What it means
When running a business, you constantly face choices about whether to launch a new product, outsource a service, or discontinue an unprofitable line. In all these situations, you will encounter many different numbers, but not all of them matter.
A relevant cost is simply an expense that will change based on the specific option you choose. If a cost stays the same no matter what you decide to do, it is irrelevant and can be safely ignored.
Understanding this concept helps non-finance managers avoid analysis paralysis. Often, people get bogged down looking at historical spending or fixed overheads that cannot be changed.
By separating relevant costs from irrelevant ones, you focus purely on the financial impact of your upcoming decision. In practice, relevant costs usually include future costs and opportunity costs, which represent the benefits you give up by choosing one path over another.
Sunk costs, which are money already spent and gone forever, are never relevant. Recognizing this distinction ensures you do not throw good money after bad simply because you invested in the past.
Using this mindset saves time and prevents costly mistakes. Whether you are pricing a special client order or deciding to buy new machinery, isolating the relevant costs gives you a clear picture of true profitability without the clutter of complex accounting noise.
In practice
Real-world examples.
Example
You consider upgrading your bakery oven for 5,000 pounds. The electricity bill will drop by 200 pounds a month. The 5,000 pounds purchase price and future electricity savings are relevant costs.
Example
A retail shop considers opening on Sundays. Staff wages will be 400 pounds and extra security 100 pounds. These new expenses are relevant costs for deciding if Sunday trade is worthwhile.
Example
A software agency evaluates leasing a larger office for 2,000 pounds more per month to accommodate a new client contract worth 8,000 pounds per month. The rent increase is a relevant cost.
Think of it
“Deciding relevant costs is like planning a road trip and choosing between two routes. The tolls and extra fuel for each route matter, but the cost of the car itself and insurance you already paid are irrelevant because you pay them either way.
Formula
Calculation
Relevant Profit = Relevant Revenue - Relevant Costs
Example: Accepting a special order for 500 items brings 5,000 pounds in revenue. The relevant costs are 3,000 pounds for materials and 1,000 pounds for extra labor.
Relevant Profit = 5,000 pounds - (3,000 pounds + 1,000 pounds) = 1,000 pounds profit.Case study
Seen in the real world.
Brighton Bikes, a mid-sized bicycle manufacturer, received a special order from a corporate client for 200 custom commuter bikes at 300 pounds per bike. The standard production cost per bike is normally 350 pounds, which led the sales team to initially reject the offer. However, the operations manager decided to calculate the true relevant costs for this specific order. The standard cost included 150 pounds of fixed factory rent and equipment depreciation, which Brighton Bikes had to pay anyway, regardless of whether they accepted the order. The actual relevant costs were 120 pounds for raw materials and 80 pounds for temporary assembly labor per bike, totaling 200 pounds per bike. By focusing purely on relevant costs, the manager realised each bike would actually generate 100 pounds of contribution margin above the direct expenses. Accepting the order added 20,000 pounds in profit to the business.
Watch out
Common mistakes.
- Including sunk costs, which are past expenses that cannot be recovered.
- Allocating fixed overhead costs to a short-term decision where those costs do not actually change.
- Forgetting to include opportunity costs, which are the hidden losses of passing up alternative options.
Questions
People also ask.
Are historical costs ever relevant?
No. Historical costs are sunk costs. They are in the past and cannot be altered by any decision you make today.
How do fixed costs fit into relevant costing?
Fixed costs are usually irrelevant because they stay the same. However, if a decision changes your total fixed costs, they become relevant.
What is the difference between relevant costs and variable costs?
Variable costs change with production volume, while relevant costs are any future costs that change specifically because of a given decision.
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