The closure of Production Line A would also result in the revenue lost being greater than the value of the costs saved, so this isn’t a good idea either. Therefore, the closure of Production Line B is not a good idea as the revenue lost is greater than the value of the costs saved. The only additional cost is the labor to load the passenger’s luggage and any food that is served mid-flight, so the airline bases the last-minute ticket pricing decision on just a few small costs. The decision could result in higher expenses or lower expenses as well as higher or lower revenue. Generally, the cost can be deemed worthwhile if it pays off and results in a higher overall profit. These costs are not static, will vary depending on which path is taken, and can be avoided.

If a client wants a price quote for a special order, management only considers the variable costs to produce the goods, specifically material and labor costs. Fixed costs, such as a factory lease or manager salaries, are irrelevant because the firm has already paid for those costs with prior sales. A relevant cost is one that we incur as a direct response to a particular decision. And likewise, a relevant revenue is the same, just instead of a cost, we incur a revenue as a result of a particular decision. Relevant costs have three features, and then there are also two other types of relevant costs that we need to be aware of. Relevant costs are costs that are relevant to short term decisions, or one-off decisions, and we’ll be looking at some of the key features of relevant costs.

A relevant cost is a cost that only relates to a specific management decision, and which will change in the future as a result of that decision. The relevant cost concept is extremely useful for eliminating extraneous information from a particular decision-making process. Also, by eliminating irrelevant costs from a decision, management is prevented from focusing on information that might otherwise incorrectly affect its decision. For example, a furniture manufacturer is considering an outside vendor to assemble and stain wood cabinets, which would then be finished in-house by adding handles and other details. The relevant costs in this decision are the variable costs incurred by the manufacturer to make the wood cabinets and the price paid to the outside vendor. If the vendor can provide the component part at a lower cost, the furniture manufacturer outsources the work.

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In all examples we ignore the time value of money. Irrespective of what treatment is used in the company’s management accounts to split up costs, if the total costs remain the same, there is no cash flow effect caused by the decision. A company that needs a special item can either make one on its own or outsource it. The decision to make or buy it depends on the cost-effectiveness of either alternative.

Definition of Relevant Costs

Assume, for example, a chain of retail sporting goods stores is considering closing a group of stores catering to the outdoor sports market. The relevant costs are the costs that can be eliminated due to the closure as well as the revenue lost when the stores are closed. If the costs to be eliminated are greater than the revenue lost, the outdoor stores should be closed. It happens when the company opt-out of other activities that can save it from incurring expenses. Variable costs vary with different levels of production. It means that if there is zero production, there is no spending.

1. And likewise, a relevant revenue is the same, just instead of a cost, we incur a revenue as a result of a particular decision.
2. A managerial accounting term for costs that are specific to management’s decisions.
3. Make vs. buy decisions are often an issue for a company that requires component parts to create a finished product.
4. If buying the item costs less than making it internally, the company opts for outsourcing it.

Sunk costs, on the other hand, are existing expenses that have already been incurred and are unrecoverable. A big decision for a manager is whether to close a business unit or continue to operate it, and relevant costs are the basis for the decision. Relevant costs are future potential expenses, whereas sunk costs are existing expenses that have already been made. Relevant costs can be thought of as future expenses that are incurred only if an opportunity is pursued. They are studied by companies to determine if one decision is more cost-effective than another. The opposite of a relevant cost is a sunk cost, which has already been incurred regardless of the outcome of the current decision.

What Is the Difference Between Relevant Cost and Sunk Cost?

Management can use this concept to make cost-effective business decisions and avoid unnecessary expenses. A company decides to buy loading machinery for a factory unit. This machine can save the wage expenses of 20 manual laborers.

If buying the item costs less than making it internally, the company opts for outsourcing it. In business, a customer may request a one-time item from a company. They could have made this order right after the company had calculated all its costs on normal sales. The company shall then consider the lowest price for producing that order. It considers taking special orders if the costs involved will generate income in the long run.

The future expenses that might occur due to a decision made in the present are called future cash flows. The current value is used to project future revenues to see if a decision will incur future costs. Here, we can price the expected ongoing-project revenues with the current value. Then, a discounted rate is formulated to arrive at discounted cash flows.

When making a decision, you should always take relevant costs into consideration, and ignore all sunk costs. A particular cost may what is relevant cost be relevant for one situation but irrelevant for another. The opposite of relevant costs is sunk cost or irrelevant costs, which refers to the expenses already incurred. Thus, incurring an expense may be avoided by deciding not to perform a certain activity.

Relevant cost is a management accounting term that describes avoidable costs incurred when making specific business decisions. This concept is useful in eliminating unnecessary information that might complicate the management’s decision-making process. Businesses use relevant costs in management accounting to conclude whether a new decision is economical. Relevant cost is a managerial accounting term that describes avoidable costs that are incurred only when making specific business decisions. The concept of relevant cost is used to eliminate unnecessary data that could complicate the decision-making process. As an example, relevant cost is used to determine whether to sell or keep a business unit.

The company shall free some space that can be leased if it decides to outsource. The management can outsource to make an extra income from leased space. The relevant cost analysis thus helped the company to conclude that buying the part was a more financially sound decision.

The total fixed costs of $24m have been apportioned to each production line on the basis of the floor space occupied by each line in the factory. Say, for example, that 4 hours of labour were simply removed by ‘sacking’ an employee for four hours, one less unit of Product X could be made. Using the contribution foregone figure of $24 is the net effect of losing the revenue from that unit and also saving the material, labour and the variable costs.