Relevant costing (2024)

Relevant costs and revenues are those costs and revenues that change as a direct result of a decision taken.

Relevant costs and revenues have the following features:

They are future costs and revenues – as it is not possible to change what has happened in the past, then relevant costs and revenues must be future costs and revenues.

They are incremental – relevant costs are incremental costs and it is the increase in costs and revenues that occurs as a direct result of a decision taken that is relevant. Common costs can be ignored for the purposes of decision making. In exam questions look out for costs detailed as differential, specific or avoidable.

They are cash flows – in addition, future costs and revenues must be cash flows arising as a direct consequence of the decision taken. Relevant costs do not include items which do not involve cash flows (depreciation and notional costs for example).

Non relevant costs

Costs which are not relevant to a decision are known as non relevant costs and include: sunk costs; committed costs; non cash
flow costs; general fixed overheads; and net book values.

Sunk costs are past costs or historical costs which are not directly relevant in decision making, for example development costs or market research costs.

Committed costs are future costs that cannot be avoided, whatever decision is taken.

Non cash flow costs are costs which do not involve the flow of cash, for example, depreciation and notional costs. A notional cost is a cost that will not result in an outflow of cash either now or in the future, for example sometimes the head office of an organisation may charge a ‘notional’ rent to its branches. This cost will only appear in the accounts of the organisation but will not result in a ‘real’ cash expenditure.

General fixed overheads are usually not relevant to a decision. However, some fixed overheads may be relevant to a decision, for
example stepped fixed costs may be relevant if fixed costs increase as a direct result of a decision being taken.

Net book values are not relevant costs because like depreciation, they are determined by accounting conventions rather than by future cash flows.

Opportunity costs

Opportunity cost is an important concept in decision making. It represents the best alternative that is foregone in taking the decision. The opportunity cost emphasises that decision making is concerned with alternatives and that a cost of taking one decision is the profit or contribution forgone by not taking the next best alternative.

If resources to be used on projects are scarce (e.g. labour, materials, machines), then consideration must be given to profits or contribution which could have been earned from alternative uses of the resources.

For example, the skilled labour which may be needed on a new project might have to be withdrawn from normal production. This withdrawal would cause a loss in contribution which is obviously relevant to the project appraisal.

The cash flows of a single department or division cannot be looked at in isolation. It is always the effects on cash flows of the whole organisation which must be considered.

Examples and short cuts

The relevant cost of materials

Any historic cost given for materials is always a sunk cost and never relevant unless it happens to be the same as the current purchase price.

The relevant cost of labour

Relevant cost of non-current assets

The relevant costs associated with non-current assets, such as plant and machinery, are determined in a similar way to the relevant costs of materials.

• If plant and machinery is to be replaced at the end of its useful life, then the relevant cost is the current replacement cost.
• If plant and machinery is not to be replaced, then the relevant cost is the higher of the sale proceeds (if sold) and the net cash inflows arising from the use of the asset (if not sold).

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Now, let's delve into the concepts covered in the provided article on Relevant Costing and short-term decisions:

Relevant Costing and Short-Term Decisions:

1. Relevant Costs and Revenues:

• Features of Relevant Costs and Revenues:
  • Future Orientation: Relevant costs and revenues are future-oriented, focusing on what will happen rather than past events.
  • Incremental Nature: They are incremental, meaning they represent the increase or decrease in costs and revenues directly resulting from a decision.
  • Cash Flows: Future costs and revenues considered must involve cash flows, excluding non-cash items like depreciation.

2. Non-Relevant Costs:

• Definition: Costs that are not pertinent to decision-making.
• Types:
  • Sunk Costs: Historical costs that are irrelevant to current decisions.
  • Committed Costs: Future costs unavoidable regardless of the decision.
  • Non-Cash Flow Costs: Costs not involving cash outflows, e.g., depreciation and notional costs.
  • General Fixed Overheads: Usually not relevant, but exceptions exist.
  • Net Book Values: Determined by accounting conventions, not future cash flows.

3. Opportunity Costs:

• Definition: The cost of forgoing the next best alternative when making a decision.
• Application: Relevant when resources (e.g., labor, materials) are scarce, emphasizing the importance of considering profits or contributions foregone from alternative uses.

4. Examples and Shortcuts:

• The Relevant Cost of Materials:
  • Historic material costs are sunk unless identical to the current purchase price.
• The Relevant Cost of Labour:
  • Determined by considering incremental costs associated with labor decisions.
• Relevant Cost of Non-Current Assets:
  • Determined similarly to materials; replacement cost for assets to be replaced, and for assets not replaced, the higher of sale proceeds or net cash inflows.

This understanding of relevant costing is crucial for effective decision-making, particularly in scenarios involving short-term decisions and resource allocation. It ensures that managers focus on costs and revenues that directly impact the decision at hand, contributing to sound financial choices.