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.
Two main characteristics of relevant costs are that these are either the future possible costs to be incurred or these are incremental or avoidable costs. What do these characteristics actually mean? It simply means the cost which has already been incurred (become past cost now) does not qualify to be relevant cost anymore. Similarly, if the cost is unavoidable in nature and must have to be incurred irrespective of profit or loss arising from the investment it also does not qualify to be a relevant 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.