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What is meant by relevant costs?

Relevant costs are costs that change with respect to a particular decision. Sunk costs are never
relevant. Future costs may or may not be relevant. If the future costs are going to be incurred
regardless of the decision that is made, those costs are not relevant. Committed costs are future
costs that are not relevant. Even if the future costs are not committed, if we anticipate incurring
those costs regardless of the decision that we make, those costs are not relevant. The only costs
that are relevant are those that differ as between the alternatives being considered.

Including sunk costs in a decision can lead to a poor choice. However, including future irrelevant
costs generally will not lead to a poor choice; it will only complicate the analysis. For example,
if I am deciding whether to buy a Toyota Camry or a Subaru Legacy, and if my auto insurance
will be the same no matter which car I buy, my consideration of insurance costs will not affect
my decision, although it will slightly complicate the analysis.

Relevant costs are those costs that will make a difference in a decision. Relevant costs are future
costs that will differ among alternatives.

We can demonstrate relevant costs with the following situation. A company is deciding whether
or not to eliminate a product line. The product line accounts for approximately 4% of the
company¶s activities. If the product line is eliminated, the officers of the corporation will
continue to receive the same salaries and the central office expenses will not change. The product
line managers and other employees working directly on the product line will be terminated.
Hence, their salaries will be eliminated.

The salaries of the product line managers and other employees whose salaries will be eliminated
are relevant to the decision. If these salaries are $700,000 with the product line and $0 without
the product line, the $700,000 of savings is relevant. Those cost savings and other possible cost
savings will be considered along with the loss of sales revenues.

On the other hand, the officers¶ salaries are not relevant in the decision. In other words, it doesn¶t
matter if the officers¶ salaries are $500,000 or $5,000,000. The officers¶ salaries will be the same
with or without the product line. Similarly, the decision maker does not need to know the amount
of its central office expenses, since they will be the same with or without the product line.
Expenses from previous years are also irrelevant.

To recap, relevant costs are the future costs that will differ among alternatives. You might use
the past costs to help you predict those future costs, but the past costs are otherwise irrelevant to
the decision. Accountants refer to the past costs as sunk costs.

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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.

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A company is considering publishing a limited edition book bound in a special leather. It has in
stock the leather bought some years ago for $1,000. To buy an equivalent quantity now would
cost $2,000. The company has no plans to use the leather for other purposes, although it has
considered the possibilities:

a) of using it to cover desk furnishings, in replacement for other material which could cost $900
b) of selling it if a buyer could be found (the proceeds are unlikely to exceed $800).

In calculating the likely profit from the proposed book before deciding to go ahead with the
project, the leather would m
be costed at $1,000. The cost was incurred in the past for some
reason which is no longer relevant. The leather exists and could be used on the book without
incurring any specific cost in doing so. In using the leather on the book, however, the company
will lose the opportunities of either disposing of it for $800 or of using it to save an outlay of
$900 on desk furnishings.

The better of these alternatives, from the point of view of benefiting from the leather, is the
latter. "Lost opportunity" cost of $900 will therefore be included in the cost of the book for
decision making purposes.

The relevant costs for decision purposes will be the sum of:

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

ii) the opportunity cost of the leather (not represented by any outlay cost in connection to the
project).

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

IRRELEVANT COST
IRRELEVANT COST, in managerial accounting decision-making situations, is any
positive or negative implications phenomenon which is not consequent upon the
production process, whether it is denominated in money terms or not.

Example:

Suppose you are an automobile manufacturer making two lines of cars in plants A and B. The
cars you are making in plant A are manufactured at a cost of $10,000 per car.

You plan to make a new line of cars in plant B. Do any of the costs of manufacturing cars in
plant A enter into the costs of cars manufactured in plant B? No, they are irrelevant. Only plant B
costs are relevant. However, keep in mind that there are general overhead costs of the company

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that may be spread over the costs of operating each plant.

On the other hand, suppose you plan to start manufacturing the same cars in plant B as in plant
A. You compute a manufacturing cost of $9,000 dollars in plant B. Now the costs of
manufacturing in plant A become relevant since your new manufacturing cost will lie
somewhere between $9,000 and $10,000 depending on quantities produced in each plant.

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 that are dealt with below.

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.

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Name: Mohd Arif

Id: 1308
Class: BBA-8
Course: Managerial Accounting
Date: 28-04-10

Submitted to: ©s. Nousheen Abbas

KASBIT
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