Relevant Cost and Decision Making

Definition
Relevant cost, in managerial accounting, refers to the incremental and avoidable cost of
implementing a business decision.
Topic Contents:
1. Definition
2. Concept
3. Types of relevant costs
4. Types of non-relevant costs
5. Example
6. Application & Limitations

Concept
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 Costs Types of Non-Relevant Costs

Future Cash Flows Sunk Cost

Cash expense that will be incurred in the Sunk cost is expenditure which has already
future as a result of a decision is a relevant been incurred in the past. Sunk cost is
cost. irrelevant because it does not affect the future
cash flows of a business.

Avoidable Costs Committed Costs

Only those costs are relevant to a decision Future costs that cannot be avoided are not
that can be avoided if the decision is not relevant because they will be incurred
implemented. irrespective of the business decision bieng
considered.

Opportunity Costs Non-Cash Expenses

 Cash inflow that will be sacrificed as a result Non-cash expenses such as depreciation are
of a particular management decision is a not relevant because they do not affect the
relevant cost. cash flows of a business.

Incremental Cost General Overheads

Where different alternatives are being General and administrative overheads which
considered, relevant cost is the incremental are not affected by the decisions under
or differential cost between the various consideration should be ignored.
alternatives being considered.

Example
Rubber Tire Company (RTC) received a request to provide a price quote for an order for the
supply of 1000 custom made tires required for industrial vehicles. RTC is facing stiff competition
from its business rivals and is therefore hoping to secure the order by quoting the lowest price.
RTC plans to quote a price at 10% above its relevant cost.
Following is the calculation of total cost in respect of the order:

Relevant Cost

Rubber $10,00 The order requires a special type of rubber. 

0
Only 25% rubber is currently available in stock. The rubber was
purchased 2 years ago at the cost of $3,000. If the rubber is not
used on this order, it will have to scraped at a price of $1,000. 

Remaining quantity shall have to be procured at the price of

$7,000.

Oil $1,000 All the required quantity of oil is currently available in stock. The
cost of oil that will be used on the order is $1,000. 

The current market value of the required quantity of oil is

$1,200. If oil is not used on the order, it could be used in the
production of other tires.

Other Materials $2,000 All other materials will have to be procured.

Direct Labor $5,000 $5,000 represents the cost that would be paid to direct labor in
respect of the time that they work on the order. 

If direct labor is not utilized on this order, they remain idle for the
entire time. Direct labor is paid idle time equal to 60% of the
normal pay in order to retain them.

Supervisor's $1,000 This represents the share of factory supervisor's salary for the
Salary number of days in which production for the order will take place.
 Depreciation of $3,000 This represents the manufacturing equipment's depreciation for
equipment the number of days in which production for the order will take
place.

Lease rental of $12,00 This represents the share of lease rentals of the factory plant for
factory plant 0 the number of days in which production for the order will take
place.

Electricity $8,000 The order would require 3000 units of electricity which is
expected to cost $8,000.

Overheads $6,000 This represents the apportionment of general and administrative

Allocation overheads based on the number of machine hours that will be
required on the order.

Total $48,00
0
Calculate the relevant cost for the order and the price RTC should quote.

Manufacturing Cost

Rubber $8,000 25%   -   Scrap Value    $1,000

75%   -   Purchase Cost  $7,000
         Relevant Cost   $8,000 
The $3,000 paid two years ago is a sunk cost and should
therefore be ignored. $1,000 represents the opportunity cost of
using the rubber available in stock on this particular order.

Oil $1,200 The $1,000 cost of oil is a sunk cost. 

The $1,200 current market value of the required oil is the

relevant cost because utilizing it on this order will require
purchase of additional oil at the market rates to meet the
production needs of other tires. Alternatively, the oil could be
sold for $1200.

Other Materials $2,000 As these materials are not available in stock, these will have to
be purchased at the market price which is their relevant cost.

Direct Labor $2,000 Since $3,000 (60% of $5,000) idle time pay will be incurred even
if this order is not taken, the relevant cost is the incremental cost
of $2,000 ($5,000 - $3,000).

Supervisor's - As supervisor's salary is a fixed cost unchanged by the work

Salary performed on this order, it is a non-relevant cost.
 Depreciation of - Non-cash expenses are not relevant for decision making.
equipment

Lease rental of - Lease rentals are a committed cost which cannot be avoided by
factory plant withdrawing from this order which is why they should be ignored
for the purpose of this analysis.

Electricity $8,000 Electricity charges are incremental to this order and therefore
relevant.

Overheads - General and administrative overheads that are not incurred

Allocation directly as a result of this order should be considered irrelevant.

Relevant Cost $21,20

of order 0

Profit Margin $2,120 10% of the relevant cost of $21,200

Price to be $23,32
quoted 0

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.
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