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How can you use relevant costs to evaluate performance?

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Relevant costs are the costs that change as a result of a decision. They are also known as incremental, differential, or avoidable costs. Using relevant costs can help you evaluate performance by comparing the benefits and sacrifices of different alternatives and choosing the one that maximizes profit or minimizes loss. In this article, you will learn how to identify and apply relevant costs in various scenarios, such as outsourcing, make or buy, and special orders.

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Tejas Parikh (ACMA, MBA)

Finance Transformation Specialist | Delivering Finance Digitalisation: Efficiency & Effectiveness Improved +100% |…

1 What are relevant costs?

Relevant costs are the costs that differ between two or more alternatives. They are the only costs that matter for decision making, because they reflect the impact of choosing one option over another. Relevant costs can be variable or fixed, depending on the situation. For example, if you decide to outsource a part of your production, the variable costs of making that part in-house are relevant, because they can be avoided by outsourcing. However, the fixed costs of maintaining the factory are not relevant, because they will not change regardless of your decision.

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Shamsuddeen Lawal

A Thinker | Transforming Financial Planning and Analysis (FP&A) with Data Science
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To put it simply, relevant costs are those costs that will be impacted by a specific decision. When making choices, it's crucial to focus on costs that change based on the alternatives under consideration, as these are the ones that directly influence the decision-making process.

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2 What are irrelevant costs?

Irrelevant costs are the costs that do not change as a result of a decision. They are also known as sunk, historical, or unavoidable costs. They should be ignored for decision making, because they do not affect the outcome of choosing one option over another. Irrelevant costs can be variable or fixed, depending on the situation. For example, if you decide to buy a new machine, the depreciation of the old machine is irrelevant, because it is a sunk cost that has already been incurred and cannot be recovered.

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3 How to identify relevant costs?

To identify relevant costs, you need to compare the total costs of each alternative and isolate the costs that differ. You can use a table or a diagram to organize the information and highlight the relevant costs. You should also consider the opportunity costs, which are the benefits foregone by choosing one option over another. For example, if you decide to use your existing capacity to produce a special order, the opportunity cost is the profit you could have earned by selling your regular products.

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Tejas Parikh (ACMA, MBA)

Finance Transformation Specialist | Delivering Finance Digitalisation: Efficiency & Effectiveness Improved +100% | Business Intelligence & Budgeting / Forecasting Technology | FP&A Thought Leader?? See recommendations??
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Identifying relevant costs is a critical step in financial analysis and decision-making. Start by distinguishing between fixed and variable costs, focusing on those directly impacted by the decision at hand. Consider the time frame; only costs that will change as a result of the decision are relevant. Look for opportunity costs, which are benefits foregone from choosing one option over another. Exclude sunk costs, as they've already been incurred and cannot be recovered. Assess direct and indirect costs, but be mindful to include only those that will change with the decision. This careful selection ensures that your analysis is accurate, focused, and ultimately, more meaningful for strategic planning.

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4 How to apply relevant costs?

To apply relevant costs, you need to calculate the net benefit or net cost of each alternative and choose the one that maximizes profit or minimizes loss. You can use a formula or a ratio to compare the relevant costs and benefits. You should also consider the qualitative factors, such as customer satisfaction, quality, reputation, and strategic goals, that may influence your decision. For example, if you decide to outsource a part of your production, you should weigh the cost savings against the potential risks of quality issues, delivery delays, or loss of control.

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5 Examples of relevant costs

When considering different scenarios, there are a variety of relevant costs to consider. For example, when outsourcing, the variable costs of making the product in-house versus the outsourcing price should be taken into account, as well as any additional costs or savings related to transportation, inventory, and quality. When deciding whether to make or buy a product, the variable costs of making the product versus the purchase price should be considered, as well as any additional costs or savings related to capacity and overhead. Special orders should factor in the variable costs of producing the special order versus the incremental revenue, plus any opportunity costs or benefits related to regular sales, capacity, and customer loyalty. Lastly, when replacing equipment, the variable costs of operating the old machine versus the new machine should be weighed along with the initial cost of the new machine minus the salvage value of the old machine, adjusted for the time value of money.

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Tejas Parikh (ACMA, MBA)

Finance Transformation Specialist | Delivering Finance Digitalisation: Efficiency & Effectiveness Improved +100% | Business Intelligence & Budgeting / Forecasting Technology | FP&A Thought Leader?? See recommendations??
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Example of Relevant Costs in the Manufacturing Industry: - **Direct Material Costs**: Cost of raw materials needed for production, varying with output levels. - **Direct Labor Costs**: Wages paid to workers directly involved in manufacturing, scaling with production volume. - **Variable Overheads**: Costs like electricity and machinery maintenance that fluctuate with production intensity.

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6 Benefits of using relevant costs

Incorporating relevant costs can help you evaluate performance by streamlining the decision making process, increasing the accuracy and efficiency of your analysis, and ultimately improving the profitability and competitiveness of your business. This is achieved by focusing on essential information, avoiding double-counting or missing costs or benefits, and selecting the best alternative that aligns with your objectives and constraints.

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7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Nancy Ambrose

Transforming Finance Careers | English Mastery for Accountants | Expert in Global Communication, Strategic Speaking & Interview Success | 12 Years of Excellence
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Understanding your costs is a cornerstone of strategic decision-making. By incorporating relevant costs, you not only streamline the decision-making process but also gain a deeper understanding of your cost structure. This understanding is crucial for making informed choices that have a direct impact on your business's profitability and competitiveness. It allows you to identify areas where cost efficiencies can be achieved, highlights potential cost-saving opportunities, and ensures that decisions are grounded in a comprehensive knowledge of the financial implications. In essence, a clear understanding of costs is key to navigating the complexities of business decisions and driving sustainable success.

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How can you use relevant costs to evaluate performance?

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1 What are relevant costs?

2 What are irrelevant costs?

3 How to identify relevant costs?

4 How to apply relevant costs?

5 Examples of relevant costs

6 Benefits of using relevant costs

7 Here’s what else to consider

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