Relevant Cost

Relevant cost is a managerial accounting concept describing costs that will be affected by a specific decision. These are future costs that can be avoided depending on the choice made. Identifying relevant costs helps managers focus on the financial effects that matter for comparing alternatives and avoids being misled by costs that are already incurred.

Key characteristics

• Future-oriented — they will be incurred only if a particular action is taken.
• Avoidable — the organization can eliminate them by choosing an alternative.
• Differential — they differ between decision options (one option has them, the other does not).
• May include opportunity costs — the benefit foregone by not choosing the next-best option.

Why relevant costs matter

Relevant costs narrow the decision set to only those financial effects that change with the decision. This improves clarity when evaluating:
Whether to continue, expand, reduce, or close operations
Whether to produce internally or buy from an outside supplier
* Whether to accept special or last-minute orders or offers

Ignoring relevant-cost analysis can lead to poor decisions driven by sunk costs or fixed costs that won’t change because of the decision.

How to identify relevant costs

1. Define the decision alternatives clearly.
2. List all future costs and revenues associated with each alternative.
3. Exclude sunk costs (already incurred) and unavoidable fixed costs.
4. Include variable, incremental, and avoidable costs and any applicable opportunity costs.
5. Compare the net financial impact across alternatives.

Common decision types and how relevant costs apply

Make vs. buy
* Compare the incremental cost of producing a component in-house (materials, direct labor, variable overhead) with the price charged by the outside vendor. Include any avoidable fixed costs or opportunity costs.

Continue operating vs. close a business unit
* Consider costs that would be eliminated and revenues that would be lost if the unit closed. If avoidable costs exceed lost revenue, closure may be justified.

Special orders
* When production capacity exists and fixed costs are already covered, evaluate only the variable costs of the special order (materials, direct labor). Fixed costs already incurred are irrelevant.

Pricing a last-minute seat (airline example)
* Most flight costs (fuel, gate fees, crew pay) are sunk for that flight; the only relevant incremental costs may be baggage handling and onboard services. Price decisions for late bookings should be based on those small incremental costs and potential incremental revenue.

Relevant cost vs. sunk cost

• Relevant cost: future, avoidable, and differs across options.
• Sunk cost: already incurred, unrecoverable, and irrelevant to current choices.

Other names

Relevant costs are also called avoidable costs or differential costs.

Bottom line

Use relevant-cost analysis to focus on costs and benefits that change with a decision. Exclude sunk and unavoidable fixed costs, include incremental and opportunity costs, and compare the net effects across alternatives to select the most profitable or least costly option. Key takeaway: only future costs that differ between options should drive the decision.