A key element of making any decision is having the right information. With the right information to hand, the respective costs and benefits of various options can be compared and the most suitable option chosen. Not all costs are relevant to decisions. A relevant cost is one which differs between alternatives.
A relevant cost typically has two main traits:
- It is a future cost (incurred in the future), and
- There must be a cost differential between decision alternatives.
Taking these two traits briefly, any costs incurred in the past (that is, sunk costs) are never relevant to decision making. Any sunk costs have been incurred already and cannot be undone. Secondly, if future costs differ, they are relevant; if they do not differ they are irrelevant.
Example 1 gives a brief insight on distinguishing relevant from irrelevant costs. A relevant revenue is one which differs due to a particular course of action. In essence, it is the additional or differential revenues arising from making a decision.
Example 1 Identifying relevant costs
A clothing manufacturer has a profitable business line making cashmere overcoats for corporate customers. The customers use the overcoats as gifts to retiring executives and their own customers. The garments use only high-quality cashmere which currently cost 80 dollar per coat. Labor costs are 25 dollar per coat. Several customers have recently requested that only fine Italian cashmere from a certain mill is used in their overcoats. Although small in number, these customers make up 80 per cent of the sales volume. Thus, the managers are considering using only the Italian cashmere for all overcoats. The Italian cashmere will cost $100 per coat.
The costs of the two options are set out below:
|Existing cashmere cost||Italian cashmere coat|
|Material cost $||80||100|
|Labor cost $||25||25|
|Total cost $||105||125|
The only relevant cost in the above Example is the material cost, as it both differs and is a future cost if we assume the decision is made to use the higher-quality fabric. Labor cost remains the same regardless of any decision.
As shown in Example 1, by isolating the relevant costs, a manager can quickly concentrate on the short-term effects of the decision being made, there is no need to analyze each and every cost. Using this approach, effects of decisions on profits can be easily assessed.
Finally, before delving into each of the decisions you may find it useful to consider the relevant cost of some cost elements, as follows:
- Materials – the relevant cost of materials is typically the current replacement cost if they have to be re-stocked. However, if materials are available and will not be replenished, the relevant cost will be the higher of their alternative use value and current resale value.
- Plant and equipment – the cash cost of purchasing new equipment is relevant, but any cost of existing equipment is not relevant. Depreciation is also irrelevant as it is an accounting entry. Any other incremental costs will be relevant.
- Labor – the cost of labor is usually not relevant unless any incremental labor cost is incurred as a result of taking a decision.