What Is Relevant Cost?

What Is Relevant Cost?

Let me explain relevant cost to you—it's a term in managerial accounting for avoidable costs that you only face when making certain business decisions. You use this concept to cut out irrelevant data that might confuse your choices. For instance, it helps decide if you should sell or keep a business unit.

The flip side is a sunk cost, which you've already spent no matter what you decide now.

Key Takeaways

Relevant costs are those affected by the management decision you're considering. They're the opposite of sunk costs. You, as a manager, rely on them for decisions like shutting down a unit, choosing to make or buy parts, or handling special customer orders.

Understanding Relevant Cost

Relevant costs tie directly to a decision—they're not fixed, they change based on your choice, and you can avoid them. Your decision might increase or decrease expenses and revenues. Generally, if it leads to higher profit, it's worth it.

Think of them as future costs you only incur if you pursue an opportunity. Companies analyze them to see if one option is more cost-effective than another.

Remember, relevant costs are potential future expenses, while sunk costs are ones you've already paid.

Example of Relevant Cost

Picture this: a passenger rushes to buy a ticket for a flight leaving in 25 minutes. The airline must consider relevant costs for pricing. Most costs—like fuel, gate fees, and crew salaries—are already sunk. The only extras are loading luggage and mid-flight food, so they price based on those small costs.

Types of Relevant Cost Decisions

One key decision is whether to keep operating or close a business unit. You base it on relevant costs—the ones you eliminate by closing versus lost revenue. If eliminated costs exceed lost revenue, close it.

Another is make versus buy. Say a furniture maker considers outsourcing cabinet assembly and staining. Relevant costs are your variable costs to make them versus the vendor's price. If the vendor is cheaper, outsource.

Then there's factoring in a special order. If a customer orders late in the month after fixed costs are covered, you only consider variable costs like materials and labor. Fixed costs are irrelevant since they're already paid. If you skip the order, those production costs are avoidable.

What Is Another Name for a Relevant Cost?

You might hear relevant costs called avoidable costs or differential costs.

What Are the Two Characteristics of Relevant Costs?

They are avoidable and vary depending on the action you take.

Why Is Relevant Cost Important?

All business costs matter, but relevant costs are key because they're future ones you can avoid, pursued only if profitable. You track them, and if they don't pay off, jobs could be at risk.

What Is the Difference Between Relevant Cost and Sunk Cost?

Relevant costs are future expenses tied to a decision, avoidable, and varying by choice. Sunk costs are past expenses already incurred and unrecoverable.

The Bottom Line

Relevant costs are avoidable ones you incur only for specific decisions. Many management choices impact finances, like closing operations or chasing opportunities. The path you choose affects expenses and revenues, and it's your job to use data to pick the more profitable one.