Learning Outcomes
After reading this article, you will be able to identify and apply the principles of relevant costing in short-term decision scenarios for the ACCA Performance Management exam. You will distinguish between relevant and irrelevant costs, recognise sunk and committed costs, and correctly incorporate opportunity costs into analysis. You will learn how to evaluate scenarios such as one-off contracts, make-or-buy, and shutdown decisions by focusing only on relevant incremental future cash flows.
ACCA Performance Management (PM) Syllabus
For ACCA Performance Management (PM), you are required to understand how relevant costing principles should be applied in short-term decision making scenarios. This article will prepare you to:
- Explain the concept of relevant costing.
- Identify and calculate relevant costs and revenues from given data for specific decision-making situations.
- Apply the concept of opportunity cost to practical short-term decision problems.
- Distinguish between relevant and irrelevant costs, including sunk costs and committed costs.
- Recognise the treatment of non-cash items, such as depreciation, and committed costs in short-term analysis.
- Apply relevant costing to scenarios such as make-or-buy, one-off contracts, and shutdown decisions.
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What two characteristics must a cost have to be relevant for a short-term decision?
- Identify which of the following costs are relevant to a shutdown decision: (a) Depreciation on machinery to be scrapped, (b) Redundancy payments, (c) Unavoidable fixed head office costs, (d) Rent savings from closing a facility.
- A company uses a material already in stock for a special contract. The material has no other use, but could be sold for scrap. What cost should be included in relevant costing for the contract?
- Define 'opportunity cost' in the context of business decisions and provide one example.
Introduction
Relevant costing is the process of identifying which costs and revenues should be considered when making a decision—especially in the short term. Understanding what costs are genuinely relevant, and excluding costs that are irrelevant, is essential for objective analysis and scoring marks in the ACCA PM exam. This article will help you identify relevant, irrelevant, sunk, committed, and opportunity costs, and apply these concepts to practical scenarios commonly tested in the exam.
Key Term: relevant cost
A future cash flow that will change as a direct result of making a particular decision.Key Term: irrelevant cost
A cost that will not be affected by the decision at hand and should be excluded from the analysis.
RELEVANT COSTS: WHAT TO INCLUDE
Relevant cash flows must satisfy all the following criteria:
- Future: Only costs and revenues that have not yet been incurred and will arise due to the decision.
- Incremental: Only changes in cash flows resulting specifically because of the decision.
- Cash flows: Non-cash items (e.g. depreciation) are not relevant.
Relevant costs may be direct costs, such as materials and labour if they would only be incurred due to the decision, or indirect, such as extra overheads directly resulting from an activity.
Worked Example 1.1
A business is considering a one-off contract that requires 150 kg of Material X. 100 kg is already in stock, bought for $2 per kg but now obsolete for regular use. It can be scrapped for $1 per kg. Current purchase price is $3 per kg.
What is the relevant cost of Material X for the contract?
Answer:
Relevant cost for 100 kg in stock: loss of scrap value ($1 x 100 = $100)Relevant cost for 50 kg to be purchased: current purchase price ($3 x 50 = $150)
Total relevant material cost: $100 + $150 = $250
IRRELEVANT, SUNK, AND COMMITTED COSTS
Many costs in the accounts are irrelevant for short-term decisions. The most common of these are sunk costs and committed costs.
Key Term: sunk cost
A cost that has already been incurred and cannot be changed or recovered by any future action.Key Term: committed cost
A future cost that an entity has already decided to incur and cannot avoid, regardless of the decision being considered.
Examples
- Sunk costs: Past purchase costs, research spent on a project now under review, or advertising charges paid upfront.
- Committed costs: A signed lease for future equipment payments even if a factory is shut down.
Sunk and committed costs are always ignored in relevant cost analysis, as they cannot be altered by the current decision.
Worked Example 1.2
A company bought a machine last year for $10,000. It is now evaluating whether to use this machine for a new project or to sell it for $2,000. The depreciated book value is $6,000. If used, it could not be sold later.
What is the relevant cost of using the machine?
Answer:
The purchase price and book value are sunk and therefore irrelevant. The relevant cost is the opportunity cost: the foregone proceeds from selling now ($2,000).
OPPORTUNITY COSTS
Key Term: opportunity cost
The value of the best alternative use or benefit forgone when a resource is used for a chosen purpose.
Opportunity costs are relevant whenever a decision causes a loss of benefit that could otherwise have been obtained. Common examples:
- Using labour that could earn contribution elsewhere.
- Using storage space that could be rented out.
- Employing material in stock that could otherwise be resold.
Worked Example 1.3
A skilled technician is required for an urgent order, but they are currently making items which earn a contribution of $300 per day. If reassigned, this contribution will be lost.
What is the relevant labour cost per day for using the technician?
Answer:
The relevant cost is the opportunity cost: lost contribution of $300 per day.
NON-CASH AND NOTIONAL COSTS
Only actual cash flows are relevant. Non-cash expenses (such as depreciation or notional charges) should be ignored. The exception is where an item will trigger an actual cash payment or saving because of the decision.
Depreciation is always irrelevant unless it reflects a real incremental cash cost (such as extra tax payable or savings in cash payments).
Key Term: notional cost
A hypothetical or imputed cost not involving actual cash outflow, included to make an estimate more realistic; not relevant for decision-making.
COMMON SHORT-TERM DECISION SCENARIOS
1. One-off Contracts
Bid only covers relevant costs—included are incremental cash materials, direct labour, and any costs arising only due to the contract (e.g. overtime, specific transport, disposal costs). Do not include regular overheads unless they increase.
2. Make-or-Buy Decisions
Compare the relevant cost of making (variable costs, extra fixed costs, lost alternative contribution) with the price to buy. Ignore sunk overheads or allocated costs that will not change.
3. Shutdown and Outsourcing
Include only savings and extra costs that would really occur (actual fixed cost savings, redundancy payments, profitable use of freed resources). Ignore fixed costs that are unavoidable.
Exam Warning
Irrelevant costs, such as sunk and committed expenditures or non-cash items, must never be included in relevant cost calculations. Loss of easy marks by including these is a frequent exam mistake.
Summary
Relevant costs and revenues are those future cash flows arising as a direct consequence of a specific decision. For the ACCA exam, the critical skills are to:
- Include only incremental future cash flows (including opportunity costs).
- Exclude sunk costs, committed costs, and notional charges.
- Use current replacement or disposal values for materials and assets.
- Identify opportunity costs where resources are limited or have alternative uses.
Key Point Checklist
This article has covered the following key knowledge points:
- Define relevant costs and identify their characteristics.
- Recognise and exclude irrelevant, sunk, and committed costs in decision-making.
- Include only future, incremental, actual cash flows for relevant costing.
- Identify and quantify opportunity costs where applicable.
- Distinguish between relevant and irrelevant costs for materials, labour, and overheads.
- Apply relevant costing correctly in scenarios such as make-or-buy, shutdown, and one-off contracts.
Key Terms and Concepts
- relevant cost
- irrelevant cost
- sunk cost
- committed cost
- opportunity cost
- notional cost