SBL
Syllabus G. Finance In Planning And Decision-Making G3. Cost And Management Accounting

G3abc. Relevant Costs

Relevant costs for decision making

Decision making costs are often referred to as "Relevant Costs"

(ie They're relevant to this decision)

Relevant Costs must be:

  1. Future

    Past costs are irrelevant, decisions are about now and the future

  2. Incremental

    Only include extra costs incurred or avoided as a result of making the decision.

  3. Cash Flow

    Depreciation isn't a cash flows and therefore not relevant.

Other terms:

  • Common Costs

    Costs which will be identical for all alternatives are irrelevant

    e.g. rent or rates on a factory would be incurred whatever decision is made

  • Sunk Costs

    Another name for past costs, which are always irrelevant

    e.g. dedicated fixed assets, development costs already incurred.

  • Committed Costs

    A future cash outflow that will be incurred anyway (and so isn't relevant), whatever decision is taken now

    E.g. contracts already entered into which cannot be altered.

Opportunity cost

Relevant costs may also be expressed as Opportunity costs. 

An opportunity cost is the benefit foregone by choosing one opportunity instead of the next best alternative.

  • Example

    A company is considering a project with a 9% return - to make it though, they can't do another project which would have made a 6% return

    The Opportunity cost of doing the 9% project is the 6% that the alternative project forgone would have brought in

Relevant Costs will be the sum of:

  1. Avoidable Outlay costs

    i.e. those costs which will be incurred only if the project is approved, and will be avoided if it is not

  2. Opportunity costs

  3. This total is a true representation of 'economic cost'.

The Assumptions in Relevant costing

  • Cost behaviour patterns are known, e.g. if a department closes down, the attributable fixed cost savings would be known.

  • The amount of fixed costs, unit variable costs, sales price and sales demand are known with certainty.

  • The objective of decision making in the short run is to maximise 'short-term profit'.

  • The information on which a decision is based is complete and reliable.