Relevant costing is neither a cost flow assumption nor a method of costing a product. Better call it a method of costing various decisions or alternatives to compare and select the best. It as a forward looking, practical and nutshell approach. This small post is to summarize the few major aspects which make up the concept of relevant costing
Ignoring Past costs:
One of the very essences of relevant costing is to ignore all past costs, Past costs (or sunk costs as they are popularly called) are comparable to arrows already out of our bow and which cannot return back to us except where it is a boomerang. Of course when one wants to dig into the past and see how a business had performed, he will have to run through the entire list of costs recorded and unrecorded which is only a post mortem exercise. But if the same person is confronted with a decision say, whether to stay put in business or not, the following things are ‘irrelevant’
1. Revenues earned in the past out of the business.
2. All costs incurred in the business in the past
The following things become relevant
1. Revenue foregone (that which will not come forth) if business is discontinued.
2. Costs saved if business is discontinued. There is always a need for clear understanding on cost allocations from a Head office to decide whether they will stop completely on business shut down or not. Take for example a subsidiary Y running two businesses in the same building for which Rent is paid by the parent X. Perhaps even if one business is closed, the rental allocation on the whole over Y will remain the same since rent is paid for the unused space as well considering short term future needs. But if Y only had a solitary business and parent X wants the subsidiary itself to be liquidated due to strategic reasons, then the entire rental allocations will stop following a plan to discontinue the rent agreement.
The above principle is the same to be followed for other similar decision makings such as make or buy, lease or buy etc. with only a respective change in the usage of words and terms.
Naturally we work with a foresighted approach when it comes to decision making which is exactly all about Relevant costing.
Exploring the Hidden/opportunity costs:
There may be hidden costs which do not unearth on a prima facie look at the alternatives. We can demonstrate one such cost whose relevance is driven by difference in circumstances through an example. Suppose we want to buy a car and have to decide between Car X and Car Y. Assuming the on road price (i.e. inclusive of taxes and insurance) of Car X is Rs.500000/- and that of Car Y is Rs. 507000/-. We also assume that the cash flows on account of maintenance in a year are more or less the same under both the options. Let us tabulate the things as below,
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PARTICULARS
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Car X
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Car Y
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1
2
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On road purchase price
Annual Maintenance
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500000
50000
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507000
50000
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Apparently a layman is tempted to prefer Car X over Car Y given minimal cash flows. But let us assume that Car X is a huge seller such that the buyer has to bear a waiting period of 45 days, whereas Car Y being a new launch is readily deliverable. We may not have any other conveyance to go to office and entirely depend on this new purchase
Suppose we decide to buy Car X we will have to use an Auto to go to office during the 45 days wait which will cost say Rs.9000/- on the whole. This Rs.9000/- is actually an opportunity cost which will go to add to the total cost of Option 1 i.e. Car X which now makes the total cash flow of Car X as Rs.559000/- rather than just Rs.550000/-. This also turns Car Y option more lucrative than Car X! It is indeed surprising that a regular conveyance expense which received very little attention from us all along becomes a ‘relevant’ factor all of a sudden only during these 45 days. After this waiting period and the purchase getting over even if the buyer continues going by auto out of eccentricity, these expenses are irrelevant since they are not forcibly influencing the decision making. Such situations are common whatever the subject may be; say even a house where during the waiting period up to occupancy we may have stay in a paying guest house. Thinking along these lines will save us from major judgment errors. Therefore one has to keep his cool, ransack all such costs and place them under respective alternatives and then take a decision.
Incremental Approach
The Incremental approach to relevant costing is predominantly to make our excel spreadsheet tabulations look simpler. In the above given example the annual maintenance of Rs.50000/- is common under both alternatives. Therefore if one follows an incremental approach, this Rs.50000/- need not be placed under both alternatives while working out on the spreadsheet. Also, as the name suggests only the excess amount under a line item for particular option over the other is sufficient to be entered in the spreadsheet. Therefore in the example, we need to enter the incremental Rs.7000/- in purchase price under Car Y column and zero in Car X column and not the entire amounts.
Considering the relevant things in life is a matter of common sense and necessary for proper decision making.
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