Definition
Relevant cost, in finance, refers to the potential future cost related to a specific management decision that can change based on the choice made. It only includes those costs that will make a difference in the decision-making process. These costs are also future-oriented and are not sunk costs or historical costs.
Key Takeaways
- Relevant Cost refers to the anticipated future costs that are pertinent to a specific management decision. It considers only those costs and revenues that will be affected by the decision in question.
- These costs are used in short-term decision making and planning because they directly impact the profitability of a business. Costs that aren’t affected by management decisions are considered irrelevant.
- Relevant costs can include future costs, opportunity costs, and incremental costs. They do not include sunk costs, which have already been incurred and can’t be recovered.
Importance
Relevant cost is an important financial term as it guides decision making in business management.
It refers to the specific costs related to a particular decision that can change in the future based on the decision made.
By focusing on these costs, businesses can streamline their decision-making process, making it more efficient and strategic.
The analysis helps to eliminate unnecessary data, allowing managers to concentrate on the costs and revenues directly affected by the business decision at hand.
Consequently, employing applicable costs can lead to better profitability, strategic planning, budgeting, and overall improved financial management.
Explanation
Relevant cost serves a crucial function in financial decision-making particularly when an organization is contemplating specific business decisions including accepting special orders, pricing, make or buy, replace or keep equipment, sell or process further, and shut down or continue operations. The core essence of the relevant cost is that it influences the future cash flows, and hence, the financial health of an organization based on the business decisions being made.
This is a variable cost that changes depending on the type of decision or direction the business chooses to take. In more specific terms, relevant costs are used in evaluating choices for business investment opportunities or production processes.
They serve as key components of marginal and incremental analysis where they help determine the cost or benefit of one additional unit or decision. They also play a key role in the budgeting process where they help to devise various budget scenarios and plan resources accordingly.
In summary, relevant costs aid businesses in selecting the most cost-effective and profit-maximizing strategies based on sound financial analysis.
Examples of Relevant Cost
Manufacturing Decisions: Suppose a company is deciding whether to manufacture a product in-house or outsource it. The relevant cost here would involve both the cost of manufacturing the product internally, like raw materials, labor, etc., and the cost of outsourcing including the vendor’s fee, shipping costs, etc. The company would analyze all these costs while making a decision.
Marketing Campaigns: Suppose a retail company is planning to run a marketing campaign. The relevant costs for this decision might include the cost of designing the campaign, hiring marketing professionals, purchasing advertising space, and the cost of producing additional goods to meet expected demand. The company would have to consider these costs against the expected increase in sales from the campaign.
Selecting Suppliers: Consider a restaurant deciding whether to buy produce from a local supplier or an international one. The relevant costs for this decision would include the price of the produce, but also the delivery cost, the freshness and quality of the produce (and its effect on customer satisfaction), and potentially the restaurant’s reputation if customers value locally-sourced ingredients. The choice would be made considering all these relevant costs.
FAQ: Relevant Cost
What is Relevant Cost?
Relevant Cost refers to the costs and revenues that will occur in the future as a result of a decision being made in the present. These costs will have an impact on cash flows and are therefore relevant for decision making.
What is an example of Relevant Cost?
An example could be a company deciding whether to continue manufacturing a product or buy it from an external supplier. The relevant costs to consider in this situation could include the cost of raw materials, direct labor costs, and manufacturing overheads that can be avoided by buying the product externally.
What is the difference between Relevant Cost and Sunk Cost?
Relevant costs refer to future costs that can be changed by a decision made in the present, whereas sunk costs are costs that have already been incurred and cannot be recovered. Sunk costs are considered irrelevant for decision-making purposes.
How does Relevant Cost affect decision making?
Relevant costs play a crucial role in managerial decision making. They help determine whether a particular business decision will be profitable or not. Decisions such as pricing, make or buy, shut down or continue operations, etc., are all based upon analysis of relevant costs.
Related Entrepreneurship Terms
- Opportunity Cost
- Sunk Cost
- Direct Cost
- Indirect Cost
- Incremental Cost
Sources for More Information
- Investopedia: A comprehensive source of financial knowledge that explains the finance term Relevant Cost.
- Accounting Tools: A practical source that offers comprehensive accounting and finance explanations, including Relevant Cost.
- Corporate Finance Institute: An excellent educational platform featuring comprehensive financial guides, including about Relevant Cost.
- My Accounting Course: A source offering a broad range of accounting courses and explanations, Relevant Cost included.
