Applications of Relevant Costs and Revenues in Making Decisions

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What are Relevant Costs and Revenues?

Relevant costs and revenues relate to probable future costs and revenues that would vary whenever two or more alternatives are available. To wit, the following are considered relevant in making quantitative management decisions: differential or incremental costs (the discrepancy between or among probable future costs of two or more alternatives); avoidable costs – these costs are those which could be removed completely or partially whenever another alternative is chosen or another course of action has been done instead of another; next are the opportunity costs, these refers to benefits foregone because of choosing another option.

If there are relevant costs/revenues to come up with an economic decision, costs such as sunk costs are most often irrelevant. The reason is that sunk costs are past costs, to be relevant costs must relate to the future and such should vary, as well, between or among alternative courses of actions. It is logical then that future costs may be considered irrelevant if these would remain the same despite of which decision is chosen to be implemented. Though sunk costs are more often not relevant, these costs may supply information for making forecasts/predictions; or if through these (sunk costs), a future cash inflow that would differ among alternatives would be expected – then in this case, sunk costs are relevant.

Relevant Costs and Revenues Applied

Concepts about relevant costs and revenues may be applied in the following manner: whether to accept or reject a special order; in make or buy decisions; to continue or discontinue a business segment (a product, department/division); whether to sell a product or process it further; or on product emphasis decisions (with production constraints, also known to be in “bottleneck operations”).

Decision Criteria

In the first application – whether to accept or reject a special order, the decision rule is: accept the order when the revenue from the special order is more than the incremental/additional costs. In make or buy decisions, the alternative that results to a lower relevant cost should be chosen.

In the third application – whether to continue or discontinue the operations of a business segment, one must continue operations if the business segment at hand would contribute to the reduction of fixed costs and this reduction is much more than the other business investment opportunities if the operations of that segment would be discontinued.

In decisions whether to sell the product as it is, or process it further – the decision to process the same further should be disregarded when the additional processing costs exceed the additional revenue expected to be generated, as a result.  Finally, for decisions of determining what product(s) should be produced in bottleneck operation - the decision rule is: the product(s) with the highest contribution margin per unit of the constrained resource should be preferred. 

Discussion Questions for Further Study

1. Illustrate (by preparing analyses) the following applications of relevant costs and revenues: whether to accept or reject a special order; in make or buy decisions; to continue or discontinue a business segment (a product, department/division); whether to sell a product or process it further; or on product emphasis decisions.
2. Explain this phrase taken from the article: “….or if through these (sunk costs), a future cash inflow that would differ among alternatives would be expected – then in this case, sunk costs are relevant”.
3. Describe/illustrate the use of linear programming and capital budgeting techniques in “product emphasis” management decisions.