Lesson 1, Topic 1
In Progress

Why Isolate Relevant Costs?


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Relevance is one of the key characteristics of good management accounting information. This means that management accounting information produced for each manager must relate to the decisions which he/she will have to make. ‘Relevant costs’ are the costs that meet this requirement of good management accounting information. The Chartered Institute of Management Accounting defines relevant costs as: ‘the costs appropriate to a specific management decision’

This definition could be restated as ‘the amount by which costs increase and benefits decrease as a direct result of a specific management decision’. Relevant benefits are ‘the amounts by which costs decrease and benefits increase as a direct result of a specific management decision’. Before the management of an enterprise can make an informed decision on any matter, they need to incorporate all of the relevant costs which apply to the specific decision at hand in their decision-making process. To include any non-relevant costs or to exclude any relevant costs will result in management basing their decision on misleading information and ultimately to poor decisions being taken.

While the topics examined in these notes deal exclusively with relevant and non-relevant costs, the ideas raised and discussed apply with equal force to the importance and identification of the relevant and non-relevant’ benefits’ of various decisions. Relevant costs and benefits only deal with the quantitative aspects of decisions. The qualitative aspects of decisions are of equal importance to the quantitative and no decision should be made in practice without full consideration being given to both aspects.

Identifying relevant and non-relevant costs

The identification of relevant and non-relevant costs in various decision-making situations is based primarily on common sense and the knowledge of the decision maker of the area in which the decision is being made. Armed with these two tools you should be able to sift through all the information that is available in respect of any decision and extract those costs (and benefits) which are appropriate to the decision at hand.

In identifying relevant costs for various decisions, you may find that some costs not included in the normal accounting records of an enterprise are relevant and some costs included in such records are non-relevant. It is important that you realise that there is a substantial difference between recorded accounting costs and relevant costs for decision making, and while the latter may be recorded in the former this is not always the case. Accounting records are used to record the incidence of actual costs and revenues as they arise. Decisions, on the other hand, are based only on the relevant costs and benefits appropriate to each decision while the decision is being made. This point is particularly appropriate when you come to examine opportunity costs and sunk costs.

In practice, you may also find that the information presented in respect of a decision does not include all the relevant costs appropriate to the decision, but the identification of this omission is very difficult unless you are familiar with the area in which the decision is being made.Exercise The more common types of costs which you will meet when evaluating different decisions are incremental, non-incremental and spare capacity costs. Are these likely to be relevant or non-relevant?

Suggested Solution

Incremental costs: An incremental cost can be defined as a cost which is specifically incurred by following a course of action and which is avoidable if such action is not taken. Incremental costs are, by definition, relevant costs because they are directly affected by the decision (i.e. they will be incurred if the decision goes ahead and they will not be incurred if the decision is scrapped). Rounded Rectangle:  
1.  Describe why relevant cost is isolate from other cost?
For example, if an enterprise is deciding whether or not to accept a special order for its product, the extra variable costs (i.e. number of units in special order x variable cost per unit) which would be incurred in filling the order are an incremental cost because they would not be incurred if the special order were to be rejected.

SELF-CHECK ACTIVITY

  1. Describe why relevant cost is isolate from other cost?