Relevant costs' can be defined as any cost relevant to a decision. A matter is relevant if there is a change in cash flow that is caused by the decision.

The change in cash flow can be:

additional amounts that must be paid

a decrease in amounts that must be paid

additional revenue that will be earned

a decrease in revenue that will be earned.

A change in the cash flow can be identified by asking if the amounts that would appear on the company's bank statement are affected by the decision, whether increased or decreased. Banks record cash so this test is reliable.

1. Sunk costs (past costs) or committed costs are not relevant

Sunk, or past, costs are monies already spent or money that is already contracted to be spent. A decision on whether or not a new endeavour is started will have no effect on this cash flow, so sunk costs cannot be relevant.

For example, money that has been spent on market research for a new product or planning a new factory is already spent and isn't coming back to the company, irrespective of whether the product is approved for manufacture or the factory is built.

Committed costs are costs that would be incurred in the future but they cannot be avoided because the company has already committed to them through another decision which has been made.

For example, if a company has two year lease for piece of machinery, that cost will not be relevant to a decision on whether to use that machinery on a new project which will last for the next month.

2. Re-apportionment of existing fixed costs are not relevant

Irrespective of what treatment is used in the company's management accounts to split up costs, if the total costs remain the same, there is no cash flow effect caused by the decision.

Note that additional fixed costs caused by a decision are relevant. So, if you were evaluating the viability of a new production facility, then the rent of a building specially leased for the new facility is relevant.

3. Depreciation and book values (notional costs) are not relevant

Depreciation is not a cash flow and is dependent on past purchases and somewhat arbitrary depreciation rates. By the same argument, book values are not relevant as these are simply the result of historical costs (or historical revaluation) and depreciation.

4. Increases or decreases in cash flows caused by a project are relevant

So, if an old product is discontinued three years early to make room for a new product, the revenue and cost decreases relating to the old product are relevant, as are the revenue and cost increases on the new. The cost effects relate to both changes in variable costs and changes in total fixed costs.

5. Revenues forgone (given up) because of a decision are relevant

If a company decides to keep an asset for use in the manufacture of a new product rather than selling it, then its cash flow is affected by the decision to keep the asset, as it will now not benefit from the sale of the asset. This effect is known as an opportunity cost, which is the value of a benefit foregone when one course of action is chosen in preference to another. In this case, the company has given up its opportunity to have a cash inflow from the asset sale.

Question 1: Relevant cost of materials

A company is considering making a new product which requires several types of raw material:

What is the relevant cost of each of the materials required for manufacturing of the new product (Material A, B, & C)?

Question 2 : Relevant cost of labour

A company has a new project which requires the following three types of labour:

What are the relevant costs of the various labour hours required for the new project (Unskilled, Semi-skilled, & Skilled)?

Question 3: Relevant cost of machinery Some years ago, a company bought a piece of machinery for $300,000. The net book value of the machine is currently $50,000. The company could spend $100,000 on updating the machine and the products subsequently made on it could generate a contribution of $150,000. The machine would be depreciated at $25,000 per annum. Alternatively, if the machine is not updated, the company could sell it now for $75,000.

What are the relevant costs of retaining this piece of machinery versus selling it? On a relevant cost basis, should the company update and use the machine or sell it now?

Question 4: Relevant cost of machinery A business rents a factory for $60,000 per annum. Only half of the floor space is currently used and the company is considering installing a new machine in the unused part. The machine would cost $2.1m, be depreciated over 10 years at $200,000 per annum and then be sold for $100,000. The company would insure the new machine against damage for $5,000 per annum.

What are the relevant costs of the new machine purchase?

Question 5: Further processing decision A company buys a chemical for $12,000, which it breaks down into two components:

Component A can be converted into Product A if $6,000 is spent on further processing. Product A would sell for $12,000.

Component B can be converted into Product B if $8,000 is spent on further processing. Product B would sell for $15,000.

What processing decision should the company make in order to maximise profits?

Question 6: Shut down decision A company has two production lines and its management accounts show the following:

The total fixed costs of $24m have been apportioned to each production line on the basis of the floor space occupied by each line in the factory.

The company is concerned about the loss that is reported by Production Line B and is considering closing down that line. Closing down either production line would save 25% of the total fixed costs.

Should the company close down Production Line B? What about closing down Production Line A?

Question 7: Make or buy decision A company makes a product which requires two sequential operations (Operation 1 and Operation 2) on the same machine. The machine is fully utilised. Material costs $12 per unit.

Instead of carrying out Operation 1, the company could buy in components, for $15 per unit. This would allow production to be increased because the machine has to deal with only Operation 2.

Operation 1 takes 0.25 hours of machine time and Operation 2 takes 0.5 hours of machine time. Labour and variable overheads are incurred at a rate of $16/machine hour and the finished products sell for $30 per unit.

Should the company make the entire product internally or buy in the components and complete them in Operation 2?