Relevant Costs

RELEVANT COST

My printer at home conked out on me the other day.

Working at home has its perk but this…was definitely not one of them.

So while I dragged my feet about deciding whether it is worthwhile to go out and buy a new printer, a light bulb lit up and my accountant head was suddenly filled with relevant costs.

What is relevant to my decision?

Relevant cost is an accounting term, which describes a cost that makes a difference in  specific management decisions. The concept is extremely helpful when we are trying to determine which costs should be considered. It is vital to remember that not all costs matter when trying to reach a resolution.

So let’s take my “buying a new printer” scenario for a moment. Relevant costs are related to the future and there must be a cash outflow associated with it. A new printer will cost me $89. Whether I pay for it in cash or credit card, I will be out by $89.

Relevant costs are also directly involved in an increase or decrease of future cash flows as a result of the decision. If I buy the new printer, and the new printer is different from my old printer, then I may have to buy new cartridges for it as well. The purchase of the new cartridges would be incremental costs.

If an expense is avoidable, then it is relevant to the decision. In this case, I “avoided” having the printer repaired for $50 because I’m getting a new one. So this is relevant to my decision.

One other relevant cost is something referred to as opportunity cost. Opportunity costs are benefits, which are sacrificed because of the decision. There wasn’t really much of an opportunity cost with my decision to buy a new printer. Perhaps the $5 interest I would’ve earned if I had just kept the $89 in the bank? Yeah, I really lost out on that one.

Having talked about the relevancy of some costs to my decision, what about some of the decisions that would be irrelevant?

I’ve bought some reams of paper for my old printer (RIP), which I can still use for my new printer. These reams would be considered sunk costs as I have already spent money on this and is not relevant to my decision of whether to buy a new printer or not.

Incidentally, I got my previous printer on a “buy now pay later” scheme and I was still paying it off on an instalment plan. Regardless of whether the printer is now unusable, I am still committed to pay off my debt. Committed costs are irrelevant because we still have to pay these whether we undertake the decision or not.

The last 2 irrelevant cost types are allocated costs and depreciation/amortisation.

In bigger terms (like in a huge company setting, I mean), allocated costs would be costs distributed to other parts of the business regardless of whether the decision goes through or not. In my smaller setting, perhaps I could say this is the electricity bill that I pay for powering my printer, my TV, my fridge, etc. I allocate the charge to each item regardless of whether it’s a new printer or not.

And lastly, why would depreciation and amortization not be relevant? The simple reason is that these are just accounting adjustments made in the books.

You may have wondered at an earlier comment I made about having the printer repaired. It would have only cost me $50 to do so. Much cheaper than buying a new one.

However, decisions should not only be based on what is the cheapest option. Considerations such as is it really worth it to have repaired? $50 is definitely cheaper but it is just over half of the price of a new one. If you put it in perspective, it seems a little pricey to have it repaired than to replace it. Plus the new printer is a much better, technologically advanced equipment.

In business, factors like maintaining competitive advantage, lost of control of the process and quality of the products or services are some of the considerations to think about before embarking on these management decisions.

By looking at the different relevant costs, I am now more resolved to acquire my new printer. So I am off! Ta!

Check out Relevant Costs on Astranti’s CIMA Management Level OT Courses.

Check out Relevant Costs on Practice Test Academy’s CIMA P2 Package.

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