What Is Relevant Cost in Accounting for Business Decisions?

Relevant cost is a fundamental concept in managerial accounting that guides business decision-making. It involves identifying specific costs and revenues that will change as a direct result of a particular choice or action a company is considering. This principle focuses only on the financial elements that differ between alternatives, helping management make sound choices.

Characteristics of Relevant Costs

Relevant costs must be incurred in the future, as past expenditures, regardless of their size, cannot be altered by current or future decisions.

Additionally, relevant costs must be differential, meaning they vary between the alternative courses of action under consideration. If a cost remains the same regardless of the decision made, it holds no relevance because it does not help distinguish one option from another.

Furthermore, relevant costs involve a direct cash flow impact, representing a cash outflow or inflow. The focus for relevant costs is on the direct cash effects that will result from a decision.

Distinguishing Relevant and Irrelevant Costs

Relevant costs are those that change based on a choice, and they include several specific categories. Opportunity costs represent the value of the next best alternative that is forgone when a particular decision is made. For instance, if a company uses a vacant factory space for a new product line, the opportunity cost is the rental income that could have been earned if the space had been leased to an external party.

Avoidable costs are expenses that can be eliminated by choosing one alternative over another. These often include variable costs like direct materials, direct labor, and variable overhead directly tied to a specific product or activity. If a product line is discontinued, the direct costs associated with its production are typically avoidable. Relevant decisions also incorporate incremental revenues, which are the additional sales generated by a specific action, campaign, or new product. This additional income helps assess the profitability of a decision by comparing it against the incremental costs.

Irrelevant costs are those that will not be affected by a management decision. Sunk costs are past expenditures that have already been incurred and cannot be recovered or changed by any future action. For example, the money spent on research and development for a product that is now being considered for discontinuation is a sunk cost and should not influence the decision to stop production.

Committed costs are future costs that an organization is obligated to incur regardless of the decision being made, often due to long-term contracts or past agreements. Examples include long-term lease payments for a factory or the fixed salaries of administrative staff who will not be affected by a specific production decision. Non-differential costs are those that remain the same across all decision alternatives.

Applying Relevant Costs in Decision Making

Relevant costs are applied across various business scenarios. In “make or buy” decisions, a company assesses whether to produce a component internally or purchase it from an external supplier. Relevant costs include the differential manufacturing costs (direct materials, direct labor, variable overhead) of in-house production compared to the external purchase price, along with any avoidable fixed costs or opportunity costs of using internal capacity.

When considering “special order” decisions, a business evaluates whether to accept a one-time order, often at a reduced price. The analysis focuses only on the incremental costs and revenues directly associated with that specific order, such as additional variable production costs. Existing fixed costs that will not change with the order are irrelevant.

Decisions about “adding or dropping a product line or segment” require careful consideration of avoidable fixed costs and the lost contribution margin from discontinuing a product. Companies must ignore allocated fixed costs that would simply be reallocated to other products if the line were dropped. The decision hinges on whether the eliminated avoidable costs outweigh the lost revenue and variable costs.

For “equipment replacement” decisions, businesses consider the cost of new equipment, differences in operating costs (like energy or maintenance) between the old and new machinery, and the salvage value of the old equipment. The historical cost of the existing equipment is a sunk cost and is irrelevant to the replacement decision. The focus is on the future cash flows and operational efficiencies gained or lost.