What are Relevant Costs?
This article discusses relevant costs. Relevant costs are costs that are relevant to short term decisions, or one-off decisions, and we'll be looking at some of the key features of relevant costs. We will also discuss non-relevant costs.
Information for Decision Making
Before discussing what relevant costs are, we have to consider what costing information will be important to us when we're making decisions in a business. And when I say decisions, we're primarily focusing in this article on short-term or one-off decisions. So, in this article we're ignoring decisions with time horizons that might be any longer than a year.
There are two costing systems that we're going to discuss.
The first costing system is the marginal costing system. Marginal costing is a system where the cost per unit is just the variable cost of production. And what we do is, we take the fixed costs and we put them on a single line and write them off against costs in the statement of profit or loss, and we attribute those fixed costs to the period in which they relate to. So, very simply, under a marginal costing system, we just attribute the variable cost of production to the cost per unit, and then we take our fixed costs and we have them on a single line written off in full. As you can see in the image above, marginal costing is primarily useful in decision making problems, and the reason for that is because marginal costing allows us to split fixed and variable costs into their separate cost behaviours, and this is really useful because in some decisions, we just need to consider the variable costs of production and not the actual fixed costs. A good example of this would be if we have some excess capacity in a production facility. We have spare capacity, and we might be able to produce extra units in a certain month. If we have spare capacity, we do not actually need to consider the fixed costs in the immediate short term, and the reason for that is that we will incur those fixed costs regardless of whether we decide to use this capacity or not. We'll only be considering the variable costs. So, that's the marginal costing system, and we're assuming and we're saying that it is the optimum costing methodology for decision making.
So what about absorption costing? Absorption costing is where we take a piece of the fixed overhead and we allocate it and absorb it into each unit that's produced. So, under absorption costing, the cost per unit includes a component of fixed costs. So in that regard, each unit that we produce, we're attributing a component of fixed costs to that particular unit. The reason why absorption costing is not that appropriate for decision making is because we're factoring the fixed costs into each unit. And so, in that regard, we're actually considering fixed costs where we might not actually need to consider them. If you think of that example that we had above, where we have excess capacity, we don't need to consider fixed costs in those types of short-term decisions. Now, absorption costing might not be very useful in decision making in the short-term, but it is very useful for profit reporting and inventory valuation, and the reason for that is that under IAS 2 Inventories, we have to use absorption costing for inventory valuation.
So, in terms of the two costing systems, just to reiterate, marginal costing is very useful for decision making, and absorption costing is very useful for profit reporting and inventory valuation.
Relevant Costs and Revenues
What is a relevant cost? A relevant cost is one that we incur as a direct response to a particular decision. And likewise, a relevant revenue is the same, just instead of a cost, we incur a revenue as a result of a particular decision. This would normally be a management decision. Relevant costs have three features, and then there are also two other types of relevant costs that we need to be aware of.
So, what are the features of relevant costs?
1. The first feature is that it they are future oriented. That means that a relevant cost is one that we will incur in the future as a direct result of a management decision.
2. The next feature relates to cash. Relevant costs are cash transactions rather than accounting or paper transactions. This means that a relevant cost is not going to be depreciation or notional rent, for example.
3. The next feature is that relevant costs are incremental in nature. This means that the cost will increase or maybe the revenue will increase in direct relation to a particular decision. If management decide to manufacture a certain number of units of a specific product in a factory, and if the cost of that unit is factored in (e.g. we decide to make 20 units at a certain price), that is an incremental cost because we incur those costs in direct response to that particular decision to produce those products.
4. There are two other types of relevant cost that we need to be aware of. The first is opportunity cost. An opportunity cost represents the benefit forgone as a result of choosing a particular option. So, what does that mean? Let's take a simple example to explain. Suppose I get paid every week to do a certain job. If I decided to go on holidays any particular week, the opportunity cost of me going on holiday will be the wage or the amount of money that I was going to get paid from my job that particular week. So, the opportunity cost is basically a benefit lost as a result of carrying out a certain decision.
5. Avoidable costs are costs that we avoid as a result of discontinuing a certain set of activities. So, for example, if we shut down a particular division of a business, all the costs that are avoided as a result of that shutdown would be avoidable costs. Perhaps that could be staff salaries, if we’re making people redundant. It could be the cost of rent or electricity for that specific division. Those would be avoidable costs.
We also need to consider non-relevant costs and revenues. These would be costs and revenues that we would not consider in short-term decision making. There are four main non-relevant costs that we're going to run through - sunk costs, committed costs, notional costs, and fixed costs.
1. The first we're going to look at are sunk costs. So, what are sunk costs? Sunk costs are costs that we have already incurred. They're never relevant in short-term decision making. A good example of a sunk cost would be as follows; suppose we're producing a new product and we've paid for customer surveys to see how good this product is or what our customers’ reaction is to this proposed idea. If we decide to produce the product, we will have incurred that cost anyway. No matter what decision we make, we've already incurred that cost. Therefore, it's a sunk cost and it's never relevant in short-term decision making.
2. The next non-relevant cost is a committed cost. A committed cost is one that we've committed to and so, regardless of whichever decision we intend to make or whichever decision we decided to choose, we will incur this cost regardless. Therefore, it is a non-relevant cost because we will incur this regardless of whether we decide to pursue a particular course of action or not.
3. The next is a notional cost. Very simply, these are non-cash items. As you'll recall from earlier on in this article, in order to be considered a relevant cost, it has to be a cash transaction. So, a non-cash transaction or a non-cash item would be depreciation or notional rent, or maybe a translation gain or loss on foreign exchange. Those would be examples of non-cash items.
4. Finally, we have fixed costs. Fixed costs are a little tricky because some fixed costs we do include as being relevant, and some we would say are non-relevant. Relevant fixed costs would be fixed costs that are specific to that particular decision. So, what do I mean by that? Let's say we have a shutdown decision. If we avoid certain fixed costs, maybe rental payments or salaries for supervisors, as a result of shutting down a particular division, then fixed costs would be considered a relevant cost. That's really important. Fixed costs can be relevant but they have to be related to a specific decision. On the other hand, fixed costs that are general in nature (i.e. fixed costs that we incur regardless of whichever decision is made), would not be considered relevant. Also, fixed cost absorption is normally non-relevant, because it's more of an accounting entry rather than actual fixed costs being incurred for a particular decision.
The above is just a short extract from our CIMA P1 Management Accounting course. Taught by former CIMA prizewinner, Hugh Martin, VIVA's P1 course has over 15 hours of video lectures covering the entire syllabus, 800+ exam style questions and an online version of BPP's 2019 textbook. Students can avail of the P1 course as part of our All Access membership.
You might also want to read: What is Activity Based Costing?
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