Question

I understand that it is smart to isolate relevant cost sometimes instead of total cost, but how do you know when it is more efficient to isolate relevant cost sometimes?

Answer 1

Relevant Costing assigns future costs and revenues to the decision being made. It includes only those cash flows which will be affected by the decision.

Relevant cost must be future (incremental) cash flows affected by the decision and therefore ignore the following:

• Sunk Cost: Those costs which have already been incurred before the decision is made. For example - if a company already purchased material then the cost of the material at that time is irrelevant. Instead the current replacement value (if material is still regularly used) or the scrap value (if material is no longer used) would be considered the relevant cost to the decision.
• Unavoidable Cost (committed cost): Those costs which will be incurred / cannot be avoided regardless of the decision. The difference between these and the sunk cost is the time at which the costs are incurred. These are future cost whereas sunk cost is in the past. For example – Expenses like Depreciation, property tax, lease payment, interest expense already incurred before the decision and any difference will be treated accordingly.
• Apportioned Costs: Those costs which have been split between units of production or service based on some arbitrary allocation method, For example – fixed machine service cost apportioned based on the number of machine hours used.

However Relevant cost do include Opportunity cost; of the benefits foregone when the decision being made means that alternative opportunity must be rejected. For example: If a company owns a asset which can be leased out to other companies, but is used on short term internal contract instead, them the relevant cost would include the external rental income foregone.