What is a Relevant Cost?
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.
This concept is only applicable to management accounting activities; it is is not used in financial accounting, since no spending decisions are involved in the preparation of financial statements.
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Example of Relevant Costs
For example, the Archaic Book Company (ABC) is considering purchasing a printing press for its medieval book division. If ABC buys the press, it will eliminate 10 scribes who have been copying the books by hand. The wages of these scribes are relevant costs, since they will be eliminated in the future if management buys the printing press. However, the cost of corporate overhead is not a relevant cost, since it will not change as a result of this decision.
As another example, if ABC wants to close its medieval book division entirely, the only relevant costs will be those costs specifically eliminated as a result of the decision. Once again, the cost of corporate overhead is not a relevant cost when making this decision, since it will not change if the division is sold.
Relevant Costs vs. Sunk Costs
The reverse of a relevant cost is a sunk cost. 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.
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Now, let's delve into the key concepts discussed in the article on relevant costs:
Relevant Cost Concept:
The concept of relevant costs is fundamental to managerial decision-making. A relevant cost is a cost that is directly associated with a specific management decision and is expected to change in the future due to that decision. This concept is paramount for filtering out extraneous information, enabling management to focus on critical factors influencing a decision.
Applicability to Management Accounting:
The relevance of costs is emphasized in management accounting activities. It is not applied in financial accounting, where the primary focus is on preparing financial statements rather than making spending decisions. In managerial accounting, the goal is to streamline decision-making by considering only costs that are pertinent to a particular choice.
Example of Relevant Costs:
The provided example involving the Archaic Book Company (ABC) illustrates the application of relevant costs. In the decision to purchase a printing press, the wages of 10 scribes, who would be eliminated if the press is bought, are considered relevant costs. On the other hand, corporate overhead costs are deemed irrelevant since they will not change based on this decision.
Decision to Close a Division:
The article also highlights that in scenarios where a company contemplates closing a division, only costs directly impacted by the decision are relevant. Corporate overhead costs, which remain unchanged regardless of the division's fate, are considered irrelevant in this context.
Relevant Costs vs. Sunk Costs:
The concept draws a clear distinction between relevant costs and sunk costs. Relevant costs are future-oriented and influence decisions, whereas sunk costs are expenditures that have already been incurred and do not change as a result of a management decision. This differentiation is crucial in avoiding the inclusion of past costs that should not impact future decisions.
In conclusion, the understanding and application of relevant costs are essential for effective managerial decision-making, allowing businesses to make informed choices by considering only the costs that are pertinent to the decision at hand.
