Relevant cost analysis is a very integral part of financial and management accounting. Relevant cost is used to describe those expenses that have been incurred in making a business decision which otherwise could have been avoided. The system of relevant cost analysis helps to reduce unnecessary expenses and eliminate relevant information that can complicate the decision-making process in a company.
Businesses use the concept of relevant cost analysis to determine whether a new decision is cost-effective or not. It helps companies make profitable decisions and reduce non-essential expenses. Financial analysis is a flourishing profession and to have a career in financial analysis one can learn through various online courses and modules to get a good start.
Read on to know what is relevant cost analysis and how it helps the management in the decision-making process.
What is Relevant Cost?
Relevant costs can be defined as any cost that is related to and relevant to making any important decision. Relevant costs are the financial costs that result in making a business decision. These costs are also known as differential costs.
For instance, if a decision affects the profit and loss statement of a company then that decision is important and any cost incurred to carry out such a decision is a relevant cost. Businesses base their choices and decisions on the anticipated expenses in order to reduce wasteful expenditures and identify successful investment areas and initiatives.
Types of Relevant Costs
Types of relevant costs can be categorised into four broad areas that are enumerated as follows:
- Avoidable: Avoidable relevant costs are the ones when an organisation can make an alternative decision in order to avoid such costs that seem to be additional.
- Incremental: Incremental relevant costs are the ones that fluctuate or change with time. It does not remain stagnant and is generally related to production progress. Higher amount of production results in more incremental relevant costs.
- Opportunity: Opportunity-relevant cost is the one that is incurred as a value of selecting an option over another. This expense is a result of selecting one option when there are other options available as well. It depends upon the management which option seems more viable and important to them.
- Future cash flow: Future cash flow relevant costs are the expenses that do not affect the present situation of the company. These are the costs that may be incurred in future as a result of the decisions and choices made today.
How Relevant Cost Analysis is Used in Decision Making?
Relevant cost analysis is an important consideration in the modern-day managerial process. Relevant cost is taken into consideration when making any major business decision. Also, relevant cost is not separable from financial modelling. Whenever financial accounting or aspects of financial modelling are concerned, relevant costs always remain a core consideration in such cases.
Relevant cost analysis is used in the decision-making process in an organisation in the following ways:
Whether to make or buy
A business that deals in the manufacture of final products requires specific raw materials and parts to make the end product. Here the management makes decisions about whether they want to outsource such raw materials or specific parts or do they want to make it on their own. Such a decision is taken by considering the lowest cost option. The make-or-buy situation is a very common scenario in a company and direct labour, direct materials and the various overload costs are the most common examples of the make-or-buy situation.
Consider a situation where a company wants a specific part of any machine. Here the company has two alternatives; they can either buy such a part from outsiders or they can make the necessary part on their own. If the management finds that outsourcing reduces the cost and also gets the required part of the machine then they will switch to outsourcing rather than making it in their factory. It helps to save time, effort and cuts down on expenses. Thus, the relevant cost analysis assisted the company in making a sound decision regarding buying or making the required part of the machinery.
Continue production or close a business unit
Businesses often face the dilemma of whether to continue running business operations or close down some business units. In such cases, the management has to go through a detailed analysis of whether the business units are making enough profits or not and whether they are incurring high maintenance costs or not. By doing a comparison of both parameters, the management has to take the right call.
Appropriate relevant cost analysis form helps the management easily get the details for making the comparison. With the help of relevant cost analysis, the management chooses either of the options and makes a sound decision.
Some businesses specialised in specific areas. Customers may at times ask for a one-time item from a business. Such an order may appear right after the cost calculation and evaluation of the organisation. In such scenarios, the company will not disown the order of a customer but it will produce the item at the lowest possible cost and will also not compromise on the quality of the same.
However, companies only consider these special orders when it depicts a profitable future for the company in the long run. This is a form of investment by the company for generating income in the coming years. Before taking any special order a company takes into consideration whether the company has the necessary capacity to successfully complete the order and whether the order covers the cost of production or not.
Relevant cost analysis is undoubtedly one of the major parameters when taking any major business decision. Relevant cost is a part of financial and managerial accounting and it is a very important domain for management and finance professionals. If you want to build a career in financial analysis, consider signing up for the Financial Analysis Prodegree In Collaboration With KPMG by Imarticus. This course will help you inculcate the necessary knowledge and skill set about relevant cost analysis that will help you get ahead of your contemporaries.
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