What is Relevant Cost?

What includes on Relevant Costs?

Relevant Cash flow includes:

  • Incremental future costs
  • Opportunity Costs
  • Incremental working Capital costs
  • Additional fixed costs
  • Infrastructural costs etc.

Non-Relevant Costs includes:

  • Past Costs/Sunk Costs
  • Committed Costs
  • Depreciation Expenses

Definition of Relevant Costs

The relevant cash flows are future, incremental cash flows arising from the decision being made. This means that the cash flows are only relevant if they are future, incremental costs. Relevant costs are used for taking an investment decision.

Techniques to identify Relevant Costs

  • All incremental future costs are relevant costs
  • Opportunity Costs: Whether costs saved, or revenue foregone
  • The extra tax payable on the profits from the project
  • Residual value/ salvage value of the additional fixed assets are also relevant
  • Incremental working capital of the project
  • Infrastructure costs i.e additional information technology, or communication system
  • Marketing Costs i.e. Market research, promotion and branding if needed for the new product
  • Human resource cost if needed for the new project
  • Additional fixed costs for the project

Techniques to identify Non- Relevant Costs

  • All sunk costs/ past costs
  • The committed costs whether the projects are undertaken or not
  • Depreciation expenses
  • Research costs that are already incurred
  • Centrally allocated overhead costs
  • Management costs and marketing research costs that are already incurred
  • Finance costs are also non-relevant costs

Examples of Relevant Cost

i) Research Costs : A research project, which to date has cost the company CU150,000, is under review.

Answer: Research costs already incurred. This is Sunk costs, hence, this is not ” Relevant Cost.”

ii) Materials. This material has just been purchased at a cost of CU60,000. It is toxic; if not used in this project, it must be disposed of at a cost of CU5,000.

Answer: Material already purchased at a cost of CU60,000, hence Non-Relevant cost. Disposal value at a cost of CU5,000 is Relevant costs as this is Opportunity cost.

Labour. Skilled labour is hard to recruit. The workers concerned were transferred to the project from a production department, and at a recent meeting the production manager claimed that if these people were returned to him they could generate sales of CU150,000 in the next year. The prime cost of these sales would be CU100,000, including CU40,000 for the labour cost itself. The overhead absorbed into this production would amount to CU20,000.

Answer: Labour cost CU 40,000 will be incurred regardless of whether the project is undertaken , or not. So, it is not Relevant.

Research staff. It has already been decided that, when work on this project ceases, the research department will be closed. Research wages for the year are CU60,000, and redundancy and severance pay has been estimated at CU15,000 now, or CU35,000 in one year’s time.

Answer : Research costs CU60,000 will be incurred, this is incremental cost. Hence, this Relevant Cost. Redundancy payment increase (35,000 – 15,000) = CU20,000

Equipment. The project utilises a special microscope which cost CU18,000 three years ago. It has a residual value of CU3,000 in another two years and a current disposal value of CU8,000. If used in the project it is estimated that the disposal value in one year’s time will be CU6,000.

Answer: Microscope cost is CU18,000 is sunk costs as purchased 3 years back. Current disposal value of CU is Opportunity cost – revenue foregone, hence Relevant cost. Disposal value in one year’s time CU6,000 is Relevant Cash flows.