What is relevant cost

Relevant cost: Relevant costs are the costs that differ between alternatives. Sunk costs and future costs that will not differ between alternatives are irrelevant costs.

Relevant costs are used to make the following decisions

1. Make or Buy Decisions: - Decisions about producing a product in-house or purchase it from outside suppliers.  Fixed costs of production are irrelevant here, only variable costs of manufacturing should be considered for making such decisions.

2. Accepting or Rejecting Special Orders: - Decisions about whether receiving a special order from customers or not. For making such decisions only the costs associated with carrying the special order should be considered and if it is considered that current sales will not be affected by choosing the special order then the company may accept that order.

3. Adding or Dropping a Product Line: - Decisions about adding a new product line or dropping a losing unit. If a unit is making loss then it does not mean that the unit should be dropped. If the contributions from the loosing unit can contribute to the allocated fixed costs then the unit should not be dropped.

4. Utilization of constraint resources: - Resources are always limited so we need to use resources in a way that will generate optimum gain. For example ABC Company produces two products, Product X and Y. Product X require 1 machine hour per unit and product Y requires 1.5 machine hours per unit. Per machine hour product X contributes tk.2, Product Y contributes tk.3. ABC Company has limited machine hours so it will pay first preference for utilization of machine hours to product Y because it contributes more than Product X per machine hour.

5. Decisions about selling or further processing: - In some industries, a number of end products are produced from a single raw material input. Two or more products produced from a common input are called joint products. The point where each joint product is recognized as separate product is called the split off point. Some products need further processing after the split off point. If incremental revenue is greater than the incremental costs of further processing then we will do further processing.