Past costs may help you predict and estimate the future costs, but the past costs are otherwise irrelevant to the decision. That is why accountants will refer to a past cost as a sunk cost. The first feature is that it they are future oriented. That means that a relevant cost is one that we will incur in the future as a direct result of a management decision.

A managerial accounting term for costs that are specific to management’s decisions. The concept of relevant costs eliminates unnecessary data that could complicate the decision-making process. A construction firm is in the middle of constructing an office building, having spent $1 million on it so far. It requires an additional $0.5 million to complete construction. Because of a downturn in the real estate market, the finished building will not fetch its original intended price, and is expected to sell for only $1.2 million. However, the $1 million is an irrelevant cost, and should be excluded.

1. The next feature is that relevant costs are incremental in nature.
2. Relevant cost is a management accounting term that describes avoidable costs incurred when making specific business decisions.
3. Assume a passenger rushes up to the ticket counter to purchase a ticket for a flight that is leaving in 25 minutes.
4. ‘Relevant costs’ can be defined as any cost relevant to a decision.

As you’ll recall from earlier on in this article, in order to be considered a relevant cost, it has to be a cash transaction. So, a non-cash transaction or a non-cash item would be depreciation or notional rent, or maybe a translation gain or loss on foreign exchange. The material has no use in the company other than for the project under consideration. ‘Relevant costs’ can be defined as any cost relevant to a decision. A matter is relevant if there is a change in cash flow that is caused by the decision. For example, a person has to choose between vacationing and spending time with their family.

Definition of Relevant Costs

Component A can be converted into Product A if $6,000 is spent on further processing. Paid at $8 per hour and existing staff are fully utilised. The company will hire new staff to meet this additional demand. The above is just a short extract from our CIMA P1 Management Accounting course.

Continue Operating vs. Closing Business Units

For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. Relevant costs stand out because they haven’t been incurred yet, can be avoided, and are only pursued if it’s believed the action will be profitable. Companies keep track of these costs and jobs could be in jeopardy if they don’t pay off. Production volume – this can increase by 50% because currently each item takes 0.5 hours in Operation 2, but 0.25 hours per unit will be released by Operation 1 which now will not be needed.

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According to the above illustration, it will cost XYZ $250,000 to buy from a supplier. And it will cost $390,000 to make the same internally. Material – if the buy-in option is accepted, the material cost increases from $12 to $15 per unit. Component B can be converted into Product B if $8,000 is spent on further processing.

The additional travel expenses to the new territory and the additional sales from the new territory are relevant to the decision. Relevant costs are future costs that will differ between two or more alternative actions. Expressed another way, relevant costs are the costs that will make a difference when making a decision. There are two other types of relevant cost that we need to be aware of.

If we decide to produce the product, we will have incurred that cost anyway. No matter what decision we make, we’ve already incurred that cost. Therefore, it’s a sunk cost and it’s never relevant in short-term decision making. A sunk cost is an expenditure that has already been made, and so will not change on a go-forward basis as the result of a management decision.

Material B – The 100 units of the material already in inventory has no other use in the company, so if it is not used on the new product, then the assumption is that it would be sold for $12/unit. If the new product is made, this sale won’t happen and the cash flow is affected. The original purchase price of $10 is a sunk cost and so is not relevant. In addition, another 50 units are needed for the new product and these will need to be bought in at a price of $14/unit. They can buy the part from a vendor or make it in the factory.

A committed cost is one that we’ve committed to and so, regardless of whichever decision we intend to make or whichever decision we decided to choose, we will incur this cost regardless. Therefore, it is a non-relevant cost because we will incur this regardless of whether we decide to pursue a particular course of action or not. This is not worthwhile as incremental costs exceed incremental revenues. Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the decision to invest. As the relevant cost is a net cash outflow, the machine should be sold rather than retained, updated and used. These employees are difficult to recruit and the company retains a number of permanently employed staff, even if there is no work to do.

A special order occurs when a customer places an order near the end of the month, and prior sales have already covered the fixed cost of production for the month. If the product cost price is below production cost, the company can safely decide to take special orders. Therefore, it is worth buying in as incremental revenue exceeds incremental costs. Machine running costs – the machine is already fully utilised on Operations 1 and 2 and will remain fully utilised, but only on Operation 2. Therefore, the machine running costs will not change, so are not relevant to the decision. Instead of carrying out Operation 1, the company could buy in components, for $15 per unit.

In this situation however, the labour is simply being redeployed so $24 understates the effect of this, as the labour costs are not saved. Along the line of business, there is the production of several units. Thus, these costs increase as the production increases or drops with low production. If a company decides not to undertake an activity, the company can avoid some expenses.

If you think of that example that we had above, where we have excess capacity, we don’t need to consider fixed costs in those types what is relevant cost of short-term decisions. Business management uses relevant costs to finalize a decision. Relevant costs help to eradicate unnecessary data that can complicate a decision-making process.