What it means
Two conditions have to be met for a cost to be relevant: it must lie in the future, and it must differ between the alternatives. Anything failing either test, such as money already spent or a rent bill payable whatever you decide, is excluded from the comparison.
The most common irrelevant cost is the sunk cost, money already committed and unrecoverable. The $200,000 already spent on a struggling project tells you nothing about whether to spend the next $50,000, because only future costs and future benefits can be changed by the decision.
Allocated fixed overhead is the second big trap, because it looks like a genuine cost of whatever product is carrying it. Unless closing that product or declining that order actually removes the overhead from the business, the allocation is a bookkeeping split and should be left out.
Opportunity cost, by contrast, is relevant even though it never appears in the ledger. If accepting a special order means giving up $40,000 of contribution from regular sales, that lost contribution is a real cost of saying yes.
Relevant costing sits behind make or buy, accept or reject, keep or close, and further processing decisions. Absorption costing answers a different question, namely how to value stock and report profit, and using it for short term decisions produces the classic error of closing a product line that was comfortably covering overheads.
In practice
Real-world examples
Example 1
A machinery firm buys a bracket for $9.40 that it could make in house for $7.20 of variable cost plus $3.10 of allocated overhead. Since the allocation would not disappear either way, the relevant comparison is $7.20 against $9.40, and making 30,000 brackets a year saves 30,000 x $2.20 = $66,000.
Example 2
A documentary producer has already spent $340,000 on a film that will now fetch a licence fee of only $150,000. The $340,000 is sunk, so the relevant question is whether $150,000 exceeds the $90,000 still needed to finish, which it does, and the film gets completed despite the overall loss.
Example 3
A laundry weighs replacing a machine with a book value of $80,000 that costs $46,000 a year to run. The book value is irrelevant, while the $27,000 annual saving against a new machine's $19,000 running cost pays back the $95,000 purchase price in a little over three and a half years.
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 cost = future incremental cash outflows caused by the decision + opportunity cost of any resources diverted
Accept the option when incremental revenue exceeds relevant cost
A manufacturer is offered a one off export order for 5,000 units at $18 each, against a normal selling price of $26. Its reported full cost is $18 a unit, made up of $12 of variable production cost and $6 of allocated factory overhead, and it has spare capacity so no regular sales would be lost.
The allocated $6 is not relevant, because total factory overhead will not change whether the order is taken or not. The relevant costs are variable production of 5,000 x $12 = $60,000, extra shipping of 5,000 x $1 = $5,000, and one off tooling of $15,000, giving $80,000 altogether.
Revenue is 5,000 x $18 = $90,000, so the order adds $90,000 - $80,000 = $10,000 of profit and should be accepted. Judged on full cost the same order appears to cost 5,000 x $18 = $90,000 plus $15,000 of tooling, showing a misleading loss of $15,000 and prompting the wrong answer.Case study
Seen in the real world
The following is an illustrative and entirely fictional example. Ashcombe Plastics, an invented moulding business, reviewed its four product lines and found that its garden furniture range was reporting a loss. The range generated $1,200,000 of revenue against $900,000 of variable cost, leaving $300,000 of contribution, but it carried $460,000 of allocated factory and head office overhead, producing a reported loss of $160,000.
The obvious conclusion was to close it, and the sales director had already begun telling customers. The finance manager asked a different question: how much of that $460,000 would genuinely leave the business if the range disappeared? The answer, once she had walked the factory, was $120,000, being one supervisor's salary and some machine specific maintenance. The rest was rent, insurance, central salaries and depreciation that would simply be reallocated to the surviving lines.
Closing the range would therefore have lost $300,000 of contribution to save $120,000, leaving the fictional company $180,000 a year worse off and making three other product lines look less profitable overnight. Ashcombe kept the range, repriced its two weakest products, and changed its internal reporting to show contribution before overhead allocation so the same mistake would not be repeated.
Watch out
Common mistakes
- Letting sunk costs drive the decision, so a project is continued because of what has already been spent rather than what it will still earn.
- Treating allocated overhead as if it would vanish when a product or department closes, when most of it simply moves to whatever remains.
- Ignoring opportunity cost, particularly when a special order quietly consumes capacity that full price customers were going to need.
Questions
People also ask
Are fixed costs always irrelevant?
No, a fixed cost is relevant whenever the decision changes it, such as taking on an extra supervisor or an additional unit of factory space.
Is depreciation a relevant cost?
Normally not, since it is an accounting allocation of money already spent, although the future disposal proceeds and any tax effects of the asset can be relevant.
What about the book value of an asset being replaced?
It is sunk and irrelevant, but the cash you would receive for selling it, and any tax on that sale, do belong in the analysis.