Definition of Relevant Cost and Revenue

Relevant cost and revenue can be defined as any cost or revenue that may occur or change due to a
decision.

Incremental costs are Relevant costs

it is the increase in costs and revenues that occurs as a direct result of a decision taken that is relevant.

Fixed costs are Irrelevant costs

if the total costs remain the same, there is no incremental effect caused by the decision.

Additional Fixed costs are Relevant costs

If due to a decision an additional fixed cost may be incurred then it will be a relevant cost.

Future costs are Relevant costs.

Decisions are taken today but their impact in terms of cost and revenue may be seen in future. So,
cost that may occur and revenue that may generate in future due to a decision taken in present are
relevant cost.

Past Cost are Irrelevant costs.

Cost incurred or revenue generated in past are not relevant for decision taken in present for
company’s future. Therefore, Sunk, or past, costs are monies already spent or money that is already
contracted to be spent. A decision on whether or not a new endeavor is started will have no effect on
this cash flow, so sunk costs cannot be relevant.

For example, money that has been spent on market research for a new product or planning a new
factory is already spent and isn’t coming back to the company, irrespective of whether the product is
approved for manufacture or the factory is built.
Avoidable costs are Relevant costs
These are costs which would not be incurred if the activity to which they relate did not
exist. Therefore, they are relevant to a decision.

Committed costs are Irrelevant costs

Committed costs are costs that would be incurred in the future but they cannot be avoided because the
company has already committed to them through another decision which has been made.

For example, if a company has two-year lease for piece of machinery, that cost will not be relevant to
a decision on whether to use that machinery on a new project which will last for the next month.

Cashflows are Relevant costs

Cost or revenue which increase or decrease company’s cash due to a specific decision are relevant to
such decision.

For example, if company take decision to buy a new machine, then its purchase cost and increase in
sales due to such machine shall be relevant cost and revenue however, depreciation to be charged on
such machine in future shall not be a relevant cost.
Opportunity cost are Relevant costs
If company has two options i.e. to buy machine A or machine B. And, company took decision to buy
machine A, then, the benefits which company may get from machine B will become the opportunity
cost of machine A. It means when company prepare cost of machine A then this opportunity cost may
also be taken into the account.

Important point: Always think what future cash flows are changed by the decision? Changes in
future cash flows reliably indicate which amounts are relevant to the decision.

Example 1
Some years ago, a company bought a piece of machinery for $300,000. The net book value of the
machine is currently $50,000. The company could spend $100,000 on updating the machine and the
products subsequently made on it could generate a contribution of $150,000. The machine would be
depreciated at $25,000 per annum. Alternatively, if the machine is not updated, the company could
sell it now for $75,000.

On a relevant cost basis, should the company update and use the machine or sell it now?

Solution:
Sunk cost
$300,000 is a purchase cost and is not relevant

Non-cash flows
$50,000 book value and $25,000 depreciation charge are not relevant.

If the investment in the machinery is made, then the following cash flow changes are triggered:

Machine update cost: $100,000

Contribution from products: $150,000
Opportunity cost: $75,000

Therefore, relevant costs are update cost, opportunity cost and relevant revenue will be contribution
from products.

Then, net cashflow if company decides to update a machine will be 150-100-75= -25 (outflow). If
company decides to sell it now company would earn an inflow of $75,000. So, should decide to sell
the machine.

Example 2
A business rents a factory for $60,000 per annum. Only half of the floor space is currently used and
the company is considering installing a new machine in the unused part. The machine would cost
$2.1m, be depreciated over 10 years at $200,000 per annum and then be sold for $100,000. The
company would insure the new machine against damage for $5,000 per annum.

Solution:
Rent – this is not a relevant cost. Irrespective of how the company might use the floor space in the
factory to generate a return, there is no change in cash flow relating to the rent as a result of the new
machine.
Cost of machine - this is a relevant cost as $2.1m has to be paid out.

Depreciation – this is not a relevant cost as it is not a cash flow.

Sale proceeds – this is a relevant revenue as it is a cash inflow which will occur in 10 years as a result
of the decision to invest.

Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the
decision to invest.

These costs will have to be compared to the contribution that can be earned by the new machine to
determine if the overall investment in the asset is financially viable.

Example 3: Further processing decision

A company buys a chemical for $12,000, which it breaks down into two components:

Component Sales value ($) Allocated costs ($)

A 7,000 6,000

B 4,000 6,000

Component A can be converted into Product A if $6,000 is spent on further processing. Product A
would sell for $12,000.

Component B can be converted into Product B if $8,000 is spent on further processing. Product B
would sell for $15,000.

Solution:
As the initial chemical is split into both components, it is not possible to make one component
without the other, therefore if the company were to make only the components, the costs and
revenues of both components will need to be recognised:

Incremental revenue (sales of both components) = $11,000

Incremental costs (cost of the chemical) = $12,000

Net loss ($1,000)

This is not worthwhile as incremental costs exceed incremental revenues.

Next, we should consider whether the components should be further processed into the products.

Further processing Component A to Product A incurs incremental costs of $6,000 and incremental
revenues of $5,000 ($12,000 - $7,000).

It is not worthwhile to do this, as the extra costs are greater than the extra revenue.

Further processing Component B to Product B incurs incremental costs of $8,000 and incremental
revenues of $11,000 ($15,000 – $4,000).

It is worthwhile to do this, as the extra revenue is greater than the extra costs.