Relevant CostTypes along with examples
What is Relevant Cost?
An important management accounting concept that is used to describe avoidable costs when making specific business decisions is the Relevant Cost.
The idea behind this is to eliminate data that could complicate management’s decision-making process.
Decisions such as continuing operations or closing a business unit is an example of using a Relevant Cost.
The opposite of Relevant Cost is Sunk Cost, which refers to costs that have already been incurred regardless of the business decision made.
Example of Relevant Cost
Company X is looking at purchasing a piece of high-end machinery that can increase production by 100% and reduce manpower by 50%, equivalent to 10 personnel.
In this example, the relevant cost is the salary of 10 personnel.
If Company X decides not to go ahead with the machinery, their production output remains as is and it will still pay for the salary of the 10 personnel.
Types of Relevant Cost Decisions
Continue Operations vs Close Business Units
When deciding to close a business unit or units, an important decision that every manager has to make is to choose which decision they should go for.
For example, a clothing chain is contemplating whether to close 2 or more branches or to continue their operations.
The alternative cost in this scenario would be the revenue that will be lost should they decide to close the business units, or the cost incurred should they continue operations.
The sound decision, in this case, would be to choose the option that will generate the company a higher revenue and less cost.
If the cost to continue operations is higher than the revenue that will be generated, the business units should be closed.
Make vs Buy
This typically applies to manufacturing companies who have the option to outsource work or purchase other materials from outside vendors.
An example would be if a furniture-making company needs to decide whether to outsource the painting of furniture or to do it in-house.
If the cost to outsource the job is more than doing it in-house, the logical choice would be the one that cost less and that is in-house production.
Factor a Special Order
Towards the end of the month, most of the production fixed costs have already been covered by the company.
So when a customer places an order towards month end, companies need to factor it in as a special order.
When accounting for this order, only the variable costs are taken into consideration such as labor and material costs.
Other costs, specifically fixed costs, have already been factored in and covered from the sales of the prior month.
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College of San Mateo " Relevant Costs for Decision Making" Page 1. October 18, 2022
Texas Southern University "Identify relevant and irrelevant costs and benefits in a decision" Page 1 - 85. October 18, 2022