Relevant costing is a term that fills many people with fear. Whether it is the fact that the word contains eight letters or the fact that someone sometime linked this topic with doom, relevant costing might appear more daunting than it actually is.
The principle of relevant costing is primarily applicable where decisions have to be made. The inclusion of irrelevant information during the process, could lead to the incorrect decision being made. A relevant cost/income is any cost/income that will NOT be incurred if one decision is made instead of another. This can be illustrated by the following example of a person having to decide between renting or buying a townhouse. The following information relates to the alternatives under consideration:
|Area of townhouse||125m2||202m2|
|Rent/Bond per month||R7 100||R9 800|
|Water and Electricity per month||R1 000||R1 500|
|Rates and Taxes||R0||R400|
|Cable subscription||R1 000||R1 000|
|Cleaning per month||R750||R750|
|Original building cost||R700 000||R1 000 000|
The person in the example knows that he will receive a salary increase of R5 000 for the 2018 financial year. He now has to determine whether this increase will ensure that he can afford to buy the larger townhouse. In this decision-making process, the above mentioned costs can be divided between relevant and irrelevant as follows:
|Area of townhouse||125m2||202m2||?|
|Rent/Bond per month||R7 100||R9 800||R2 700 Relevant|
|Water and Electricity per month||R1 000||R1 500||R500 Relevant|
|Rates and Taxes||R0||R400||R400 Relevant|
|Levies||R0||R1 100||R1 100 Relevant|
|Cable subscription||R1 000||R1 000||Irrelevant|
|Cleaning per month||R750||R750||Irrelevant|
|Original building cost||R700 000||R1 000 000||Irrelevant
The irrelevant cash flows with regards to this decision are the cable subscription, cleaning cost and the original building cost. The cable subscription and cleaning costs are irrelevant since they will remain the same amount regardless of whether the decision is to rent or to buy. This means that there will be no additional costs that have to be covered by the R5 000 salary increase and we therefore do not take these cash flows into consideration. The original cost to build both buildings is irrelevant since regardless of the decision, those amounts have been incurred and cannot be changed. Cost incurred in the past which does not have an impact on a decision is also known as sunk cost.
This means that for the decision that has to be made, an amount of R4 700 (R2 700 + R400 + R1 100 + R500) is relevant. This amount is less than the expected salary increase of R5 000 and accordingly this person will be able to afford buying the larger house purely covering additional cash flows from his increase.
If the cleaning and DSTV costs were also taken into account, the total amount under consideration would be R6 450 (R4 700 + R1 000 + R750) which is more than the R5 000 increase and would mean that the person would stick to renting and not buying, which would be the incorrect decision.
The only line item that has not been taken into account at this point is the area of both buildings. The question remains whether this will affect our decision or not. Factors that do not have a monetary value attached to it in a decision-making scenario are called qualitative factors. Qualitative factors that might have an impact on a decision must also be taken into account in the process. The area of the buildings is an example of a qualitative factor and will have an impact on the decision in the example since a person that is in dire need of additional space, will still consider buying a more spacious building as opposed to renting a smaller building, even if the relevant cash outflows exceeded the additional income of R5 000 per month.
The above example is a question that a lot of people have been faced with and, without them even realising it, made their decision by applying relevant costing principles. This shows that the concept of relevant costing is not as daunting as the eight letter word leads us to believe.
Now that relevant costing has been simplified, the principle can be applied in all areas of business. The decisions might be more complex like deciding to manufacture goods in-house or rather purchasing it from an outside supplier or the need to rent additional factory or storage space or even decisions such as whether to hire an additional manager or not. Whatever business decision lies ahead, applying the principle discussed above of only taking relevant costs/income and qualitative factors into account will ensure the best possible outcome.