All businesses are run by business managers at effectively three levels of operations, management, and strategic. Every successful business needs a well-planned strategy and implementation of these plans. These Managers make decisions regularly which may affect the businesses. In a simple example; a restaurant serving a customer with a customized order in late hours is an operational decision. The kitchen staff and materials are there, the decision will only affect overtime for the staff, and extra energy costs. That decision will make all the relevant costs and revenue on the spot.
“Any cost or revenue that incurs as a direct result of a decision taken”
The definition of Relevant Cost is simple. It is a managerial accounting concept, and it deals with decisions at all levels of the management. The decision taken makes that cost relevant, meaning if that decision is not taken the costs will be avoided.
All relevant costs are future costs, no decision can be taken about past costs that are already committed. For example, costs incurred on a feasibility study before launching a new project are historic; these are called committed or sunk costs.
Relevant costs should have these characteristics:
- The relevant costs should be futuristic in nature, all decisions regarding future costs and revenue associated with future actions.
- The relevant costs always increase the already committed costs and affect revenue. These costs are often avoidable in nature.
- The relevant costs will only be those involving cash flows. For example, costs incurring due to a change in depreciation policy will not be counted as relevant costs.
As relevant costs are directly associated with managerial decisions, these should be categorized according to the managerial decision levels.
OPPORTUNITY COSTS: At Operations levels
These costs are often relevant costs, as at operations level the management makes decisions that are always relevant costs and revenues. For example, a manufacturing facility has skilled labor and receives a customized order from a regular customer, the decision here will the best utilization of the labor hours.
If the labor is committed to a new project, the on-going project is affected i.e. an opportunity is lost. These opportunity cost decisions cannot be taken on the basis of the needs of one project only. The cash flow associated with the new projects and the profitability will be the key decision making points.
THE MAKE OR BUY DECISIONS: At Managerial level
In the second tier of management, the dilemma of make or buy products is often critical. The costs and revenues associated with this decision are incremental, cash flows, and always make the impact on future operations.
In the famous example of Toyota Japan; when they adapted the JUST IN TIME (JIT) approach, they outsourced many products to suppliers. That make or buy decision would not have been taken without careful considerations about product quality, costs, and profitability measures. A manufacturing facility often faces this situation when receiving a customized order.
THE CONTINUITY DECISION: At Strategic level
These relevant costing decisions occur at the strategic level of management. Large firms often need to make such decisions. For example, a construction company working on several projects will decide whether to take any new project before shutting down any of the ongoing ones.
A franchise based company will decide on the profitability of different franchise branches and make the decision about closing or continuity of a particular branch. All these decisions are relevant cost or revenue decisions for the company as a whole.
Opposite of relevant costs are irrelevant costs, i.e. the costs that will not be affected by any decision. Purchase of property, machinery, and hired staff are all decisions taken and hence are considered irrelevant costs for any future decision making.
In conclusion, the relevant cost can be used as a helpful tool in future decision making. This approach helps make correct decisions about incremental costs. It can help make decisions about make or buy products.
However, this method should not be considered as a sole decision making tool in itself. As any long term decision will require considering other factors too. Relevant costing approach can save management time about decision making in short term, as it avoids unnecessary or irrelevant costs.