Lesson 1, Topic 1
In Progress

Identifying Relevant costs and benefits


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Relevant costing attempts to determine the objective cost of a business decision. An objective measure of the cost of a business decision is the extent of cash outflows that shall result from its implementation. Relevant costing focuses on just that and ignores other costs which do not affect the future cash flows.

The underlying principles of relevant costing are fairly simple and you can probably relate them to your personal experiences involving financial decisions.

For example, assume you had been talked into buying a discount card of ABC Pizza for $50 which entitles you to a 10% discount on all future purchases. Say a pizza costs $10 ($9 after discount) at ABC Pizza and it subsequently came to your knowledge that a similar pizza is offered by XYZ Pizza for just $8. So the next time you would have ordered a pizza, you would have (hopefully) placed an order at XYZ Pizza realizing that the $50 you have already spent is irrelevant (see sunk cost below).

Relevant costing is just a refined application of such basic principles to business decisions. The key to relevant costing is the ability to filter what is and isn’t relevant to a business decision.

Types of Relevant CostsTypes of Non-Relevant Costs
Future Cash Flows

Cash expense that will be incurred in the future as a result of a decision is a relevant cost.
Sunk Cost

Sunk cost is expenditure which has already been incurred in the past. Sunk cost is irrelevant because it does not affect the future cash flows of a business.
Avoidable Costs

Only those costs are relevant to a decision that can be avoided if the decision is not implemented.
Committed Costs

Future costs that cannot be avoided are not relevant because they will be incurred irrespective of the business decision being considered.
Opportunity Costs

Cash inflow that will be sacrificed as a result of a particular management decision is a relevant cost.
Non-Cash Expenses

Non-cash expenses such as depreciation are not relevant because they do not affect the cash flows of a business.
Incremental Cost

Where different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered.
General Overheads

General and administrative overheads which are not affected by the decisions under consideration should

Application & Limitations

While relevant costing is a useful tool in short-term financial decisions, it would probably not be wise to form it as the basis of all pricing decisions because in order for a business to be sustainable in the long-term, it should charge a price that provides a sufficient profit margin above its total cost and not just the relevant cost.

Examples of application of relevant costing include:

  • Competitive pricing decisions
  • Make or buy decisions
  • Further processing decisions

For long term financial decisions such as investment appraisal, disinvestment and shutdown decisions, relevant costing is not appropriate because most costs which may seem non-relevant in the short term become avoidable and incremental when considered in the long term. However, even long term financial decisions such as investment appraisal may use the underlying principles of relevant costing to facilitate an objective evaluation.

SELF-CHECK ACTIVITY

  1. Identify relevant cost?
  2. Describe the benefit of relevant cost?