‘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.
The change in cash flow can be:
- additional amounts that must be paid
- a decrease in amounts that must be paid
- additional revenue that will be earned
- a decrease in revenue that will be earned.
A change in the cash flow can be identified by asking if the amounts that would appear on the company’s bank statement are affected by the decision, whether increased or decreased. Banks record cash so this test is reliable.
1. Sunk costs (past costs) or committed costs are not relevant
Sunk, or past, costs are monies already spent or money that is already contracted to be spent. A decision on whether or not a new endeavour is started will have no effect on this cash flow, so sunk costs cannot be relevant.
For example, money that has been spent on market research for a new product or planning a new factory is already spent and isn’t coming back to the company, irrespective of whether the product is approved for manufacture or the factory is built.
Committed costs are costs that would be incurred in the future but they cannot be avoided because the company has already committed to them through another decision which has been made.
For example, if a company has two year lease for piece of machinery, that cost will not be relevant to a decision on whether to use that machinery on a new project which will last for the next month.
2. Re-apportionment of existing fixed costs are not relevant
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.
Note that additional fixed costs caused by a decision are relevant. So, if you were evaluating the viability of a new production facility, then the rent of a building specially leased for the new facility is relevant.
3. Depreciation and book values (notional costs) are not relevant
Depreciation is not a cash flow and is dependent on past purchases and somewhat arbitrary depreciation rates. By the same argument, book values are not relevant as these are simply the result of historical costs (or historical revaluation) and depreciation.
4. Increases or decreases in cash flows caused by a project are relevant
So, if an old product is discontinued three years early to make room for a new product, the revenue and cost decreases relating to the old product are relevant, as are the revenue and cost increases on the new. The cost effects relate to both changes in variable costs and changes in total fixed costs.
5. Revenues forgone (given up) because of a decision are relevant
If a company decides to keep an asset for use in the manufacture of a new product rather than selling it, then its cash flow is affected by the decision to keep the asset, as it will now not benefit from the sale of the asset. This effect is known as an opportunity cost, which is the value of a benefit foregone when one course of action is chosen in preference to another. In this case, the company has given up its opportunity to have a cash inflow from the asset sale.
Types of decision
We will now look at some typical examples where you have to decide which costs are relevant to decision-making. We suggest that you try each example yourself before you look at each solution. In all examples we ignore the time value of money.
Always think: what future cash flows are changed by the decision? Changes in future cash flows reliably indicate which amounts are relevant to the decision.
Example 1: Relevant cost of materials
A company is considering making a new product which requires several types of raw material:
What is the relevant cost of the materials required for manufacture of the new product?
Solution:
Taking each material in turn:
Material A – As there is no inventory, all 40 units required will have to be bought in at $7 per unit. This is a clear cash outflow caused by the decision to make the new product. Therefore, the relevant cost of Material A for the new product is (40 units x $7) = $280.
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.
The total relevant cost for Material B is:
