Management Accounting - Relevant Costs

Relevant Costs

Right, onto the proper lecture material!

What is cost?

Basically there isn't a single way to define cost, which is quite inconvenient for us. What you're going to use the cost to figure out should tell you how to calculate it however.

There are different ways (classifications) to work out cost information, which are:

Differential future cash flows (DFC)

Considers relevant and irrelevant costs. You might notice that this post is called 'relevant costs' so that's what we'll be focusing on in this post.

Cost behaviour in relation to output

Considers fixed and variable costs

Assignment to cost object

Considers direct and indirect costs

Financial statement perspective

Considers product and period costs

Business function

Considers manufacturing and non manufacturing costs.

NOTE: I'll update these with links to the main posts on each classification when they have been covered in class.

Relevant costs

For a cost to be relevant it must match 2 criteria:

1. Must relative to business objectives


2. Must differ from one possible decision outcome to the next

Here's an example to explain:

A company is buying a new van and has to choose between a Renault, and a Mercedes. The Mercedes costs more than the Renault. Obviously the van needs a driver, but a driver can drive either make equally well, for the same wage. Is the driver's wage a relevant cost?

Press Ctrl+A (or Command+A on OS X) for the answer!

Answer: No. It is not a relevant cost because the wage does not change if the company chooses one van over the other.

Another example:

If the company is now deciding whether or not to buy an additional van or not, is driver's wage a relevant cost?

Press Ctrl+A (or Command+A on OS X) for the answer!

Answer: Yes, because if they buy another van they have to pay more in wages for a second driver, so cost of wages increases.

So what can we derive from these examples?

• Relevant costs are the costs that are appropriate to a specific management decision (buying a van in the example)


• It's a future cost that will be affected by a decision taken


• A cost is not relevant if the decision will not affect it


• Historical costs are always non relevant

Relevant revenues

These are pretty similar to relevant costs, as you might imagine. In fact they are so similar that I am literally copy & pasting the bulletpoints from above and changing 'cost' into 'revenues'.

• Relevant costs revenues are the costs that are appropriate to a specific management decision


• It's a future cost revenue that will be affected by a decision taken


• A cost revenue is not relevant if the decision will not affect it


• Historical costs revenues are always non relevant

So basically they are exactly the same as relevant costs!

Types of relevant costs

There are 2:

• Opportunity cost


• Future outlay

Let's start with opportunity cost: This is a measure of the benefit sacrificed when one course of action is chosen in preference to another.

And future outlay: This is a future cost that changes depending on what decision is made.

Types of irrelevant costs

There's 2 here too:

• Sunk costs: Costs incurred in the past and is irrelevant to future decisions


• Committed costs: Future costs that were committed too before reaching a decision point. As it's been committed to, it can't be affected by future decisions.

Making a decision

How do we work out what if something is relevant or non relevant? Ask yourself two questions:

1. Is the cost / benefit related to the future?


2. Will the decision cause cash flow to change?

If you answered yes to both of those questions, you've got yourself a relevant cost

Limitations

• You can't always predict the future accurately (or at all)


• It's tough to consider everything that a decision could impact (stepping on a butterfly)


• Relevant costs don't take non financial info into account

That's everything for relevant costs. Check back soon for the next section!