This refers to the cost or revenues that are related to specific management decisions. Relevant cost, are costs incurred at a future time that differ between each option available to the management.
Relevant costs and revenues are simply cash flows that arise as the result of a decision. If a cash flow if unaffected by a decision then it is not relevant.
Relevant cash flows are future cash flows
In the example of the pump development costs for the product are not taken into account. They are sunk (historical costs) that will not be changed as a result of a decision.
Relevant cash flows are incremental cash flows
The quarterly bill for materials used to make pumps could be £50,000. Increasing the number of pumps produced by one unit increases the bill to £50,500. The relevant cost of the extra pump is neither £50,000 nor £50,500. It is the change in total material costs triggered by the decision to make one more pump – £500.
As with most decisions financial information plays an important part, make or buy decisions are no exception. Make-or-buy decisions extend to:
- Manufacture or buy from a supplier
- Doing something ourselves or hiring another company to do it
The comparison of the cost of each alternative can be based on its marginal costs, plus any additionally incurred fixed costs. We should ignore any costs which are unaffected by our decisions (current fixed costs), since they are not really relevant.
Faced with a loss making product/service or business unit, senior management are often tempted to take the decision to close the unit and reduce losses. However, care needs to be taken when making this kind of decision as under certain circumstances closing a loss making product or service can increase company losses!
Careful consideration should be given to what actually changes if the loss-making product is discontinued i.e. a relevant costing approach should be adopted.
Product-mix decisions & Limiting Factor
Some businesses may face situations in which sales demand is in excess of current productive capacity. For example, the output may be restricted due to a shortage of labour, materials or equipment. When sales demand is in excess of a company’s productive capacity, the resources responsible for limiting the output should be identified. This type of lack of resources is also known as limiting factors.
In the short-term it is unlikely that a business will be able to overcome such issues or that they will be acquire additional resources. The limiting factor emphasized that profit is maximized when the greatest possible contribution to profit is obtained each time the limiting factor is used.
Special pricing decisions
Relates to pricing decisions made outside the main market of a business. Typically they involve one-time only orders or orders at a price below the prevailing market price.