Costs that are affected by the managerial decision are known as relevant cost. Relevant costs for decision making are excepted future cost that will differ under various alternatives. The relevant cost concept helps the management to take right decision by elimination the extraneous information from a particular decision-making process.
Types of relevant cost
The relevant costs are such as follow:-
- Future cash Flows
- Avoidable cost
- Opportunity cost
- Increments cost
Future Cash Flow: –
Any relevant cash flow that should arise in future. To evaluate the investment opportunities, a manager must determine the relevant cash flows such as incremental cash outflows or inflows. Any costs that occurred in the past are called suck cost. It should be excluded from the relevant cash flow.
Avoidable Cost: –
Avoidable costs are those cost which can be eliminated if the particular course of action is not taken or if any department is closed. For an example, if an organization chooses to close a production line, then the cost of the warehouse in which store the production unit is an avoidable cost because you can sell the warehouse. In generally, we can say that variable cost is an avoidable cost, on other hands, a fixed cost is not considered to be an avoidable cost.
Opportunity cost: –
Relevant costs are also an opportunity cost. An opportunity cost is the value of sacrifices made or benefit of opportunity gone in acceptance of alternatives course of action. Opportunity cost plays an important role in decision making.
Incremental cost: –
Incremental cost is a relevant cost for decision making and incremental cost is the increase in total costs resulting from an increase in production and other activities. Incremental cost referred to as the differential costing For an example:- If a company total cost increase from $2,20,000 to $2,40,000 as a result of increasing the production unit. The incremental cost $40000.
Relevant cost for decision-making
The most important task of the successful managers is to take the right decision for the business. For taking the right decision a manager have to choice between at least two alternatives. The decision process may be complicated due to irrelevant data, incomplete information, the volume of data etc. The costs and benefits of different activities are needed to be compared and contrasted before making the right decision for the business. The right decision should be based only on relevant information. The relevant information includes the predicted future cost or incremental cost and revenue that differ among the alternatives. If any cost or revenue that does not differ between alternatives are caller irrelevant cost and it should be ignored in a decision-making process.
Suck cost is an example of irrelevant cost because it will be same for any kind of alternatives. Future cash flow, opportunity cost or incremental costs are an example of relevant cost. All these costs are helpful in taking managerial decisions.
The managers have to identify that which costs are relevant in a particular situation, follow the three steps–
- First of all eliminate the sunk costs
- Eliminate all these costs and benefits that do not differ between alternatives.
- For making proper right decision, a manager should compare the remaining costs and benefits that do not differ between alternatives
There are different types of decisions such as;-
Make or buy decision: – Make or buy decision involve whether an organization has to make a product internal or buy it from the outsiders. For taking right decision a manager should have to compare the production cost with the buying cost.
Adding or dropping product line or other segments: – A manager has to decide whether a new product line should be added or deleting any other product line or segments which creating a loss.
Special orders: – Special orders are one-time orders that do not affect company’s normal sale and profits arise from these special orders are equal the incremental revenue less incremental cost. Special orders should be accepted when the incremental revenue exceeds the incremental costs.
Sell or process further decision:- A decision has to make about selling a joint product as is or processing it further if it profitable to continue further processing a joint product when incremental revenue from such processing exceeds the incremental processing cost.