What Are Relevant Costs?
Relevant Costs Definition
Relevant costs are items of expenditure that will change as a result of making a particular business decision.
Relevant costs have three distinct features:
- Future Based
- Incremental
- Cash Flow
Future Based
Relevant costs are costs that will be incurred in the future.
Costs have that already been incurred in the past (sunk costs) cannot be changed, and while these sunk costs can help to predict future costs, they are largely irrelevant to any future decisions.
Incremental
Relevant costs for decision making are incremental.
Incremental costs will increase as a direct result to making a specific business decision ie the costs on top of what was happening previously.
For example, if a business makes a decision, how much extra will that decision cost them?
Cash Flow
Relevant costs affect the cash flows of a business.
Therefore, after a specific business decision is made, these relevant costs would need to come out of the company bank account.
For this reason, non-cash items such as depreciation would not be classed as a relevant cost.
For the cost to be considered ‘relevant’, it needs to satisfy all three criteria.
Relevant costs can help the management of a business to only focus on the important information connected with making a business decision.
Variable costs are always relevant costs.
Relevant costs are also only relevant to decisions made in the short term, or one-off decisions.
This is because, over a long time period, most costs are relevant.
For example, if a business is planning for the next decade, then all types of costs would have to be considered, including any fixed and sunk costs that may be incurred.
Examples of Relevant Costs
Some real-world examples of identifying relevant costs would be:
Example 1 – Supermarket
A supermarket is considering replacing three of their checkouts with self-service checkouts.
If the supermarket goes ahead with this decision, it will mean that some staff will be made redundant.
These salary costs are relevant since these expenses change in the future due to the buying decision.
Example 2 – Television Manufacturer
A television manufacturer is reviewing whether to continue to make the circuit boards used in production of the televisions, or buy them from an external company.
This is often referred to as a ‘make or buy’ decision.
Management would review the cost of continuing to produce the circuit boards themselves compared to outsourcing the materials and labour to another business.
The relevant costs would be the cost of keeping production in house, or the cost of buying externally.
Example 3 – Underwear Manufacturer
An underwear company has been approached by a large fashion retailer to produce a large, one-off limited-edition order of men’s briefs.
In order to fulfil this order, extra staff would have to be recruited, or existing staff would have to work additional overtime hours.
When deciding whether or not to accept this order, the management decide that the relevant cost to produce the extra garments would be more profitable than their standard operation, so they accept.
Example 4 – Restaurant
A restaurant chain has 30 diners across the nation, but only half are profitable.
Consequently, they are considering closing down some of their stores, to focus their efforts on making all remaining diners profitable through an increased marketing push.
To help make this decision, they would look to compare the relevant costs incurred from closing the stores, with the relevant costs from the proposed marketing campaign to make them profitable.
Example 5 – Jewelry Brand
A small luxury jewelry brand has been approached by a social media influencer with a large following to work together to create an advertising strategy where the influencer would keep 30% of all profits generated from the campaign.
The jewelry brand must now establish whether the relevant costs of pursuing this opportunity will be profitable and beneficial to their business.
Non-Relevant Costs
To further understand what is a relevant cost, and what isn’t, we can just look at the opposite of what a relevant cost is:
Not Future
For example, historic sunk costs that have already happened.
This would include any committed costs, which are costs that would be incurred at a future date, but cannot be avoided as the business is already obligated to pay them through another decision that was made.
An example of a committed cost would be a company that has already agreed a 10-year lease on a storage warehouse, as that cost would not be relevant to a decision on whether to use that warehouse for a new project.
Not Incremental
For example, reapportioning existing fixed costs and salary of existing staff.
Not a Cash Flow
For example, depreciation, revaluation of an asset or provisions.
These amendments are accounting adjustments, and therefore do not have any impact on a business’ cash flow.
Categorising Relevant and Non-Relevant Costs
Consider this example, a small comedy venue has put on a comedy night which will take place in a month’s time.
Ticket sales have been poor, and it is forecast that unless more tickets are sold, the event will result in a loss for the music venue.
The venue needs to make a decision on whether the event should be cancelled, or for it to go ahead regardless.
A number of costs are to be incurred for the event, and the management will need to decide which are relevant to the decision-making process:
Performer’s Fee
Non-relevant – Comedians have already been paid in advance in full
Permanent Staff Salaries
Non-relevant – Permanent staff will still be paid even if event is cancelled
Temporary Staff Salaries
Relevant – Temp staff not needed so won’t need to be paid
Food and Drink Costs
Relevant – Food and drink not ordered yet, so potential cost saving if event doesn’t take place
Ticket Printing
Non-relevant – Tickets have already been printed
Event Advertising Costs
Non-relevant – Flyers and posters have already been printed and distributed. Local radio and newspaper adverts have already been paid for.
Event Videography Costs
Relevant – Videographer not needed if event is cancelled, so won’t need to be paid
Security Costs
Relevant – Security firm not needed if event doesn’t happen, so won’t need to be paid