What it means
When running a business, you constantly face choices, such as whether to launch a new product line, outsource a service, or accept a special customer order. To make the right financial call, you need to filter out the noise and look only at relevant costs.
These are future costs that differ between your available options. To spot a relevant cost, ask two simple questions.
First, does this cost happen in the future? If money was already spent yesterday, it is history and cannot be changed.
Second, will this cost differ depending on the path I choose? If the expense stays identical whether you say yes or no, it is irrelevant to the decision.
In practical management, ignoring irrelevant information prevents emotional bias and poor choices. For instance, managers often fall into the trap of considering sunk costs money already lost on a project when deciding whether to keep funding it.
Relevant cost analysis strips away those distractions, focusing your attention purely on incremental changes in your cash flow and profits.
In practice
Real-world examples.
Example
An app developer deciding whether to hire a freelance designer for a project. The designer charges 2,000 pounds, which is a relevant cost because it changes based on the hiring choice.
Example
A bakery deciding whether to open on Sundays. The monthly rent of 1,500 pounds is paid regardless, making it irrelevant. Extra flour and Sunday wages are relevant costs.
Example
A logistics firm deciding whether to service an extra delivery route. Fuel and driver overtime are relevant costs, while the office insurance premium remains completely unchanged.
Think of it
“Imagine deciding whether to take a scenic route home. The petrol you already used to get to work is a sunk cost and does not matter. Only the extra petrol and time for the scenic detour are relevant to your choice.
Formula
Calculation
Relevant Cost = Future Costs Under Option A - Future Costs Under Option B
Example: Option A (keep old machine) incurs 5,000 pounds in repairs. Option B (buy new machine) incurs 2,000 pounds in new parts. Relevant Cost Difference = 5,000 - 2,000 = 3,000 pounds.Case study
Seen in the real world.
GreenLeaf Catering was invited to supply food for a local charity event for 1,200 pounds. The manager needed to calculate if this was profitable. The standard food ingredients would cost 400 pounds. Rent for the commercial kitchen is 1,000 pounds per month, which is paid anyway. A temporary kitchen assistant must be hired for the day, costing 150 pounds. The manager correctly identified the relevant costs as the food (400 pounds) and the assistant (150 pounds), totalling 550 pounds. The monthly kitchen rent was ignored because it was not affected by taking on this single event. Since the revenue of 1,200 pounds exceeded the relevant costs of 550 pounds, the profit margin was 650 pounds. Accepting the event was a financially sound decision because the relevant revenue outweighed the relevant expenses.
Watch out
Common mistakes.
- Including sunk costs, which are past expenses that cannot be recovered.
- Allocating general overhead costs to a specific decision where total overhead does not actually change.
- Forgetting to include opportunity costs, such as the profit lost from giving up an alternative project.
Questions
People also ask.
Are historical costs ever relevant?
No. Historical costs are sunk costs and cannot be changed by any current decision.
What is the difference between a fixed cost and a relevant cost?
Fixed costs stay the same in total, but they can be relevant if a specific decision causes that fixed cost to change or disappear.
Why do managers ignore depreciation when making short-term pricing decisions?
Depreciation is an accounting record of past asset purchases, making it a non-cash sunk cost that does not affect future cash flows.
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