Relevant cost is a fundamental concept in managerial accounting that plays a crucial role in information-based decision-making. It refers to avoidable costs that are incurred specifically in response to business decisions. Understanding relevant costs helps managers streamline their decision-making process by focusing on the costs that truly matter.
What Are Relevant Costs?
Relevant costs can be identified as costs that will be affected by specific management decisions. This focus on pertinent information differentiates them from costs that do not contribute directly to decision-making, such as sunk costs. Sunk costs are expenses that have already been incurred and cannot be recovered, regardless of future outcomes.
Key Takeaways
- Relevant Costs: Costs that will change depending on the decision made.
- Sunk Costs: Past costs that are irrelevant to current decision-making.
Examples of Use
Managers leverage relevant costs in various critical decision-making scenarios, such as: - Closing a business unit. - Deciding between manufacturing a product in-house or purchasing it from an external supplier. - Evaluating special customer orders.
Understanding the Nature of Relevant Costs
Relevant costs are inherently linked to future expenditures and can be avoided based on a course of action taken. Unlike fixed costs—which remain constant regardless of business operations—relevant costs can fluctuate based on the decisions made by management. This makes them crucial in evaluating potential expenses and calculating profitability.
Future vs. Past Expenses
- Relevant Costs: Future avoidable expenses tied to a decision.
- Sunk Costs: Historical costs that have already been incurred, irrelevant to future planning.
A Practical Example of Relevant Costs
Imagine a customer urgently requires a flight ticket just before departure. In this scenario, almost all associated costs (like fuel and crew salaries) are sunk costs. The airline's decision on the ticket price relies heavily on the additional costs entailed by accommodating the last-minute passenger, which primarily involves the labor to handle the passenger's luggage and any food service details.
Types of Decisions Based on Relevant Costs
1. Continue Operating vs. Closing Business Units
A fundamental managerial dilemma involves deciding whether to keep a business unit open or shut it down. For instance, a retail chain may need to analyze the variable costs it can eliminate by closing stores that are underperforming, compared to the revenue loss expected from such a decision.
2. Make vs. Buy
Companies often face the make-or-buy decision when it comes to manufacturing components. For instance, a furniture manufacturer considering outsourcing its cabinet assembly must analyze both the cost of in-house production and the cost of outsourcing. The decision will hinge on which option incurs lower relevant costs.
3. Evaluating Special Orders
When a customer requests a special order late in the month, management will assess the relevant costs associated with fulfilling it. They will only factor in variable costs, such as those for materials and labor, while fixed costs are ignored as they have already been covered by previous sales.
Other Terminologies and Characteristics
Alternative Names for Relevant Costs
Relevant costs may also be referred to as avoidable costs or differential costs, highlighting their nature as costs that can be sidestepped depending on operational decisions.
Key Characteristics
For a cost to be regarded as relevant, it must share two main characteristics: 1. Avoidability: The cost can be avoided if the decision is made not to pursue a certain option. 2. Differentiable: The cost may differ depending on the action chosen.
Importance of Relevant Costs
Relevant costs are vital for managerial budgeting and forecasting. They help management to: - Identify cost-saving opportunities. - Make informed decisions that can maximize profits. - Evaluate potential projects or operational changes effectively.
A thorough understanding of relevant costs is imperative for managers, as poor decision-making based on irrelevant costs can threaten the financial health of the business.
Conclusion
Relevant costs are a crucial aspect of managerial accounting that allows businesses to make informed financial decisions. By focusing specifically on costs that can be avoided and will affect the outcome of business choices, companies can analyze their options better and ultimately improve profitability. Decisions ranging from shutting down business units to evaluating special orders all hinge on a clear understanding of relevant costs, underscoring their importance in strategic financial management.