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. 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.
In practice
Real-world examples
Example 1
An app developer is deciding whether to hire a freelance designer for a project. The designer charges $2,000, which is a relevant cost because it changes based on the hiring choice. The $1,200 the developer already spent on design software last year is irrelevant, since it cannot be recovered whichever way the decision goes.
Example 2
A bakery is deciding whether to open on Sundays. The monthly rent of $1,500 is paid regardless, making it irrelevant. Extra flour, Sunday wages and electricity are relevant costs, and the owner compares them with the extra sales expected before deciding.
Example 3
A logistics firm is deciding whether to service an extra delivery route. Fuel and driver overtime are relevant costs, while the office insurance premium remains completely unchanged. If the route earns $900 a week and adds only $600 of fuel and overtime, the firm gains $300 a week, even though the route also looks unprofitable once a share of head office costs is allocated to it.
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 Difference = Future Costs Under Option A - Future Costs Under Option B
Example: Option A (keep the old machine) incurs $5,000 in repairs. Option B (buy a new machine) incurs $2,000 in new parts. Relevant Cost Difference = 5,000 - 2,000 = $3,000. The price originally paid for the old machine does not appear anywhere in the calculation because it is a sunk cost.
A make-or-buy decision shows the same logic. Making a part in-house costs $4 of materials and $3 of labour per unit, plus $2 per unit of allocated factory overhead that will be paid whether or not you make it. Buying the part costs $8 per unit. The relevant cost of making is 4 + 3 = $7, because the overhead is unchanged, which is $1 per unit cheaper than buying; on 10,000 units that is a saving of $10,000.Case study
Seen in the real world
This is a fictional, illustrative scenario. GreenLeaf Catering was invited to supply food for a local charity event for $1,200. The manager needed to calculate if this was profitable. The standard food ingredients would cost $400. Rent for the commercial kitchen is $1,000 per month, which is paid anyway.
A temporary kitchen assistant must be hired for the day, costing $150. The manager correctly identified the relevant costs as the food ($400) and the assistant ($150), totalling $550. The monthly kitchen rent was ignored because it was not affected by taking on this single event. Since the revenue of $1,200 exceeded the relevant costs of $550, the contribution was $650. The manager also tested the opportunity cost.
If the same day could have been used for another booking worth $500 in profit, the true cost of accepting the charity event would be $550 + $500 = $1,050. Even then, the event still produced $150 more than the alternative, so accepting it remained a financially sound decision. Had the manager wrongly charged a share of the monthly rent to the event, the answer might have looked marginal and a good job might have been turned down.
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.