What is Relevant Cost?
A relevant cost is a cost that differs between alternatives in a decision and will affect the future cash flows of a business. It is a cost that is pertinent to a specific business decision because it will be incurred or avoided depending on the choice made. Irrelevant costs, such as sunk costs or costs that do not change regardless of the decision, are excluded from consideration.
Key Characteristics of Relevant Costs
- They are future costs that will be affected by the decision.
- They differ between the alternatives under consideration.
- They often include opportunity costs, which are the benefits foregone by choosing one option over another.
- They exclude historical costs or sunk costs, which cannot be changed by current decisions.
Types of Decisions Involving Relevant Costs
- Accept or reject a special order: Only costs that change as a result of accepting the order are relevant.
- Make or buy decisions: Relevant costs are compared to decide whether to produce in-house or purchase externally.
- Add or drop a product line: Costs that will be saved or incurred by dropping a product line are considered.
- Further processing decisions: Deciding whether to process goods further or sell them as-is depends on relevant cost analysis.
Why Use Relevant Cost Analysis?
Relevant cost analysis helps businesses:
- Make profitable decisions by focusing on costs that matter.
- Avoid unnecessary expenses based on irrelevant past costs.
- Evaluate alternatives objectively for better cash flow management.
- Incorporate opportunity costs into decision-making for better resource allocation.
Example of Relevant Cost in Decision Making
Suppose you have purchased a $50 discount card for pizza that entitles a 10% discount on future purchases. Later, you find a similar pizza available for $8 elsewhere, while the discounted pizza costs $9 after discount. The $50 you have spent on the card is a sunk cost and should be ignored. The relevant cost is the actual payment difference in future purchases, guiding you to choose the cheaper option.
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