A relevant cost is a cost that only relates to a specific management decision, and which will change in the future as a result of that decision. The relevant cost concept is extremely useful for eliminating extraneous information from a particular decision-making process. Also, by eliminating irrelevant costs from a decision, management is prevented from focusing on information that might otherwise incorrectly affect its decision.
A relevant cost (also called avoidable cost or differential cost) is a cost that differs between alternatives being considered. In order for a cost to be a relevant cost it must be:
- Cash Flow
It is often important for businesses to distinguish between relevant and irrelevant costs when analyzing alternatives because erroneously considering irrelevant costs can lead to unsound business decisions. Also, ignoring irrelevant data in analysis can save time and effort.
Types of irrelevant costs are:
- Sunk costs
- Committed costs
- Notional or Non cash costs (e.g depreciation and amortization)
This concept is only applicable to management accounting activities; it is is not used in financial accounting, since no spending decisions are involved in the preparation of financial statements.
For example, the Archaic Book Company (ABC) is considering purchasing a printing press for its medieval book division. If ABC buys the press, it will eliminate 10 scribes who have been copying the books by hand. The wages of these scribes are relevant costs, since they will be eliminated in the future if management buys the printing press. However, the cost of corporate overhead is not a relevant cost, since it will not change as a result of this decision.
The reverse of a relevant cost is a sunk cost. A sunk cost is an expenditure that has already been made, and so will not change on a go-forward basis as the result of a management decision.