In other to aid decision within a short time, management has to understand which costs are relevant and irrelevant. But what is relevant costs and how can you spot it?
Definition of relevant cost
This is the cost that changes an entity’s cash flow within a short period of time.
It can also be referred to as costs that are necessary for entities to make a decision.
In addition, relevant cost is the cost which causes changes in a firm’s cash flow as a result of a decision taken by management.
Note that the term relevant cost can also be replaced as relevant revenue.
How to know if a cost or revenue is relevant
A cost or revenue is relevant if:
1 An additional amount must be paid to effect the decision or
2 The value of the cost involved will be reduced in respect of the decision or
3 The value of revenue will increase as a result of the decision or
4 The amount of revenue will be decreased in respect of the decision.
Finally, what makes a cost or revenue relevant is if it will change the entity’s cash flow in the nearest future.
The matter of relevancy comes to play when management is making a decision among alternatives. A company may decide to engage in project A or project B. After making a decision among the alternatives, the expenditure incurred on the chosen project is relevant while the leftover expenses are irrelevant.
For example, a firm plans to spend 50 million Naira on a project. This amount of money is relevant. It had the power to affect the business cash flow. However, if during the project it spent less than 50 million Naira, say 48 million Naira, then 48 million Naira is no longer relevant because the money is already spent. Therefore, it is a past cost.
It also arises in the short run. This is so, as not all cost can change a business cash flow within a short period of time. For example, past or sunk costs cannot change the entity’s cash flow. These costs are spent in the past. Therefore, they can’t affect the entity’s management present decision.
To illustrate, the company’s management has already spent 20 million Naira on a project but decided to abandon the project for a new project of which it will spend the remaining 30 million on it.
The 20 million is already spent, so it’s a sunk cost while the 30 million is what the management plans to spend on the new project. This is the relevant cost.
Notional and committed costs are not relevant costs.
Notional costs like depreciation cannot be relevant. Depreciation cannot change the entity cash flow. Committed costs on it part, are costs planned for a particular decision which had been made in the past, therefore, such cost is no longer relevant.
Note that for a cost or to be relevant, it must cause changes in the entity’s cash flow and must be incurred or earned in a future time.