Relevant Cost and Decision Making
Relevant cost, in managerial accounting, refers to the incremental and avoidable cost of implementing a business decision.
- Types of relevant costs
- Types of non-relevant costs
- Application & Limitations
Relevant costing attempts to determine the objective cost of a business decision. An objective measure of the cost of a business decision is the extent of cash outflows that shall result from its implementation. Relevant costing focuses on just that and ignores other costs which do not affect the future cash flows.
The underlying principles of relevant costing are fairly simple and you can probably relate them to your personal experiences involving financial decisions.
For example, assume you had been talked into buying a discount card of ABC Pizza for $50 which entitles you to a 10% discount on all future purchases. Say a pizza costs $10 ($9 after discount) at ABC Pizza and it subsequently came to your knowledge that a similar pizza is offered by XYZ Pizza for just $8. So the next time you would have ordered a pizza, you would have (hopefully) placed an order at XYZ Pizza realizing that the $50 you have already spent is irrelevant (see sunk cost below).
Relevant costing is just a refined application of such basic principles to business decisions. The key to relevant costing is the ability to filter what is and isn't relevant to a business decision.
Types of Relevant Costs
Types of Non-Relevant Costs
|Future Cash Flows|
Cash expense that will be incurred in the future as a result of a decision is a relevant cost.
Sunk cost is expenditure which has already been incurred in the past. Sunk cost is irrelevant because it does not affect the future cash flows of a business.
Only those costs are relevant to a decision that can be avoided if the decision is not implemented.
Future costs that cannot be avoided are not relevant because they will be incurred irrespective of the business decision bieng considered.
Cash inflow that will be sacrificed as a result of a particular management decision is a relevant cost.
Non-cash expenses such as depreciation are not relevant because they do not affect the cash flows of a business.
Where different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered.
General and administrative overheads which are not affected by the decisions under consideration should be ignored.
Rubber Tire Company (RTC) received a request to provide a price quote for an order for the supply of 1000 custom made tires required for industrial vehicles. RTC is facing stiff competition from its business rivals and is therefore hoping to secure the order by quoting the lowest price. RTC plans to quote a price at 10% above its relevant cost.
Following is the calculation of total cost in respect of the order:
The order requires a special type of rubber.
Only 25% rubber is currently available in stock. The rubber was purchased 2 years ago at the cost of $3,000. If the rubber is not used on this order, it will have to scraped at a price of $1,000.
Remaining quantity shall have to be procured at the price of $7,000.
All the required quantity of oil is currently available in stock. The cost of oil that will be used on the order is $1,000.
The current market value of the required quantity of oil is $1,200. If oil is not used on the order, it could be used in the production of other tires.
|Other Materials||$2,000||All other materials will have to be procured.|
$5,000 represents the cost that would be paid to direct labor in respect of the time that they work on the order.
If direct labor is not utilized on this order, they remain idle for the entire time. Direct labor is paid idle time equal to 60% of the normal pay in order to retain them.
|Supervisor's Salary||$1,000||This represents the share of factory supervisor's salary for the number of days in which production for the order will take place.|
|Depreciation of equipment||$3,000||This represents the manufacturing equipment's depreciation for the number of days in which production for the order will take place.|
|Lease rental of factory plant||$12,000||This represents the share of lease rentals of the factory plant for the number of days in which production for the order will take place.|
|Electricity||$8,000||The order would require 3000 units of electricity which is expected to cost $8,000.|
|Overheads Allocation||$6,000||This represents the apportionment of general and administrative overheads based on the number of machine hours that will be required on the order.|
Calculate the relevant cost for the order and the price RTC should quote.
25% - Scrap Value $1,000|
75% - Purchase Cost $7,000
Relevant Cost $8,000
The $3,000 paid two years ago is a sunk cost and should therefore be ignored. $1,000 represents the opportunity cost of using the rubber available in stock on this particular order.
The $1,000 cost of oil is a sunk cost.
The $1,200 current market value of the required oil is the relevant cost because utilizing it on this order will require purchase of additional oil at the market rates to meet the production needs of other tires. Alternatively, the oil could be sold for $1200.
|Other Materials||$2,000||As these materials are not available in stock, these will have to be purchased at the market price which is their relevant cost.|
|Direct Labor||$2,000||Since $3,000 (60% of $5,000) idle time pay will be incurred even if this order is not taken, the relevant cost is the incremental cost of $2,000 ($5,000 - $3,000).|
|Supervisor's Salary||-||As supervisor's salary is a fixed cost unchanged by the work performed on this order, it is a non-relevant cost.|
|Depreciation of equipment||-||Non-cash expenses are not relevant for decision making.|
|Lease rental of factory plant||-||Lease rentals are a committed cost which cannot be avoided by withdrawing from this order which is why they should be ignored for the purpose of this analysis.|
|Electricity||$8,000||Electricity charges are incremental to this order and therefore relevant.|
|Overheads Allocation||-||General and administrative overheads that are not incurred directly as a result of this order should be considered irrelevant.|
|Relevant Cost of order||$21,200|
|Profit Margin||$2,120||10% of the relevant cost of $21,200|
|Price to be quoted||$23,320|
Application & Limitations
While relevant costing is a useful tool in short-term financial decisions, it would probably not be wise to form it as the basis of all pricing decisions because in order for a business to be sustainable in the long-term, it should charge a price that provides a sufficient profit margin above its total cost and not just the relevant cost.
Examples of application of relevant costing include:
- Competitive pricing decisions
- Make or buy decisions
- Further processing decisions
For long term financial decisions such as investment appraisal, disinvestment and shutdown decisions, relevant costing is not appropriate because most costs which may seem non-relevant in the short term become avoidable and incremental when considered in the long term. However, even long term financial decisions such as investment appraisal may use the underlying principles of relevant costing to facilitate an objective evaluation.