Relevant costs

Question 1

Briefly discuss the characteristics of relevant costs

Answer 1

Characteristics of Relevant Costs

Relevant costs are future-oriented financial data used in decision-making (e.g., accepting orders, outsourcing, or discontinuing products). They have the following key characteristics:

1. Future-Oriented

Only future costs that will change due to the decision are relevant.
Example: When deciding to launch a new product, only expected production and marketing costs matter—past R&D expenses (sunk costs) are irrelevant.

2. Differential (Incremental)

Costs must differ between alternatives.
Example: Choosing between two suppliers; only the cost difference between them is relevant.

3. Avoidable

Costs that can be eliminated if a decision is taken.
Example: Closing a department avoids its salaries and utilities (relevant), but not allocated corporate overhead (irrelevant if unavoidable).

4. Cash Flow Impact

Must affect actual cash flows (non-cash expenses like depreciation are irrelevant).
Example: A machine’s purchase cost is relevant, but its book depreciation is not.

5. Opportunity Cost Consideration

Includes benefits foregone by choosing one option over another.
Example: Using idle factory space for a new project has an opportunity cost (rent lost from not leasing it out).

6. Short-Term Focus

Relevant costs typically apply to tactical decisions (e.g., pricing, make-or-buy) rather than long-term strategy.

Question 2

Briefly discuss the characteristics of relevant costs
 Select two types of decisions which make use of the relevant cost principle and
(i) Explain in detail how this underlying principle is applied using a numerical illustration.
(ii) Evaluate the limitations of the relevant cost principle used in these two types of decisions

Answer 2

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