Relevant costs are those expected future costs that vary under various alternatives. Relevant costs can also be defined as the costs that are affected due to decision making.
Non-recognition of relevant costs can also lead to wrong decisions. Let’s take an example, in the case of whether to retain or replace an old machine, the realisable value and dismantling cost of the old machine are relevant costs but the present written down value (WDV) of the old machine will be irrelevant.
Relevant expenses have two primary characteristics: they are either future potential costs to be incurred or they are incremental or avoidable expenditures. What do these features entail in practice? It simply indicates that a cost that has already been incurred (has become a past expense) no longer qualifies as a relevant cost. Similarly, if the expense is inescapable in nature and must be incurred regardless of whether the investment generates profit or loss, it does not qualify as a significant cost.
Two Common Pitfalls in Relevant Cost Analysis
- The first pitfall is to assume that all variable costs are relevant. All variable costs are not relevant. Variable costs that remain unchanged under various alternatives are not relevant but the variable costs that differ under different alternatives are relevant.
- The second pitfall is to assume that all fixed costs are irrelevant. All fixed costs are not relevant. Fixed costs that remain unchanged under different alternatives are irrelevant but fixed costs which differ under various alternatives are relevant.