Relevant Costing
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In business, a relevant cost, also known as a differential cost, is one that specifically affects a decision being made. These are expenses that will differ depending on the course of action you choose. They are contrasted with sunk costs, which have already been incurred and can’t be changed.
Here are some examples of relevant costs:
- The cost of materials for a new product
- The additional labor costs of operating a machine for an extra hour
- The opportunity cost of giving up on one project to pursue another
There are several key benefits to considering relevant costs when making business decisions:
Improved Decision-Making: By focusing only on the costs that will be impacted by your choice, you avoid getting bogged down by irrelevant information. This allows for clearer analysis and a more focused approach to making the best decision.
Cost Efficiency: Relevant costs help identify the most cost-effective option. You can compare the incremental costs (difference in costs) between alternatives to see which one offers the best value for your money.
Reduced Waste: By understanding the future cash flow impact of your decision, you can avoid unnecessary spending. Relevant costs help you prioritize resources and avoid wasting money on options that won’t be financially beneficial.
Stronger Financial Planning: When you focus on relevant costs, you gain a clearer picture of the financial implications of your decisions. This allows for better financial planning and budgeting in the long run.
More Objective Analysis: Since relevant costs exclude past costs (sunk costs) that can’t be changed, they promote a more objective analysis of the situation. You’re basing your decision on what will happen moving forward, not what has already been spent.
The main objectives of relevant costing are all about improving decision-making for businesses by:
Identifying the Right Costs: Relevant costing helps separate the noise from the signal. It ensures managers focus on costs that will actually be impacted by the decision at hand, not historical costs or costs that won’t change regardless of the choice.
Simplifying the Process: By discarding irrelevant information, relevant costing allows for a more streamlined decision-making process. This avoids getting bogged down in unnecessary details and keeps the focus on the financial aspects that truly matter for the specific situation.
Making Better Choices: By highlighting the costs that will differ between options, relevant costing allows for a clear comparison of alternatives. This improves the chances of businesses selecting the course of action that leads to the most favorable financial outcome
There are four main types of relevant costs that businesses consider when making decisions:
Avoidable Costs: These are variable costs that can be eliminated if a certain course of action is taken. For example, if a company decides to outsource production instead of doing it in-house, the labor costs associated with in-house production would be avoidable costs.
Incremental Costs: These are the additional costs that will be incurred if a particular option is chosen. They represent the difference in costs between two alternatives. For instance, if a company is considering launching a new product line, the incremental costs would include the cost of new materials, labor, and marketing specific to that product line.
Opportunity Costs: These are the potential benefits that are given up when choosing one option over another. They represent the forgone revenue or profit associated with the rejected alternatives. For example, if a company decides to invest in a new machine, the opportunity cost might be the potential return on investment they could have achieved by using those funds for another project.
Future Cash Flows: These are the expected future inflows and outflows of cash associated with a particular decision. They encompass all the relevant costs and benefits that will occur over the lifetime of the chosen option. When evaluating different projects, businesses consider the future cash flows each option generates to determine the most financially viable choice.
The core concept of relevant costing is incredibly simple: It’s all about future cash flows and how they differ between choices.
Here’s why this matters:
- Future Focus: Business decisions impact the future, not the past. Relevant costing ignores sunk costs (past expenses) because they can’t be changed.
- Differential Impact: Not all costs are created equal. Relevant costing only considers the costs that will be different depending on the decision made. Costs that are the same across all options are irrelevant because they don’t affect the comparison.
By focusing solely on these future, differential cash flows, relevant costing helps cut through unnecessary information. It ensures managers base their choices on the financial consequences that truly matter for the specific situation they’re facing.
Imagine you’re deciding which phone to buy. Relevant costing wouldn’t consider the research and development costs each company spent creating the phones (sunk costs). Instead, it would focus on the price difference between the phones (differential cost) and any potential future costs associated with each phone (e.g., different data plan costs).
This core concept allows businesses to make informed financial decisions that can lead to better outcomes in several ways:
- Improved Profitability: By focusing on the costs that truly impact the bottom line, companies can make choices that optimize their operations and potentially increase profits.
- Better Resource Allocation: Resources like time and money can be directed towards the areas that will have the most significant impact when relevant costs are identified.
- Enhanced Short-Term Planning: Since relevant costing emphasizes future costs, it’s particularly valuable for short-term decisions where future financial impacts play a bigger role.