Relevant costs

What it means

Relevant costs are costs that differ between the options being considered and that the decision will actually affect. They are future cash outlays that arise under one choice but not another. They are the foundation of rational decision-making in management accounting.

By contrast, sunk costs, money already spent that cannot be recovered, are not relevant, because no decision will change them. Nor are costs that arise whatever is decided, such as office rent paid regardless of whether an order is accepted.

Relevant costs also include opportunity costs, the benefit forgone from the best alternative the company gives up. If a machine can make product A or B, the profit lost on B is a relevant cost of deciding to make A.

How it works in practice

In a make or buy decision, only the costs that change are compared: materials, direct labour, extra energy and any fixed costs that can genuinely be eliminated. Allocated overheads that remain anyway do not belong in the comparison.

A special order at a lower price can be worth accepting if it covers relevant costs and makes a contribution margin towards fixed costs, provided the company has spare capacity. Without spare capacity, the profit lost on displaced orders must also be counted.

When deciding whether to drop a product or close a unit, assess which costs will really disappear. It often turns out that a product showing a loss after overhead allocation actually contributes to fixed costs, and dropping it would worsen the overall result.

What to watch out for

The most common mistake is letting sunk costs influence decisions, such as continuing a failing project simply because much has already been invested. All that matters is what the project will still cost and what it will bring.

Short-term relevant cost analysis can lead to wrong long-term conclusions. A company that repeatedly accepts orders priced only at relevant cost never covers its fixed costs. Pricing must also take full costs into account.