Short Term Decision Making:Understand Relevant Costs(Part1)

It is important that Management needs to have sufficient and relevant information to make the correct decisions. Hence,the need to understand relevant costs.

What really is Relevant cost?

• A relevant cost relates to future expected costs that will differ with each alternative used.
• Because of the difference amongst alternative,hence it has a bearing on the decision to be made.
• On the other hand,irrelevant costs simply are costs that will not affect the decision. By analyzing these types of irrelevant costs,management will be wasting their time and efforts as these costs do not affect the decision they are going to make.

Some features or criteria of Relevant Costs are:

• Relevant cost is a cost that will be incurred in the future. Historical costs are sunk costs which has no relevancy in the decision making.
• The costs must differ between alternatives. If a cost is the same whether we choose alternative A or B then this is an irrelevant cost. A good example is factory rental which remains the same irrespective of management wanting to manufacture product A or B.
• Only CASH flow item And Incremental fixed costs are relevant. Non cash item like depreciation and absorbed fixed overheads are not relevant costs as they do not involve any additional cash flow.

Some of the following areas where short term decisions where relevant costs are applicable:

• Limiting factor due to scarce resources;
• Make or Buy decision;
• Accept or Reject special order;
• To continue or discontinue or shut down decisions;
• Pricing

• Short Term Decision Making:Other Relevant Cost Techniques(Part2)
• Short Term Decision Making:Make Or Buy (Part4)
• Short Term Decision Making-Special Order(Part5)
• Short Term Decision-Limiting Factor(Part3)
• Current Assets As Collaterals For Short Term Financing (Part 1)
• Short Term Finance:Taking Cash Discount From Supplier
• Short Term Financing-Bank Overdraft Facility