Why are relevant costs important?
Relevant costs are significant because they encourage sound decision-making processes that have an impact on your current financial situation and future financial development. Relevant costs can help to address some of those uncertain variables, such as:
Time to develop
The time it takes to develop each option makes this a pertinent cost decision because the cost could rise as the development stage goes on. For instance, a small family-run business has a product that needs extra hours of work before it is ready for sale. The product might not be worth spending the extra time and money to make if the costs associated with extended production time outweigh the potential benefits. Relevant costs in this situation refer to the cost of having to pay for more labor due to the prolonged production time.
Development resources
This is an appropriate cost decision that takes into account all the resources required before coming to a final conclusion. The necessary materials, the number of workers, and the cost of their wages all have an impact on the relevant cost value.
Time to market
Regarding delivery times, time to market is an important cost consideration. It speaks of the period of time between a development and its release to the market. It aims to ascertain how that period of time impacts costs and sales.
Perception of performance
This speaks to the potential performance of the choice and inquires as to whether one choice provides better returns than another choice. Depending on how well a decision is perceived to have performed, the relevant costs may change significantly. This is due to the fact that consumers and investors are less likely to financially support a company that is underperforming or that makes decisions that have an impact on the quality of the goods and services they offer.
What are relevant costs?
The financial costs associated with a business decision are referred to as relevant costs, also known as differential costs. The cost is a dynamic metric that changes depending on the choice made. A useful financial metric is relevant cost because it aids businesses in minimizing unnecessary or irrelevant costs that would otherwise make decision-making more difficult. If something has no economic impact on your decisions, it is a waste of money. A decision is relevant and its costs should be taken into account if they have the potential to affect cash flow.
To reduce wasteful spending and choose profitable investments, businesses base their decisions on the projected relevant costs. Businesses use the fundamental ideas of relevant costs every day to make crucial decisions that have an impact on their capital. You may observe factors such as these affect the cash flow because relevant costs are a fluid metric, meaning that they fluctuate depending on various external factors that affect cash flow:
Types of relevant costs
Four pertinent costs to take into account when making business and management decisions are listed below:
Make vs. buy costs
Make vs. the price of purchasing the parts and components needed to complete a product. The decision to manufacture the product internally or to outsource its development to another vendor is taken into account by this pertinent cost. The factor of costs incurred by hiring an outside vendor to complete the work represents the decision’s actual relevant cost. The most cost-effective course of action is to outsource the product’s manufacturing and production if an external vendor can do so for less money than it would cost to do so internally.
Special order costs
When a customer wants to place an order near or at the very end of the month after a business has calculated its sales and used those profits to cover the production costs for that time period, that is referred to as a “special order.” The management team’s only concern for a client seeking a quote on the cost of a special order is the costs associated with manufacturing the item. The price of additional materials and production labor is among these pertinent costs.
Continue vs. closing costs
Continue vs. The term “closing” refers to the necessary expenses associated with deciding whether to shut down a specific business unit or keep it open. The pertinent costs in this type attempt to calculate the cost savings and revenue loss resulting from the closure of a business unit. It’s probably best to select the most cost-effective option if the costs saved by closing the unit outweigh the loss of reliable revenue.
Opportunity costs
Opportunity costs are the potential gains that an individual or business may realize if they choose one course of action over another. Opportunity costs are used to determine whether a given opportunity is worthwhile. It’s crucial to weigh the benefits and drawbacks of a particular opportunity before deciding whether to take it or pass it up.
Examples of relevant costs
The four relevant cost types mentioned above are illustrated by the following four examples:
Make vs. buy
A luxury bed manufacturer has launched a campaign to produce bed frames out of a brand-new material. The cost of this new material, however, is higher and the construction of bed frames using it requires significantly more labor than bed frames made of earlier materials. The management is comparing the price of producing the bed frames versus contracting out the materials and labor to a foreign firm. Analyzing the pertinent costs revealed that manufacturing the bed internally would result in higher costs. They outsourced the production of the bed frames in order to save money.
Special order
A bakery just finished creating its seasonal holiday cakes as the season of giving draws to a close. These holiday cakes have much more expensive ingredients than anything else they’ve ever sold. A sizable special order for their seasonal holiday cakes arrives just as the business is about to resume normal business operations and determine their final holiday earnings. They evaluated the cost of producing more and decided against fulfilling the order because the cost of doing so would not cover the costs of the existing order.
Continue vs. closing
A large clothing retailer is thinking about changing its image to become a more upscale boutique. They currently operate 50 stores across the country, but they want to reduce that number to just 10. They weigh the costs involved in either keeping the stores open and earning more money or closing them and losing significant revenue. In the end, management decided that keeping the stores open was preferable to losing the associated costs.
Opportunity
In order to work with them to develop a limited-edition ice cream flavor using a rare fruit from abroad, a celebrity approached a small ice cream company. The small ice cream company must decide whether the opportunity’s costs will be more profitable than those of making this ice cream with the expensive and rare fruit. They come to the conclusion that the potential revenue gains outweigh the expense of obtaining this rare fruit, so they proceed with the collaboration.
Relevant Costs (Managerial Accounting)
FAQ
What is meant by relevant cost?
A useful financial metric is relevant cost because it aids businesses in minimizing unnecessary or irrelevant costs that would otherwise make decision-making more difficult. If something has no economic impact on your decisions, it is a waste of money.
What is relevant cost and irrelevant cost?
- Avoidable costs.
- Incremental costs.
- Opportunity costs.
- Future cash flows.
What are the two types of relevant costs?
In managerial accounting, the term “relevant cost” refers to avoidable costs that are only incurred in connection with particular business decisions. To remove extraneous information that might make decision-making more difficult, the concept of relevant cost is used.
Why is relevant cost important?
Costs that will be impacted by a managerial decision are relevant costs. When you choose one course of action over another, irrelevant costs are those that won’t change in the future. Sunk costs, committed costs, and overhead are a few examples of unnecessary expenses because they cannot be avoided.
