What is a 'Relevant Cost'
Relevant cost is a managerial accounting term that describes past or sunk costs that are not used to make current business decisions. The concept of relevant cost is used to eliminate unnecessary data that could complicate the decision-making process. As an example, relevant cost is used to determine whether to sell or keep a business unit.
BREAKING DOWN 'Relevant Cost'Assume, for example, a passenger rushes up to the ticket counter to purchase a ticket for a flight that is leaving in 15 minutes, and the airline needs to consider the relevant costs to make a decision about the ticket price. Almost all of the costs related to adding the extra passenger have already been incurred, including the plane fuel, airport gate fee and the salary and benefits for the entire plane’s crew. Because these costs have already been incurred, none of the costs are relevant. The only additional cost is labor to load the passenger’s luggage and any food that is served, so the airline bases the ticket-pricing decision on just a few small costs.
How to Decide About a Business Unit’s Future
A big decision for a manager is whether to close a business unit or continue to operate the company division, and relevant costs are the basis for the decision. Assume, for example, a chain of retail sporting goods stores is considering closing a group of stores catering to the outdoor sports market. The relevant costs are the costs that can be eliminated due to the closure, as well as the revenue lost when the stores are closed. If the costs to be eliminated are greater than the revenue lost, the outdoor stores should be closed.
The Differences Between Make vs. Buy Decisions
Make vs. buy decisions are often an issue for a company that requires component parts to create a finished product. Say, for example, a furniture manufacturer is considering an outside vendor to assemble and stain wood cabinets, which are then finished by adding wood handles and other details. The relevant costs are the variable costs incurred by the manufacturer to make the wood cabinets and the price paid to the outside vendor. If the vendor can provide the component part at a lower cost, the furniture manufacturer outsources the work.
Factoring in a Special Order
A special order occurs when a customer places an order near the end of the month, and prior sales have already covered the fixed cost of production for the month. If a client wants a price quote for a special order, management only considers the variable costs to produce the goods, specifically material and labor costs. Fixed costs, such as a factory lease or manager salaries are irrelevant, because the firm has already paid for those costs with prior sales.