A manager is asked whether to launch a new product. The company has already spent ₦2.4m on development and ₦0.6m on market research. The finance clerk puts both on the evaluation, and the product looks like a loss. The money has gone, whether the product launches or not, so it cannot influence the decision.
A different clerk adds a share of head office cost and the depreciation of a machine the company owns anyway, and the product looks worse again. Neither figure will change if the product is launched. Decisions need a different way of looking at cost. They look forward, and they count only the cash that the decision itself will change.
This topic explains the idea of relevant cost and revenue, the terms used (incremental, differential, avoidable, unavoidable, committed, sunk and opportunity cost), why decisions use future cash flows and not accounting profit, and how to test any item for relevance. It builds on the environmental costs topic, and it begins the study of decision making. The next topic applies these rules to materials, labour, equipment and overheads.
In 30 seconds
A relevant cost is a future cash flow that will occur as a direct consequence of a decision. It must be future (past costs are sunk), caused by the decision (costs that happen anyway are not relevant) and a cash flow (depreciation, notional interest and absorbed fixed costs are not).
An incremental cost is an additional cost if a decision is taken; a differential cost is the difference in future cost between two options; an avoidable cost can be saved by the decision; an unavoidable cost will be incurred anyway; a committed cost is an unavoidable obligation already made; a sunk cost is already incurred; an opportunity cost is the benefit lost by choosing one option instead of the next best.
Decisions use future cash flows, not accounting profit. Full marks come from testing each item and explaining why it is in or out.
Information for decisions
Management decisions are about the future. They are a choice between options, and managers need reliable estimates of the likely financial results of each. Traditional cost information comes from historical costs, which are right for judging past profit and for control. Accounting information for decisions must be different, because a decision can change the future but not the past.
It should be based on estimates of future costs and revenues, and on cash flows, because cash flows show the economic reality of a decision while accounting conventions such as accruals and depreciation do not. Managers should consider what their decision will do to future cash flows, not to reported profit.
Marginal costing and relevant costing
Marginal costing can be used for decisions such as limiting factor analysis and linear programming. It is suitable when future fixed costs will be the same whatever is decided and all variable costs are future cash flows that the decision causes.
When these assumptions do not hold, for example when a decision brings a new fixed cost or avoids an existing one, relevant costs should be used to judge the economic result.
The definition
A relevant cost is a future cash flow that will occur as a direct consequence of making a particular decision. Three tests follow from it:
- Future. Costs already incurred cannot be relevant.
- Caused by the decision. Costs that will be incurred whatever is decided cannot be relevant.
- Cash. Notional items, such as depreciation, notional interest and absorbed fixed costs, are not cash flows and cannot be relevant.
The same applies to revenue: only future cash receipts that depend on the decision are relevant.
The terms used in relevant costing
- Incremental cost. An additional cost that will arise if a particular decision is taken. If it is a cash flow, it is relevant. The incremental cost of one more unit is usually its variable cost. If extra units mean new fixed costs, such as renting more premises, those fixed costs are incremental and must be included.
- Differential cost. The amount by which future costs differ between two courses of action. If it is a cash flow, it is relevant. Hiring a larger photocopier at ₦4,300 a month instead of the current one at ₦2,500 has a differential cost of ₦1,800 a month, or ₦14,400 over eight months.
- Avoidable cost. A cost that can be saved depending on the decision. Avoidable costs are relevant.
- Unavoidable cost. A cost that will be incurred anyway. It is not relevant.
- Committed cost. A kind of unavoidable cost: an obligation already made, which cannot be avoided by any means. A lease is normally a committed cost for its full term. Not relevant.
- Sunk cost. A cost already incurred, or already committed by an earlier decision. It must be ignored.
- Opportunity cost. The benefit lost by taking one course of action instead of the next most profitable. It is not a payment but a comparative cost, and it is relevant. The same idea applies to opportunity revenue.
Examples of each term
- Avoidable and unavoidable. A company has a year left on a lease of an unwanted warehouse at ₦120,000. If it closes the warehouse it still pays the rent, but saves local tax of ₦19,000 and security of ₦48,000. The relevant costs of closing are ₦67,000. The rent is not.
- Committed. A machine bought a year ago has a three-year maintenance contract. The contract must be paid whether the machine is kept or sold, so it is irrelevant to the decision to sell.
- Sunk. Development and market research already paid are ignored when deciding whether to launch.
- Opportunity. If a special job uses 40 skilled hours that would otherwise earn ₦750 contribution an hour, the contribution lost, ₦30,000, is a relevant cost of the job.
Relevant cost is not always zero for spare resources, and not always the book value for stock. The next topic shows how to find it for each kind of resource.
Layouts
- List the cash flows that change if the decision is taken: extra revenue, extra variable costs, extra or avoided fixed costs, opportunity costs.
- Leave out: sunk costs, committed costs, depreciation, absorbed or apportioned overhead that will not change, and costs that are the same in every option.
- Net relevant benefit = relevant revenue − relevant costs. Accept if positive.
- Opportunity cost = contribution lost per unit of resource × units of resource used.
- Differential cost = cost of option B − cost of option A, per period × number of periods.
Money is in naira and answers are exact unless stated.
Worked examples
Example 1: launching a product. A company considers launching a product. Development costing ₦2,400,000 and market research ₦600,000 have been paid. Sales would be ₦8,000,000 and the variable cost ₦4,600,000. Extra premises would cost ₦1,200,000 in rent. Depreciation of a machine the company already owns, ₦900,000, and an apportioned share of head office cost of ₦1,500,000 would be charged to the product. A maintenance contract of ₦800,000 exists whatever is decided. Required: the net relevant benefit and the treatment of each item.
- Development and research. Sunk. Excluded.
- Depreciation. Not a cash flow. Excluded.
- Head office share. Apportioned and unchanged by the decision. Excluded.
- Maintenance contract. Committed. Excluded.
- Relevant: revenue ₦8,000,000; variable cost ₦4,600,000; extra rent ₦1,200,000.
- Net relevant benefit.
8,000,000 − 4,600,000 − 1,200,000 = ₦2,200,000.
Launch the product, because it adds ₦2.2m of cash to the company.
The full-cost view would have shown a loss.
Example 2: opportunity cost. A special job needs 40 hours of skilled labour. These employees would otherwise earn a contribution of ₦750 an hour. Decide whether to accept the job if its contribution before this cost is (a) ₦38,000, (b) ₦27,000.
- Opportunity cost.
40 × 750 = ₦30,000. - (a)
38,000 − 30,000 = +₦8,000.
Accept. - (b)
27,000 − 30,000 = −₦3,000.
Reject: the labour earns more elsewhere.
Expect variants: a lease to be kept or broken, a machine with a book value and a sale value, several options compared on differential cost, and questions that ask you to explain each item.
Common mistakes
- Including sunk costs. Past spending is never relevant.
- Including depreciation or absorbed overhead. They are not cash flows caused by the decision.
- Ignoring opportunity cost. A resource in short supply has a cost beyond its pay.
- Including committed costs. They are payable either way.
- Using accounting profit. Use cash flows.
- Giving a definition without saying why an item is in or out. The reason earns the mark.
Quick revision
- Relevant = future cash flow caused by the decision. Ignore sunk, committed, notional and unchanging items.
- Incremental: extra if the decision is taken. Differential: difference between options. Avoidable: can be saved.
- Opportunity cost: benefit lost from the next best use; compare, do not pay.
- Decisions use cash flows, not accounting profit.
How the marks are earned
- Explain terms: a definition and an example, about two marks each.
- Classify items: a mark for the right answer and a mark for the reason.
- Calculate: list relevant items only, then the net result and the decision.
Practice questions
These are original questions, written in the style of the Skills examination. Work each one before you open the answer.
Recall check: multiple choice
Question 1. A relevant cost is:
- A future cash flow that arises as a direct consequence of the decision
- Any cost in the ledger
- A cost already paid
- An apportioned overhead
Show the answer
A. It must be future, cash and caused by the decision.
Question 2. Which of these is not relevant to a decision?
- Extra rent for new premises
- Variable cost of extra units
- Depreciation of an existing machine
- Extra revenue
Show the answer
C. Depreciation is not a cash flow.
Question 3. A sunk cost is:
- A future cost
- A cost already incurred that cannot be changed
- A cost that can be saved
- The benefit of the next best option
Show the answer
B. It must be ignored.
Question 4. An opportunity cost is:
- The price paid for goods
- An accounting entry
- A tax
- The benefit lost by choosing one option instead of the next best
Show the answer
D. It is a comparative cost.
Question 5. A committed cost is:
- An unavoidable obligation already made
- An avoidable future cost
- The cost of one extra unit
- A cost of the next best option
Show the answer
A. A lease is an example.
Question 6. An incremental cost is:
- A cost already incurred
- A notional cost
- An additional cost that arises if a decision is taken
- A cost that stays the same
Show the answer
C. If it is a cash flow, it is relevant.
Question 7. A differential cost is:
- A cost of one product
- A past cost
- The cost of capital
- The amount by which future costs differ between options
Show the answer
D. For example the extra monthly rent of a larger machine.
Question 8. An absorbed share of fixed overhead is:
- Always relevant
- Not relevant, because it is not extra cash spending
- An opportunity cost
- A sunk revenue
Show the answer
B. Unless the decision changes the cash spent.
Question 9. Decisions should be based on:
- Past profit
- Depreciation
- Future cash flows
- Book values
Show the answer
C. Cash flows show the economic reality of a decision.
Question 10. An avoidable cost is one that:
- Can be saved depending on the decision
- Is always paid
- Has been paid
- Is a sunk cost
Show the answer
A. Avoidable costs are relevant.
Section B style: written questions
Question 11 (10 marks). (a) Define a relevant cost and state its three characteristics. (4 marks) (b) Explain sunk cost, committed cost, incremental cost and opportunity cost, with an example of each. (6 marks)
Question 12 (15 marks). A company has a year left on the lease of a warehouse it no longer needs. Rent is ₦150,000 a year and cannot be avoided. Closing it would save rates of ₦22,000, security of ₦54,000 and a caretaker’s salary of ₦36,000. Depreciation of fittings is ₦40,000 a year and an apportioned head office charge of ₦30,000 would continue.
(a) State whether each of the six items is relevant to the decision to close, with a reason. (7 marks) (b) Calculate the saving from closing. (3 marks) (c) Advise the company. (2 marks) (d) State why the lease payments are irrelevant. (3 marks)
Question 13 (20 marks). A project would use a machine bought five years ago for ₦210,000, now valued in the books at ₦60,000. The machine could be sold now for ₦38,000. If used on the project for eight months it could then be sold for ₦26,000. The project has already had ₦300,000 of development cost.
(a) Calculate the relevant cost of using the machine. (3 marks) (b) Explain the treatment of the book value, the original cost and the development cost. (6 marks) (c) Explain why decisions should use cash flows and not accounting profit. (5 marks) (d) Explain what is meant by saying that an opportunity cost is a comparative cost. (6 marks)
Model answers
Show the model answer to Question 11
(a) A relevant cost is a future cash flow that will occur as a direct consequence of a decision (1). It is in the future, not already incurred (1); it is caused by the decision, so costs that occur anyway are excluded (1); it is a cash flow, so notional costs such as depreciation are excluded (1).
(b) Sunk: already incurred, such as development cost already paid (1.5). Committed: an unavoidable obligation already made, such as a lease (1.5). Incremental: an additional cost if the decision is taken, such as extra rent (1.5). Opportunity cost: the benefit lost by choosing one option instead of the next best, such as contribution lost on labour moved to a special job (1.5).
Show the model answer to Question 12
(a) Rent ₦150,000: not relevant, committed and payable either way. Rates ₦22,000: relevant, avoided by closing. Security ₦54,000: relevant, avoided. Caretaker ₦36,000: relevant, avoided. Depreciation ₦40,000: not relevant, not a cash flow. Head office charge ₦30,000: not relevant, continues whatever is decided (1 for each answer, 1 extra for the quality of reasons) (7).
(b) 22,000 + 54,000 + 36,000 = ₦112,000 (3).
(c) Close the warehouse: it saves ₦112,000 of cash. The rent remains, but it is the same either way (2).
(d) The lease is a committed cost for its full term, so the payments will be made whether the warehouse is open or closed and cannot change the decision (3).
Show the model answer to Question 13
(a) Relevant cost = sale value now less sale value after use = 38,000 − 26,000 = ₦12,000 (3).
(b) The book value of ₦60,000 is an accounting figure and not a cash flow, so it is ignored (2). The original cost of ₦210,000 is a past cost and sunk (2). The development cost of ₦300,000 is already spent and sunk (2).
(c) Decisions affect future cash, and cash flows reflect economic reality (1). Accounting profit includes accruals, depreciation and allocations that do not change cash (2). A project can show an accounting profit and lose cash, or the reverse (2).
(d) An opportunity cost is not an amount paid out but the benefit given up by choosing one option over the next best (2). It is found by comparing the two options (2). Here the machine’s next best use is to be sold now, so the cost of using it is what is lost by waiting (2).
Pathfinder on Relevant costs, revenues and opportunity cost
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Relevant cost of a one-year engineering project (hire v buy machine, labour, materials); why reported profit differs; contribution theory; opportunity cost.
Revise first: Layouts
Relevant cost estimate for painting contract and non-monetary factors.
Revise first: Layouts
Relevant revenue and cost of a contract (labour grade 1 idle, replacement cost, NRV, lost contribution of Y); job-cost report; reconcile relevant and routine figures.
Revise first: Layouts
Choose between two mutually exclusive contracts using incremental revenues and costs (Abuja, Lagos).
Revise first: Layouts
Relevant cost schedule for a contract (nine items); limits of relevant costing; skimming launch price.
Revise first: Layouts
Product contribution/profit, drop a product, extra sales to cover advertising; relevant cost quote for a one-off job; incremental, differential, committed, sunk, opportunity cost.
Revise first: Layouts
Relevant costs: reduce output, shut down, special order; techniques and principles.
Revise first: Layouts
Single limiting factors for two components, spare capacity outlets, ways to overcome constraints, opportunity cost of material/labour/overhead.
Revise first: Layouts
Source: ICAN Pathfinder, Performance Management. Diets covered: March/July Diet, 2020 to May Diet, 2026. All 13 diets in the Pathfinder are mapped.
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