Concept of Relevant Costs in Management Accounting

The theory of Relevant cost suggests that only those costs (or revenues) which will be affected by a decision are "relevant" should be considered while taking a decision in short-run. Relevant cost concept is applicable for short-term decision making and also in case of one-off decision making (say, a new customer seeking quotation for a product). For example, an entity that makes computers and buys raw material for production of computers, may have acquired some raw materials long time ago which are not used for manufacturing anymore.

 

In case of relevant costs, this cost of purchase of raw material is not relevant while taking a decision. In case there is no alternative use of the product or that no value can be derived by the use of the raw material, the entity may conclude that the relevant cost of the raw material is nil.

 

Relevant costs include:

 

  • Future costs and revenues; historical costs and revenues are not relevant, as they have already been incurred (explained above);

 

  • Incremental costs (the amount by which costs/revenues will change as a result of the decision); if a course of action is not taken, incremental costs will be saved. For example, a cost to convert finished goods to meet customer’s specific requirement would result into an incremental cost, hence will be relevant in decision making. Usually, variable costs are incremental in nature.

  • Cash flows: Non-cash expenses and income are not relevant as they represent expenditure already made. For example, depreciation is a non-cash expense that arises from the accounting treatment of an asset that has already been acquired. Profit or loss on disposal is similarly a non-cash item and therefore not relevant.

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