluating different alternatives, provided that this additional cost is a cash flow and not a notional cost.
Example: Incremental cost
Watch World Inc. is a company involved in manufacturing and selling wrist watches. Cost of one wrist watch is as follows:
|Amount in $|
|Direct labor cost||80|
|Variable production overheads||20|
|Fixed production overheads absorbed||75|
Answer:Work out the incremental cost of producing:
a) One additional wrist watch
b) Twenty additional wrist watches
a) Incremental cost of making one additional wrist watch is $ 500.
b) Incremental cost of making twenty additional wrist watches is $ 10,000.
Making extra wrist watches will not affect the fixed production costs and only variable costs will be incurred, therefore fixed production overheads are not part of the incremental cost in this example.
Differential cost is the amount by which future costs will be different, depending on which alternative is chosen. It is therefore the difference between the costs of two alternatives. A differential cost is an amount by which future costs will be higher or lower, if a particular course of action is chosen. Differential cost is relevant cost and should be considered while evaluating different alternatives, provided that this differential cost is a cash flow and not a notional cost.
Example: Differential cost
A company needs to hire a car for the next three months and is considering the following two options:
a) Continue using car “A” which is already in use by the company. Monthly rental is $2,500 and monthly fuel expenses are approximately $2,200.
b) Hire a new car “B” whose mileage is better. Monthly rental is $3,200 and expected fuel expenses are $1,100.
Instead of calculating total costs of both options and then comparing them, another way of analyzing the comparative costs is to calculate the differential costs of shifting to new car.
|Amount in $|
|Differential cost of monthly rental ($3,200 – $2,500)||700|
|Differential cost of fuel ($1,100 – $2,200)||–1,100|
|Monthly differential cost/ (savings)||–400|
|Number of months||3|
|Total differential cost/ (savings)||1200|
According to this approach, it can be said that option of hiring new car “B” is less expensive by $400 each month. The differential cost savings by hiring car “B” will be $1,200 over the next three months, so the company should select option-II.
Avoidable and Unavoidable Costs
Avoidable costs are costs that can be avoided or saved, depending on whether a particular decision is made or not. As these costs depend on the decision and can be saved if a particular decision is made, therefore avoidable costs are relevant costs.
Unavoidable costs are costs that cannot be avoided and that will be incurred anyway. These costs will be incurred irrespective of what course of action is selected or the other. As these costs are not dependent on the decision and will be incurred anyway, therefore unavoidable costs are not relevant to a decision.
Example: Avoidable and unavoidable costs
Stylish Manufacturers & Co. uses a machine for manufacturing joggers. Machine was acquired under a lease agreement which has one year remaining. The rental cost is $50,000 per year. The firm has been incurring losses on the manufacture and sale of joggers and is considering closing this division and starting the manufacture of high quality shoes. Machine would no longer be required but the firm would be liable to pay a penalty equal to 40% of the remaining rentals i.e. $20,000 on early termination of lease agreement.
The decision about whether to close the division manufacturing joggers will be based on relevant costs.
In this case, 60% of the annual rental amounting to $30,000 (avoidable cost) is relevant cost as it can be saved if the Joggers Division is closed.
40% of the remaining rentals amounting to $20,000 (unavoidable cost) is not relevant cost as it will be incurred anyway whether the Joggers Division is closed or not. Hence it should be ignored while evaluating the above options.
Committed costs are a type of unavoidable costs. Committed costs are those costs which a company has already committed to or an obligation to which a company has already agreed to, and these costs cannot be avoided by any of the decisions under consideration.
As the costs will be incurred irrespective of what decision is made, hence committed costs are not relevant costs for decision making.
Example: Committed costs
A company acquired a building on rent for three years at an annual rental of $60,000. The company started operating its retail outlet in that shop. Response from the community was not satisfactory and after one year, the company is considering to close this retail outlet and open a new one somewhere else. Lease agreement cannot be terminated, so the Company will sublet this building at an annual rental of $35,000.
Relevant costs in this case are:
- Net profits which are expected from new retail outlet and the two year rentals which will be received from subletting the building ($35,000 x 2 = $70,000); and
- Expected net profits from the existing retail outlet
Annual rentals payable in respect of building amounting to $120,000 ($60,000 x 2 years) are irrelevant as the company has to pay these rentals whether existing retail outlet is closed or not. This represents a committed cost and therefore it should not be considered while evaluating the above options.
Sunk costs are those costs which have already been incurred. As the decisions to be made are related to future and the costs already incurred cannot be overturned whether one alternative is chosen or the other, therefore they are not relevant costs for decision making. Hence sunk costs or historical costs should be ignored while evaluating decisions.
Example: Sunk costs
A company is considering whether to invest in the shares of XYZ Company or not. Feasibility studies were carried by a firm of professional consultants and a fee of $10,000 was paid by the company in this regard.
Financial evaluation of whether to invest in shares of XYZ company or not should ignore the fee of $10,000 paid for feasibility studies as it has already been paid and it cannot be reversed or changed whether the company decides to invest or not.
Relevant costs can be measured in terms of opportunity costs. An opportunity cost is a benefit which is forgone or lost as a result of opting a particular alternative instead of the next most profitable alternative. When there are greater opportunities but the resources are limited, a rationale person has to choose the best option but at same time, has to forego the benefit that could have been earned if another option was chosen. This forgone benefit is the opportunity cost, which is usually measured as the contribution forgone.
Example: Opportunity cost
A restaurant has three brilliant chefs who are masters of Chinese and Italian cuisine. These three chefs are currently serving Chinese food but due to the lack of interest in Chinese food by the local community, the restaurant is considering to shift its focus on Italian cuisine. Current contribution per year earned by Chinese cuisine is $250,000. Basic salary of each chef is $100,000 per year.
The relevant costs of three chefs in first year of shifting to Italian cuisine would be:
|Amount in $|
|Salaries of chefs||300,000|
|Contribution forgone/ opportunity cost||250,000|
|Total relevant cost||550,000|
The Italian cuisine would be feasible only if it generates sufficient revenue to cover the salaries expense and make the contribution currently being earned by serving Chinese cuisine. To do so, the revenue from new scheme must be equal to or more than $550,000.