Making good financial decisions—like deciding whether to sell a business unit—is a big part of running a business. But how do you determine which decisions are better than others? One consideration is how cost effective they are.
This is where relevant costs come into play. Understanding relevant costs enhances the decision-making process by eliminating irrelevant costs and making sure time isn’t wasted on unnecessary data.
This article covers the types of relevant costs and their importance in decision making, and gives a detailed comparison of relevant versus sunk costs.
- What is a relevant cost?
- The importance of relevant costs
- Relevant costs vs. sunk costs
- 4 types of relevant costs to consider
What is a relevant cost?
A relevant cost, also referred to as a differential cost, is the avoidable cost that comes from making a business decision. It’s primarily used in managerial accounting.
Taking into account only relevant costs allows you to focus on matters that will impact your cash flow caused by a particular decision. Excluding irrelevant and nonessential costs uncomplicates the decision-making process, which tends to lead to better outcomes.
For example, let’s say you’re considering an investment in automated production equipment that could allow you to reduce or redistribute your workforce.
As you weigh the pros and cons of the decision, you’ll categorize the workers’ wages as a relevant cost that the equipment could reduce or eliminate in the future. On the other hand, corporate overhead costs aren’t relevant because they’ll stay the same irrespective of your decision.
Keep in mind that what costs are relevant will change based on the decision at hand. Learning what costs should be considered in any given situation is a skill that can be honed with practice.
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The importance of relevant costs
How well your business performs depends on your decision-making practices. Making rash decisions, without really considering what they mean for your finances, can get you in deep trouble. Considering only relevant costs promotes sound decision making and helps minimize loss.
In other words, relevant costs can help you make the right call when considering factors like time-to-market and performance perception. The latter refers to the potential impact of your decision on stakeholders, including customers and investors. It allows you to determine whether one decision is better than another, based on their different relevant costs and potential outcomes.
Relevant costs are critical to making the right choices because financial planning involves identifying future cash flows linked to a particular decision. Past costs (sunk costs) have no role in this type of decision making, and disregarding them reduces the amount of information you need to consider. The same goes for future costs that can’t change regardless of what you decide.
You may find the concept of relevant costs useful when dealing with certain types of decisions, including:
- Determining whether to discontinue a particular product or close a business unit
- Outsourcing (make or buy) decisions
- Determining the lowest selling price at which you can accept or reject a special order
- Deciding when it makes sense to replace equipment
Relevant costs vs. sunk costs
While relevant costs and sunk costs both involve an outflow of cash—reducing your business’s profitability and income—they differ in importance when it comes to decision making.
A sunk cost is money that’s already been spent, so you can’t recover it. This means you don’t want to consider it when making future management decisions. In other words, it’s irrelevant to your future cash flow.
You might also hear sunk costs referred to as committed costs if money has already been committed to an earlier decision.
Suppose you spent $2,000 on a marketing automation tool and the software fails to meet expectations. The time it takes to negotiate a refund is a relevant cost. Should the vendor not refund your money, that $2,000 investment becomes an irrecoverable and unchangeable cost. When you later must decide on what new printer to buy, the money lost on the marketing automation tool shouldn’t affect this new investment—for this decision, the software is a sunk cost.
On the other hand, relevant costs can change based on the results of your decisions, and so should still influence those decisions.. Their costs and outcomes change based on what alternative courses of action are available to you.
Unlike sunk costs, relevant costs help keep you focused on immediate expenses that affect future cash flows.
4 types of relevant costs to consider
Keeping the right relevant costs in mind can make a big difference in your decisions. Four types of relevant costs to consider include:
- Make vs. buy costs
- Continue vs. closing costs
- Special order costs
- Opportunity costs
Make vs. buy costs
With this type of cost, you’ll assess the amount of money needed to produce a good internally versus the cost of buying it from an external partner. Essentially, you’re deciding which is the lowest-cost alternative. You’ll want to pay attention to factors like your company’s capabilities, volume, and timing.
As an example of relevant costs, suppose your company manufactures air conditioning parts and you receive a bid for the production of 65,000 components. Before accepting that bid, you’ll want to assess the viability of manufacturing the parts in-house or outsourcing the contract to another manufacturer who might offer better services or lower prices.
To see if it makes sense to pay an outside vendor to do the work, you’ll want to consider manufacturing expenses, which might look like our chart below.
As you can see, in this case, the cost of manufacturing the parts in-house is higher than outsourcing, making it smarter to partner with this external manufacturer.
Continue vs. closing costs
The decision to close or continue operating a business unit shouldn’t be taken lightly, and you’ll want to look at it from different angles. Factoring in relevant costs can help you make the right call.
For example, let’s say you own a component manufacturing company that makes $800,000 monthly in sales. Meanwhile, your operating costs look like this:
- Equipment maintenance costs: $60,000
- Labor expenses: $350,000
- Material costs: $80,000
- Miscellaneous expenses: $37,000
This shows that your business is running profitably, given that your expenses totaling $527,000 are much lower than your monthly sales figure, which stands at $800,000. As a result, you’ll probably decide to keep that business operational.
Special order costs
When a customer needs a special order, knowing the relevant costs can help you decide whether to go ahead. You can classify a particular order as special if, for example, a customer wants you to supply a product or service at month-end when you’ve already calculated your sales and deployed the profits to cover production expenses.
Let’s say your company typically produces 5,000 units (air conditioning parts) at a variable manufacturing cost of $5, and the maximum capacity is 20,000 units. On the other hand, you’ve got a fixed operating cost per unit of $1, translating to $20,000 in fixed operating costs.
Given this background, a customer wants you to deliver a special order for 1,000 units at $10 per component. The question is, should you reject or accept the order under the circumstances?
In this case, you’ll first need to determine whether you’ve got excess production capacity. You need to be able to fill this order by the customer’s deadline without constraining your product line or incurring marginal costs.
Now, you’ll want to turn your attention to the variable costs, such as manufacturing costs. (The good news is that you don’t have to worry about the total fixed cost because it remains the same irrespective of production levels.) The selling price of $10 is significantly higher than your variable manufacturing cost of $5. So, you can expect an additional income of $5,000 (1,000 x $5).
Opportunity costs revolve around the difference between the best plan of action and the next viable alternative. In other words, it refers to the missed potential profits of the foregone alternative. By attaching a number to the forgone profit, you recognize the loss of benefit (the money you could have made) associated with the unchosen option.
As an example, let’s say two customers place identical orders with varying profit margins. The first customer’s order has a profit of $5,000 and the second comes with a profit of $4,500. The first customer’s order makes more profit, so you’d go for that. In turn, this decision has an opportunity cost of $500 based on the profit difference between the chosen option and the foregone option.
Make the right business decisions with a relevant costs metric
Keeping the numbers looking good and your business running smoothly requires sound financial accounting and management decisions.
Thankfully, working with a freelance accountant via Upwork makes it easier to get the job done right. They can help with everything from managerial accounting to financial statements to budgeting.
The platform is also a great place for independent accountants looking for flexibility and the opportunity to provide different services to a range of clients. Explore job listings available on Upwork to find a project that suits your expertise and personal preferences.
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