Key takeaways
– Relevant costs are future, avoidable costs (also called differential or avoidable costs) that change depending on the decision alternative.
– Sunk costs—past expenditures that cannot be recovered—are not relevant to current decisions.
– To make good short‑term or tactical decisions (e.g., accept a special order, close a product line, make vs. buy) identify only those costs and revenues that will change as a direct result of the choice.
– Include opportunity costs and any avoidable fixed costs in your analysis; exclude allocated fixed costs that will not be eliminated.
– Use a consistent step‑by‑step process to list alternatives, quantify incremental revenues and costs, and test assumptions.
Source: Investopedia (Theresa Chiechi). See
What is a relevant cost?
A relevant cost is any cost (or revenue) that meets two requirements:
1. It is future‑oriented (it has not yet been incurred).
2. It differs between the decision alternatives — that is, it is avoidable or incremental depending on the choice you make.
Relevant costs are the financial effects that matter for a specific decision. They allow managers to ignore irrelevant data (like sunk costs or fixed costs that will remain unchanged) and focus only on the incremental economics.
Other names
Relevant costs are commonly called avoidable costs or differential costs.
Two defining characteristics
– Future (not sunk): The cost will be incurred only in the future and therefore can be influenced by the decision.
– Differential/avoidable: The cost differs among alternatives — it can be eliminated or altered by choosing a different option.
Why relevant cost matters
Decision quality improves when you analyze only the costs and revenues that change with the decision. Using relevant costs prevents the common errors of:
– letting sunk costs bias choices (the “throwing good money after bad” fallacy), or
– double‑counting fixed costs that won’t actually be eliminated.
When managers correctly isolate relevant costs, they can choose the option that increases profit, reduces loss, or delivers the best use of scarce resources.
Common decision types and how relevant costs are used
1. Continue operating vs. close a business unit
– Relevant elements: costs that would be eliminated if the unit closed (avoidable fixed costs, variable costs) and the revenue lost by closing.
– Irrelevant elements: corporate overhead allocated to the unit that will continue regardless.
– Decision rule: close the unit if avoidable cost savings > lost contribution margin; keep it open if lost contribution margin > avoidable cost savings.
2. Make vs. buy (insourcing vs. outsourcing)
– Relevant elements: variable manufacturing costs and any fixed costs that would be avoided if you buy; vendor price; any opportunity cost from redeploying production capacity.
– Decision rule: buy if vendor price + any added costs incremental costs (and non‑financial impacts are acceptable).
Illustrative numeric examples
A. Special order
– Variable cost per unit = $10; special order price = $12; no extra fixed costs and capacity is available.
– Incremental profit per unit = $12 − $10 = $2 → accept the order (unless nonfinancial considerations or long‑term price effects rule it out).
B. Make vs. buy
– In‑house variable cost per unit = $20. Allocated fixed manufacturing overhead = $8/unit (but only $2/unit of that would be saved if you buy). Vendor quote = $22/unit. If you buy, you can repurpose capacity to make another product generating $1/unit incremental contribution (opportunity benefit).
– Relevant in‑house cost = variable $20 + avoidable fixed $2 − opportunity benefit $1 = $21. Vendor price = $22. Decision: continue making in house (relevant cost $21 $1 or if long-term fixed cost savings or quality benefits justify it.
3) Special order (printing company)
Scenario: A printing company has idle capacity. Usual selling price is $200 per job. A customer offers $120 for a one-off order of the same job. Variable cost per job: ink & paper $50; direct labor $30; incremental delivery $10. Fixed overheads are covered by prior sales for the month.
Relevant analysis:
– Incremental revenue: $120
– Incremental variable cost: $50 + $30 + $10 = $90
– Contribution from special order: $30
Decision: Accept the special order if the firm has idle capacity and accepting it does not displace regular customers or reduce regular prices. If capacity is constrained (order displaces regular business at higher margin), then the opportunity cost of lost contribution replaces the simplistic $30.
4) Close a store (retail chain)
Scenario: A chain considers closing five stores. Per store average monthly numbers:
– Sales: $80,000
– Variable costs: $40,000
– Avoidable fixed costs (store manager salary, utilities, local advertising): $20,000
– Allocated corporate overhead (not avoidable if stores close): $10,000
Contribution margin if open: Sales – Variable costs = $40,000. Avoidable fixed costs: $20,000. Net avoidable income per store: $20,000.
If the store closes, the chain loses $40,000 in contribution but saves $20,000 in avoidable fixed costs, net loss = $20,000 (so closing would reduce profit). The allocated corporate overhead is irrelevant because it will be incurred regardless.
Opportunity cost examples
– Using an idle machine to produce product A that yields $15 contribution per unit vs. producing product B that yields $10 contribution per unit: the opportunity cost of producing B is the foregone $5 contribution per unit.
– Renting out idle warehouse space for $5,000/month: if you instead use it for internal storage, the opportunity cost is $5,000 per month.
Long-term investments, depreciation, and salvage values
– For capital budgeting or long-term decisions, use relevant future cash flows, not accounting depreciation (unless depreciation affects taxes).
– Sunk capital costs (past expenditures) are irrelevant. However, future incremental depreciation on a new investment, tax impact, and expected salvage value are relevant.
– Discount relevant future cash flows (time value of money) for multi-period decisions (use NPV or IRR analysis).
Common pitfalls and how to avoid them
– Treating sunk costs as relevant: Avoid using past expenditures to justify continuing an unprofitable activity.
– Blindly allocating fixed overhead to alternatives: Only include fixed costs that will be eliminated by the decision.
– Ignoring opportunity costs: Always ask what alternative uses of the resource are foregone.
– Overlooking qualitative/strategic effects: Customer relationships, brand value, employee impact, and regulatory risk can alter a financially “best” decision.
– Using accounting profit rather than incremental cash flows in long-term decisions: taxes, working capital changes, and cash timing matter.
Advanced considerations
– Capacity constraints: When capacity is limited, prioritize products or orders by contribution per unit of constrained resource (e.g., contribution per machine hour).
– Risk and uncertainty: Model different scenarios, use sensitivity or Monte Carlo analysis for uncertain inputs.
– Transfer pricing: When dealing with internal divisions, set transfer prices using relevant costs plus desired contribution or market prices, mindful of incentives.
– Behavioral factors: Managers may resist decisions that eliminate jobs even when financially justified. Recognize and manage these human elements.
Practical template managers can use (short)
1. Decision description and alternatives.
2. Time horizon (short/long).
3. List of future cash flows/revenues by alternative.
4. Sunk costs (list and exclude).
5. Avoidable costs by category (material, labor, avoidable fixed).
6. Opportunity costs (monetary value).
7. Incremental net benefit (revenue − relevant costs).
8. Non-financial considerations.
9. Risk assessment and break-even sensitivity.
10. Recommendation and rationale.
Why understanding relevant cost matters (recap)
– It clarifies which costs truly matter to a decision, preventing wasteful analysis or biased decisions.
– It prevents the “sunk cost fallacy,” where past expenditures misguide the decision to continue.
– It helps managers compare alternatives using the correct incremental measures, improving profitability and allocation of scarce resources.
Concluding summary
Relevant cost analysis is a cornerstone of managerial decision-making. It focuses attention on future costs and benefits that change depending on the alternative chosen — costs that are avoidable and therefore useful for choosing between options. Key principles: ignore sunk costs, include avoidable fixed costs and variable costs that change, and account for opportunity costs. Apply a disciplined step-by-step process, test assumptions with sensitivity analysis, and incorporate qualitative factors. Doing so results in clearer choices, better use of resources, and improved financial outcomes for the firm.
Sources and further reading
– Investopedia — Relevant Cost (Theresa Chiechi).
– Garrison, R., Noreen, E., & Brewer, P., Managerial Accounting — common textbook coverage of differential, sunk, and opportunity costs (for deeper study).