Relevant costs are defined as the costs that arise in future and are different for different alternatives. The concept of relevant costs are used by management for making various decisions such as special or one-time order pricing, make or buy decisions, add or drop product lines, in-sourcing vs. outsourcing etc. Relevant costs are issue specific. An item of cost may be relevant for one situation and irrelevant for other.
Characteristics of Relevant Costs
Two important characteristic features of relevant costs are ‘Occurrence in Future’ and ‘Different for Different Alternatives’. This does not mean that all costs which occur in future are not relevant cost. For a cost item to be relevant, both the conditions should be present. A future cost has also to be different in the different alternative to making it a relevant cost important for decision making. In other words, the costs which do not change with the alternative situation are irrelevant costs not considered by management. Normally, sunk costs and future costs (not changing with alternatives under consideration) are irrelevant costs. Relevant and irrelevant costs are mutually exclusive events. A cost item in one situation cannot be both relevant and irrelevant cost at the same time.
Relevant Cost Example
We will take an example of two alternatives viz. ‘rearranging facility layout’ or ‘maintain status quo’ to understand the relevant cost situation. Assume a company manufacturing scooters reorganizes its facility layout. The company has advanced order book for the scooters. Therefore, whatever is produced is sold. The step of ‘reorganizing’ will increase production by 100 units from 1000 to 1100. It will also save the manufacturing labor cost by $100 per scooter. The cost of reorganizing is $150,000. The price of a scooter is $1200, material cost per unit is $500, and manufacturing labor cost is $400.
Apparently, the reorganizing looks profitable but we have analyzed the situation in the following table. There are two approaches to analyze the alternatives – All Costs and Relevant Costs. Both the approaches show the same result. Reorganizing is not a profitable move. The cost of reorganizing offsets both the increase in revenue and reduction in cost by $10,000.
Relevance for Decision Making
Only Relevant Cost
|Revenue (1000*1200) or (1100*1200)|
|Material Cost @ $500|
|Manufacturing Labor @ $400 and $300|
|Difference in Alternatives|
Now, let us talk about two techniques of analyzing. Since relevant cost technique takes into account only the relevant costs and relevant revenues, it simplifies the management decisions. Taking all the costs will complicate the situation and focus will be lost between important and relevant costs and irrelevant costs. Deciding relevance of a cost item is most important here.
A manager must take the precaution of two probable mistakes. Firstly, by mistake, irrelevant costs are taken as relevant costs. They will complicate the situation as well as increase the chance of faults. Secondly, same unit costs of fixed manufacturing costs are taken for different activity level. In our example, with the change in activity, the fixed overheads of $75,000 will change with the change from 1000 units to 1100 units. They can hamper the whole calculation and decisions relying on those will adversely affect the profits of the company.